Financial System

1. Chapter Two Financial System

2. Chapter Outline • Financial System and Functions • Basic Puzzles about Financial Structure • Asymmetric Information Problem • Why different interest rates on bond? • The term Structure of Interest rate • Market Indexes for stocks • Inflation and Real rate of return

3. I- The Financial System • Includes: • Financial Markets: • Derivatives • Capital : - Debt (Money & Bonds) - Stocks • Exchange Rate • Financial Intermediaries: • Commercial Banks • Investment banks : mergers acquisition • Insurance companies • Pensions, Retirement and Mutual funds • Venture Capital Firms • Information Services : Moody’s &(S&P 500)

4. The Financial System • Financial infrastructure • Regulation • Government and Quasi Governmental Organization

5. The Main Functions of Financial System 1-Transferring Resources Across Time and Space Stock & Bond Direct financing Markets Individual Firms Government Individual Firms Government Banks buys stocks Banks issue stocks Surplus Units Deficit Units National & International National & International Intermediaries Indirect financing The Flow of Funds Diagram

6. The Functions of Financial System • Managing Risk • Clearing and settling Payments efficiently • Subdividing Shares (financing firms ) • Providing Information: • Dealing with asymmetric information • Definition: One party has no sufficient information about the other party • Two types : • Adverse selection (before signing the contract). Lemon prevail • Moral hazard (after signing the contract) • The principal - agent problem • Herd instinct, snowball effect, financial crises

7. II-Basic Puzzles about Financial Structure Financing Business in USA • Stocks and debt are not the most important source of external financing for business. • Indirect finance ( Banks) are the most important • Why companies relay mainly on indirect financing?

8. Explanation of the puzzles • Problems facing the direct financing • 1- Transaction costs • 2- Asymmetric Information: • Adverse selection: • Potential bad credit risks are the ones who most active seeking funds. The lender may refuse to lend. • Moral hazard • You may playing with someone else’s money • Indirect financing provide solutions

9. How Adverse selection influence Financial Structure • Example 1 Cars: The Lemons Problem • Used cars market. Volvo S60 (2010). • Two Qualities Good Bad (Lemon) Buyers willing • Price 150 000 50 000 100 000 • Only the sellers know the quality • The seller of bad has incentive to make his care look like a good one. • The buyers will discover that • Likely that used care market will not work • Solutions: • The buyers should know as much about the quality of used cars as the seller: • Subscribe in consumer report • Mechanic to evaluate the particular car • Buy from a dealer so asymmetric information is eliminated.

10. How Adverse selection influence Financial Structure? • Example 2 : Stocks. • Example 3: Bonds • Solutions • Private production and sales of information • S & P, Moody’s • Doesn’t eliminate asymmetricbecause of the Free-Rider. • Government Regulation: • Politically difficult to refer to bad firms. • Regulation instead • Still bad firms have incentives to look like good firms • Doesn’t eliminate asymmetric information • 3- Financial Intermediaries • Financial intermediaries function as a car dealer:

11. How Moral Hazard influence Financial Structure? • A- Moral Hazard in Equity Contracts • Example : You build a factory with Mr. X who is the manager. • The Principal-Agent problem • The separation involve moral hazard (manager act in their own interest) • Tools to solve the Principal-Agent problem: • 1- Monitoring: • but expensive in time and money • 2- Government regulation: lows for standard accounting • 3- Financial intermediation : Venture capital firms:

12. How Moral Hazard influence Financial Structure? • B- Moral Hazard in Debt Contracts • The borrower can undertake riskier projectand the lender may lose all his money. • Because of the moral hazard the lender may not make the loan • Tools to Reduce moral hazard in debt contracts • 1- Net worth) : • 2- Monitoring • 3- Enforcement of restrictive covenants (skriftligtavtal) • 4- Financial Intermediation:

13. III- Financial Markets Rates • Why different interest rates on bonds? • Because different: • Unit of account • Maturity • Default risk • Taxes • Liquidity • Effect of Unit of account • What is risk free in one currency is not in another. • ExampleiSEK= 3%, i$ = 9% E=10 SEK/$. You have 10000 SEK to invest for one year. • Two investment strategies: • Invest in SEK:10000kr (1.03)=10300 =300kr (3%) • Invest in $: 1000$(1.09) = 1090$ (10900kr) = 900 kr(9%) • But, if $ depreciate to 8 SEK/$ • R$= $1090 x 8 = 8720 Rate of return = -12.8%

14. Managing Exchange Rate exposures • Covered Interest Parity (CIP) • A risk averse investor is indifferent between placing an extra 1kr into home or foreign treasury bill when returns on them are equal: • or • Given any 3 variables, we can solve for the fourth:

15. Financial Markets Rates • Effect of maturity • Yield Curve . • The slope could be negative, positive or constant • Three theories? • 1- Expectation theory (Förväntningshypotesen ): • The long interest rate is the average of short and future short interest rates. • Perfect substitute therefore the curve should be constant . • Ex. The one-year interest rate over the next five years is expected to be: 5%, 6%, 7%,8% and 9%. What are the interest rates on : a two-year bond, a three-year bond, a four-year bond and a five-year bond? What is happening to the yield curve. • it= Year 1 interest rate = 5%, - iet+1= Year 2 interest rate = 6%, • iet+2 = Year 3 interest rate = 7%, - iet+3 = Year 4 interest rate = 8%, iet+4 = Year 5 interest rate = 9%, int= The long term interest rate

16. Financial Markets Rates • The interest on the two-year bond: • The interest on the three-year bond: • The interest on the four-year bond: • The interest on the five-year bond : • Yield curve should be constant . • If in reality • Positive the short would rise. • Negative the short will fall. • The theory cannot explain: why the yield curve is positive often.

17. Financial Markets Rates • 2-Segmented market theory (marknadssegmenteringsteorin) • No substitutions • Positive, negative, or constant • 3- Liquidity preference theory (Likviditetspreferensteorin) • There is substitute but it is not perfect • Most investors would prefer short, therefore they should be offered higher rate of return for long term.

18. Exempel- Liquidity preference theory • Ex: The one-year interest rate over the next five years is expected to be: 5%, 6%, 7%, 8% and 9%. Investors’ preferences for holding short-term bonds have the liquidity premium for one-year to five-year bonds as 0%, 0.25%, 0.5%, 0.75%, and 1%, respectively. What are the interest rates on : a two-year bond, a three-year bond, a four-year bond and a five-year bond? What is happening to the yield curve. • The interest on the two-year bond : • The interest on the three-year bond : • The interest on the four-year bond:

19. Market Predictions of Future Short Rates

20. Market Indexes For Stocks • Two major indexes: • Dow Jones Index (major 30 stocks in US) • Ex: With only 2 stocks • S & P 500 = 0.8 * 0.5 + 0.2 * 2.2 = 84 • Weight : • IBM = 20Bil/25bil • DEC: 5bil/25bil

21. Inflation and Real rate of return • Calculating the real rate of return: • 1- Fisher equation: • i= r + nominal return • or r = i -  Approximationof real return • 2- : 1+ r= (1+ i) / (1+) or r = (I - )/(1+ ) exact • Ex1: Amount = 100, i = 8% and  = 5%, calculate real rate of return for 1year. • Approximately  100(0.08-.05) = 3kr or 3%. • Exact : 1+ r = (1.08)/(1.05) = 1,02857. Then r = 1,02857 -1= 0.02857 or 2.857% • Note that what is risk free in nominal is not in real.

22. Example of Real and Nominal Return • Calculation of Real Return: • 1- Approximation: • Fisher equation • 2- Exact • 1+ r = (1+ i) / (1+)= = 1.10/1.05 =1,0476 • 3- or