FNCE 3020 Financial Markets and Institutions Fall Semester 2005

1. FNCE 3020Financial Markets and Institutions Fall Semester 2005 Professor Michael Palmer Professor of Finance University of Colorado at Boulder Fall Semester 2006 Lecture 1: Introduction and Basic Concepts

2. What is your current understanding of financial markets? • Who is the current chairman of the Federal Reserve? • Who was the previous chairman of the Federal Reserve? • What is the Federal Reserve responsible for? • Define the Federal Funds rate? • What is the current level of the Federal Funds Rate? • Is the Federal Funds Rate higher or lower than one year ago? • Which country currently has the highest (lowest) short term (long term) interest rate? • United States, United Kingdom, Japan, Germany, Australia • Which is bigger, the U.S. stock market or the U.S. bond market? • Which country has the largest stock market (by capitalization)? • Japan, the United States, the United Kingdom • Which of the following central banks is the “newest?” • The Federal Reserve, the Bank of England, the Bank of Japan, the European Central Bank.

3. Ben Bernanke: The 14th Chairman of the Federal Reserve Board • Ben Bernanke replaced Alan Greenspan on February 1, 2006 • Greenspan had served since August 1987. • Background: The Chairman of the Federal Reserve Board is named by the President and is confirmed by the U.S. Senate. They serve a term of four years, and can be reappointed. • The Federal Reserve is responsible for the conduct of monetary policy, which means, setting interest rates and promoting money supply growth, with the main goal of promoting price stability. • Columbia Business School's Video parody of Dean Glenn Hubbard (Note: he is not the real Dean) singing about wanting Alan Greenspan's job that went instead to Ben Bernanke. • http://www.youtube.com/watch?v=3u2qRXb4xCU&eurl=

4. Federal Funds Rate • The short term rate in the U.S. interbank market for bank reserves. • One bank lending reserves to another. • This is a key (“benchmark”) short interest rate in the United States: • It is set (and managed) by the Federal Reserve. • Changes (or lack thereof) indicate the stance (direction and accommodation) of monetary policy. • Other interest rates follow closely (especially short term rates). • Markets all over the world pay close attention to the Fed Funds Rate as well as other major central bank equivalent rates.

5. U.S. Federal Funds Rate • Current Level: 5.25% (July 2004: 1.0%)

6. Fed Funds Rate and Prime Rate

7. Interest Rates: August 17, 2006 • Source: http://www.economist.com/markets/indicators/

8. Final Three Questions • Which is bigger, the U.S. stock market or the U.S. bond market? • Which country has the largest stock market (by capitalization)? • Japan, the United States, the United Kingdom • Which of the following central banks is the “newest?” • The Federal Reserve, the Bank of England, the Bank of Japan, the European Central Bank.

9. Financial Markets and Financial Institutions • How would you define these? • Perhaps in terms of functions? • Perhaps in terms of institutions?

10. Working Definitions • Financial Markets: • “Markets through which entities with surplus (“excess”) financial funds transfer those surplus funds to entities who have a shortage (“shortfall”) of available funds.” • Stock markets, bond markets, mortgage markets, money markets… • Financial Institutions: • Entities that facilitate and manage the movement of funds from surplus entities to final borrowers. • Commercial banks, investment banks, asset managers (pension funds, insurance companies), hedge funds, foreign exchange brokers…

11. Functions of Financial Markets • Mechanism for raising funds! • Primary financial markets (e.g., IPOs) • Mechanism for converting financial assets into cash before maturity. • Secondary financial markets (e.g., NYSE, bond markets) • Provides the means for entities to protect their financial/commercial positions. • Derivatives markets. • Mechanism for generating a return on surplus funds. • Corporates with excess cash

12. Functions of Financial Markets • Allocates financial resources among competing users. • And, if done so in the most efficient manner (i.e., to the most productive users) • The process will improve economic efficiency and • Result in highest possible economic growth! • Provides financial signals to market participants • Interest rates, stock prices, exchange rates! • Tells us something about individual entities (for example, companies). • Tells us something about global perceptions of countries.

13. Characteristics of a Well Functioning (i.e., Efficient) Financial Market • Market Transparency: • All participants need to have access to reliable and important information at the same time. • Cannot have insider trading opportunities. • Importance of trading platforms. • How quickly is trading information made available? • Do all potential traders have access to same trading information (bid and ask prices publicly displayed). • Importance of financial services providers • Dow Jones, Bloomberg, Reuters • Central banks play in role in this process by pursuing transparency in terms of their monetary policy processes. • Web sites: http://www.bis.org/cbanks.htm

14. Characteristics of a Well Functioning (i.e., Efficient) Financial Market • Regulation: • Need to have regulation which ensures level and fair playing field and appropriate behavior. • Discourage insider trading, price manipulations, unethical behavior; provide appropriate reporting. • Securities and Exchange Act of 1934 makes it unlawful for any person "to use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device…” • SEC 2002 Regulation Fair Disclosure (Reg FD): “A company releasing market-moving information to anyone has to disclose it publicly.” • Issue for regulators: A what point does regulation become a burden and/or drive users to other markets?

15. Characteristics of a Well Functioning (i.e., Efficient) Financial Market • Competition: • Markets need to be structured and regulated so as to offer easy access and exit. • Not segmenting financial service providers. • Not overly protecting poorly run firms. • Will ensure best prices and services for end users. • Market Structure which Allows for Innovation: • To provide needed new services. • New product development. • Allow financial service providers to respond to needs of end users. • Development of derivative products in the 1970s through today. • Rise of hedge funds.

16. Importance of Transparency to Financial Markets • (Former) SEC Chairman Arthur Levitt (1998) • “[U.S. financial] markets are a success precisely because they enjoy the world's highest level of confidence. Investors put their capital to work – and put their fortunes at risk – because they trust that the marketplace is honest. They know that our securities laws require free, fair, and open transactions.” • Sometimes this breaks down. • Financial scandals in U.S. resulted in the passage of SOX act.

17. Classifications of Financial Markets • Debt Markets • Short-Term (maturity < 1 year) Money Market • Treasury bills, commercial paper, CDs • Long-Term (maturity > 1 year) Capital Market • Treasury and corporate bonds, mortgages • Equity Markets • Ownership claims • Common stock • Derivative Markets • Securities, whose value, is based upon some underlying assets. • Futures, forwards, options…

18. Classifications of Financial Markets • Primary Market • New security issues sold to initial buyers (e.g., IPOs) • Important for raising capital. • Secondary Market • Wheresecurities previously issued (in primary markets) are bought and sold. • Through organized exchanges (central locations; e.g., NYSE, LSE) or over-the-counter arrangements (dealers in different locations; e.g., NASDAQ, and U.S. Government bond market) • Markets provide liquidity for previously issued securities! • Conversion of financial assets into cash.

19. Definition of Financial Instruments • Financial Instrument: • A claim on an issuer’s (borrower’s) future income and/or assets: • Bond: Debt instrument with a contractual agreement (indenture specifies interest payment, maturity date, etc.). • Stock or equity: Ownership position in a corporation • Both bonds and stocks are financial instruments and thus part of the financial system • i.e., they are offered in and trade in financial markets. • Used by issuers to raise capital. • Businesses, individuals, and governments. • Both domestic and foreign.

20. Observations about Financial Instrument Prices • Prices potentially not very stable • Subject to substantial longer term trend changes • Subject to large short term moves. • This is what causes problems for participants in financial markets! • Let’s look at a examples

21. Short term interest rates: 1970-

22. Long term interest rates: 1970 -

23. Stock Prices: 1990 -

24. Observations about Financial Instrument Prices: Debt and Stock • Changes in interest rates: • Affect the cost of borrowing and investment decisions. • Influence the returns to interest sensitive financial institutions. • Changes in stock prices: • Affect the economy’s perception of wealth: • Influence spending decisions (wealth effect). • Affect the IPO market • Changes in interest rates and changes in stock prices both have an impact on: • Company’s cost of capital

25. Foreign Exchange Market: Yen 1993-

26. Observations about Financial Instrument Prices: Foreign Exchange • Changes in exchange rates • Affect the returns to global business firms. • Both non-financial and financial firms. • Determines the home currency equivalent profits. • Strong overseas currencies adds to consolidated profits. • Weak overseas currencies lowers consolidated profits. • Affect the competitive position of global firms • Export and import firms.

27. Flow of Funds Through an Economy

28. Direct Financial Flows • Borrowers borrowing directly from lenders by selling them securities: • Issuing bonds • Issuing stocks • Financial institutions do play a role in this process: • Investment bankers underwriting new stock issues. • However, these financial institutions do not manage the funds of lenders, they simply carry out transactions!

29. Indirect Financial Flows • Lenders placing funds with financial institutions (financial intermediaries) who in turn make decisions about lending those funds: • Commercial banks, saving associations, credit unions • Accepting deposits and making loans. • Insurance companies • Accepting policy receipts and making investments. • Mutual funds • Selling shares and making investments. • Thus financial institutions stand between lenders and borrowers and help transfer funds from one to the other. • This process is called financial intermediation!

30. Reasons for Financial Intermediation • Transactions Costs: The time and money spent in carrying out financial transactions. • Search costs and monitoring costs • Financial intermediaries can reduce transactions costs by developing needed expertise and taking advantage of economies of scale • This encourages savers to place funds in these financial intermediaries!

31. Adverse Selection and Moral Hazard • Adverse Selection: • Occurs when potential borrowers who are most likely to produce an undesirable outcome are the ones who are most actively seeking loans. • Occurs before transaction (loan) takes place. • Moral Hazard: • The risk that the borrower might engage in activities that are undesirable from the lenders point of view and result in reducing the likelihood of loan repayment. • Occurs after transaction (loan) takes place.

32. Financial Intermediation: Adverse Selection and Moral Hazard • Adverse selection and moral hazard can occur because of asymmetric information: • Inequality or lack of important information. • Assumption: Financial intermediaries are better able to deal with adverse selection and moral hazard. • Why: They have the “expertise” to do so. • Thus, the possibility of encountering adverse selection and moral hazard encourages savers to place funds in financial intermediaries.

33. Observations on Financial Flows • Majority of funds raised by corporations is through financial intermediaries (i.e., indirect financing): • This is true throughout industrial world: • U.S. , U.K., Canada, Germany, France, Japan • With regard to the direct markets, the picture is mixed in the industrial world: • U.S. and Japan: bond market is larger than stock market. • France and Italy: bond and stock markets about equal in size.

34. Internationalization (Globalization) of Financial Markets • Observations: • Before the mid 1980s, most financial markets were segmented (closed) to the rest of the world. • Exception: the U.S. financial markets. • These markets were also relative small by U.S. standards. • Over the last two decades, financial markets around the world have been deregulated to allow more free cross border capital flows. • Growth in savings in foreign markets has contributed to the growth in non-U.S. financial markets. • Japan and Western Europe. • Thus financial markets around the world are increasing in importance as sources of funds and potential investment.

35. Implications of Financial Market Globalization • Foreign markets are now potentially attractive as sources of funds and opportunities for investment. • Major corporations are no longer confined to their domestic financial markets for sources of funds. • True for U.S. companies as well. • Financial institutions are no longer confined to their domestic financial markets for investment activities. • Growth of “international” mutual funds. • Pension funds investing cross border. • Banks lending cross border.

36. International Comparisons: August 2005 and August 2006 Country Corporate Spread from Corporate Spread from Bond Rate U.S. rate Bond Rate U.S. rate (2005) (2005) (2006) (2006) U.S. 5.13% ----- 5.89% ----- Australia 6.19% +106 6.98% +109 Canada 5.33% + 20 5.51% - 38 U.K. 5.19% + 6 5.74% - 15 Germany 3.44% - 169 4.51% - 138 Japan 1.55% - 3582.04% - 385 Source: The Economist.com

37. Concluding Statement “Uncertainty is …the central problem confronting … financial markets.” Mr. Jacob Frenkl Chairman, Merrill Lynch International September 2002 We will develop this theme and issues surrounding this throughout this course! Financial markets DO NOT like uncertainty!