Structureandfunction PDF

Notes
Economics of Capital Markets
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Major Topics
– Financial Markets Structure
– Financial Economics
– Capital Markets
– Basic Securities
– Introduction to Pricing
– Sizing the Capital Markets
– Studying Capital Markets
– Function of Capital Markets
Version 1.0 Outline Page 1
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Financial
Financial Markets
Markets Structure
Structure
Recall that physical capital is traded in the
funds, or financial, markets and
consumption is smoothed through the use of
the financial markets
Page 1
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Financial
Financial Markets
Markets Structure
Structure (Continued)
(Continued)
Financial markets are the focal point for

much of our economic operations
From an economic growth perspective, they
are viewed as the main driver allowing
growth
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Financial
Financial Markets
Markets Structure
(Continued)
From an economic growth perspective

(Continued)
– Sir J.R. Hicks
– J. Schumpeter
Page 2
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Financial
Financial Markets
Markets Structure
(Continued)
From an economic growth perspective

(Continued)
– There is a preponderance of empirical evidence

that there is a positive first-order relationship
between financial development and economic
growth
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Financial
Financial Markets
Markets Structure
(Continued)
Financial Markets - Allocates Funds

- Sets Prices
Capital Market Credit Market Money Market

- Claims or Ownership - Facilitates Borrowing - Money and Short-term
Traded and Lending Near Monies
- More Than One Year - Combination Of Short- - Less Than One Year Maturity
Maturity And Long-term - Money, Fed Funds, T-Bills
- Stocks, Bonds, Futures, - Nonstandardized - Financial Intermediaries And
Options - Usually Not Tradable FED
- Standardized - Financial
- Organized Exchanges Intermediaries
Page 3
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Financial
Financial Markets
Markets Structure
(Continued)
Financial Markets

Only market in which Long-term and Strictly short-term finds
long-term, impersonal short-term personal transfers
investments and investments and
borrowings can occur borrowings
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Financial
Financial Economics
Economics
Financial Economics studies how financial
markets impact allocations via pricing of
financial assets or securities
– Methodology: micro-based via close substitutes
– Capital markets one component: long-term
Page 4
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Capital
Capital Markets
Markets
Terms for holding claims set in capital
markets
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Capital
Capital Markets
Markets (Continued)
(Continued)
A function of capital markets and contracts

is to establish and provide for the exchange
of claims to assets, the income they
generate and the value or price of those
claims
Page 5
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Capital
Capital Markets
Markets (Continued)
(Continued)
Only market in which

Capital long-term, impersonal
Markets investments and
borrowings can occur
Determine
Set Value
Title
- At a Point in Time - Assets

- Capitalized Income Stream - Income

Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Capital
Capital Markets
Markets (Continued)
(Continued)
Financial Markets

- Long-term - Nonstandardized - Short-term Monies
- Standardized - Financial Intermediaries -Financial Intermediaries and
- Organized Exchanges FED
Bring Borrowers and Lenders Together
Sets Value, Determines No Ownership Claims to Assets

Title Determined
Version 1.0 Outline Jump to slide 20 Page 12
Page 6
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Capital
Capital Markets
Markets (Continued)
(Continued)
Trading in terms of new issues and

outstanding issues of claims
– Exchange of outstanding issues represents
transfer of property rights
– Exchange of new issues represents transfer of
funds from savers to borrowers
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Basic
Basic Securities
Securities
Equities or stock
– Equities residual claims on “risky” and
uncertain future income stream of assets
– Holders have incentive to promote - or push
company to promote - efficient use of assets to
minimize costs
– Example: common stock
Page 7
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Basic
Basic Securities
Securities (Continued)
(Continued)
Types of equities
– Common stock
» Last to be paid on dissolution of firm
– Preferred stock
» Reduces “risks” to investor compared to common
stock holder, but...
– Preferred stock adds constraints on the firm
– Would expect fewer issues of preferred stock than
common stock
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Basic
Basic Securities
(Continued)
Common stock income components

– Dividend payments
» Dividends are profits distributed to owners; i.e.,
holders of stock
– Capital gains and losses
» Stock price changes
Page 8
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Basic
Basic Securities
(Continued)
Debt
– Claim to a prespecified portion of future
income stream of an asset
» Portion: not whole income stream of asset
» Prespecified: know portion before time
– Example: bonds
» Value depends on value of underlying asset; i.e., its
income stream
– If income stream is “risky”, bond is “risky”
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Basic
Basic Securities
(Continued)
Bond income components

– Coupon payments: C = λF
» Fixed income stream
» Based on
– Coupon rate (λ )
– Fixed at time of issue
– Face value of bond (F)
– What it is worth
– Usually $1000 face value
– Repayment of loan: F
Page 9
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Basic
Basic Securities
(Continued)
Example coupon bond

– Face value: amount of bond
» Example: $1000
– Coupon rate: rate attached to bond at issuance
and is amount issuer promises to pay each
period
» Example: 6%
– Coupon amount: $1000*0.06 = $60
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Basic
Basic Securities
(Continued)
Simple equations
Income from stocks:
Income = Dividend Stream + Gains/Losses
Income from bonds:

Income = Coupon Payments + Repayment
Page 10
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Basic
Basic Securities
(Continued)
The dollar income from any security is the

dollar return from that security
– Denote the dollar return in period t by Rt
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Introduction
Introduction to
to Pricing
Pricing
Introduce simple pricing concepts
– Begin with bonds and then do stocks
– Assumptions
» No risk
– Adjust for risk later
» No inflation
– Adjust for inflation later
– All dollar amounts are in real terms
Page 11
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Introduction
Introduction to
to Pricing
Pricing (Continued)
(Continued)
Bond prices set where suppliers and

demanders agree
– Can prove that bond price is present value of
future expected coupon amounts
– Use infinite-lived bond called a perpetuity or
consol
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Introduction
Introduction to
to Pricing
Pricing (Continued)
(Continued)
Bond price is
C
PB = B
rf
where C is the constant real coupon amount
and rfB is the bond real discount factor
devoid of risk
– Follows from simple supply and demand
framework: agreement at the margin
Page 12
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Introduction
Introduction to
to Pricing
Pricing (Continued)
(Continued)
Key observation
– Price of bond and real interest rate vary
inversely
» Know one, then other is known automatically
» Only need to know one of these
– Bond real discount factor is called the yield or
rate of return - it is an interest rate
– Clearly C
B
rf =
PB
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Introduction
Introduction to
to Pricing
Pricing (Continued)
(Continued)
Stock price is similar

– Present value of dividends plus value of stock
tomorrow if sold
– Assume just one holding period so that
0 D1 PS1
PS = +
1 + rfS 1 + rfS
where D1 is the real dividend tomorrow, PS1 Is
price tomorrow and rfS is the stock real discount
factor devoid of risk
Page 13
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Introduction
Introduction to
to Pricing
Pricing (Continued)
(Continued)
Simple algebra shows that stock discount

factor is
S D1 PS1 − PS0
rf = 0 +
PS PS0
Dividend %Appreciation
Yield In Value
– Stock real discount factor is called the rate of
return - it is an interest rate
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Introduction
Introduction to
to Pricing
Pricing (Continued)
(Continued)
Notice that the rates of return for stocks and

bonds were presented as different amounts
rfS and rfB
– What is their relationship?
» The two rates of return must be equal
– If not, then rational investor can earn a profit by buying
the higher yielding security driving its price up and the
rate of return down; conversely for the lower yielding
security
– Process is called arbitrage
Page 14
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Introduction
Introduction to
to Pricing
Pricing (Continued)
(Continued)
Law of One Rate of Return

– Must have just one rate of return in the market
– Therefore,
rfS = rfB = rf
– Actual rates of return will differ at times
because there are different “drivers” for each
market (e.g., economy, policy, psychology)
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Introduction
Introduction to
to Pricing
Pricing (Continued)
(Continued)
For stocks and bonds, basically have
$ Re turn
rf =
PToday
Page 15
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets
1994
Capital Market
(Debt + Equity)
$843.5B
Underwritten Private Placement

$702.5B $141.0B
Debt Equity Debt Equity

$625.5B $77.1B $117.1B $23.9B
Straight Corp Conv Asset Backed Preferred Common

$367.4B $4.7B $253.4B $15.5B $51.6B
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
Value of US Corp. Underwritings

and Private Placements
$1,400
$1,200
$1,000
$ Billions
$800
$600
$400
$200
$0
1980 1982 1984 1986 1988 1990 1992 1994
1994
($ Billions) Total Underwritten Private
Total Under- Private
written Placements
$843.5 $702.5 $141.0
Page 16
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
Value of US Private Placements

$200
$150
$ Billions
$100
$50
$0
1980 1982 1984 1986 1988 1990 1992 1994
1994
($ Billions) Total Debt Equity
Total Debt Equity
$141.0 $117.1 $23.9
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
1994
($ Billions)
Total Debt Equity
Total Value of US Corp. $702.5 $625.5 $77.1
Underwritings
$1,200
$1,000
$800
$ Billions
$600
$400
$200
$0
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Total Total Debt Total Equity
Page 17
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
1994
($ Billions)
Total St. Corp. Conv. Asset
Corp. Backed
$702.5 $367.4 $4.7 $253.4
Total Debt Underwritten
$1,000
$800
$ Billions
$600
$400
$200
$0
1980 1982 1984 1986 1988 1990 1992 1994
Straight Corp. Debt Conv. Debt Asset Backed Debt Total Debt
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing the
the Capital
Sizing1994 Capital Markets
Markets (Continued)
(Continued)
($ Billions)
Total Preferred Common
$77.1 $15.5 $61.6 Total Equity Underwritten
$140
$120
$100
$ Billions
$80
$60
$40
$20
$0
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Pref. Stock Common Stock Total Equity
Page 18
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
Equity and Debt Outstanding

$7,000
$6,000
$5,000
$ Billions
$4,000
$3,000
$2,000
$1,000
$0
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Corp. Equities Corp. Bonds US Gov't Sec. Mun. Bonds
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
1994 Equity and Debt

Outstanding
Mun. Bonds (7.86%)
Corp. Equities (39.51%)
US Gov't Sec. (36.85%)
Corp. Bonds (15.79%)
Page 19
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued) Holders of US
Equities Outstanding
$6049B
Households Institutions
$2913B $3136B
Private Pension Funds

$1047B
Public Pension Funds

$520B
Mutual Funds
$738B
Closed End Funds

$33B
Foreign
$341B
Life Ins. Cos.

$159B
Other Ins. Cos.

$105B
Bank Personal Trusts

$156B
Brokers/Dealers
$20B
Savings Inst.
$10B
Commercial Banks
$7B
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
Holdings of US Equities Outstanding

(% of Market Value)
60.0%
55.0%
Percent
50.0%
45.0%
40.0%
1980 1982 1984 1986 1988 1990 1992 1994
Households Institutions Households Institutions

48.2% 51.8%
Page 20
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
Share of Household
Liquid Financial Assets
60.0%
50.0%
40.0%
Perecnt
30.0%
20.0%
10.0%
0.0%
1980 1982 1984 1986 1988 1990 1992 1994
Equities Bk. Dep/CDs Mut. Funds US Gov't Secs.
Muni. Bonds Money Mkt. Funds Corp. Bonds
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
1994 Share of Household

Financial Assets
Corp. Bonds (2.30%)
Money Mkt. Funds (4.10%)
Muni. Bonds (4.70%)
Equities (33.57%)
US Gov't Secs. (12.49%)
Mut. Funds (11.19%)
Bk. Dep/CDs (31.67%)
Page 21
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Sizing
Sizing the
the Capital
Capital Markets
Markets (Continued)
(Continued)
Household ownership characteristics - 1990

– Number of individual shareholders: 51,440K
» Female: 17,750K
» Male: 30,220K
– Adult shareholder incidence: 1 in 4
– Median household income: $43,800
– Median age: 43
– Median portfolio: $11,400
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Studying
Studying Capital
Capital Markets
Markets
Studying and understanding capital markets
goes beyond just understanding how terms
for holding capital are set
– Major issue is resource allocation, but there are
other issues
Page 22
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Studying
Studying Capital
Capital Markets
Markets (Continued)
(Continued)
The capital markets, especially Wall Street,

exert large influence on investment
decisions of firms
– Firms have been accused of favoring short-term
investments just to meet investor demands
– Implication: innovation and R&D stifled
negatively impacting long-term economic
growth and competitiveness
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Studying
Studying Capital
Capital Markets
Markets (Continued)
(Continued)
Understanding capital markets, especially

global capital markets, important for
understanding international developments
and U.S. competitiveness
– Capital markets not restricted to national
borders
– Investments can take place electronically
– One implication: trying to regulate or control
capital markets next to impossible
Page 23
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Studying
Studying Capital
Capital Markets
Markets (Continued)
(Continued)
Understanding capital markets (Continued)

– Example
» Japanese government tried to prevent trading of
some “modern complex financial derivatives” tied to
the Nikkei in Tokyo
» Trading simply moved to Singapore
» A trader for Barings Securities (Nick Leeson)
Placed A $29B bet in Singapore on the Nikkei (and
lost!)
– Barings, one of the world’s oldest banks, collapsed
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Studying
Studying Capital
Capital Markets
Markets (Continued)
(Continued)

– Everyone effectively borrows capital on an
“equal-access basis” on the world capital
markets in New York, London, Tokyo
» For investing, “there are no rich or poor countries.”
Page 24
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Studying
Studying Capital
Capital Markets
Markets (Continued)
(Continued)

– Global capital markets and electronic trading
systems enable huge sums of money to move
around the world quickly
» On a normal day, world capital markets move $1.3T
but world’s exports are only $3T in a year
» In 2 days, the world’s capital markets can move as
much money as all economies can move in a year
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Studying
Studying Capital
Capital Markets
Markets (Continued)
(Continued)

– Problem this creates
» Linkages make potential crashes potentially larger
and more far reaching than previous crashes
Page 25
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Studying
Studying Capital
Capital Markets
Markets (Continued)
(Continued)
Capital markets and crashes

– Dramatic movements in the capital markets, in
particular, the stock market, can have big
impact on the business cycle and growth
» We are all aware of the 1929 Stock Market Crash
» In 1987, the stock market fell but was so short-lived
that it had minimal impact
– We will discuss both briefly later in course
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Studying
Studying Capital
Capital Markets
Markets (Continued)
(Continued)
Capital markets and crashes (Continued)

– From 12/89 To 8/92, at least, the Nikkei fell
from 38916 to 14309
» Bigger decline than American stock market decline
in 1929 and 1932
» Led to recession in Japan that seems to still be
continuing
Page 26
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Function
Function of
of Capital
Capital Markets
Markets
Previously viewed the capital markets as a
way to bring borrowers and lenders of
loanable funds together
– Naive view of this market since all markets
bring two parties together
– Capital markets do more...
Capital Markets manage risk
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Function
Function of
of Capital
Capital Markets
Markets (Continued)
(Continued)
To understand the management function, we

must understand…
– The operations of capital markets
– The concepts of risk and uncertainty
Page 27
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Review
Review Questions
Questions
Describe the structure of Financial Markets and
the individual submarkets.
How does the capital market differ from the credit
and money markets?
Discuss the international linkages in the capital
markets.
What is the function of the financial markets?
Describe some common income streams.

Structure
Structure and
and Function
Function of of Capital
Capital Markets
Markets
RReview
eview Questions
Questions (Continued)
(Continued)
Describe the basic structure of the capital markets.

Distinguish between common and preferred stock.
What is debt?
Page 28
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Key
Key Concepts
Concepts and
and Terms
Terms
Capital Markets
Debt
Financial Economics
Financial Markets
Money Markets
New issues
Outstanding issues
Preferred and common stock
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Suggested
Suggested Readings
Readings
Friedman, B. M. 1987. “Capital, Credit and Money Markets”
in The New Palgrave.
Hakansson, N.H. 1987. “Financial Markets” in The New
Palgrave
Hicks, J.R. 1946. Value and Capital. 2nd. ed. London:
Oxford Un. Press.
Hirshleifer, J. 1970. Investment, Interest and Capital.
Englewood Cliffs, NJ: Prentice-Hall.
Ross, S.A. 1987. “Finance” in The New Palgrave
Tobin, J. 1987. “Financial Intermediaries” in The New
Palgrave
Page 29
Notes
Structure
Structure and
and Function
Function of
of Capital
Capital Markets
Markets
Suggested
Suggested Readings
Readings (Continued)
(Continued)
Campbell, T.S. 1982. Financial

Institutions, Markets, and Economic
Activity. NY: McGraw-Hill.
Page 30

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Notes

Economics of Capital Markets

Economics of Capital Markets

Version 1.0 Outline Page 2

Economics of Capital Markets

 Financial markets are the focal point for

Version 1.0 Outline Page 3

Economics of Capital Markets

 From an economic growth perspective

– Sir J.R. Hicks

Version 1.0 Outline Page 4

Economics of Capital Markets

 From an economic growth perspective

– There is a preponderance of empirical evidence

Version 1.0 Outline Page 5

Economics of Capital Markets

Financial Markets - Allocates Funds

Capital Market Credit Market Money Market

Economics of Capital Markets

Capital Market Credit Market Money Market

Version 1.0 Outline Page 7

Economics of Capital Markets

Version 1.0 Outline Page 8

Economics of Capital Markets

Version 1.0 Outline Page 9

Economics of Capital Markets

 A function of capital markets and contracts

Version 1.0 Outline Page 10

Economics of Capital Markets

Only market in which

- At a Point in Time - Assets

Version 1.0 Outline Page 11

Economics of Capital Markets

Capital Market Credit Market Money Market

Bring Borrowers and Lenders Together

Sets Value, Determines No Ownership Claims to Assets

Economics of Capital Markets

 Trading in terms of new issues and

Version 1.0 Outline Page 13

Economics of Capital Markets

Version 1.0 Outline Page 14

Economics of Capital Markets

Version 1.0 Outline Page 15

Economics of Capital Markets

 Common stock income components

Version 1.0 Outline Page 16

Economics of Capital Markets

Version 1.0 Outline Page 17

Economics of Capital Markets

 Bond income components

Economics of Capital Markets

 Example coupon bond

Version 1.0 Outline Page 19

Economics of Capital Markets

Income from bonds:

Version 1.0 Outline Page 20

Economics of Capital Markets

 The dollar income from any security is the

Version 1.0 Outline Page 21

Economics of Capital Markets

Version 1.0 Outline Page 22

Economics of Capital Markets

 Bond prices set where suppliers and

Financial markets are the focal point for

From an economic growth perspective

From an economic growth perspective

A function of capital markets and contracts

Trading in terms of new issues and

Common stock income components

Bond income components

Example coupon bond

The dollar income from any security is the

Bond prices set where suppliers and

Stock price is similar

Simple algebra shows that stock discount

Notice that the rates of return for stocks and

Law of One Rate of Return

For stocks and bonds, basically have

Household ownership characteristics - 1990