CENTRAL BANK AND THE CREATION OF MONEY - Financial Institutions and Markets by Fabozzi

CHAPTER 5

CENTRAL BANK

AND THE CREATION OF MONEY

CENTRAL BANKS AND THEIR PURPOSE

The primary role of a central bank is to maintain the stability of the currency and money supply for a country or a group of countries. The role of central banks can be categorized as: (1) risk assessment, (2) risk reduction, (3) oversight of payment systems, (4) crisis management.

One of the major ways a central bank accomplishes its goals is through monetary policy. For this reason, central banks are sometimes called monetary authority. In implementing monetary policy, central banks, acting as a reserve bank, require private banks to maintain and deposit the required reserves with the central bank. In times of financial crisis, central banks perform the role of lender of last resort for the banking system. Countries throughout the world may have central banks. Additionally, the European Central Bank is responsible for implementing monetary policy for the member countries of the European Union. 

There is widespread agreement that central banks should be independent of the government so that decisions of the central bank will not be influenced for short-term political purposes such as pursuing a monetary policy to expand the economy but at the expense of inflation.

In implementing monetary and economic policies, the United States is a member of an informal network of nations. This group started in 1976 as the Group of 6, or G6: US, France, Germany, UK, Italy, and Japan. Thereafter, Canada joined to for the G7. In 1998, Russia joined to form the G8.

THE CENTRAL BANK OF THE UNITED STATES: THE FEDERAL RESERVE SYSTEM

The Federal Reserve System consists of 12 banking districts covering the entire country. Created in 1913, the Federal Reserve is the government agency responsible for the management of the US monetary and banking systems. It is independent of the political branches of government. The Fed is managed by a seven-member Board of Governors, who are appointed by the President and approved by Congress.

The Fed’s tools for monetary management have been made more difficult by financial innovations. The public’s increasing acceptance of money market mutual funds has funneled a large amount of money into what are essentially interest-bearing checking accounts. Securitization permits commercial banks to change what once were illiquid consumer loans of several varieties into securities. Selling these securities gives the banks a source of funding that is outside the Fed’s influence.

INSTRUMENT OF MONETARY POLICY: HOW THE FED INFLUENCES THE SUPPLY OF MONEY

The Fed has three instruments at its disposal to affect the level of reserves.

Reserve Requirements

Under our fractional reserve banking system have to maintain specified fractional amounts of reserves against their deposits. The Fed can raise or lower these required reserve ratios, thereby permitting banks to decrease or increase their lending and investment portfolios. A bank’s total reserves equal its required reserves plus any excess reserves.

Open Market Operations

The Fed’s most powerful instrument is its authority to conduct open market operation. It buys and sells in open debt markets government securities for its own accounts. The Fed prefers to use Treasury bills because it can make its substantial transactions without seriously disrupting the prices or yields of bills.

The Federal Open Market Committee, or FOMC, is the unit that decides on the general issues of changing the rate of growth in the money supply, by open market sales or purchases of securities. The implementation of policy through open market operations is the responsibility of the trading desk of the Federal Reserve Bank of New York.

Open Market Repurchase Agreements

The Fed often employs variants of simple open market purchases and sales, these are called the repurchase agreement (or repo) and the reverse repo. In a repo, the Fed buys a particular amount of securities from a seller that agrees to repurchase the same number of securities for a higher price at some future time. In a reverse repo, the Fed sells securities and makes a commitment to buy them back at a higher price later.

Discount Rate

A bank borrowing from the Fed is said to use the discount window. The discount rate is the rate charged to banks borrowing directly from the Fed. Raising the rate is designed to discourage such borrowing, while lowering should have the opposite effect.

DIFFERENT KINDS OF MONEY

Money is that item which serves as a numeraire. In a basic sense money can be defined as anything that serves as a unit of account and medium of exchange. We measure prices in dollars and exchange dollars for goods. Hence coins, currency, and any items readily exchanged into dollars (checking deposits or NOW accounts) constitute our money supply.

MONEY AND MONETARY AGGREGATES

Monetary aggregates measure the amount of money available to the economy at any time. The monetary base is defined as currency in circulation (coins and federal reserve notes) and reserves in the banking system. The instruments that serve as amedium of exchange can be narrowly defined as M₁, which is currency and demand deposits. M₂ is M₁ plus time and savings accounts, and money market mutual funds. Finally, M₃ is M₂ plus short-term Treasury liabilities. While all three aggregates are watched and monitored, M₁ is the most common form of the money supply, with its trait as being the most liquid. The ratio of the money supply to the economy’s income is known as the velocity of money.

THE MONEY MULTIPIER: THE EXPANSION OF THE MONEY SUPPLY

The money multiplier effect arises from the fact that a small change in reserves can produce a large change in the money supply. Through our fractional reserve system, a small increase will allow an individual bank, to lend out the greater part of these additional funds. These loans subsequently become deposits in other banks allowing them to expand proportionately. So, while one bank can expand its loans (or deposits) by an amount 1% of reserves required, all banks in the system can do likewise. Thus, in a simple format total change in deposits can be stated as change in reserves divided by the reserve requirement, which is also the formula for perpetuity. For example, if the change in the level of reserves is $100 and the reserve requirement is 20%, the change in total deposits will be $500 for a multiplier of 5. Of course, major assumptions are that banks will fully loan out their excess reserves and that depositors will not withdraw any of these extra reserves.

THE IMPACT OF INTEREST RATES ON THE MONEY SUPPLY

High rates of interest may make keeping excess reserves costly, since unused funds represent loans not made and interest not earned. High rates of interest will also affect the public’s demand for holding cash. If deposits pay competitive interest rates, customers will be more willing to hold such bank liabilities and less cash. Therefore, a higher rate of interest can actually spur growth of the money supply. More likely, however, it will deter borrowing and slow monetary growth.

THE MONEY SUPPLY PROCESS IN AN OPEN ECONOMY

In the modern era, almost every country has an open economy. Foreign commercial and central banks hold dollar accounts in the United States. Their purchases and sales of these deposits can affect exchange rates of the dollar against their own currency. The Fed has responsibility for maintaining stability in exchange rates. A purchase of foreign exchange with dollars depreciates the dollar’s value, but it also adds dollars to the accounts of foreign banks in this country, thus adding to theU.S. monetary base. Most central banks of large economies own or stand ready to own a large amount of each of the world’s major currencies, which are consideredinternational reserves. Sales of foreign exchange transactions have monetary base implication and hence consequences for the domestic money supply, emphasis is given to coordinating monetary policies among developed nations.

ANSWERS TO QUESTIONS FOR CHAPTER 5

(Questions are in bold print followed by answers.)

1. What is the role of a central bank?

The role of a central bank has several functions: risk assessment, risk reduction, oversight of payment systems, and crisis management. It can do this through monetary policies, and through the implementation of regulations.

2. Why is it argued that a central bank should be independent of the government?

Central banks should be independent of the short-term political interests and political influences generally in setting economic policies.

3. Identify each participant and its role in the process by which the money supply changes and monetary policy is implemented.

The Fed determines monetary policy and seeks to implement it through changes in reserves. It is up to the nation’s banking system to act on changes in reserves thereby affecting deposits, which constitute the greater part of the M₁ definition of the money supply.

4. Describe the structure of the board of governors of the Federal Reserve System.

The Board of Governors of the Federal Reserve System consists of 7 members who are appointed to staggered 14-year terms. The Board reviews discount operations and sets legal reserve requirements. In addition, all 7 members of the Board serve on the Federal Open Market Committee (FOMC), which determines the direction and magnitude of open-market operations. Such operations constitute the key instrument for implementing monetary policy.

5.

1. Explain what is meant by the statement “the United States has a fractional reserve banking system.”
2. How are these items related: total reserves, required reserves, and excess reserves?

a.       A fractional reserve system requires that a fraction or percent of a bank’s reserve be placed either in currency in vault or with the Federal Reserve System.

b.      Total reserves are the amounts that banks hold in cash or at the Fed. Required reserves are amounts required by the Fed to meet some specific or legal reserve ratio to deposits. Excess reserves are bank reserves in currency and at the Fed which are in excess of legal requirements. Since these amounts are non-interest bearing, banks are often willing to lend these surplus funds to deficit banks at the Fed funds rate.

6. What is the required reserve ratio, and how has the 1980 Depository Institutions Deregulation and Monetary Control Act constrained the Fed’s control over the ratio?

The required reserve ratio is the fraction of deposits a bank must hold as reserves. The DIDMCA constrained the Fed’s control over the ratio by letting Congress set ranges of reserves for demand and time deposits.

7. In what two forms can a bank hold its required reserves?

A bank can hold its reserves in the form of currency in vault or in deposit at the Fed.

8.

1. What is an open market purchase by the Fed?
2. Which unit of the Fed decides on open market policy, and what unit implements that policy?
3. What is the immediate consequence of an open market purchase?

a.       An open market purchase by the Fed consists of the purchase of U.S. Treasury securities.

b.      The FOMC decides on open market policy and directs the Federal Reserve Bank ofNew York to implement it through sales and purchases of these securities.

c.       The immediate consequence of an open market purchase is to supply the seller of the security with a check on the Federal Reserve System that he can deposit in his bank, thereby immediately increasing the excess reserves and thus nation’s money supply.

9. Distinguish between an open market sale and a matched sale (which is the same as a matched sale-purchase transaction or a reverse repurchase agreement).

A matched sale or reverse repo involves the sale of a Treasury security with an agreement to buy it back at a later date and at a higher price as the cost for borrowing the funds. This contrasts with an outright sale at some discounted or premium price.

10. What is the discount rate, and to what type of action by a bank does it apply?

The discount rate is the rate a bank pays to borrow at the “discount window” of the Fed. Such borrowings are often undertaken to meet temporary liquidity needs. Bank needs are monitored and the Fed likes to state that borrowing from it is a “privilege and not a right.”

11. Define the monetary base and M₂

The monetary base includes total bank reserves plus currency in the hands of the public. M₂ = M₁ (currency and demand deposits) + savings and time deposits.

12. Describe the basic features of the money multiplier.

The money multiplier is crucial to the concept of money creation and is analogous to the idea of the autonomous spending multiplier and formula for a perpetuity. It is the inverse of the required reserve ratio (1/rr). If the reserve ratio is .2 then the money supply will expand five times any increase in new deposits. The multiplier will be less if banks hold excess reserves or experience cash drains.

13. Suppose the Fed were to inject $100 million of reserves into the banking system by an open market purchase of Treasury bills. If the required reserve ratio were 10%, what is the maximum increase in M₁ that the new reserves would generate? Assume that banks make all the loans their reserves allow, that firms and individuals keep all their liquid assets in depository accounts, and no money is in the form of currency.

The maximum increase in M₁ will be $1 billion assuming no cash drains in the system, and banks are fully loaned up.     

14. Assume the situation from question 13, except now assume that banks hold a ratio of 0.5% of excess reserves to deposits and the public keeps 20% of its liquid assets in the form of cash. Under these conditions, what is the money multiplier? Explain why this value of the multiplier is so much lower than the multiplier from question 13.

Substitute the given values of currency ratio, required reserves ratio, and excess reserves ratio of 20%, 10% and 0.5% respectively into the formula given on page 94 of the textbook. Now we have a lower multiplier value of 3.9=1.20/. 305. This is because public and banks do not deposit or lend, all they can

FINANCIAL INSTITUTIONS, FINANCIAL INTERMEDIARIES, AND ASSET MANAGEMENT FIRMS - Financial Institutions and Markets by Fabozzi

CHAPTER 2

FINANCIAL INSTITUTIONS,

FINANCIAL INTERMEDIARIES,

AND ASSET MANAGEMENT FIRMS

FINANCIAL INSTITUTIONS

Financial institutions perform several important services:

1.      Transforming financial assets acquired through the market and constituting them into a different, and more widely preferable, type of asset, which becomes their liability. This is the function performed by financial intermediaries.

2.      Exchange financial assets for their customers, typically a function of brokers and dealers.

3.      Exchange financial assets for their own account.

4.      Create financial assets for their customers and sell them to other market participants—the underwriter this role.

5.      Give investment advice to others and manage portfolios of customers.

6.      Managing the portfolio of other market participants.

Financial intermediaries including depository institutions, which acquire the bulk of their funds by offering their liabilities to the public mostly in the form of deposits, insurance companies, pension funds, and finance companies.

ROLE OF FINANCIAL INTERMEDIARIES

Intermediaries obtain funds from customers and invest these funds. Such a role is called direct investment. Customers who give their funds to the intermediaries and who thereby hold claims on these institutions are making indirect investments. Acommercial bank accepts deposits and uses the proceeds to lend funds. Financial intermediaries, such as investment companies, play a basic role of transforming financial assets which are less desirable for a large part of the public into other financial assets which are broadly preferred by the public. By doing so they provide at least one of the following four economic functions: (1) providing maturity intermediation, (2) reducing risk via diversification, (3) reducing costs of contracting and information process, (4) providing a payment mechanism.

Maturity Intermediation

The customer (depositor) often wants only a short-term claim, which the intermediary can turn into a claim on long-term assets. In other words, the intermediary is willing and able to handle the liquidity risk more readily than the customer. This is called maturity intermediation.

Risk Reduction Via Diversification

By pooling funds from many customers the financial intermediary can better achievediversification of its portfolio than its customers.

Reduced Costs of Contracting and Information Processing

Financial institutions provide expert analysis, better data access, and loan enforcement. Costs of writing loan contracts are referred to as contracting costs. Also there are information processing costs. They also benefit from economies of scale.

Providing a Payments Mechanism

Financial depositories provide a payment mechanism, e.g. checking accounts, credit cards, certainty debt cards, and electronic transfers of funds.

OVERVIEW OF ASSET/LIABILITY MANAGEMENT FOR FINANCIAL INSTITUTIONS

All intermediaries face asset/liability management problems. The nature of the liabilities dictates the investment strategy a financial institution will pursue.

Nature of Liabilities

The liabilities of a financial institution mean the amount and time of the cash outlays that must be made to satisfy the contractual terms of the obligations issued. These liabilities can be categorized into four types.

Type I Liabilities: Both amounts of cash outflows and timing are known, e.g., fixed-rate certificates of deposit and guaranteed investment contracts. The former are among liabilities of financial depositories. Life insurance companies offer the latter.

Type II Liabilities: Cash outflows are known, but timing is not, e.g. life insurance policies.

Type III Liabilities: Cash outflows are not known, but timing is known, e.g. floating-rate certificates of deposit.

Type IV Liabilities: Neither cash outflows nor timing are known, e.g., auto or home insurance policies.

Liquidity Concerns

Due to different degrees of certainty about timing and outlay, some institutions must have deposits more cash on hand or accessible in order to satisfy their obligations, e.g. the offering of demand means customers can obtain whatever amount of their funds whenever they wishplays . The greater the concern over liquidity, the fewer less-liquid investments an intermediary can hold.

CONCERNS OF REGULATORS

The risks of a financial institution are: credit, settlement, market, liquidity, operational, and legal.

Credit risk is the risk that the obligor of a financial instrument held by a financial institution will fail to fulfill its obligation. Settlement risk is the risk that when there is a settlement of a trade or obligation, the transfer fails to take place. Counterparty risk is the risk that a counterparty fails to satisfy its obligation.

Liquidity risk in the context of settlement risk means that the counterparty can eventually meet its obligations, but not at the due date. Liquidity risk has two forms.Market liquidity risk is the risk that a financial institution is unable to transact in a financial instrument at a price near its market value. Funding liquidity risk is the risk that the financial institution will be unable to obtain funding to obtain cash flow necessary to satisfy its obligations.

Market risk is the risk of a financial institution’s economic well being that results from an adverse movement in the market price of the asset it owns or the level or the volatility of market prices. There are measures that can be used to gauge this risk. One such measure endorsed by bank regulators is value-at-risk.

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The definition of operational risk includes legal risk. This is the risk of loss resulting from failure to comply with laws as well as prudent ethical standards and contractual obligations. Sources of operation risk include: employees, business process, relationships, technology, and external factors.

ASSET MANAGEMENT FIRMS

Asset management firms manage the funds of individuals, businesses, endowments and foundations, and state and local governments. Types of funds managed by asset management firms include regulated investment companies, insurance company funds, pension funds, and hedge funds. Asset management firms are ranked based onassets under management. These firms receive compensation primarily from management fees charged based on the market value of the assets managed for clients. Also, they are increasingly adopting performance-based management fees for other types of accounts.

Hedge Funds

There is not a single definition of hedge fund. There are several characteristics.

1.      The word “hedge” is misleading. Many funds do not hedge risk at all, but engage in highly risk, leveraged transactions.

2.      Hedge funds use a wide range of trading strategies and techniques to earn a superior return. These strategies include: leverage, short selling, arbitrage, and risk control.

3.      Hedge funds operate in all of the financial markets: cash markets for stocks, bonds, and currencies and the derivatives markets.

4.      The management fee structure for hedge funds is a combination of a fixed fee based on the market value of assets managed plus a share of the positive return.

5.      Investors are interested in the absolute return generated by the asset manager, not the relative return. Absolute return is simply the return realized. Relative return is the difference between the absolute return and the return on some benchmark or index.

Types of hedge funds: There are various ways to categorize the different types of hedge funds.

1.   A market directional hedge fund is one in which the asset manager retains some exposure to systemic risk.

2.   A corporate restructuring hedge fund is one in which the asset manager positions the portfolio to capitalize on the anticipated impact of a significant corporate event. These funds include: (1) hedge funds that invest in the securities of a corporation that is either in bankruptcy or is highly likely in the opinion of the asset manager to be forced into bankruptcy; (2) hedge funds that focus on merger arbitrage, (3) hedge funds that seek to capitalize on other types of broader sets of events impacting a corporation.

3.   A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields, an arbitrage strategy. Technically, arbitrage means riskless profit. Some strategies used by hedge funds do not really involve no risk, but instead low risk strategies of price misalignments.

4.   An opportunistic hedge fund is one that has a broad mandate to invest in any area that it sees opportunities for abnormal returns. These include fund of funds, and global macro hedge funds that invest opportunistically on macroeconomic considerations in any world market.

Concerns with hedge funds in financial markets: There is concern that the risk of a severe financial crisis due to the activities and investment strategies of hedge funds, most notably the use of excess leverage. The best known example is the collapse of Long-Term Capital Management in September 1998. Most recently, in June 2007, there was the collapse of two hedge funds sponsored by Bear Stearns. Obviously, subsequent market develops in 2008 relate to the concern with hedge fund activities in financial markets.

ANSWERS TO QUESTIONS FOR CHAPTER 2

(Questions are in bold print followed by answers.)

1. Why is the holding of a claim on a financial intermediary by an investor considered an indirect investment in another entity?

An individual’s account at a financial intermediary is a direct claim on that intermediary. In turn, the intermediary pools individual accounts and lends to a firm. As a result, the intermediary has a direct contractual claim on that firm for the expected cash flows. Since the individual’s funds have in essence been passed through the intermediary to the firm, the individual has an indirect claim on the firm. Two separate contracts exist. Should the individual lend to the firm without the help of an intermediary, he then has a direct claim.

2. The Insightful Management Company sells financial advice to investors. This is the only service provided by the company. Is this company a financial intermediary? Explain your answer.

Strictly speaking, the Insightful Management Company is not a financial intermediary, because it lacks the function of deposit taking and creating liabilities.

3. Explain how a financial intermediary reduces the cost of contracting and information processing.

Financial intermediaries can reduce the cost of contracting by its professional staff because investing funds is their normal business. The use of such expertise and economies of scale in contracting about financial assets benefits both the intermediary as well as the borrower of funds. Risk can be reduced through diversification and taking advantage of fund expertise.

4. “All financial intermediaries provide the same economic functions. Therefore, the same investment strategy should be used in the management of all financial intermediaries.” Indicate whether or not you agree or disagree with this statement.

Disagree. Although each financial intermediary more or less provides the same economic functions, each has a different asset-liability management problem. Therefore, same investment strategy will not work.

5. A bank issues an obligation to depositors in which it agrees to pay 8% guaranteed for one year. With the funds it obtains, the bank can invest in a wide range of financial assets. What is the risk if the bank uses the funds to invest in common stock?

Practically, it is not a valid statement as banks are not allowed to hold stocks. The bank has a funding risk. On the liability side, amount of cash outlay and timing are known with certainty (Type I). However, on the asset side, both factors are unknown. Thus, there is liquidity risk and price risk.

6. Look at Table 2-1 again. Match the types of liabilities to these four assets that an individual might have:

a.      car insurance policy

b.      variable-rate certificate of deposit

c.       fixed-rate certificate of deposit

d.      a life insurance policy that allows the holder’s beneficiary to receive $100,000 when the holder dies; however, if the death is accidental, the beneficiary will receive $150,000

a.       Car insurance: neither the time nor the amount of payoffs are certain, which is Type IV liability

b.      Variable rate certificates of deposit: times of payments are certain, the amounts are not, which is Type II liability.

c.       Fixed-rate certificate of deposit: both times of payments and cash outflows are known, which is Type I liability.

d.      Life insurance policy: time of payout is not known, but the amount is certain, which is Type III liability.

7. Each year, millions of American investors pour billions of dollars into investment companies, which use those dollars to buy the common stock of other companies. What do the investment companies offer investors who prefer to invest in the investment companies rather than buying the common stock of these other companies directly?

In investing funds with the investment companies, investors are reducing their risk via diversification and the cost of contracting and information. These companies also provide liquidity to the investor.

8. In March 1996, the Committee on Payment and Settlement Systems of the Bank for International Settlements published a report entitled “Settlement Risk in Foreign Exchange Transactions” that offers a practical approach that banks can employ when dealing with settlement risk. What is meant by settlement risk?

Counterparty risk is that risk that a counterparty to a transaction cannot fulfill its obligation. It is related to settlement risk in that counterparty party risk bears on the question of whether settlement can take place or not.  

9. The following appeared in the Federal Reserve Bank of San Francisco’sEconomic Letter, January 25, 2002:

Financial institutions are in the business of risk management and reallocation, and they have developed sophisticated risk management systems to carry out these tasks. The basic components of a risk management system are identifying and defining the risks the firm is exposed to, assessing their magnitude, mitigating them using a variety of procedures, and setting aside capital for potential losses. Over the past twenty years or so, financial institutions have been using economic modeling in earnest to assist them in these tasks. For example, the development of empirical models of financial volatility led to increased modeling of market risk, which is the risk arising from the fluctuations of financial asset prices. In the area of credit risk, models have recently been developed for large-scale credit risk management purposes.

   Yet, not all of the risks faced by financial institutions can be so easily categorized and modeled. For example, the risks of electrical failures or employee fraud do not lend themselves as readily to modeling.

What type of risk is the above quotation referring to?

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.  

10. What is the source of income for an asset management firm?

The sources of income are a fee based on assets under management, and sometimes a performance fee based on returns that meet certain benchmarks or targets.

11. What is meant by a performance-based management fee and what is the basis for determining performance in such an arrangement?

Performance based management fees are typically seen in hedge funds. Increasingly, they are also used by managers of asset management firms. These fees are fees based on performance that meet specified criteria.

12. a. Why is the term hedge to describe “hedge funds” misleading?

b. Where is the term hedge fund described in the U.S. securities laws?

a.       Hedge denotes hedging risk. Many hedge funds, however, do not use hedge as a strategy, and these funds take significant risk in their attempt to achieve abnormal returns.

b.      The term is not described in US securities laws, and hedge funds are not regulated by the SEC.

13. How does the management structure of an asset manager of a hedge fund differ from that of an asset manager of a mutual fund?

Asset management firms are compensated by a fee on asset under management. Hedge funds are compensated by a combination of assets under management and a performance fees. Clearly, investment strategies of these firms will be different since hedge funds seek to generate abnormal returns.

14. Some hedge funds will refer to their strategies as “arbitrage strategies.” Why would this be misleading?

Arbitrage means riskless profit. These opportunities are few and fleeting. Hedge funds take great risk. The arbitrage typically taken is where there is a disparity between the risk and the return, such as pricing disparities across markets.

15. What is meant by a convergence traded hedge fund?

A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields.

16. What was the major recommendation regarding hedge funds of the President’s Working Group on Financial Markets?

The major recommendation was that commercial banks and investment banks that lend to hedge funds improve their credit risk management practices.

FINANCIAL ASSETS - Financial Institutions and Markets by Fabozzi

CHAPTER 1

INTRODUCTION

FINANCIAL ASSETS

An asset is any possession that has value in an exchange.  It can be tangible or intangible, the latter being a financial asset.  Specifically, a financial asset is a claim to a future benefit.  For example, in the case of an automobile loan the borrower issues a note to the lender, who now holds a claim to future cash flows. 

Debt versus Equity Instruments

A debt instrument is a contractual claim, paying fixed dollar amounts. An equity instrument (or residual claim) obligates the issuer to pay the holder an amount based on earnings after holders of debt instruments are paid. Some securities combine both debt and equity features, such as preferred stock or convertible debt.

Price of a Financial Asset and Risk

The price (or value) of any financial asset is equal to the present value of expected cash flows.  The return on an asset is the amount paid to the investor relative to the price paid by him.  Related to return is the degree of risk, namely the certainty of expected cash flows.  The degree of risk ranges from very low -- as in the case of payments on U.S. Treasury securities -- to very high in the cases of some equities and low-rated bonds.  Uncertainty or risk takes several forms: (1) purchasing power risk (or inflation risk); (2) credit or default risk; (3) foreign exchange risk.

Financial Assets versus Tangible Assets

Both types of assets are expected to generate cash flows to their owners.  They are also linked in the sense that tangible assets are financed by the issuance of some type of financial claim, e.g. mortgages finance commercial buildings.  The use of the offices generates income that helps pay off the loan.

Role of Financial Assets

The principal economic functions of financial assets are: (1) to transfer funds from persons who have surplus funds to those who need funds to invest in tangible assets (e.g. mortgage funds lending to homebuyers); (2) transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds (seekers of funds ask others to share the risks in their undertakings).

FINANCIAL MARKETS

Financial markets where financial assets are exchanged.  Delivery of the actual asset may occur immediately (spot or cash market) or in the future (future or forward market).

Role of Financial Markets

Financial markets provide the following functions.

1.  Price discovery process.  Price is determined by supply and demand, the interaction of buyers and sellers.  The returns provide signals for funds allocations among investments;

2.  Liquidity.  Well-developed markets provide an opportunity to convert a financial asset into cash at close to real value of the asset;

3.  Reduced transactions costs. In the price discovery process, searching for counter parties and information costs (assessing merits of an investment or the likelihood of expected cash flows) are costly. An informationally efficient market exists when prices reflect all information known by market participants.

Classification of Financial Markets

There are various ways to classify financial markets.

Maturity of claim. Money market for financial instruments a year or less to maturity.  Capital market for securities longer than a year.

Seasoning of claim. Primary market is for new or first issue market.  Secondary market involves sales of previously marketed claims.

Time of delivery. While prices are set immediately, the actual delivery of the financial asset may be now (spot or cash market) or later (futures or forward market).

Organizational structure. Auction market involving brokers acting for clients in organized exchanges, over-the-counter markets (OTC) wherein trades are made through dealers who buy for and sell from their own inventory.  In intermediated markets, financial institutions sell their own securities issues to customers and invest the proceeds.

Market Participants

Participants run the full range, from households, non-financial business firms, financial institutions, and public regulators.

GLOBALIZATION OF FINANCIAL MARKETS

The existence of foreign financial markets permits raising and investing funds outside of the domestic market.  There is a trend toward integration of financial markets throughout much of the world.  The factors that have led to integration are:

1.  Deregulation or liberalization of markets to encourage competition;

2.  Technological advances permit more information flows and rapid execution of orders;

3.  Increased participation of financial institutions in global markets relative to individuals.  Such firms are more willing and able to transfer funds to diversify their portfolios and to take advantage of possible mis-pricing in markets.

Classification of Global Financial Markets

Financial markets can be classified as either internal or external.

Internal:  securities issued in the domestic or foreign markets.  Foreigners can issue securities in other country markets, subject to national regulations, e.g., Japanese firms can issue dollar-denominated securities in the United States, but they must follow U.S. regulations, which apply to nationals and foreigners alike.

External:  securities issued outside jurisdiction of any country, e.g., offshore or Eurodollar offerings can be dollar-denominated.  They thereby fall outside of foreign rules, which are designed to deal with domestic financial concerns. The external market is sometimes called the offshore market or Euromarket.

Motivation for Foreign and Eurodollar Markets

Some funds needs cannot be met in small country markets, e.g. giant firm Philips cannot raise all the funds it needs if it is restricted to the Dutch capital market.  Also, many underdeveloped nations simply do not have a sizeable capital market to meet their funds needs.

Lower funding costs when imperfections exist among capital markets, e.g. Eurodollar loans are often less expensive since institutions holding such funds are not hampered by regulations as would be the case in the U.S. market.

DERIVATIVE MARKETS

A derivative instrument is a financial asset whose value derives from the value of some other asset, index, or interest rate. A futures transaction is a contract that exchanges an asset or commodity at a fixed price in the future. In an option, owner has right but not the obligation to buy (call option) or sell (put option) an asset at a specified price. In a swap, parties exchange one form of cashflow for another, typically a fixed cashflow for a variable one.

Role of Derivative Instruments

Derivatives have several uses: (1) hedging interest rate risk and foreign exchange risk; (2)  lower transactions costs than on cash market; (3) faster transactions than on the cash market; (4) greater liquidity than on the cash market.

ROLE OF THE GOVERNMENT IN FINANCIAL MARKETS

Justification for Regulation

The government plays a significant role in the financial markets. It regulates the financial markets. One justification for regulation is market failure, when the market’s pricing mechanism is incapable of maintaining all the requirements of a competitive, efficient market. Regulation has several purposes: (1) to prevent issuers of securities from defrauding investors; (2) to promote competition and fairness in trading; (3) to promote the stability of financial institutions; (4) to restrict the activities of foreign concerns in domestic markets and institutions; (5) to control the level of economic activity.

Disclosure regulation is the form of regulation that requires issuers of securities to make public a large amount of financial information to investors. This addresses the problem of asymmetric information and the problem of agency.

Financial activity regulation consists of rules on trading financial assets.

Regulation of financial institutions is that form of governmental monitoring that restricts these institutions’ activities in the vital areas of lending, borrowing and funding.

Regulation of foreign participants is that form of governmental activity that limits the roles foreign forms can have in domestic markets and their ownership or control of financial institutions. Authorities use banking and monetary regulationto try to control changes in a country’s money supply.

Regulation in the United States

Regulation in the United States is largely due to the stock market crash of 1929 and the Great Depression of the 1930s.

ANSWERS TO QUESTIONS FOR CHAPTER 1

(Questions are in bold print followed by answers.)

1. What is the difference between a financial asset and a tangible asset?

A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital equipment and machines.  A financial asset, which is an intangible asset, represents a legal claim to some future benefits or cash flows.  The value of a financial asset is not related to the physical form in which the claim is recorded.

2. What is the difference between the claim of a debtholder of General Motors and an equityholder of General Motors?

The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal.  The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder.

The equity holder has a residual claim to assets and income.  He can receive funds only after other claimants are satisfied.  Income is in terms of dividends, the amount and timing of which are not certain.

3. What is the basic principle in determining the price of a financial asset?

The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows.

4. Why is it difficult to determine the cash flow of a financial asset?

The estimation and determination of cash flows is difficult because of several reasons.  These include accounting measures, possibility of default of the issuer, and embedded options in the security.  Interest payments can also change over time.  There is uncertainty as to the amount and the timing of these payments.

5. Why are the characteristics of an issuer important in determining the price of a financial asset?

The characteristics of the issuer are important because these determine the riskiness or uncertainty of the expected cash flows.  These characteristics, which determine the issuer’s creditworthiness or default risk, have an impact on the required rate of return for that particular financial asset.

6. What are the two principal roles of financial assets?

The first role of financial assets is to transfer funds from surplus spending units (i.e. persons or institutions with funds to invest) to deficit spending units (i.e. persons or firms needing funds to invest in tangible assets).

The second role is to redistribute risk among persons or institutions seeking and providing funds.  Funds providers share the risks of expected cash flows generated by tangible assets.

7.  In September 1990, a study by the U.S. Congress, Office of Technology Assessment, entitled “Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,” included this statement:

Securities markets have five basic functions in a capitalistic economy:

a.      They make it possible for corporations and governmental units to raise capital.

b.      They help to allocate capital toward productive uses.

c.       They provide an opportunity for people to increase their savings by investing in them.

d.      They reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers.

e.       They generate employment and income.

For each of the functions cited above, explain how financial markets (or securities markets, in the parlance of this Congressional study) perform each function.

The five economic functions of a financial market are: (1) transferring funds from those who have surplus funds to invest to those who need funds to invest in tangible assets, (2) transferring funds in such a way that redistributes the unavoidable risk associated with the cash flow generated by tangible assets, (3) determining the price of financial assets (price discovery), (4) providing a mechanism for an investor to sell a financial asset (to provide liquidity), and (5) reducing the cost of transactions.

The five economic functions stated in the Congressional Study can be classified according to the above five functions:

1.      “they make it possible for corporations and governmental units to raise capital” --functions 1 and 2;

2.      “they help to allocate capital toward productive uses” -- function 3;

3.      “they provide an opportunity for people to increase their savings by investing in them” -- functions 1 and 5;

4.      “they reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers” --function 3;

5.      “they generate employment and income” -- follows from functions 1 and 2 allowing those who need funds to use these funds to create employment and income opportunities.

8. Explain the difference between each of the following:

a.      money market and capital market

b.      primary market and secondary market

c.       domestic market and foreign market

d.      national market and Euromarket

a.       The money market is a financial market of short-term instruments having a maturity of one year or less.  The capital markets contain debt and equity instruments with more than one year to maturity;

b.      The primary market deals with newly issued financial claims, whereas the secondary market deals with the trading of season issues (ones previously issued in the primary market);

c.       The domestic market is the national market wherein domestic firms issue securities and where such issued securities are traded.  Foreign markets are where securities of firms not domiciled in the country are issued and traded;

d.      In a national market securities are traded in only one country and are subject to the rules of that country.  In the Euromarket, securities are issued outside of the jurisdiction of any single country.  For example, Eurodollars are dollar-denominated financial instruments issued outside the United States.

9. Indicate whether each of the following instruments trades in the money market or the capital market:

a.      General Motors Acceptance Corporation issues a financial instrument with four months to maturity.

b.      The U.S. Treasury issues a security with 10 years to maturity.

c.       Microsoft Corporation issues common stock.

d.      The State of Alaska issues a financial instrument with eight months to maturity.

a.       GMAC issue trades in the money market.

b.      U.S. security trades in the capital market.

c.       Microsoft stock trades in the capital market.

d.      State of Alaska security trades in the money market.

10. A U.S. investor who purchases the bonds issued by the government ofFrance made the following comment: “Assuming that the French government does not default, I know what the cash flow of the bond will be.” Explain why you agree or disagree with this statement.

One would tend to disagree with this statement.  Even though there is no default risk with French bonds issued by the government, some other risks include price risk and foreign exchange risk.

11. A U.S. investor who purchases the bonds issued by the U.S. government made the following statement: “By buying this debt instrument I am not exposed to default risk or purchasing power risk.” Explain why you agree or disagree with this statement.

This is not true.  There is no default (credit) risk of U.S. government securities.  However, it is not free of purchasing power or inflation risk.  There is also price risk, which is related to maturity of any bond.

12. In January 1992, Atlantic Richfield Corporation, a U.S.-based corporation, issued $250 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

The corporate bonds issued by Atlantic Corporation are in the domestic market, but the investors can also be from foreign markets.

13. In January 1992, the Korea Development Bank issued $500 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

This issue can be classified as a domestic issue.

14.       14. Give three reasons for the trend toward greater integration of financial markets throughout the world.

There are several reasons.  These include:

a.       Deregulation and/or liberalization of financial markets to permit greater participants from other countries;

b.      Technological innovations to provide globally-available information and to speed transactions;

c.       Institutionalization -- financial institutions are better able to diversify portfolio and exploit mis-pricings than are individuals.

15. What is meant by the “institutionalization” of capital markets?

The term “institutionalization” refers to the dominance of large institutional investors such as pension funds, investment companies, banks, insurance companies, etc. in the money and capital markets.

16.a. What are the two basic types of derivative instruments?

b. “Derivative markets are nothing more than legalized gambling casinos and serve no economic function.” Comment on this statement.

a.       The two basic types of derivative instruments are futures and options contracts.  They are called derivatives because their values are derived from the values of their underlying stocks or bonds.

b.      The statement implies that derivative instruments can be used only for speculative purposes.  Actually, derivatives serve an important economic function by permitting hedging, which involves shifting risks on those individuals and institutions (speculators) that are willing to bear them.

17. What is the economic rationale for the widespread use of disclosure regulation?

The economic rationale is that disclosure mitigates the potential for fraud by the issuer. Typically, there information asymmetry between the issuer (management) and the investors, and disclosure regulation mitigates the harm to investors that could result from this informational disadvantage. As a result, there is confidence in the market and the pricing mechanism of the market.

18. What is meant by market failure?

Market failure occurs when the market cannot produce its goods or services efficiently. In the context of financial market failure, it occurs when the pricing mechanism fails and thus the supply and demand equilibrium is disrupted. This results in failure to price securities efficiently and reduced liquidity.

19. What is the major long-term regulatory reform that the U.S.Department of the Treasury has proposed?

The long-term proposal is to replace the prevailing complex array of regulators with a regulatory system based on functions. Specifically, there would be three regulators: (1) market stability regulator, (2) prudential regulator, (3) business conduct regulator.

20. Why does increased volatility in financial markets with respect to the price of financial assets, interest rates, and exchange rates foster financial innovation?

Increased volatility of the prices of financial assets has fostered innovation as investors and institutions seek ways to mitigate financial risk. Among other things, these innovations include the advancement of the modern derivatives markets.