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Chapter One



Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Why study Financial Markets and Institutions?

Markets and institutions are primary channels to allocate capital in our society

Proper capital allocation leads to growth in:  Societal Wealth  Income  Economic opportunity


Why study Financial Markets and Institutions?

In this text we will examine:

the structure of domestic and international markets the flow of funds through domestic and international markets an overview of the strategies used to manage risks faced by investors and savers


Financial Markets

Financial markets are one type of structure through which funds flow Financial markets can be distinguished along two dimensions:

primary versus secondary markets money versus capital markets


Primary versus Secondary Markets

Primary markets

markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds) markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq)

Secondary markets


Primary versus Secondary Markets


Primary versus Secondary Markets

Do secondary markets add value to society or are they simply a legalized form of gambling?

How does the existence of secondary markets affect primary markets?


Money versus Capital Markets

Money markets

markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills) little or no risk of capital loss, but low return markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year substantial risk of capital loss, but higher promised return

Capital markets


Money Market Instruments Outstanding, ($Bn)


Capital Market Instruments Outstanding, ($Bn)


Foreign Exchange (FX) Markets

FX markets

trading one currency for another (e.g., dollar for yen) the immediate exchange of currencies at current exchange rates the exchange of currencies in the future on a specific date and at a pre-specified exchange rate

Spot FX

Forward FX


Derivative Security Markets

Derivative security

a financial security whose payoff is linked to (i.e., derived from) another security or commodity, generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future, the main purpose of the derivatives markets is to transfer risk between market participants.


Derivative Security Markets

Selected examples of derivative securities

Exchange listed derivatives

Many options, futures contracts Forward contracts Forward rate agreements Swaps Securitized loans

Over the counter derivatives



Derivatives and the Crisis


Mortgage derivatives allowed a larger amount of mortgage credit to be created in the mid-2000s. Mortgage derivatives spread the risk of mortgages to a broader base of investors. Change in banking from originate and hold loans to originate and sell loans.



Decline in underwriting standards on loans


Derivatives and the Crisis


Subprime mortgage losses have been quite large, reaching over $700 billion. The Great Recession was the worst since the Great Depression of the 1930s.  Trillions $ global wealth lost, peak to trough stock prices fell over 50% in the U.S.  Lingering high unemployment in the U.S.  Sovereign debt levels in developed economies at alltime highs



Financial Market Regulation

The Securities Act of 1933

full and fair disclosure and securities registration Securities and Exchange Commission (SEC) is the main regulator of securities markets

The Securities Exchange Act of 1934


Financial Institutions (FIs)

Financial Institutions

institutions through which suppliers channel money to users of funds whether they accept insured deposits,  depository versus non-depository financial institutions whether they receive contractual payments from customers.

Financial Institutions are distinguished by:


Asset Size and Number of Selected U.S. Financial Institutions 2010




Commercial Banks Savings Associations Credit Unions Insurance Companies Private Pension Funds Finance Companies Mutual Funds Money Market Mutual Funds

$12,130 $ 1,253 $ 885 $ 6,459 $ 5,661 $ 1,613 $ 7,376 $ 2,746

6,622 1,138 7,554

Data from September 2010, data sources include Federal Reserve Board, Flow of Funds Accounts, Levels Tables, FDIC Stats at a Glance and the NCUA website. The mutual funds category excludes money market funds.


Non-Intermediated (Direct) Flows of Funds

Flow of Funds in a World without FIs
Direct Financing

Financial Claims (equity and debt instruments)

Users of Funds (corporations) Suppliers of Funds (households)



Intermediated Flows of Funds

Flow of Funds in a World with FIs
Users of Funds Intermediated Financing FIs Suppliers of Funds (brokers)


Financial Claims (equity and debt securities)

FIs (asset transformers)


Financial Claims (deposits and insurance policies)


Depository versus Non-Depository FIs

Depository institutions:

commercial banks, savings associations, savings banks, credit unions Contractual:  insurance companies, pension funds, Non-contractual:  securities firms and investment banks, mutual funds.

Non-depository institutions


FIs Benefit Suppliers of Funds


Reduce monitoring costs Increase liquidity and lower price risk Reduce transaction costs Provide maturity intermediation Provide denomination intermediation


FIs Benefit the Overall Economy


Conduit through which Federal Reserve conducts monetary policy Provides efficient credit allocation Provide for intergenerational wealth transfers Provide payment services


Risks Faced by Financial Institutions



Credit Foreign exchange Country or sovereign Interest rate Market


Off-balance-sheet Liquidity Technology Operational Insolvency


Regulation of Financial Institutions

FIs are heavily regulated to protect society at large from market failures Regulations impose a burden on FIs and before the financial crisis, recent U.S. regulatory changes were deregulatory in nature Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation


Regulation of Financial Institutions

New Dodd-Frank Bill


Promote robust supervision of FIs  Financial Service Oversight Council to identify and limit systemic risk,  Broader authority for Federal Reserve (Fed) to oversee non-bank FIs,  Higher equity capital requirements,  Registration of hedge funds and private equity funds.


Regulation of Financial Institutions


New Dodd-Frank Bill


Comprehensive supervision of financial markets New regulations for securitization and over the counter derivatives Additional oversight by Fed of payment systems Establishes a new Consumer Financial Protection Agency



Regulation of Financial Institutions

New Dodd-Frank Bill


New methods to resolve non-bank financial crises More oversight of Fed bailout decisions Increase international capital standards and increased oversight of international operations of FIs.



Globalization of Financial Markets and Institutions

The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before, Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access, International mutual funds allow diversified foreign investment with low transactions costs, Global capital flows are larger than ever.


Appendix: FIs and the Crisis

Timeline of events  Home prices decline in late 2006 and early 2007

Delinquencies on subprime mortgages increase Huge losses on mortgage-backed securities (MBS) announced by institutions

Bear Stearns fails and is bought out by J.P. Morgan Chase for $2 a share (deal had government backing).

Appendix: FIs and the Crisis

Timeline of events  September 2008, the government seizes governmentsponsored mortgage agencies Fannie Mae and Freddie Mac

The two had $9 billion in losses in the second half 2007 Now run by Federal Housing Finance Agency (FHFA)

September 2008, Lehman Brothers files for bankruptcy; Dow drops 500 points


Appendix: FIs and the Crisis


Appendix: FIs and the Crisis


Appendix: Government Rescue Plan


Appendix: Government Rescue Plan


Appendix: Government Rescue Plan


Chapter Two

Determinants of Interest Rates


Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Interest Rate Fundamentals

Nominal interest rates: the interest rates actually observed in financial markets

Used to determine fair present value and prices of securities Two types of components  Opportunity cost  Adjustments for individual security characteristics


Real Interest Rates

Additional purchasing power required to forego current consumption


What causes differences in nominal and real interest rates? If you wish to earn a 3% real return and prices are expected to increase by 2%, what rate must you charge? Irving Fisher first postulated that interest rates contain a premium for expected inflation.


Loanable Funds Theory

Loanable funds theory explains interest rates and interest rate movements Views level of interest rates in financial markets as a result of the supply and demand for loanable funds Domestic and foreign households, businesses, and governments all supply and demand loanable funds


Supply and Demand of Loanable Funds

Demand Interest Rate Supply

Quantity of Loanable Funds Supplied and Demanded


Net Supply of Funds in U.S. in 2010

Source Federal Reserve Flow of Funds Matrix Net Supply in Billions Year 2010 data of Dollars Households & NPOs $ 786.9 Business Nonfinancial 75.3 State & Local Govt. -19.3 Federal Government -1378.6 Financial Sector -178.3 Foreign 324.3 Totals (Discrepancy) -$389.7


Source: Federal Reserve Bank of St. Louis


Determinants of Household Savings

1. 2.

3. 4.


Interest rates and tax policy Income and wealth: the greater the wealth or income, the greater the amount saved, Attitudes about saving versus borrowing, Credit availability, the greater the amount of easily obtainable consumer credit the lower the need to save, Job security and belief in soundness of entitlements,


Determinants of Foreign Funds Invested in the U.S.


2. 3. 4.

Relative interest rates and returns on global investments Expected exchange rate changes Safe haven status of U.S. investments Foreign central bank investments in the U.S.


Determinants of Foreign Funds Invested in the U.S.

Country China Saudi Arabia Russia Taiwan S. Korea
Source: Economist, February 2011

Foreign Currency Reserves (all $ in billions) $2,847 456 444 382 292


Federal Government Demand for Funds

Source: 2011 report, CBO CBO 2011 report BudgetUpdate.pdf


Federal Government Demand for Funds

Federal debt held by the public was at $9.0 trillion at end of 2010 (62% GDP) and is projected to grow to $17.4 trillion by 2020 (76% of projected 2020 GDP, 120% of current GDP)

Large potential for crowding out and/or dependence on foreign investment


Federal Government Demand for Funds

Total Federal Debt is currently $14.1 trillion (97% GDP) and is projected to grow to $23.1 trillion by 2020 (64% increase)

Interest expense is projected to grow to 3.5% of GDP by 2020


Shifts in Supply and Demand Curves change Equilibrium Interest Rates

Increased supply of loanable funds
Interest Rate

Increased demand for loanable funds

Interest Rate





i** i* i** Q* Q** E E* E i*


Quantity of Funds Supplied

Q* Q**

Quantity of Funds Demanded


Factors that Cause Supply and Demand Curves to Shift

Increase in Affect on Supply Affect on Demand Wealth & income Increase N/A As wealth and income increase, funds suppliers are more willing to supply funds to markets. Result: lower interest rates Risk Decrease Decrease As the risk of an investment decreases, funds suppliers are less willing to purchase the claim. All else equal, demanders of funds would be less willing to borrow as well. Result: higher interest rates Near term spending needs Decrease N/A As current spending needs increase, funds suppliers are less willing to invest. Result: higher interest rates Monetary expansion Increase N/A As the central bank increases the supply of money in the economy, this directly increases the supply of funds available for lending. Result: lower interest rates


Factors that Cause Supply and Demand Curves to Shift

Increase in Affect on Supply Affect on Demand Economic growth Increase Increase With stronger economic growth, wealth and incomes rise, increasing the supply of funds available. As U.S. economic strength improves relative to the rest of the world, foreign supply of funds is also increased. Business demand for funds increases as more projects are profitable. Result: indeterminate effect on interest rates, but at more rapid growth rates interest rates tend to rise. Utility derived from assets Decrease Increase As utility from owning assets increases, funds suppliers are less willing to invest and postpone consumption whereas funds demanders are more willing to borrow. Result: higher interest rates Restrictive covenants Increase Decrease As loan or bond covenants become more restrictive, borrowers reduce their demand for funds. Result: lower interest rates


Factors that Cause Supply and Demand Curves to Shift

Increase in Affect on Supply Affect on Demand Tax Increase Decrease Increase Taxes on interest and capital gains reduce the returns to savers and the incentive to save. The tax deductibility of interest paid on debt increases borrowing demand. Result: Higher interest rates Currency Appreciation Increase N/A Foreign suppliers of funds would earn a higher rate of return if the currency appreciates and a lower rate of return measured in their own currency if the dollar depreciates. Foreign central banks often buy U.S. Treasury securities as part of their attempts to prevent their currency from appreciating against the dollar. Result: Lower interest rates Expected inflation Decrease Increase An increase in expected inflation implies that suppliers will be repaid with dollars that will have less purchasing power than originally anticipated. Suppliers lose purchasing power and borrowers gain more than originally anticipated. This implies that supply will be reduced and demand increased. Result: Higher interest rates


Determinants of Interest Rates for Individual Securities


= f(IP, RIR, DRPj, LRPj, SCPj, MPj) Inflation (IP)

IP = [(CPIt+1) (CPIt)]/(CPIt) x (100/1)

Real Interest Rate (RIR) and the Fisher effect

RIR = i Expected (IP)


Determinants of Interest Rates for Individual Securities (contd)

Default Risk Premium (DRP)

DRPj = ijt iTt ijt = interest rate on security j at time t iTt = interest rate on similar maturity U.S. Treasury security at time t


Liquidity Risk (LRP) Special Provisions (SCP) Term to Maturity (MP)


Term Structure of Interest Rates: the Yield Curve

Yield to Maturity

(a) Upward sloping (b) Inverted or downward sloping (c) Flat (a) (c)

Time to Maturity


Unbiased Expectations Theory

Long-term interest rates are geometric averages of current and expected future short-term interest rates

RN ! [(11 R1 )(1  E ( 2 r1 ))...(1  E ( N r1 ))]


1/ N


= actual N-period rate today N = term to maturity, N = 1, 2, , 4, 1R1 = actual current one-year rate today E(ir1) = expected one-year rates for years, i = 1 to N


Liquidity Premium Theory

Long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity

RN ! [(11 R1 )(1  E ( 2 r1 )  L2 )...(1  E ( N r1 )  LN )]1/ N  1 1

Lt = liquidity premium for period t L2 < L3 < <LN


Market Segmentation Theory

Individual investors and FIs have specific maturity preferences Interest rates are determined by distinct supply and demand conditions within many maturity segments Investors and borrowers deviate from their preferred maturity segment only when adequately compensated to do so


Implied Forward Rates

A forward rate (f) is an expected rate on a shortterm security that is to be originated at some point in the future The one-year forward rate for any year N in the future is:

f1 ! [(11 RN ) /(11 RN 1 )

N 1

] 1


Time Value of Money and Interest Rates

The time value of money is based on the notion that a dollar received today is worth more than a dollar received at some future date

Simple interest: interest earned on an

investment is not reinvested Compound interest: interest earned on an investment is reinvested


Present Value of a Lump Sum

Discount future payments using current interest rates to find the present value (PV) PV = FVt[1/(1 + r)]t = FVt(PVIFr,t)
PV = present value of cash flow FVt = future value of cash flow (lump sum) received in t periods r = interest rate per period t = number of years in investment horizon PVIFr,t = present value interest factor of a lump sum


Future Value of a Lump Sum

The future value (FV) of a lump sum received at the beginning of an investment horizon FVt = PV (1 + r)t = PV(FVIFr,t)
FVIFr,t = future value interest factor of a lump sum


Relation between Interest Rates and Present and Future Values

Present Value (PV)

Future Value (FV) Interest Rate Interest Rate


Present Value of an Annuity

The present value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon
1  (1  i )t PV ! PMT [1/(1  r )] ! PMT v i j !1 PMT = periodic annuity payment
t j

PVIFAr,t = present value interest factor of an annuity


Future Value of an Annuity

The future value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon
(1  i )t  1 FVt ! PMT (1  r ) ! PMT v i j !0 FVIFAr,t = future value interest factor of an annuity
t 1 j


Effective Annual Return

Effective or equivalent annual return (EAR) is the return earned or paid over a 12-month period taking compounding into account EAR = (1 + rper period)c 1
c = the number of compounding periods per year


Financial Calculators

Setting up a financial calculator


Number of digits shown after decimal point Number of compounding periods per year

Key inputs/outputs (solve for one of five)

N = number of compounding periods I/Y = annual interest rate PV = present value (i.e., current price) PMT = a constant payment every period FV = future value (i.e., future price)