Financial Institutions and Markets

1. Financial Institutions and Markets The markets

2. Outline of contents • A recap of semester one • Money markets • Capital markets • Bond markets • Equity markets • Learning outcomes • Further work • References • A starter vocabulary list

3. The Markets A recap of semester one

4. An introduction to markets and institutions • The financial system exists to channel funds from those without productive opportunities to those with productive opportunities • This can happen directly through financial markets • E.g. bond, equity, money, derivatives… • Or indirectly through financial institutions / intermediaries • E.g. investment banks, pension funds, insurance companies… • All economies evolve financial institutions • Increased efficiency, since markets are never perfect in real life

5. Informational Problems (1) • In a perfect world, information would be symmetric and complete • I.e. all parties in a transaction have identical knowledge, which is complete • In reality, perfect information does not exist: it may be incomplete and or asymmetric • This leads to the problems of adverse selection and moral hazard

6. Informational Problems (2) Adverse selection: information asymmetry prior to a transaction • A price for the good / service is set at a level that is unsatisfactory for the most desirable candidates, who then leave the market • The price is adjusted, becoming unsatisfactory to the candidates who are the most desirable of those remaining  they now exit the market • This process continues until only the most undesirable candidates remain in the market • Note: no-one has “chosen” or “done” adverse selection – individuals act in their own best interests and this leads to adverse selection across the market

7. Informational problems (3) Moral hazard: asymmetry of information after a transaction • This only exists where there is a need but an inability for one party to monitor the counterparty after a transaction occurs • Differing incentives of the party and the counterparty exist • This leads to the counterparty behaving in a way that would not be approved of by the party • Note: no-one has “chosen” moral hazard – individuals act in their own best interests and this leads to a situation that we call moral hazard • Note: there is not a choice between adverse selection and moral hazard, they are separate problems of information asymmetry

8. Financial intermediaries (1) • Commercial banks & building societies • Core functions: • Receiving deposits • Making loans • Providing a payments mechanism • These institutions work on a fractional reserve system

9. Financial intermediaries (2) • Non-commercial banks • Investment banks • Services to firms / governments • Heavily involved in financial markets • Investment and unit trusts • Differences, similarities? • Insurance companies • Types of insurance • Reinsurance • Pension funds • Types of pension • Calculation of pension value

10. The Markets Money markets

11. On successful completion of the topic… • You should be able to: • Understand and explain the money and capital markets, including the instruments involved • Understand the process of issuing equity [see Arnold (2012: 357)] • Understand the valuation of bonds and equity

12. What is the money market? • Wholesale financial markets in which lending and borrowing on a short-term basis takes place • Wholesale: large volumes (millions of pounds) within transactions • Short-term: usually for less than one year (most for <120 days) • Money markets do not actually trade money • Short-term, highly liquid securities are traded • There is generally a low default risk on MM instruments

13. Do we really need the money markets? • Without regulation, there would be no need for MMs • The banking system should provide short term loans and accept short term deposits • Efficiency in gathering information should remove need for MMs • But there is regulation in the real world • And banks are more heavily regulated than the money markets • So if asymmetric information is not severe, the money markets can have cost advantages for short term funds

14. Sub-divisions of the money market • The money market may be split into 6 components: • The discount market • The interbank market • The certificate of deposit market • The gilt repo market • The local authority market • The eurocurrency market There will be primary and secondary markets within each category Small investors can buy shares in money market funds that investment in these vehicles Also known as parallel markets

15. The Interbank market • This is where banks lend to one another on a short term basis • Wholesale • Very short term (normally 1-14 days) • Unsecured lending • Rates tend to be higher & more volatile than discount rates • LIBOR = the rate of interest on these loans • 3 month rate is important within the wider economy • US– Federal Funds rate, influenced by interbank borrowing to maintain reserves at the Fed. • These loans cannot be traded in the money markets • No distinction between primary and secondary markets

16. The eurocurrency market • Eurocurrency markets are those which allow borrowing and lending to take place denominated in another (non-domestic) currency • Note: this can be ANY currency, not just the Euro • A eurocurrency instrument is then simply a financial instrument denominated in any non-domestic currency • Used because interest rates and regulation can differ across markets

17. The discount market: Bills explained • A bill is a certificate promising to pay a specified amount of money to the bill holder at a specified time in the future • Bills are generally issued by large firms (commercial bills) or government (treasury bills) • Bills have some important characteristics: • They are issued in very large denominations • They are highly liquid • The reward to the lender is a capital gain, not interest • Bills are fixed-interest securities • Market price approaches redemption value as maturity approaches: this is because there is low interest rate risk, so yield is lower

18. The discount market Price of bills Supply1 Supply0 PE Demand0 Demand1 QE Quantity of bills

19. The market for certificates of deposit • A certificate of deposit states that a deposit has been made with a bank for a fixed period of time, at the end of which it will be repaid with interest • A CD issuer is the bank which accepts the deposit • The CD is a liability for this institution • A CD holder is the institution which makes the deposit or purchases the certificate in the secondary market • The CD is an asset for this institution

20. The Gilt repo market • A repo is short for a repurchase agreement • This is an agreement to buy any securities from a seller on the understanding that they will be repurchased at some specified price and time in the future Now At a specified time in the future… Securities Securities

21. The local authority market • This is the (short-term) market in which funds are loaned to local authorities through bills and deposits • The bills are effectively the same as treasury bills • Deposits are a larger source of funds • Once made, deposits cannot be traded • US market: advantage is don’t have to pay federal taxes on them, so effective yields can be higher

22. General principles • Interest rates on longer term products in the money market are usually higher than for shorter term products– because of extra interest rate risk taken on. • The credit rating of the borrower has a big effect on the rates charged. • When inflation expectations rise, interest rates rise accordingly, so the price of money market products falls. • If institutions need extra money quickly, they will issue more short term securities, which pushes up their supply and drives prices down, yields up. • Central banks can intervene to lower interest rates by issuing new securities if they fell it’s necessary (and vice versa during a boom).

23. The Markets Capital Markets

24. What are the capital markets? • The capital markets refers to markets for long term financing • Bond markets • Equity markets • The capital market is used for long-term financing • In contrast to money markets for warehousing or covering temporary shortfalls • Main issuers: firms and government • Main purchasers: households (through FIs)

25. The markets Capital Markets Bonds

26. Bonds • Bonds are securities representing debt owed by the issuer to the investor with specified payments on specific dates

27. The markets Capital Markets Bonds: Government

28. Government securities • Governments may borrow money by issuing bills in the money market or notes and bonds in the capital market

29. Risk and rates on government securities • There is a very low risk of default • This leads to low interest rates (often considered the “risk-free” rate of return) Rate (%)

30. Innovation in government securities • Index-linked gilts • First issued in the UK in 1981 due to high and variable inflation • Par value and coupon are adjusted based on RPI • Generally held to maturity so secondary trading is limited • Inflation risk is therefore reduced for these bonds

31. The markets Capital Markets Bonds: Local authority / Municipal

32. Local authority / municipal bonds • These are issued by governments at sub-national levels • E.g. states, cities… • They are similar to Treasury bonds but are higher risk • Issuers cannot print money and may not be able to raise taxes • Bond insurance is frequently used in the US and EU to guarantee that the bond will be serviced on time • Reduces risk and therefore borrowing cost • Municipal bonds tend to be tax exempt in the US

33. The markets Capital Markets Bonds: Corporate

34. Corporate bonds • Many corporate bonds are listed on exchanges • But most trading is OTC • Minimum value is typically £1,000 or £50,000 (depending on type of bond and trade) • Risk is typically higher for corporate than government issued bonds • Risk varies across bonds for same issuer as well • This affects the coupon rate

35. Variations in corporate bonds • Straight, plain vanilla and bullet bonds are ordinary • Regular, fixed coupons and a specified redemption date • Exotic bonds are those with more unusual characteristics • There is a huge degree of variation in the types of bonds available • We will consider:

36. Restrictive covenants • These restrict the actions and rights of the borrower until the debt has been repaid in full • In order to reduce risk for the lender • Some examples include: • Limits on further debt issuance • Dividend level • Limits on the disposal of assets • Financial ratios

37. RECAP • What is the capital market? (what types of securities, length of maturity, who borrows & why etc). • Restrictive covenants for corporate bonds: • Some examples include: • Limits on further debt issuance • Dividend level • Limits on the disposal of assets • Financial ratios

38. Foreign bonds • Foreign bonds are corporate bonds issued within the country of denomination by a firm based outside that country A bond (in £) U.S. firm UK Markets

39. Eurobonds • Eurobonds are corporate bonds issued in a country other than that of denomination A bond (in $) U.S. firm UK Markets

40. Euro bonds • Euro bonds are denominated in Euros • Please note that eurobonds and Euro bonds are different financial instruments • It is also possible to have a Euro eurobond! A bond (in €) EZ firm U.S. markets

41. Strips • Stripping is the breaking up of a bond into its component coupon payments and its redemption value • Each strip is then sold as a zero coupon bond • This is at a discount to its redemption value • Essentially, these are long term bills

42. Secured bonds • Secured bonds have collateral attached • Mortgage bonds are backed by property • Equipment trust certificates are secured by tangible non-real-estate property • The existence of collateral reduces risk to the lender • Secured bonds pay lower interest than comparable unsecured bonds

43. Unsecured bonds • Unsecured bonds may also be termed debentures • Debentures are backed only by the general creditworthiness of the issuer • They have lower priority than secured bonds if the company defaults

44. Junk Bonds • These are debt instruments offering a high return with a high risk • Rated below Ba or BBB • These may have started as lower risk instruments and become more risky over time • Fallen angels • Or they may be specifically issued risky bonds • Typically issued when limits of bank borrowing are reached and the firm cannot / will not issue more equity

45. Financial guarantees for bonds • A financial guarantee means the bond holder will be paid the principal and interest if the borrower defaults • A form of insurance • Risk is transferred • Lower interest rate is required to compensate for the risk • Credit Default Swaps were created in 1995 • This type of insurance derivative was de-regulated in the US in 2000 • Major contributing factor to the financial crisis

46. Securitisation • Securitised products are repackaged debt • Lenders collect together the claims held on assets (interest and capital) • These claims are then packaged and sold to other investors • These packages may be called asset backed securities • These may be bonds • ABSs may be taken off-balance sheet • Covered bonds are similar but stay on-balance sheet

47. The markets Capital Markets Bonds: Yields and values

48. Bonds: Yields • Current yield, running yield or interest yield • The return on a bond taking account only of the coupon payments • The coupon expressed as a percentage of the market price • Redemption yield • The return on a bond taking account of the coupon cash flows and the capital gain or loss at redemption approx= [(coupon amount / market price)*100] – [{(Market price – nominal value)/market price}*100]

49. Bond pricing • The price of all financial assets is found in the same way: • The present value of all future cash flows • The steps involved: • Identify cash flows • Determine the discount rate required to compensate the investor for holding the security • Find the present value of the cash flows • See Mishkin and Eakins (2012) pp. 336-338 for numerical examples

50. The markets Capital Markets Equities: defining shares