Financial Markets & Institutions: Lecture Notes #3

Financial Markets & Institutions
Lecture Notes #3
Reading Material:
Frederic S. Mishkin, Stanley G. Eakins “Financial Markets &
Institutions” (8th Edition)
Chapters 20-22
Financial Markets & Institutions, Vasil Revishvili, vrevishvili@gmail.com 1

Mutual Funds
Suppose you wanted to start savings for retirement, but you
can only afford to invest $100 / month. How do you develop a
diversified portfolio? Mutual funds are one potential answer.
Mutual funds pool funds under a professional manager who
then chooses the securities to invest in.

The Growth of Mutual Funds (EUR B)
• Assets held by mutual funds have grown by over 17.5% per
year for the last 20 years, reaching over $50 trillion by 2019.

The Growth of Mutual Funds
• The first mutual fund similar to the funds of today was
introduced in Boston in 1824.
• The stock market crash of 1929 set the mutual fund industry
back because small investors avoid stocks and distrusted
mutual funds.
• The Investment Company Act of 1940 reinvigorated the
industry by requiring better disclosure of fees, etc.

Benefits of Mutual Funds
• There are five principal benefits of mutual funds:
1. Liquidity intermediation: investors can quickly convert investments
into cash while still allowing the fund to invest for the long term.
2. Denomination intermediation: investors can participate in equity
and debt offerings that, individually, require more capital than they
possess.
3. Diversification: investors immediately realize the benefits of
diversification even for small investments.
4. Cost advantages: the mutual fund can negotiate lower transaction
fees than would be available to the individual investor.
5. Managerial expertise: many investors prefer to rely on professional
money managers to select their investments

Household Ownership of Mutual Funds

Ownership Structure

Mutual Fund Structure
• Investment companies usually offer a number of different
types of mutual funds.
• Investors can often move investments among these funds
without penalty.
• The complexes often issue consolidated statements.
Mutual fund fact book

Financial Markets & Institutions, Vasil Revishvili, vrevishvili@gmail.com
http://www.ici.org/aboutfunds/factbook_toc.html 8
Mutual Fund Structure
• Closed-End Fund: a fixed number of nonredeemable shares
are sold through an initial offering and are then traded in the
OTC market. Price for the shares is determined by supply and
demand forces.
• Open-End Fund: investors may buy or redeem shares at any
point, where the price is determined by the net asset value of
the fund.

Calculating a Mutual Fund’s Net Asset Value
• Net Asset Value (NAV)
• Definition: Total value of the mutual fund’s stocks, bonds,
cash, and other assets minus any liabilities such as accrued
fees, divided by the number of shares outstanding
Stocks $35,000,000
Bonds $15,000,000
Cash $3,000,000
Total value of assets $53,000,000
Liabilities -$800,000
Net worth $52,200,000
Outstanding shares 15 million
NAV = $52,200,000/15,000,000 = $3.48

Mutual Fund Structure: the Organization
• The shareholders, or owners, of the mutual fund are the
investors.
• The board of directors oversees the fund’s activities, hires the
investment advisor, an underwriter, etc., to manage the day to
day operations of the fund.

Mutual Fund Structure:
the Organization

Mutual Fund Structure: the Organization
• In theory, the board can fire the fund manager and
hire anyone they choose. For instance, the board for
the Fidelity Magellan Fund can fire Fidelity. Of
course, if the board hires a non-Fidelity management
team, the fund will probably lose its name, and
possibly its reputation along with it.

Investment Objective Classes
• There are four primary classes of mutual funds available to
investors:
1. Stock (equity) funds
2. Bond funds
3. Hybrid funds
4. Money market funds
• The next slide shows the distribution of assets among these
different classes.


• Stock Funds
– Other than investing in common equity, the stated
objective of any particular fund can vary dramatically.
– Capital Appreciation Funds seek rapid increase in share
price, not being concerned about dividends.
– Total Return Funds seek a balance of current income and
capital appreciation.
– World Equity Funds invest primarily in foreign firms.
– Other types in Value, Growth, a particular industry, etc.

• Bond Funds
– Strategic Income Funds invest primarily in U.S. corporate
bonds, seeking a high level of current income.
– Government Bond Funds invest in U.S. Treasury, as well
as state and local government bonds.
– Others include World Bond Funds, etc.

• Hybrid Funds
– Combine stocks and bonds into a single fund.
– Account for about 7% of all mutual fund accounts.

• Money Market Mutual Funds
– Open-end funds that invest only in money market securities.
– Offer check-writing privileges.
– Net assets have grown dramatically, as seen in the next
slide.

Money
Market Funds
Size

• Money Market Mutual Funds
– Although money market mutual funds offer higher returns
than bank deposits, the funds are not federally insured.

• Index Funds
– A special class of mutual funds that do fit into any of the
categories discussed so far.
– The fund contains the stock of the index it is mimicking.
For example, an S&P 500 index fund would hold the
equities comprising the S&P 500.
– Offers benefits of traditional mutual funds without the
fees of the professional money manager.

Fee Structure of Investment Funds
• Load funds (class A shares) charge an upfront fee for buying
the shares. No-load funds do not charge this fee.
• Deferred load (class B shares) funds charge a fee when the
shares are redeemed.
• If the particular fund charges no front or back end fees, it is
referred to as class C shares.

Fee Structure of Investment Funds
• Other fees charged by mutual funds include:
– contingent deferred sales charge: a back end fee that may
disappear altogether after a specific period.
– redemption fee: another name for a back end load
– exchange fee: a fee (usually low) for transferring money
between funds in the same family.
– account maintenance fee: charges if the account balance is too
low.
– 12b-1 fee: fee to pay marketing, advertising,
and commissions.
• Today, most of the fees are incorporated in one “Management Fee”

Regulation of Mutual Funds
• Mutual funds are regulated by four primary laws:
– Securities Act of 1933: specifies disclosure requirements
– Securities Exchange Act of 1934: details antifraud rules
– Investment Company Act of 1940: requires registration and
minimal operating standards
– Investment Advisors Act of 1940: regulates fund advisors

Regulation of Mutual Funds
• Mutual funds are the only companies in the U.S. that
are required by law to have independent directors, as
follows (2001 SEC rules)
– Independent directors must constitute a majority of
the board
– Independent directors select and nominate other independent
directors
– Legal counsel to the independent directors must also be
independent

Hedge Funds
• A special type of mutual fund that received considerable
attention following the collapse of Long Term Capital
Management.
• Different from typical mutual funds, as follows:
– High minimum investment, averaging around $1 million
– Long-term commitment of funds is required
– High fees: typically 1% of assets plus 20% of profits
– Highly levered
– Little current regulation

Hedge Funds
• Hedge funds are often trying to take advantage of unusual
spreads between security prices

The LTCM Debacle
• Long Term Capital Management was a hedge fund run by John
Meriwether (the former head of bond trading at Salomon Brothers),
and its board included Nobel Laureates Myron Scholes and Robert
C. Merton. It recorded returns in excess of 30% for the first several
years.
• However, it took bets that went the wrong way. Its collapse was
eminent, and regulators decided they had to develop a bailout.
LTCM had over $80 billion in equity positions and over $1 trillion in
derivative positions. Its failure could have been devastating for the
U.S. economy.
• Hedge funds have continued to fail since LTCM. Amaranth
Advisors loss $6 billion in one week in natural gas futures. Other
funds have similar losses. Indeed, hedge fund investing is a
potentially high risk game for well-heeled investors (gamblers?)

Insurance Companies
• Insurance companies assume the risk of their clients in return
for a fee, called the premium.
• Most people purchase insurance because they are risk-averse
— they would rather pay a certainty equivalent (the
premium) than accept a gamble

Fundamentals of Insurance
• Although there are many types of insurance and insurance
companies, there are seven basic principles all insurance
companies are subject to:
1. There must be a relationship between the insured and the
beneficiary. Further, the beneficiary must be someone who would
suffer if it weren’t for the insurance.
2. The insured must provide full and accurate information to the
insurance company.
3. The insured is not to profit as a result of insurance coverage.
4. If a third party compensates the insured for the loss, the insurance
company’s obligation is reduced by the amount of the
compensation.

5. The insurance company must have a large number of insured so
that the risk can be spread out among many different policies.
6. The loss must be quantifiable. For example, an oil company
could not buy a policy on an unexplored oil field.
7. The insurance company must be able to compute the probability
of the loss’s occurring.

Adverse Selection and Moral Hazard in Insurance
• Asymmetric information plays a large role in the design of insurance
products. As with other industries, the presence of adverse selection
and moral hazard impacts the industry but is fairly well understood the
insurance companies.
• The adverse selection problem raises the issue of which policies an
insurance company should accept:
– Those most likely to suffer loss are most likely to apply for
insurance.
– In the extreme, insurance companies should turn anyone who applies
for an insurance policy.
• However, insurance companies have found reasonable solutions to deal
with this problem:
– Health insurance policies require a physical exam.
– Preexisting conditions may be excluded from the policy.
Moral Hazard in Insurance
• Moral hazard occurs in the insurance industry when the
insured fails to take proper precautions (or takes on more risk)
to avoid losses because losses are covered by the insurance
policy.
– Insurance companies use deductibles to help control this
problem.

• Another problem is that most people don’t purchase enough
insurance. Insurance companies use a strong sales force to
combat this.
– Independent agents may sell the insurance products of a
number of different insurance companies.
– Exclusive agents only sell the products of one company.
– An underwriter reviews each policy prior to its
acceptance to determine if the risk is acceptable.

Growth and Organization of Insurance Companies
• The number of insurance companies grew steadily until 1988,
and since then the number has fallen steadily.
– A stock company is owned by shareholders and has a profit motive

– A mutual insurance company is owned by the policyholders and attempts
to provide the lowest cost insurance
Types of Insurance
Insurance is classified by which type of undesirable event is
covered:
• Life Insurance
• Health Insurance
• Property and Casualty Insurance

Life Insurance
Life insurance policies come in many forms. Some of the
typical policies include:
• Term Life: the insured is covered while the policy is in effect,
usually 10–20 years.
• Whole Life: similar to term life but allows the policyholder to
borrow against the policies cash value. When the term of
policy expires, the insured can get the cash value of the policy
• Universal Life: includes both a term life portion and a savings
portion (became popular in 70s).
• Annuities: pays a benefit to the insured until death, to cover
retirement years.

Life Insurance: Company Assets and Liabilities
• Life insurance companies derive funds from two sources:
– They receive premiums that must be used to payout future
claims when the insured dies
– They receive premiums paid into pension funds managed
by the life insurance company
• Distribution of typical Life Insurance Company Assets

Life Insurance: Company Assets and Liabilities
• Life insurance companies have two primary liabilities:
– Life insurance payouts
– Pension fund payouts

Health Insurance
• Health insurance policies are highly vulnerable to the adverse
selection problem. Those with known or expected health
problems are more likely to seek coverage.
• This is why most health insurance is offered through group
policies. Individual policies must be priced assuming adverse
selection.

Health Insurance
Health insurance is a hot topic in the political environment,
focusing on increased costs and availability of coverage.
• Insurance programs are attempting to shift costs to the
employers.
• Health Maintenance Organizations are another attempt to keep
costs down.

Property and Casualty Insurance
• Property Insurance: protects businesses and owners from the
risk associated with ownership.
– Named-peril policies: insures against any losses only from
perils specifically named in the policy
– Open-peril policies: insures against any losses except from
perils specifically named in the policy
• Casualty Insurance
• Reinsurance

Property and Casualty Insurance
• Casualty Insurance: also known as liability insurance, it
protects against financial losses because of a claim of
negligence.
• Reinsurance: allocates a portion of the risk to another
company in exchange for a portion of the premium.

Insurance Regulation
• The McCarran-Ferguson Act of 1945 explicitly exempts
insurance companies from any type of federal regulation.
• Most insurance regulations is at the
state level
• Regulation is typically designed to protect policyholders from
losses, or expand insurance coverage in the state.

The Practicing Manager: Insurance Management
• Screening
• Risk-Based Premium
• Restrictive Provisions
• Prevention of Fraud
• Cancellations of Insurance
• Deductibles
• Coinsurance
• Limits on the Amount of Insurance

Pensions
• Definition: A pension plan is an asset pool that accumulates
over an individual’s working years and is paid out during the
nonworking years.
• Developed as Americans began relying less on children for
care during their later years.
• Also became popular as life expectancy increased.

Types of Pensions
• Defined-Benefit Pension Plans: a plan where the
sponsor promises the employee a specific benefit
when they retire.
• For example, Annual Retirement Payment =
2%  average of final 3 years’ income  years of service

Types of Pensions
• Defined-Benefit Pension Plans place a burden on the employer
to properly fund the expected retirement benefit payouts.
– Fully funded: sufficient funds are available to meet
payouts
– Overfunded: funds exceed the expected payout
– Underfunded: funds are not expected to meet the required
benefit payouts

Types of Pensions
• Defined-Contribution Pension Plan: a plan where a set amount
is invested for retirement, but the benefit payout is uncertain.
• Private Pension Plans: any pension plan set up by employers,
groups, or individuals
• Public Pension Plan: any pension plan set up by a government
body for the general public (e.g., Social Security)

Private Pension Plan Assets

Social Security
• Pay as you go system, where current funding is used
(partially) to pay current benefits.
• Projected number of workers is falling while projected number
of retirees is increasing, which will cause problems in years to
come if not corrected.

Social Security Assets

Projected Social Security Assets

The Future of Pension Funds
• We can expect their growth and popularity as the average
population continues to grow.
• Variety of pension fund offerings may increase as well.
• Pension funds may gain significant control of corporations as
their stock holdings increase.

Investment Banks
• Investment banks perform a variety of crucial functions in
financial markets
– Underwrite the initial sale of stocks and bonds
– Deal maker in mergers, acquisitions, and spin-offs
– Middleman in the purchase and sale of companies
– Private broker to the very wealthy

Investment Banks
• Investment banks were essentially created in the U.S. by the
passage of the Glass-Steagall Act. Prior to this, investment
banking activities were part of large, money-center
commercial banks.
• The lines between investment banks and commercial banks
again begins to blur as legal separation between investment
banks and commercial banks is no longer required.

Investment Banks
Investment banks play many roles in both the primary and
secondary markets. We will focus on their role in three areas:
• Underwriting Stocks and Bonds
• Equity Sales
• Mergers and Acquisitions

Top Underwriters (2007)


Investment Banking Revenues ($B)
JP Morgan 7.2
Goldman Sachs 6.8
Morgan Stanley 6.2
Bank of America 5.6
Citigroup 5.2
Barclays Investment Bank 3.3
Credit Suisse 3.2
Deutsche Bank 2.2
Wels Fargo 2.0
RBC Capital Markets 1.5

Underwriting Stocks and Bonds
• The process of underwriting a stock or a bond issue requires
that the investment banker purchase the entire offering at a
predetermined price and then resell the offering (securities) in
the market. The services provided during this process include:
– Giving Advice
– Filing Documents
– Underwriting, Best Efforts, or Private Placement

• Giving advice
– Explaining current market conditions in to help determine
why type of security (equity, debt, etc.) to offer
– Assisting in determining when to issue, how many, at what
price (more important with IPOs than SEOs)

• Filing Documents
– SEC registration (filing) is required for issues greater than
$1.5 million and with a maturity greater than 270 days.
– A portion of the registration statement known as the
prospectus is made available to the public.
– Debt issues require several additional steps, including
acquiring a credit rating, hire a bond counsel, etc.
– For equity issues, the investment banker may also arrange
for the securities to appear on one of the exchanges.

• Underwriting (firm commitment)
– The investment banker purchases the entire offering at a
fixed price and then resells the offering to the market.
– An underwriter may form an underwriting syndicate to
diffuse part of the underwriting risk.

• The goal of underwriting is for all of the shares in an offering
to be spoken for. Possible outcomes:
– Fully subscribed: interest for all shares generated
– Undersubscribed: underwriting syndicate unable to
generate interest in all of the available shares
– Oversubscribed: interest in more shares than are available
(may lead to rationing).
Financial Markets & Institutions, Vasil Revishvili, vrevishvili@gmail.com 23-66


• Best Efforts: An alternative to a firm commitment, the
underwriter does not buy the issue, but rather makes its “best
effort” to sell the entire issue.
• Private Placements: The entire issue is sold to a small, select
group of investors. This is rarely done with equity issues.

• Equity Sales: when a firm sells an entire division (or maybe
the entire company), enlisting the aid of an investment banker.
– Assists in determining the value of the division or firm and
find potential buyers
– Develop confidential financial statements for the division
for prospective buyer (confidential memorandum)
– Prepare a letter of intent to continue, assist with due
diligence, and help reach a definitive agreement

Mergers and Acquisitions
• Investment bankers may assist both acquiring firms and
potential targets (although not both in the same deal).
• Deal may be a hostile takeover, where the target does not wish
to be acquired.
• Investment bankers will assist in all areas, including deal
specifics, lining up financing, legal issues, etc.

Securities Brokers and Dealers
Securities firms with brokerage services offer several types
of services:
• Brokerage Service
• Other services
• Full-Service Brokers versus Discount Brokers

• Securities Orders: when you call a brokerage house to buy or
sell a security, you essentially have three options:
– Market Order: buy or sell security at current price
– Limit Order: you specify the most you are willing to pay
(buy) or the least you are willing to accept (sell) for
a security
– Short Sales: sell a security you don’t own with the intent of
buying it back at a later date (hopefully at a lower price)

• Other Services
– Insurance against loss of actual security documents
– Margin credit for purchasing equity with borrowed funds
– Other services driven by market demand (e.g., the Merrill
Lynch cash management account)

• Full Service Brokers: offer clients research and investment
advice, but usually charge a higher commission on trades.
• Discount Broker: provides facilities to buy/sell securities but
offers no advice. Many on-line discount brokerage firms do
have significant research available

• Securities Dealers
– Hold inventories of securities on their own account
– Provide liquidity to the market by standing by ready to buy
or sell securities (market maker)
– Especially important for thinly traded securities

Private Equity Investments
• An alternative to investing via public securities is private equity
(PE) investments. Here, a limited partnership raises funds (PE)
to invest in new companies, to buyout existing divisions, etc.
• Most common types of PE are venture funds and capital
buyouts.
• PE got a boost in 1978 when pension funds were permitted to
invest in PE firms.

Venture Capital Firms
• These firms provide funds for start-up companies
• Often become very involved with firm management and
provide expertise

Venture Capital Firms
• Description of Industry
– Typically limited partnerships
– Examples of venture-backed firms include Apple
Computer, Cisco Systems, Starbucks, TCBY, etc.

Venture Capital Investments
Financial Markets & Institutions, Vasil Revishvili, vrevishvili@gmail.com 23-79

Venture Capitalists Reduce Asymmetric Information
• Managers of start-ups may have objectives that differ
significantly from profit maximization.
• Venture capitalists can reduce this information problem in
several ways
– Long-term motivation
– Sit on the board of directors
– Disburse funds in stages, based on required results
– Invest in several firms, diversifying some risk

Origins of Venture Capital
• First U.S. venture capital firm was established in 1946.
• Most venture capital firms in the 1950s and 1960s funded
development in oil and real estate.
• Funding has shifted from wealthy individuals to pension funds /
corporations. This is one of the few risky investments pension
funds are permitted.

Structure of Venture Capital Firms
1. Most are limited partnerships

2. Source of capital includes wealthy individuals, pension
funds, and corporations
3. Investors must be willing to wait years before withdrawing
money

Life of Venture Capital Deal
1. Fundraising
– Venture firm solicits commitments, usually less than 100
per deal
2. Investment phase
– Seed investing
– Early stage investing
– Later stage investing
3. Exit
– Usually IPO as merger

Life of Venture Capital Deal

Venture Profitability
• The 20-year average return is over 16.5%, with seed investing
providing the highest average (20.4%) and later stage funding
providing the lowest (13.9%).
• Despite some phenomenal years (1999), venture capital has
had negative returns in recent years.

Private Equity Buyouts
• In this situation, a public company (or perhaps a division) is
taken private. For example, in mid-2007, Thompson Corp.
(NYSE: TOC) sold its Thompson Learning division to Apax
Partners and OMERS Capital Partners in a private equity
buyout. The price tag? $7.76 billion in cash!

• Why go private?
– Avoid SEC regulation, such as Sarbanes-Oxley.
– Provides flexibility and ability to avoid public scrutiny of
earnings. Also helps attract top talent no longer interested
in the life of a public-company CEO.
– Tax advantages, and high compensation for partners.

• Lifecycle of a Private Equity Buyout
– Investors pledge money (usually $1 million or more) and
intent to leave money in partnership for 5+ years.
– Partners identify an opportunity, buy it, and then manage
its future (typically hire a CEO for day-to-day operations).
– The company is then sold to the public via an IPO.

• Implications of the Ownership Structure
– High risk and high returns are involved, as can be seen in
the next slide.
– As the market for underperforming firms becomes more
competitive, PE may not perform as well, or industry will
shrink.

Private Equity Returns

Financial Markets & Institutions: Lecture Notes #3

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Financial Markets & Institutions

Financial Markets & Institutions, Vasil Revishvili, vrevishvili@gmail.com 1

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Mutual fund fact book

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– A stock company is owned by shareholders and has a profit motive

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