Money and Capital Markets

3
C h a p t e r
Eighth Edition
Financial Institutions and Instruments in a Global Marketplace
Peter S. Rose
McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu
Key Sources of Financial
Information
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Learning Objectives
To identify important sources of information
about the global financial system.
To understand why the efficient distribution of
information within the financial system is
important.
To learn how market participants keep track of
the prices of financial assets.
To learn about the content and concepts behind
the main social accounting systems.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
3 - 3
Introduction
Sound financial decisions require adequate and
accurate financial information.
We may divide the sources of information
relied on by financial decision makers into:
Cdebt security prices and yields,
Cstock prices and dividend yields,
Cinformation on security issuers,
Cgeneral economic and financial conditions, and
Csocial accounting data.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Efficient Markets & Asymmetric Information
The efficient markets hypothesis (EMH)
contends that information relevant to the
pricing (valuation) of loans, securities, and
other financial assets is readily available to all
borrowers and lenders at negligible cost.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Efficient Markets & Asymmetric Information
On the other hand, the concept of asymmetric
information argues that the financial
marketplace contains pockets of inefficiency in
the availability and use of information, such
that insiders can earn excess returns by
selectively trading assets based on the special
information they have been able to acquire.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Efficient Markets & Asymmetric Information
In an efficient marketplace, each individual
investor will rationally use all the relevant
information that is available to value stocks
and bonds.
Hence, each financial asset will generate an
ordinary or normal rate of return
commensurate with its level of risk.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Efficient Markets & Asymmetric Information
According to the capital asset pricing model
(CAPM), the expected return on financial asset
(or portfolio of assets) i, E(R
i
), is:
The CAPM indicates that E(R
i
) depends on
C r
F
, the time value of money (risk-free interest rate)
C E(R
M
) r
F
, the reward for bearing systematic risk
C |
i
, asset is level of systematic risk
( ) ( ) | |
F M F
R E R E r r
i i
+ =
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Efficient Markets & Asymmetric Information
The line or curve described by the CAPM
equation is usually called the security market
line (SML).
E(R
i
)
R
M

r
F

0 1.0 |

market portfolio M
SML
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Efficient Markets & Asymmetric Information
If the EMH holds, any temporary deviation of
actual returns from the SML should be quickly
eliminated as investors react to temporary
underpricing or overpricing of assets.
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Different Forms of the EMH
The weak form of the EMH argues that the
current price of a financial asset already
reflects all its price and trading volume history.
The semistrong form contends that the current
price of a financial asset already reflects all
publicly available and relevant information.
The strong form argues that the current price
of a financial asset already captures all
relevant public and private information.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Different Forms of the EMH
Repeated research studies have essentially
confirmed the weak and semistrong forms of
the EMH.
The strong form, however, has been the most
controversial, especially because of the
existence of insider trading activities and
because of the apparent asymmetrical
scattering of pockets of special information
throughout the financial system.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Problems Informational Asymmetries Can Create
Lemons and Plums. A loan officer (buyer)
cannot be sure without incurring substantial
costs whether his or her potential customer
(seller) is a lemon (sour) or plum (sweet).
Result: Plums may be driven away from the
market.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Problems Informational Asymmetries Can Create
Adverse Selection. A bank that sets one price
for all its checking account customers runs the
risk of being adversely selected against by its
high-balance, low-activity (and hence most
profitable) customers.
Solution: Enabling customer signaling via a price
schedule for different account plans.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Problems Informational Asymmetries Can Create
Moral Hazard. One party to a principal-agent
contract may decide to pursue its own self-
interest at the expense of the other party.
Solution: Contracts drawn with the appropriate
incentives and monitoring.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Asymmetry, Efficiency, & Real-World Markets
All real-world markets seem to have elements
of both efficiency and asymmetry.
Perhaps, real-world markets can be split into
two segments:
CA highly efficient segment in which well-informed
individuals and institutions trade.
CA market segment in which less-well-informed
small investors and small businesses trade.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Possible Remedies for Informational Asymmetries
Some laws and regulations are designed to
improve the flow of information between
buyers and sellers and to protect the public
against deception in valuing financial assets.
Examples (U.S. ):
1934 Securities Exchange Act
1940 Investment Company Act
1970 Securities Investor Protection Act
Regulation FD (Fair Disclosure), 2000
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Sources of Information
Debt Security Prices and Yields
Data: bid & ask prices, yields-to-maturity
Sources: real-time computer networks (e.g.
Reuters, Bloomberg), televised reports (e.g.
CNN, CNBC), financial press (e.g. The Wall
Street Journal)
Data: bond yield indexes
Sources: Moodys Investor Service, The Daily
Bond Buyer, U.S. Treasury, Dow Jones
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Sources of Information
Stock Prices and Dividend Yields
Data: prices (year-high, year-low, day-high,
day-low, closing), sales volume, most recent
dividend, dividend yield, P-E ratio, stock price
indexes (e.g. DJIA, S&P500), foreign stock
prices
Sources: computer networks (e.g. Internet),
financial press, television, radio, financial
institutions (e.g. S&P, Morningstar)
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Sources of Information
Security Issuers
Data: firm history, principal products/services,
key officers, recent operation summary,
financial statements, credit ratings, industry
performance indicators
Sources: regulatory agencies (e.g. SEC), trade
associations, commercial institutions (e.g.
Moodys, S&P, Dun & Bradstreet), directories
& databases, journals & magazines, credit
bureaus
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Sources of Information
General Economic and Financial Conditions
Data: interest rates, money supply measures,
industrial output, international transactions,
unemployment rate, inflation, forecasts
Sources: central banks (e.g. the Federal
Reserve), statistical bureaus (e.g. Bureau of
Economic Analysis), financial press
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Social Accounting Data
Social accounting refers to the system of
record keeping that reports transactions
between the principal sectors of the economy,
such as households, financial institutions,
corporations, and units of government.
The two most closely followed social
accounting systems in the U.S. are the
National Income Accounts and the Flow of
Funds Accounts.
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National Income Accounts
The National Income Accounts (NIA) present
data on the nations production of goods and
services, income flows, investment spending,
consumption, and savings.
In particular, the level and growth of the
nations economic activity is summarized by
the gross national product (GNP) and gross
domestic product (GDP).
National Income
Accounts
Sample
Table from
the U.S.
National
Income and
Product
Accounts
(NIPA)
Source: http://www.bea.gov
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2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Flow of Funds Accounts
The Flow of Funds Accounts
Ctrace the flow of savings by businesses,
households, and governments into
purchases of financial assets,
Cshow how the various parts of the financial
system interact with each other, and
Chighlight the interconnections between the
financial sector and the rest of the economy.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Flow of Funds Accounts
The construction of the Flow of Funds
Accounts requires four basic steps:
CSector the economy.
CConstruct sector balance sheets.
Flow of Funds Accounts
Sample Balance Sheet
from the U.S. Flow of Funds Accounts
Source: http://www.federalreserve.gov
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2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Flow of Funds Accounts
The construction of the Flow of Funds
Accounts requires four basic steps:
CSector the economy.
CConstruct sector balance sheets.
CPrepare a sources and uses of funds
statement for each sector.
Flow of Funds Accounts
Sample Sources and Uses of Funds Statement
from the U.S. Flow of Funds Accounts
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Source: http://www.federalreserve.gov
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Flow of Funds Accounts
The construction of the Flow of Funds
Accounts requires four basic steps:
CSector the economy.
CConstruct sector balance sheets.
CPrepare a sources and uses of funds
statement for each sector.
CConstruct a flow of funds matrix for the
economy as a whole.
Flow of Funds Accounts
Sample U.S. Flow of Funds Matrix
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Source: http://www.federalreserve.gov
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Money and Capital Markets in Cyberspace
Most key institutions provide extensive online
information. Visit, for example, the Federal
Reserve at http://www.federalreserve.gov and the
Securities and Exchange Commission at
http://www.sec.gov. Or link to worldwide central
banks from http://www.bis.org/cbanks.htm.
Many financial institutions have also made it
easier to track money and capital market
movements. Visit, for example, Money
Magazines http://money.cnn.com/.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
3 - 32
Chapter Review
Introduction
Efficient Markets and Asymmetric Information
The Efficient Markets Hypothesis (EMH)
The Security Market Line (SML)
Different Forms of the EMH
Insiders and Insider Trading
The Concept of Asymmetric Information
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Chapter Review
Efficient Markets and Asymmetric Information
cont
Problems Informational Asymmetries Can Create
Lemons and Plums
Adverse Selection
Moral Hazard
Asymmetry, Efficiency, and Real-World Markets
Possible Remedies for Informational Asymmetries
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
3 - 34
Chapter Review
Sources of Information
Debt Security Prices and Yields
Stock Prices and Dividend Yields
Security Issuers
General Economic and Financial Conditions
Social Accounting Data
National Income Accounts
Flow of Funds Accounts