Financial institutions and

markets
20.12.2019

All rights reserved. Paepen, Pascal. (2019). Financial

institutions and Markets theory [PowerPoint
presentations]
 Debt markets

Structure of Equity markets

Financial
Markets Primary market:
New security issues sold to initial
buyers
Typically involves an investment
bank who underwrites the offering

Securities previously issued are

bought and sold
Secondary market Examples include the NYSE and
Nasdaq
Involves both brokers and dealers



We can
Exchanges – trades conducted in
further central locations (e.g.: NYSE)
classify
secondary Over-the-Counter Markets –
markets as dealers at different locations buy
and sell (Treasury Securities)
follows
 ! Important trend ! the US no longer dominates the world stage
! International Bond market & Eurobonds
! Foreign bonds
! Denominated in a foreign currency
! Targeted at foreign current markets
! Eurobonds
!

!
Denominated in one currency, but sold in a different market
Now larger than US corporate bond markets
Internationalisation
!
! Over 80% of new bonds are Eurobonds
Eurocurrency Market
of Financial Markets
! Foreign currency deposited outside of home country
! Eurodollars are US dollars, say, deposited in Paris
! Gives US borrowers an alternative source for dollars
! World Stock Markets
! US stock markets are no longer always the largest (e.g.: Japan)

 Asymmetric information
! One party lacks crucial information about another party,
impacting decision-making
! Adverse selection
! Before transaction occurs
! Potential borrowers most likely to produce
adverse outcome are ones most likely to seek a
loan
! Similar problems occur with insurance where
unhealthy people want their known medical
problems covered
! Moral hazard
! After transaction occurs
! Hazard that a borrower has incentives to engage
in undesirable actions (immoral) making it more
likely that they won’t pay back the loan
! Again, with insurance, people may engage in risky
activities only after being insured



 The Securities and Exchange Commission requires
corporations issuing securities to disclose certain
The Securities and information about their sales, assets, earnings to the
public and restricts trading by the largest stockholders

Exchange (insiders) in the crop

Commission This can reduce adverse selection and moral hazard

problems in financial markets and increase their

(SEC)
efficiency by increasing the amount of information
available to investors

The SEC is active in pursuing insider trading



What do interest rates mean & What is their role in
valuation?


! Yield to maturity is the most accurate measure of interest rates
✓ the total return anticipated on a bond if the bond is held until it matures. 

Present value A dollar of cash flow paid to you one year from now is less
valuable than a dollar paid to you today

Maturity date: the date

Loan principle: the
the loan must be repaid;
amount of funds the
the Loan Term is the
lender provides to the
timeframe from initiation
borrower
to maturity date

Simple interest rate: the

Interest payment: the
interest payment divided
cash amount that the
by the loan principle; the
borrower must pay the
percentage of principal
lender for the use of the
that must be paid as
loan principle
interest to the lender
 Distinction between real
and nominal interest rates

! Real interest rate

! Interest rate that is
adjusted for expected
changes in the price
level
! When the real rate is
low, incentives are
greater to borrow and
less to lend
! Nominal interest rate
! interest rate before
taking inflation into
account.



 ! Only bond whose return = yield is one with maturity = holding period
! For bonds with maturity > holding period, i ↑ P ↓ implying capital loss
! The longer the maturity, the greater the price change associated with interest rate
change
! The longer the maturity, the more return changes with change in interest rate
! A bond with a high initial interest rate can still have a negative return if i ↑
! Maturity and volatility of bond returns: conclusion
! Prices and returns are more volatile for long-term bonds because they have a higher
interest-rate risk
! No interest-rate risk for any bond whose maturity equals its holding period

 ! Occurs when you hold a series of short

bonds over a long holding period
Reinvestment ! Interest rate at which you reinvest is
uncertain
risk ! As an investor, you gain if interest rates
↑ and you lose when they ↓

Why do interest rates change?



The quantity demanded of an asset
differs by factor
Supply & Demand in the Bond Market



Changes in equilibrium – demand curve



Changes in equilibrium – supply curve



Fischer effect – response to a change in
expected inflation
! If expected inflation rises from 5 to 10%, the expected return on bonds
relative to real assets falls and, as a result, the demand for bonds falls
! The rise in expected inflation also means that the real cost of borrowing has
declined, cause the quantity of bonds supplied to increase
! When the demand for bonds falls and the quantity of bonds supplied increases,
the equilibrium bond price falls
! Since the bond price is negatively related to the interest rate, this means that
the interest rate will rise

Business Cycle Expansion – increase of

national income
 Low Japanese Interest Rates
! In 1998, Japanese interest rates on six-month treasury bills turned slightly
negative
! Negative inflation leads to an increase in Bd ! Bd shifts to the right
! Negative inflation leads to a decrease in real rates ! Bs shifts to the left
! Net effect was an increase in bond prices (falling interest rates)
! Business cycle contraction leads to a decrease in rates ! Bd and Bs shifts to left
! Shift in Bd < shift in Bs, so net effect was also increase in bond prices

!  

 How do risk and term structure affect interest rates?

 




 Two important • Rates on different bond categories
features of the change from one year to the next
interest-rate • Spreads on different categories change
behaviour of bonds from one year to the next

Three specific risk • Default risk

factors to examine • Liquidity
these features • Income tax considerations

 The spread between the interest rates on bonds

with default risk and default-free bonds, indicates
Risk premium how much additional interest people must earn in
order to be willing to hold that risky bond
! Default risk is an important component of the size of the risk premium
! Because of this, bond investors want to know as much as possible about the
default probability of a bond

BUT HOW?

By using measures provided by credit-

rating agencies
 Term structure of interest rates

! Bonds with different maturities tend to have differed required rates, all else
equal






! Facts to be explained
! Interest rates for different maturity rates move together
! Yield curves tend to have a steep upward slope when short rates are low and a
downward slope when short rates are high
! Yield curve is typically upward sloping

! Three theories of Term structure

! Expectations theory
! Pure expectations theory explains 1 and 2, but not 3
! Market segmentation theory
! Market segmentation theory explains 3, but not 1 and 2
! Liquidity premium theory
! Combine features of both preceding theories

 Are financial markets efficient?

 




Do stock prices reflect publicly available information as
the EMH (Efficient-market hypothesis) predicts they will?

! If information is already available, a positive announcement about a company will

not, on average, raise the price of its stock because this information is already
reflected in the stock price
! Early empirical evidence confirms: favourable earnings announcement or
announcements of stock splits (a division of a share of stock into multiple shares,
which is usually followed by higher earnings) do not, on average, cause stock prices
to rise



! Random walk behaviour of stock prices that is, future change in stock prices
should, for all practical purposes, be unpredictable
! If stock is predicted to rise, people will buy to equilibrium level; if stock is
predicted to fall, people will sell to equilibrium level (both in concert with EMH)
! Thus, if stock prices were predictable, thereby causing the above behaviour, price
changes would be near zero, which has not been the case historically

! The EMH suggests that technical analysis is a waste of time

Evidence against market efficiency

! The small firm effect

! This is an anomaly
! Many empirical studies have shown that small firms have earned abnormally high
returns over long periods of time, even when the greater risk for these firms has
been considered
! This effect seems to have diminished in recent years but still is a challenge to the
theory of efficient markets
! Various theories have been developed to explain the small-firm effect, suggesting
that it may be due to rebalancing of portfolios by institutional investors, tax issues,
low liquidity of small-firm stocks, large information costs in evaluating small firms,
or inappropriate measurement of risk for small-frim stocks



The January effects

! The January effects

! The tendency of stock prices to experience an
abnormal positive return in that month that is
predictable and consistent with random-walk
behaviour
! Investors have an incentive to sell stocks before
the end of the year because they can then take
capital losses on their tax return and reduce
their tax liability. Then when the new year
starts in January, they can repurchase the
stocks, driving up their price and producing
abnormally high returns



 Market overreaction

! Recent research suggests that stock

prices may overreact to news
announcements and that the pricing
errors are corrected only slowly
! When corporations announce a major
change in earnings, say, a large
decline, the stock price may rise
back to normal levels over a period
of several weeks
! This violates the EMH because an
investor could earn abnormally high
returns, on average, by buying a
stock immediately after a poor
earnings announcement and then
selling it after a couple of weeks
when it has risen back to normal
levels



 Should you be
sceptical of hot tips?

! Yes
! The EMH indicates that you
should be sceptical of hot tips
since, if the stock market is
efficient, it has already priced
the hot tip stock so that its
expected return will equal the
equilibrium return



 Do stock prices always rise
when there is good news?

! No
! In an efficient market, stock
prices will respond to
announcements only when the
information being announced is
new and unexpected
! So, if good news was expected
(or as good as expected), there
will be no stock price response
! And, if good news was expected
(or not as good as expected),
there will be a stock price
response



Why do Financial Institutions Exist?
! This chart shows how
nonfinancial business
attain external funding
in the US, Germany,
Japan and Canada.
Indirect finance (involves intermediaries) > direct finance
(raise funds directly from lenders in financial markets)



 Agency theory ! analysis of how asymmetric
information problems affect behaviour
 

! The lemons problem: How adverse selection influence Financial

structure
! Lemons problem in Used cars
! If we can’t distinguish between good and bad lemons, we are
willing to pay only an average of good and bad lemon values
! Result: good cars won’t be sold & the used car market will
function inefficiently
! Lemons problem in securities markets
! If we can’t distinguish between good and bad securities, we are
only willing to pay on average price of the good and bad
securities’ value
! Result: good securities are undervalued, and firms won’t issue
them; bad securities are overvalued so there are too many
issued



Tools to help solve the Principal-Agent problem

! Production of information (monitoring)

! Government regulation to increase information
! Financial intermediation (e.g. Venture capital)
! Debt contracts



! Remedies to conflicts of interest
! Aside from the two cases on page 158, a lot has been done to remedy these conflicts
! Sarbanes-Oxley act of 2002
! Established an oversight board to supervise accounting firms
! Increased the SEC’s budget for supervisory activities
! Limited consulting relationships between auditors and firms
! Enhanced criminal charges for obstruction
! Improved the quality of the financial statements and board
! Global Legal Settlement of 2002
! Required investment banks to sever links between research and underwriting
! Spinning is explicitly banned
! Imposed a $1.4 billion fine on accused investment banks
! Added additional requirements to ensure independence and objectivity of research reports

Why do financial crises occur and why are they so

damaging to the economy?


 The Great
Depression


! In 1928 & 1929, stock prices doubled in the US. The Fed tried to curb this
period of excessive speculation with a tight monetary policy. But this led to a
stock market collapse of more than 20% in October 1929 and losing an
additional 20% by the end of 1929.
! What might have been a normal recession turned into something far worse,
when severe droughts in 1930 in the Midwest led to a sharp decline in
agricultural production
! Between 1930 and 1933, one-third of US banks went out of business as these
agricultural shocks led to bank failures
! For over two years, the Fed sat idly by through one bank panic after another
! Adverse selection and moral hazards in credit markets became severe. Firms
with productive uses of funds were unable to get financing. As seen in the next
graph, credit spreads increased form 2% to nearly 8% during the height of the
Depression in 1932

! The deflation during the period lead to a 25% decline in price levels
! The prolonged economic contraction lead to an unemployment rate of 25%
! The Depression was the worst financial crisis ever in the US. It explains why the
economic contraction was also the most severe experienced by the nation
! Bank panics in the US spread to the rest of the world and the contraction of US
economy decreased demand for foreign goods
! The worldwide depression caused great hardship leading to the rise of fascism and
WWII

The Global Financial crises of 2007-2009



The failure of major financial firms

! September 2008: Lehman Brothers filed for

bankruptcy. Merrill Lynch sold to Bank of America
at ‘fire’ sale prices. AIG also experiences a
liquidity crisis



Central Banks
Federal Open Market Committee (FOMC)

! Meets 8 times a year (±every 6 weeks)

! Makes decisions about open market operations
! Sets the policy interest rate (Federal funds rate)
! Tightening of monetary policy ! Fed funds rate ↑
! Easing of monetary policy ! Fed funds rate↓



 Green book

• Detailed national forecast for the next 3 years

Three Blue book

research • Projections of the monetary aggregates with

three alternative scenarios for monetary policy
documents decisions

Beige book

• State of the economy in each of the Fed districts

• Only book that is distributed publicly
• Gets a lot of attention in the press



! Central Banks: independent or not?

! Should a central bank be independent?
! Does this lead to a lower inflation? ! YES

The Bond Market

Primary market for initial sale (IPO)
Secondary market
Over-the-counter (bonds)
Organised exchanges (NYSE) (stocks)








 Municipal Bonds

! Issued by local, county and state governments

! Used to finance public interest projects
! Tax-free municipal interest rate = taxable interest rate x (1 – marginal tax
rate)
! Two types
! General obligation bunds
! Revenue bonds

 Corporate Bonds

! Typically have a face value of $1000, although some have a face value of $5000
! Pay interest semi-annually (USD) or annually (EUR)
! Cannot be redeemed anytime the issuer wishes, unless a specific clause states
this
! Degree of risk varies with each bond, even from the same issuer. Following
suite, the required interest rate varies with level of risk
! The degree of risk ranges from law-risk (AAA) to higher risk (BBB). Any bonds
rated below BBB are considered sub-investment grade debt

Corporate Bonds: Debt Ratings



The Stock Market
Organised vs. OTC

! Organised exchanges (e.g. NYSE)

! Auction markets with floor specialists (floor traders)
! 25% of trades are filled directly by specialist
! Over-the counter markets (e.g. NASDAQ)
! Multiple market makers set bid and ask prices
! Multiple dealers for any given security

 ! Electronic communication networks allow

ECNs brokers and traders to trade without the need of
the middleman.



 ETFs ! Exchange traded funds are a recent innovation

to help keep transaction costs down while
offering diversification




American Allows foreign firms to trade on US exchanges,
making their purchase easier. US banks buy foreign
depository shares and issue receipts against the shares in US
markets
receipts (ADRs)

BREAKING NEWS
BY ZAIN
VOLCKER RULE
Saudi Aramco
Christine Lagarde
EXERCISES
! Find the annual equivalent to r1/12 = 0.84%, the r0.5 equivalent to r1/4 = 3%, the
r0.25 equivalent to a daily rate of 0.025% and the per month equivalent of 5%
per half year.
! A man stipulates in his will that $50,000.00 from his estate is to be placed in a
fund from which his three daughters are each to receive the same amount
when aged 21. When the man dies, the girls are aged 19, 15 and 13. How much
will each daughter receive if the fund earns interest at a semestrial rate of 6%?
! To pay off a loan of $5,000 at a monthly rate of 1.25%, Mrs. Jones agrees to
make three payments in two, five and ten months respectively. The second
payment is to be double the first and the third payment is to be triple the
first. What is the size of the first payment?
! Starting on June 1, 2005 and continuing until December 1, 2010, a company
needs $250,000 semiannually to retire (i.e. pay back) a series of bonds. What
equal semiannual deposits in a fund paying r0.5 =5% beginning on June 1, 2000,
and continuing until December 1, 2010, are necessary to retire the bonds as
they fall due?
! Ann makes trimestral deposits of €2,000 euro into her savings account that
yields a quarterly rate of 2%. The first deposit is made on July 1, 2006, the last
one on January 1, 2009. Elisa makes monthly deposits on an account that
yields a real rate of return of 7%. She makes her first deposit on January 1,
2006, the last one on January 1, 2009. What monthly payment must Elisa make
in order to obtain the same balance in her account than Ann, right after the
final deposit on January 1, 2009?
! On Mr. Smith’s 55th birthday, the Smiths decide to sell their house and buy a
trailer. They realize $80,000 on the sale of the house and invest this in a fund
paying r = 9%. On Mr. Smith’s 65th birthday, they make the first of 15 equal
withdrawals that will exhaust the fund over 15 withdrawals. What is the
amount of each withdrawal?
 ! A loan of $8,000 is to be amortized with equal monthly payments over 2 years
and the = 15%. Find the outstanding principal after 7 months and split
the eighth into principal and interest portions.
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! You agreed with a loan of €150,000 for 15 years with monthly payments and a
monthly interest rate of 0.74%. Calculate in two ways the interest you have
been paying during the first 8 years.
 ! . A €500,000 debt is to be repaid over a 3-year period by equal monthly
installments, the first one exactly one month after the exchange of principal.
! On the 12th payment date, the borrower pays the normal installment and
makes an extra repayment of principal of €50,000. At the same time the
original loan period is shortened by six months.
! The applicable interest rate is APR = 7%.
! (a) Compute the old and the new monthly installment.
! (b) What is the debt balance right after the 18th payment

! The DEF-company issues a total of 500,000 bonds with a face value of €1,000
at 99.85% and annual coupons at 5.10%. The bond is redeemed at 102% in 5
years. The DEF-company pays the banks that support the issue a total fixed fee
of €750,000 and a commission of 0.15% on the total face value issued. For each
coupon payment banks charge a commission of 0.25% of the total coupon
value. Find the cost rate of this issue for the issuer and the yield offered to
the investor.
! . The MNO-company decides to issue a bond at an annual coupon rate of
2.45%. Assume you buy this bond at 97.65% three months after the issue date
and sell it eight months before the ninth coupon at 101.25%. What yield do you
realize on your investment
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