Financial Markets

Financial Markets
On the evening news you have heard that the bond market or stock market have been booming.
Does this mean that interest rates will fall so that it is easier for you to finance the purchase of a new computer system for your retail business?
Will the economy improve in the future so that it is a good time to build a new building or add to the one you are in?
Should you try t use to raise funds u issuing stock or bonds, or instead go to the bank for a loan?
If you improve goods from abroad should you be concerned that they will become more expense or your exports cheap?

Financial markets
Channels funds from savers to investors, thereby promoting economic efficiency.
Affects personal wealth and behavior
of business firms.
Debt markets, or bond markets, allow governments, corporations, and individuals to borrow and to finance activities.
There is a strong relationship between these markets and interest rates.

Financial markets
The stock market is the market where stock, representing ownership in a company, are traded.
Of all the active markets, it receives the most attention, probably because it is
the place where people get rich (and
poor) quickly.
The foreign exchange market is where international currencies trade and exchange rates are set.
Although most people know little about this market, it has a daily volume around
$1 trillion!

Pooling and channeling of funds
Copyright © 2003 Pearson Education, Inc.

Structure of Financial Markets
Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:
Provide liquidity, making it easy to buy and sell the securities of the companies
Establish a price for the securities.

Structure of Financial Markets
We can further classify secondary markets as follows:
Exchanges
Trades conducted in central locations
(e.g., New York Stock Exchange, CBT)
Over-the-Counter Markets
Dealers at different locations buy and sell
Best example is the market for Treasury securities
www.treasurydirect.gov

Interest rates
We develop a better understanding of interest rates. We examine the terminology and calculation of various rates, and we show the importance of these rates in our lives and the general economy. Topics include:
Measuring Interest Rates
The Distinction Between Real and Nominal
Interest Rates (Fisher equation => i ( r) = i – П) => 1+ i = (1+i ( r) ) + (1 + П)
The Distinction Between Interest Rates and Returns

Maturity and the Volatility
of Bond Returns
Only bond whose return is equals the yield to maturity is the one whose time to maturity is the same as the holding period
For bonds with maturity longer than its holding period, when i ↑ then P ↓ implying capital loss.
The Longer is maturity, the greater is the bond’s price change associated with interest rate change.
The longer is a bond to its maturity, the lower the rate of return associated with the increase in the interest rate.
Bond with high initial interest rate can still have negative return if i ↑
Prices and returns more volatile for long-term bonds because have higher interest-rate risk
No interest-rate risk for any bond whose maturity equals holding period

Reinvestment Risk
Occurs if an investor’s holding period is longer than the term to maturity of the bond, since the i at the time of reinvestment is uncertain.
If the holding period is longer than the term to maturity of the bond, then (2.1) the investor gain from i ↑, (2.2) lose when i ↓

Calculating Duration
i = 20%, 10-Year 10% Coupon Bond

Formula for Duration
Key facts about duration
All else equal, when the maturity of a bond lengthens, the duration rises as well
All else equal, when interest rates rise, the duration of a coupon bond fall
The higher is the coupon rate on the bond, the shorter is the duration of the bond
Duration is additive: the duration of a portfolio of securities is the weighted-average of the durations of the individual securities, with the weights equaling the proportion of the portfolio invested in each
The greater is the duration of a security, the greater is the percentage change in the market value of the security for a given change in interest rates
Therefore, the greater is the duration of a security, the greater is its interest-rate risk

Why interest rates change?
Determinants of asset demand
Wealth – total resources owned
Expected returns – return expected over the next period on one asset compared other assets
Risk – degree of uncertainty associated with r
Liquidity – ease and speed of converting assets to $
Supply and demand in the bond market
Demand Curve
Supply Curve
Market Equilibrium
Supply and demand analysis
Changes in equilibrium interest rates

Expected returns
Is the return expected over the next period on one asset relative to alternative assets
Re = p1R1 + p2R2 + ... + pnRn
Re – Expected return
n- number of possible outcomes
Ri- return in the i-th state of nature
p1 – probability of occurrence of the return Ri
An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset

Risk
The degree of uncertainty associated with the return on one asset relative to alternative assets
Standard deviation as a measure of risk
Holding everything else constant, If an asset’s risk rises relative to that of alternative asset, its quantity demanded will fall

Changes in Equilibrium Interest Rates
Shifts in the Supply of Bonds
Expected profitability of investment opportunities: In a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right. In a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls, and the supply curve shifts to the left
Expected inflation: An increase in expected inflation causes the supply of bonds to increase and the supply curve shifts to the right
Government budget: Higher government deficits increase the supply of bonds and shift the supply curve to the right. Government surpluses decrease the supply of bonds and shift the supply curve to the left

How do risk and term structure affect interest rates?
Risk structure of interest rates
Interest rates on different categories of bond differ from one another in any given year
The spread between interest rates varies over time
Default risk
Term structure of interest rates
Expectations theory
Market segmentation theory
Liquidity premium theory

Default Risk
A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium

Term structure of interest rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Yield curve- a plot of the yields on bonds with differing terms to maturity but the same risk, liquidity and tax considerations. It describes the term structure of interest rates for particular types of bonds.
upward sloping, flat, downward sloping (inverted yield curve)

Expectations theory
Proposition: the interest rate on long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the long-term bond
Key assumption: buyers of bonds do not prefer bonds of one maturity to another. If bonds with different maturities are perfect substitutes, the expected return on these bonds must be equal
Market segmentation: Markets for different-maturity bonds are completely separate and segmented

Efficient Market Hypothesis
The Efficient Market Hypothesis
Stronger Version of Efficient Market Hypothesis
Evidence on the Efficient Market Hypothesis
Evidence Against Market Efficiency
Behavioural Finance

The Efficient Market Hypothesis
The prices of securities in financial markets fully reflect all available information

Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return.

Rationale behind the hypothesis
Arbitrage, in which market participants (arbitrageurs) eliminate unexploited profit opportunities, i.e., returns on a security that are larger than what is justified by the characteristics of that security.
Pure arbitrage – no risk
In an efficient market, all unexploited profit opportunities will be eliminated
Not everyone in a financial market must be well informed about a security or have rational expectations for its price to be driven to the point at which the efficient market condition holds

Dynamics of crises
Stage one (initiation)
Financial liberalization (credit boom)
Asset price boom and bust
Spikes in interest rates
Increase in uncertainty
All of the above worsen the adverse selection and moral hazard
Stage two (banking crises)
Economic activity declines
Banking crisis (balance sheet, panic,
Adverse selection and moral hazard problems worsen
Stage three
Debt deflation

Top 10 causes of crisis
Credit bubble (developing countries building up large capital surpluses (post-Asia crisis) and lend to US and Europe, causing interest rates to fall – credit spreads narrowed – cheap to finance risky investments – increased investments to high-risk mortgages – US monetary policy (post Internet bubble contributed)
Housing bubble – 1990-2000s – large sustained housing bubble in the US
Nontraditional mortgages – tightened credit spread – optimistic outlook for house prices – (flood of credit to US + poor origination standards) – led to high risk investment to non-traditional mortgages – mortgage sellers deceived home buyers, who made poor financial decisions and borrowed beyond their ability to pay
Credit rating and securitization – Credit rating failures + securitization – led to toxic assets – buyers failed to do proper due diligence
Financial institutions concentrated correlated risk - Concentrated exposure to one asset class (knowingly +unknowingly)

Causes contd.
Leverage and liquidity risk – too little capital to offset higher risk – reliance on repo market for short-term liquidity
Risk of contagion – too big to fail – one fail can lead to another fails
Common shock – Failed bets on housing – unconnected financial firms failed
Financial shock and panic – Problem in large 10 firms triggered finance panic – confidence and trust in the financial system began to evaporate – asymmetric information
Financial crisis causes economic crisis – severe contraction in the real economy, until today

Post-crisis regulation
Oversight and supervision of financial institutions (Special Council to monitor systemic risks (leverage, liquidity and contingent capital)
Creation of new agencies
Stringent regulatory capital requirements (SEC)
Over the counter derivatives (clearing, counterparties)
Credit rating agencies regulation
Corporate governance and executive compensation practices (proper incentives and voting on bonuses)
Volcker Rule (no prop. trading, owning, sponsoring or investing in hedge or PE funds)
Registration of advisers to private funds (Ponzi schemes)
Securitization market changes (more of credit risk is retained)

Why do we need Central Banks?
Prevent banking crisis
Stability of financial sector
Ensuring deposits
Providing macroeconomic stability
Monetary policy

Goals of Monetary Policy
6 Goals
Inflation targeting
High employment
Economic growth
Stability of financial markets
Interest-rate stability
Foreign exchange market stability
Goals often in conflict (inflation and employment and economic growth)

Taylor Rule
It is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions.
In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point.
The rule was first proposed by the U.S. economist John B. Taylor in 1993. It is intended to foster price stability and full employment by systematically reducing uncertainty and increasing the credibility of future actions by the central bank.

Ch. 11
The Money Markets

Today’s Lecture Overview
The Money Market: definition, purpose and participants
Money Market’s instruments:
The Treasury Bills
Federal Funds
Repurchased agreements
Negotiable CDs
Commercial papers
Bank acceptance
Eurodollars
Money market mutual funds

Page 296
Copyright © 2003 Pearson Education, Inc.
Slide 8–

The Money Markets
Money Market’s securities:
Maturity is less than 1 year and liquid
Money market securities are usually sold in large denominations:
Wholesale markets ($1MM)
They have low default risk
Have an active secondary market (liquid)
Telecommunications, terminals and etc.

Purpose of Money Markets
Investors: the money markets provide a place for warehousing surplus funds for short periods of time.
Borrowers: the money markets provide a low-cost source of temporary funds.
Money market Rates (Prime rate – 3.25%, Federal funds – 0.19%, Commercial paper – 0.23%, 1 month CDs – 0.23%, LIBOR – 0.45%, Eurodollar – 0.30%, T-bills – 0.16%)

Participants in Money Markets
Government’s Treasury (e.g. US Treasury Department)
Central Bank (e.g. Federal Reserve System)
Commercial Banks
Money center banks
Businesses
Investment and Securities Firms
Investment companies: market-makers in the money markets instruments
Finance companies
Insurance companies
Pension funds
Individuals
(mostly through money market mutual funds)

Money Market Instruments
Treasury Bills
Federal Funds
Repurchase Agreements
Negotiable Certificates of Deposit
Commercial Papers
Banker’s Acceptances
Eurodollars
Money market mutual funds

Treasury Bills
Short-term borrowings of the federal government (31 days, 182 days, 12 months maturity)
Sold at discount
Zero default risk
Deep market
Liquid market
Sold through the Treasury Bills auctions

Discounting Example
You pay $9850 for a 91-day T-bill. It is worth $10,000 at maturity. What is its annualized yield?
(1)

Treasury Bill Auctions
Every Thursday, the Treasury announces how many 91-days and 182-days Treasury bills are offered for sale. 12 months Treasury bills are offered only once per month.
Competitive and non-competitive bids are available
If you submit competitive bid, you must state the amount of securities desired and the price you are willing to pay
If you submit non-competitive bids you state only the desired amount of securities.

Treasury Bill Auction
Competitive bids are satisfied starting from the lowest yield to highest or alternatively from the highest price to the lowest
All noncompetitive bids will be satisfied, but at the auction price
Auction price is the weighted average of all accepted competitive bids
Regulation for competitive bids: no one dealer is allowed to buy more than 35% of any issue.

Example: Treasury Bill Auctions
The Treasury auctioned $2.5 billion par value 91-day T-bills, the following bids were received:
Bidder Bid Amount Bid Price per 100$ of face value
1 $500 million $99.40
2 $750 million $99.01
3 $1.5 billion $99.25
4 $1 billion $99.36
5 $600 million $99.39
The Treasury also received $750 million in noncompetitive bids.
1) Who will receive T-bills, what quantity, and at what price?
2) What is the action price?

Treasury Bill Auctions Example
You have $1.750 BN left for competitive bids because all non-competitive will be satisfied but at auction price
(2.5 bill – 0.750 bill = 1.750 bill)
The Treasury accepts the following bids starting from the highest price:
Bidder Bid Amount Bid Price
1 $500 million $99.40
5 $600 million $99.39
4 $650 million $99.36
Noncompetitive bidders pay the weighted-average price (auction price): $99.38 = (500 x $99.40 + 600 x $99.39 + $650 x $99.36 ) / 1,750

Federal Funds
Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day.
Fed funds are usually overnight investments.
Most fed funds borrowings are unsecured.
Federal Funds Rate is the interest rate on the overnight loans of reserves from one bank to another.
Fed funds rate is determined by the supply and demand for the funds.

Repurchase agreements (Repos)
Repo is a securities sale contract with an agreement to repurchase them back at a pre-specified date in future.
It is similar to a short-term collateralised loan.
“To repo” = to sell the securities (collateral) = to borrow money
“To depo” = to buy the securities (collateral) = to lend money
Inverse Repos (Depos) – a securities purchase contract with the agreement to sell them back at a pre-specified date in future.
Repos are usually secured by the T bills.
The maturities of repos can vary.
Banks and non bank firms can participate.
Interest rate on Repos is determined by the parties.

KAZAKHSTAN REPOs:
Government securities and the private A-rated (at KASE) securities can be transacted and serve as collateral.
Maturities of the Repos : 1,2,3,7,14 and 28 days.
Repo currency: KZT
At maturity you have to repurchase the securities back paying interest to the holder.

Repo formula
Pc = (i/365) x n x (P0/100) + P0 , were
Pc = closing price
I = annual interest rate on Repos
N = maturity in days
P0 = opening price (or the current price of the security)

Example of the Repo transaction
BTA needs a one day funds of $10 MM and enters Repo with Kazkom
BTA sells Kazkom a specified amount of securities for L =
$10 MM with the agreement to purchase them back the following day for L + I.
Kazkom lends L = $10 MM to BTA and receives L+I from BTA in the following day.
If the Repo interest rate is 3.2%, what will be L+I amount?
(L+I) = Pc = (i/365) x n x (P0/100) + P0 =
= (3.2/365) * 1 * ($10 MM/100) + $10 MM =
= $10,000,877.
Kazkom will receive $10,000,877

Negotiable Certificates of Deposit
A bank-issued security that documents a deposit and specifies the interest rate and the maturity date.
Considered as the bearer instrument: whoever holds the instrument at maturity receives the principal and interest.
The CD can be bought and sold until maturity.
Denominations range from $100,000
to $10 million
Typical maturity is from 1 to 4 months.
The interest rate on CDs are negotiated between the bank and the customer.

Commercial Paper
Unsecured promissory notes, issued by corporations, that mature in no more than
270 days.
Issued by the largest and most creditworthy corporations.
The interest rate on the corporation is charged reflects the firm’s level of risk.
Have relatively low default risk.
Most commercial papers are issued at discount basis.
There is no strong secondary market for commercial papers.

Banker’s Acceptances
A banker’s acceptance is an order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods.
They are used to finance goods that have not been transferred from the seller to the buyer.
Because banker’s acceptances are payable to the bearer, they can be bought and sold until they mature.
They are sold on a discounted basis.
To discount a banker’s acceptance = to sell it for immediate payment.
In the US only large money center banks are involved in this market and => the risk of BAs default is low => their interest rates are low

Exporter (Seller)
Exporter‘s Bank
Importer’s Bank
Importer (Buyer)
(2) Equipment
(6) Payment
at maturity
Letter of
Credit (LC) (1) LC
(1) LC
(5) Sell the bank acceptance at
discount to the secondary market to
Collect the payment
(3)
Time draft
and
documents
(4) Accepted
Time draft
(3) Time draft
and
documents

Advantages of Banker’s Acceptances
Essentially, without the banker’s acceptances many international trade transactions would not occur because the parties would not feel properly protected from losses.
Exporter paid immediately
Exporter shielded from foreign exchange risk
Exporter does not have to assess the financial security of the importer
Importer’s bank guarantees payment

Eurodollars
Dollar denominated deposits held
in foreign banks
Time deposits with fixed maturities
Largest short term security in the world
London interbank bid rate (LIBID)
The rate paid by banks buying funds
London interbank offer rate (LIBOR)
The rate offered for sale of the funds

Money Market Mutual Funds
Money market mutual funds (MMMF) are open-edned investment funds that invest only in money market securities.
Most funds do not charge investors any fee for purchasing or redeeming shares.
Many MMMF have check-writing privileges.
Most brokerage firms contract with banks to provide the check processing facilities.
The risk of MMMF is low because the funds are invested in the money market instruments

Page 316
Copyright © 2003 Pearson Education, Inc.
Slide 8–

Next week read chapters
12 Bond Market
13 Stock Market

Basel Accords (Macro prudential)
Basel III (or the Third Basel Accord) is a global, voluntary regulatory standard on bank capital adequacy, stress testing and market liquidity risk.
As of September 2010, proposed Basel III norms asked for ratios as: 7–9.5% (4.5% + 2.5% (conservation buffer) + 0–2.5% (seasonal buffer)) for common equity and 8.5–11% for Tier 1 capital and 10.5–13% for total capital.
Capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points.
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings), but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital.

News
Slide 8–