EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Summer Term

1. EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Summer Term Revision Lecture

2. Overview of module • What do banks do? • Financial intermediation, bank runs & bank regulation • Money markets • Bond markets • Securitisation; credit ratings • Equity (stock) markets • Derivatives I: futures and options • Derivatives II: interest rate derivatives and swaps • Financial regulation after the crisis

3. Lecture 1: learning outcomes • Types of banking • Retail, corporate, commercial, investment, universal • Core elements of banking • Deposit taking, lending, payments • Lending • Types of loans made by banks • Factors that bankers consider when granting loans • Range of services offered by banks • E.g. cash management, insurance, stock broking, providing guarantees, help with overseas trade • Wide variety of activities undertaken by investment banks • ‘Shadow banking’ system

4. Lecture 2: learning outcomes • Financial intermediation; maturity (or liquidity) transformation • Bank management • Liability and asset management • Capital adequacy and liquidity management • Bank runs • Diamond & Dybvig model • Government support for the banking system • Lender of last resort • Depositor insurance • Recapitalisation of banks • Bank regulation • Prudential supervision • Capital & liquidity adequacy: Basel accords; national regulations

5. Lecture 3: learning outcomes • What the money markets are and how they are used • Money market funds • Interbank lending • The various money market instruments • Treasury bills and other government paper • Commercial paper (and asset-backed CP) • Repurchase agreements (‘repos’) • Benchmark interest rates, e.g. LIBOR • Interest rates and discount pricing • Analysis: Money markets in the financial crisis of 2007-09 • Main events of the crisis affecting the money markets • How a ‘dealer bank’ fails: loss of liquidity due to actions of counterparties • Impact of loss of money market liquidity: Northern Rock

6. Lecture 4: learning outcomes • The nature and main types of bonds • Structure of bond contracts: annual coupon, principal • Time to maturity • Why bonds are used: comparison with equities • Payments • Control rights • The main issuers of bonds • Govts (e.g. gilts), local govt, corporations, securitisation vehicles • Bond pricing and yield • Current yield • Yield to maturity • Bond demand and supply • Term structure of interest rates

7. Lecture 5: learning outcomes • Securitisation • What asset-backed securities (ABS) are • The process of securitisation • History of securitisation • Structured finance: CDOs and CMOs; CDO^2 • Structured investment vehicles (SIV) • The role of securitisation and structured securities in the financial crisis of 2007-09 • Credit rating agencies • Historical development • Role of CRAsin regulation of financial institutions • Payment for ratings; conflict of interest • Criticisms following the 2007-09 crisis

8. Lecture 6: learning outcomes • Equities • Differences between equity and debt capital • Preference shares • Stock exchanges • Innovations in equity trading: electronic trading, high frequency • Models of equity valuation • One-period model • Generalised dividend valuation model • Gordon growth model • Price-earnings ratio • Efficient Market Hypothesis (EMH) • Implications of the EMH for equity prices • Empirical evidence on EMH; behavioural finance • Asset price bubbles • Minsky’s financial instability hypothesis

9. Lecture 7: learning outcomes • Futures and forwards • The nature of forwards and futures • Specification of a futures contract • Uses of futures for hedging, speculation and arbitrage • futures increase leverage, by reducing up-front investment required • Convergence of futures price to spot price • Margin accounts and marking to market; margin calls • Options • The nature of financial options • Calls and puts; European and American exercise types • Payoff from call and put options for holder and writer • Option valuation: some simple relationships • upper and lower bounds on option price • put-call parity • six factors affecting option values

10. Lecture 8: learning outcomes • Interest rate and other derivatives • Interest rate futures • hedging a deposit or a loan • Forward rate agreements (FRA) • Spread betting and contracts for difference (CFD) • Interest rate caps and floors • Swaps • Interest rate swaps • examples • relationship between swaps and FRAs • Credit default swaps (CDS) • CDS in the financial crisis • Lehman Brothers’ bankruptcy; failure of AIG

11. Lecture 9: learning outcomes • Summing up: what went wrong in 2007-09? • Financial regulation: why regulate? • Asymmetric information between providers and consumers • Moral hazard due to deposit insurance • Social externalities: contagion effects and wider economic impact • Consumer protection; market power • Types of financial regulation • Micro-prudential regulation • Macro-prudential regulation • Principles of financial regulation • Capital requirements • Liquidity risk • Other: CRAs, OTC derivatives, resolution procedures, max LTVs, executive pay • Reform of financial regulation • Global: Basel III Accord • National/EU: US Dodd-Frank Act; EU reforms; UK regulatory reorganisation