1b fanancial markets Flashcards
monetary policy instruments
1) conventional (e.g. setting interest rates)
2) nonconventional (e.g. quantitative easing)
non-financial firm’s balance sheet
- assets
1. current assets
2. investments
3. property, plant, equipment
4. intangible assets
5. other assets - liabilities
1. current liabilities
2. long-term liabilities
3. capital (equity)
bank’s balance sheet
- assets
1. cash
2. securities
3. loans
4. other assets - liabilities
1. deposits
2. interbank market
3. capital
4. profit
bank’s profit & loss statement
- costs
1. profit - revenues
types of financial markets
- the bond market
(interest rates are determined) - the stock market
(has a major effect on people’s wealth and on firms’ investment decisions) - the foreign exchange market
(fluctuations in the foreign exchange rate have major consequences for an economy)
bond
is a security that promises to make payments periodically for a specified period of time
are financial debts of corporates (corporates bonds) and sovereigns (sovereign bonds)
long-term treasury bonds vs short-term treasury bills
types of bonds
according to:
1. coupon
zero-coupon vs coupon bonds
2. coupon-rate variability
floating-rate vs fixed-rate bond
3. issuer
public sector vs financial institutions vs companies
4. embedded options
callable vs putable vs convertible bonds
5. maturity
short-term vs medium-term vs long-term
security/stock
is a claim on the issuer’s future income or assets
share of stock
is a security that has a claim on the earnings and assets of the corporation - a residual claim on funds not otherwise committed
stock market
claims on the earnings of corporations (shares of stock) are traded in the stock market
it is the most widely followed financial market in an economy
stock markets are very volatile
stocks and bonds in the balance sheet
- investments (stocks and bonds bought)
- current liabilities (short-term bonds issued)
- long-term liabilities (long-term bonds issued)
- equity (stocks issued)
the best instrument for an investor
stocks
risk-return relationship
low risk low return bills
low risk medium return bonds
high risk high return stocks
triangle of investing
liquidity
rate of return
risk
bull/bear market
- bull = rise
optimism, prices going up - bear = decline
pessimism, prices going down
overvalued stocks
if the Price-to-earnings (p/e) ratio is above the long-term average
foreign exchange markets
the FX market is where currency conversion takes place -> instrumental in moving funds between countries
The foreign exchange rate
FX rate= the price of one country’s currency in terms of another’s is determined
functions of financial markets (8)
- allow a fund transfer from surplus to deficit entities
- capital allocation and the reallocation of capital according to its efficiency (e.g. project selection)
- securing the liquidity of financial assets and through the allocation efficiency of financial markets create prices continuously
- enforcement of contracts, debtors must repay their debts
- cost efficiency - financial markets lower costs of the payment system and financial transactions in general (so called operational efficiency)
- support for ownership rights performance in the principal-agent model, sometimes also called the financial model
- risk sharing - FMs enable the allocation, transfer and share of risk with other investors and companies (vs subprime crisis/CDOs…)
- risk diversification - with respect to expected CF from different projects
classifications of financial markets by financial instruments
- debt markets
-short-term (<1 year)
-mid-term (1-10)
-long-term (>10) - equity markets
-common stocks
-securities are assets for holders, but liabilities for issuers
-risky = high profit/loss potential
classifications of financial markets by tradability of the issue of an instrument
- Primary Market
- New security issues sold to initial buyers
- Initial Public Offering (IPO) vs. Initial Coin Offering (ICO) - Secondary Market
- Securities previously issued are bought and sold
- Investment banks are important
- Brokers (agents of investors who match buyers with sellers of securities/other name) vs. Dealers (link buyers and sellers by buying and selling securities at stated prices/own name).
Largest Global IPOs
- Aramco: $25.6bn (2019)
- alibaba (2014) ≈ $25bn
- softbank (2018) ≈ $20bn
a company with highest profit (2018)
Saudi Aramco
profit ($111,1bn) = apple + google + exxon mobil
classifications of financial markets
- by financial instruments
- by tradability of the issue of an instrument
- by maturity
- by organization of the Secondary Market
classifications of financial markets by maturity (in the USA)
- Money Market (< 1-year debt instruments)
- U.S. Treasury bills (short-term)
- Negotiable bank certificates of deposit (large denominations)
- Commercial papers
- Federal funds and security repurchase agreements - Capital Market (>1-year debt instruments and equity)
- Corporates (stocks and bonds)
- U.S. government securities (long-term), U.S. government agency securities, State and local government bonds
- Bank loans (bank commercial loans, Consumer loans, Residential mortgages, Commercial and farm mortgages)
classifications of financial markets by organization of the Secondary Market
- Exchanges
- Trades conducted in central locations (NYSE, NASDAQ, LSE) – see the next slide
- Exchange = single price (buy price = sell price)
- In the Czech Republic: Prague Stock Exchange (PSE)
www.pse.cz - Over-the-Counter (OTC) Markets
- Securities dealers at different locations buy and sell
- OTC = usually two prices (buy price and sell price)
- Derivatives (notinal value vs gross market value).
- Regulation of OTC markets/Central Counter Party (CCP)
TOP 10 world stock exchanges
(name, country, market capitalisation)
1 New York Stock Exchange
(US, 22,9 trillion)
2 NASDAQ
(US, 10.8 trillion)
3 Tokyo Stock Exchange
(Japan, 5.67 trillion)
4 Shanghai Stock Exchange
(China, 4.02 trillion)
5 Hongkong Stock Exchange
(Hongkong, 3.93 trillion)
6 Euronext
(Eurozone, 3.92 trillion)
7 London Stock Exchange
(UK, 3.76 trillion)
8 Shenzhen Stock Exchange
(China, 2.5 trillion)
9 Toronto Stock Exchange
(Canada, 2.1 trillion)
10 Bombay Stock Exchange
(India, 2.05 trillion)
The financial theory in last 50 years
1950s-2007: a very dynamic development in financial markets and banking
◦ Trend 1: liberalisation and the global integration of financial markets and banks,
◦ Trend 2: increasing sophistication, complexity and inter-connectedness
Reasons:
1) the intellectual underpinning of economic arguments for free markets,
2) international division of labour,
3) globalisation,
4) advances in financial theory and the related improvements in statistical estimation methods.
Practical implications
◦ the development of new analytical tools and techniques to price new products and their risk
7 milestones
1) Porfolio theory (Markovitz, 1952; 1991)
2) The CAPM model (Sharpe, 1964)
3) Interest Rate Structure Theory (Malkiel, 1966; Melino, 1988; Vasicek 1977)
4) Capital Structure Theory (Modigliani & Miller, 1958)
5) Agency Theory (Jensen & Meckling, 1976; Akerlof, 1970)
6) Efficient Market Theory (Alexander, 1964; Fama, 1970)
7) Option Pricing Theory (Black & Scholes, 1973)
The CAPM model
The Capital Asset Pricing (CAPM) model was developed by Sharpe (1964) is based on the Markowitz Model but supplemented with additional assumptions.
-Extension: An international (I-CAPM) model (Engel & Rodrigues, 1989)
- Strong Critique of the CAPM: (Ross, 1978, Miller, 1999, Dempsey, 2013)
- Dempsey (2013) argues that after the experiences of the recent financial crisis the CAPM and the theory of efficient markets may need to be replaced with a paradigm of markets as vulnerable to capricious behaviour
The CAPM
1) specifies market standard for risk/E(r) relationship
2) shows that the cost of equity capital is determined only by beta
3) despite its weaknesses it still remains popular due to its simplicity and utility in a variety of situations
difficulty with the Markowitz model and it’s simplification
- One of the difficulties with the Markowitz Model is that it requires
the estimation of a variance-covariance matrix, which becomes very big if the number of available securities in the investor’s investment universe is high. - Sharpe simplified the cumbersome estimation procedure by assuming that the returns of individual securities are only interrelated through their sensitivity to a common factor, typically the return of a broad market index
- Sharpe further assumed that all investors are able to lend and borrow at the risk-free interest rate, that they agree on the shape of the efficient frontier, and that transaction costs are absent.
- Under these simplifying assumptions, all investors will select a combination of the market portfolio and the risk-free asset (or borrow at the risk-free interest).
- All portfolios will lie on the “Capital Market Line”, and the slope of this line indicates the price of risk as determined by the market.
“betas” of the CAPM model
measure the sensitivity of the individual stock to movements in the return on the stock market as a whole
Sharpe Ratio
defined as the historical return of a portfolio minus the risk-free interest rate and divided by the standard deviation of the portfolio return is used by investment advisers and mutual funds all over the world. Together with other indicators, the Sharpe Ratio is used in evaluation of the performance of mutual funds and other portfolio managers.
Beta as a measure of sensitivity
Beta = a measure of sensitivity of a share price to movement in the market price (i.e. whether the investment is more or less volatile than the market)
= measure of systematic risk
B>1 aggressive portfolio or security (more risky than market portfolio)
B<1 defensive portfolio or security
In real world: almost all firms have beta>0, on average beta=1
Define beta
Define B = Covariance of i-th share and market price / Portfolio (market) variance
The SML in the CAPM model
SML gives basic equation of CAPM, expresses the central idea of capital asset pricing model (CAPM) model: E(ri)=rf+[E(rm)-rf]Bi
Market risk premium= E(rm)-rf
- Beta=measure of systematic risk
- In equilibrium all securities and portfolios exactly on SML
Recent global trends in finance
1) Digitalization (IT financial ecosystem)
2) Commoditization (products = commodities, customers rely on prices, increasing role of price comparators)
3) Globalisation (fierce competition, technology disrupters)
banking in the cloud
- lending club
- tesco bank
- paypal
Importance of global political governance
- principal
- agents (gives money to principal)
- principal’s target (voter, gives money to agents)
3 terms describing financial market
Who will pay?
1) Planet Ponzi
2) Zombie banks
3) Uroboros
Result: Recurring financial crises!
Who will pay?
- Politicians? Focus on voters/short-term targets
- Financial firms? Focus on profit maximization
- Regulators? Lack of personal responsibility
- The taxpayer will pay as usual!
Ponzi (pyramid) scheme, planet
- Ponzi scheme = an investment swindle in which high profits are promised from fictitious sources and early investors are paid off with funds raised from later ones
- Ponzi Planet implies…
1) Unsustainable governments´ debt
2) Unsustainable social security systems
3) “Printing“ money (by central banks)
4) “Paper“ economic growth models
Zombie bank
✓ a zombie bank as a financial institution with:
i) a price-to-book value (P/BV) ratio < 1,
ii) a negative economic worth,
iii) mispriced assets and
iv) support by government´ bail-outs and guarantees.
✓ History of zombie banks: USA, Japan, the Eurozone
✓ Examples: Monte dei Paschi di Siena, Citibank, Deutsche Bank, Spanish cajas, German Landesbanken, RBS, Crédit Immobilier de France (these banks should have bankrupted rather than have been rescued for political reasons).
✓ Many zombie banks are still present in Japan, what gives a negative example to follow as these banks do not provide lending to the economy and therefore do not fullfil their basic function
✓ What about the current situation in the Italian banking sector?
UROBOROS for regulation, climate change and crises
short-term distorted thinking result in long-term catastrophic consequences
why are financial intermediaries here?
- Transactions Costs
▪ Examples: mutual funds, ExchangeTraded Funds (ETFs) - Risk sharing
▪ Example: portfolio diversification of a bank (retail clients, corporate clients, financial institutions) - Asymmetric information
▪ Types: moral hazard and adverse selection.
▪ Problem: Someone must have incentives to produce reliable
information.
📍Financial markets = about asymmetric information
📍Economics = about scarce resources
financial intermediaries
FI = institutions that borrow funds from people who have saved and in turn make loans to others.
Direct vs. indirect financing
▪️Direct financing – without financial intermediaries (P2P lending)
▪️Indirect financing – with financial intermediaries that help get funds from savers to investors (banks, insurers, pension funds)
scheme of Direct financing and Indirect financing
▪️lenders/savers (households, firms, government, foreigners)
fonds to ➡️
1. financial markets (direct) ➡️ lenders/savers
2. financial intermediaries (indirect) ➡️
a)lenders/savers
b)fin.markets ➡️ lenders/savers
TOP global financial intermediaries
Global assets under management (USD trillions) (2017)
- Exchange Traded Funds (4.5)
- Hedge funds (3.1)
- Private equity (5.5)
- Sovereign Wealth Funds (8.2)
- Insurance funds (24)
- Mutual funds (49.3)
- Pension funds (41.4)
- Bank deposits (75.2)
1-4 are Non-conventional (alternative) investment management assets
5-8 are Conventional investment management assets
Financial intermediaries vs blockchain
think
