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Chapter 1

Chapter 1. Introduction. Types of Assets. Tangible Assets Value is based on physical properties Examples include buildings, land, machinery Intangible Assets Claim to future income generated (ultimately) by tangible asset(s) Examples include financial assets. Bank loans Government bonds

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Chapter 1

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  1. Chapter 1 Introduction

  2. Types of Assets • Tangible Assets • Value is based on physical properties • Examples include buildings, land, machinery • Intangible Assets • Claim to future income generated (ultimately) by tangible asset(s) • Examples include financial assets

  3. Bank loans Government bonds Corporate bonds Municipal bonds Foreign bond Common stock Preferred stock Foreign stock Types of Financial Assets

  4. Debt vs. Equity • Debt Instruments • Fixed dollar payments (‘fixed income’) • Examples include loans, bonds • Equity Claims • Dollar payment is based on earnings • Residual (varying) claims • Examples include common stock, partnership share

  5. Price of Financial Asset and Risk • The price or value of a financial asset is equal to the present value of all expected future cash flows. • Expected rate of return • Risk of expected cash flow

  6. Types of Investment Risks • Purchasing power risk = inflation risk • Default risk = credit risk (special case of PP risk) • Exchange rate risk = currency risk

  7. Role of Financial Assets • Transfer funds from those with more money than projects to those with more projects than money. • Share unavoidable risk associated with cash flows. • Equity holders bear inflation risk • Debt holders bear default risk • Both may bear exchange rate risk

  8. Role of (Financial) Markets • Provide liquidity: buyers and sellers all in one ‘place’. • price discovery  efficient resource allocation • Reduce transactions costs: • search costs • information costs (market efficiency)

  9. Classification of Financial Markets • Nature of asset: debt vs. equity markets • Maturity: money (short) vs. capital (long) markets • Seasoning: primary vs. secondary markets • Delivery: cash (= spot) vs. derivatives markets • Structure: auction vs. over-the-counter (OTC) vs. intermediated markets

  10. Financial Market Participants • Households • Business units • Federal, state, and local governments • Government agencies • Supranationals (= multilaterals) • Regulators (broader definition)

  11. Globalization of Financial Markets • In general, easier for investors to move capital internationally • Causes: • Deregulation (liberalization) of financial markets (e.g. currency controls) • Technological advances • Increased role of institutional investors (economies of scale), inc. CalPERS

  12. Classification of Global Financial Markets External Market (= international, offshore or Euromarket): securities offered outside single jurisdiction to investors in multiple countries Internal Market (= national market) Domestic Market: issuers domiciled in the country Foreign Market: issuers domiciled abroad

  13. Motivation for Using Foreign Markets and Euromarkets • Limited fund availability in internal market (esp. in poorer countries) • Reduced cost of funds • Diversifying funding sources (portfolio reduces risk)

  14. Derivatives Market • Derivatives’ value depends on underlying (financial) asset • Futures/forward contracts: parties agree to buy/sell at an agreed price and date. • Options contracts: rights (not obligations) to buy (call) or sell (put) at an agreed price on/by an agreed date.

  15. Role of Derivative Instruments • Buy/sell risk (e.g. purchasing power risk, interest rate risk, exchange rate risk) • `Zero sum’ • However, there are still advantages: • May be lower transactions costs • Can be faster to transact than cash market • Greater liquidity • Allows great scope for financial innovation…

  16. Chapter 2 Financial Intermediaries and Financial Innovation

  17. Services of Financial Institutions • Financial intermediaries transform financial assets (then their liabilities): inc. deposits, insurance, pensions • Help create, launch financial assets (underwriter) • Trade financial assets for customers (broker) • Trade their own financial assets (dealer) • Provide investment advice

  18. Role of Financial Intermediaries • Obtain funds (their liabilities, e.g. deposits) & invest them (their assets, e.g. loans): transfer funds from savers to investors • Direct investment • e.g. bank buys corporate stocks or bonds • Indirect investment • e.g. individual deposits money in a bank that buys…

  19. Intermediaries and asset transformation • Maturity intermediation • Many short term deposits = a long term loan • Longer loan terms usually more expensive • Reducing risk by diversification • portfolio, covariance, marriage [?] • Specialization reduces costs: contracting and information processing, etc. • Enable non-cash payments (cheques, plastic)

  20. Asset/Liability Management • Spread and Non-Spread Businesses • buy/bid v. sell/ask spread (inc. insurance) • non-spread: fund management fees • Nature of Liabilities • contracts specify amount, timing of payment • see chart on next page • Liquidity: redeeming liabilities prematurely • Regulations and taxation

  21. Nature of Liabilities of Financial Institutions

  22. Categories of Financial Innovation (Economic Council of Canada) • Market-broadening instruments • attract new investors • Risk-management instruments • re-allocate risk • Arbitraging instruments and processes • facilitate arbitrage

  23. Categories of Financial Innovation (BIS) • Price-risk-transferring innovations • for price/exchange rate risk • Credit-risk-transferring instruments • Liquidity-generating innovations • inc. by avoiding regulatory constraints • Credit-generating instruments (debt funds) • Equity-generating instruments (capital base)

  24. Causes of Financial Innovation • Financial innovation is a form of innovation • Reasons to innovate: • improve products (e.g. cut costs, including taxes – v. ‘Rules in OECD Countries to Prevent Avoidance of Corporate Income Tax’, Thuronyi) • differentiate products • Explosion in financial products since 1980s: • theoretical developments (e.g. Black-Scholes)  more sophisticated market participants • technical developments: computers, IT • deregulation  greater competition by intermediaries • increased risk [?]: see chart on next page • Changing global patterns of financial wealth

  25. Increased volatility? St Louis Fed: FRED II

  26. Asset Securitization • Securitization: • “homogenizing and packaging financial instruments into a new fungible [interchangeable] one” (Barkley International Inc.) • Many institutions instead of a single one: • bank A makes home mortgages • bank A hires bank B to issue securities backed by the mortgages • bank A buys credit risk insurance • bank A sells loan servicing right

  27. Benefits to Issuers • Specialization/out-source to focus on ‘core competences’: service fees (to collect & forward payments…)? • Diversification reduces risks, hence costs • Manage risk-based capital requirements • Manage interest rate volatility

  28. Other Benefits • To Investors (buyers of securities) • greater liquidity • reduced credit risk • To Borrowers • lower lending rate spreads • Social Benefits • e.g. `viatical settlement’: trade life insurance benefits

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