FE - Lecture 1 Flashcards
The 5 components of the financial system?
- Participants
- Securities
- Markets
- Trading Arrangements
- Regulations
Participants in the financial system?
Firms maximize the sum of their current and future profits, i.e. maximize their long-term value
•Replacement investment: To replace obsolete equipment.
Households maximize the expected utility derived from their current and future consumption
Financial assets are a way to “smooth” consumption over time, taking into account:
•Uncertainty about the future (risk aversion)
•Preference for liquidity
How do firms fund investment?
- Retained earnings
- Bank loans
- New equity
- Bond issuing
3 Functions of FIs?
Maturity, transaction and risk transformation
What is maturity transformation?
Holding less liquid (long-term) assets issue more liquid (short-term) liabilities
What is Tranaction transformation?
Lower search costs
•Economies of scale
•Provision of standardized forms of securities
risk transformation?
Risky liabilities issued by the borrowers safe assets for primary lenders
•What does risky mean?
•Default/credit risk: Inability of borrower to repay loan and/or interest
•Equity risk: Failure of the investment made with loan
•Risk spreading (relative to default risk)
•Spreading a risky investment across a large number of lenders
•Risk pooling (relative to equity risk)
•Constructing portfolios of assets that exploit
2 types of FI’s?
Bank, non-bank
Bank FI’s?
Retail banks •Deal with households, small businesses •What they do: •Issue deposits •Make loans
Investment banks
•Deal with institutional investors, large corporations, governments, etc
•What they do:
•Corporate finance (corporate loans, bond issues, initial flotation, M&As, etc.)
•Asset management (private banking= managing long-term equity and bond portfolios for private and institutional clients)
•Agency brokerage & market-making
•Proprietary trading (trading activity on bank’s own account to make profits)
•Equity banking (bank makes a direct investment in a company)
•International investment advice
7 Non-BFIs?
Finance houses, Building societies, pension funds, instance companies, collective investment schemes, specialist FIs and market makers.
Role of finance houses?
finance short term durable expenditure of members of the household sector: hire purchase agreements (type of leasing agreement where the buyer pays a monthly rate to use the good and becomes the owner of the good at the end of the period)
Role of building societies?
finance long term durable expenditure of members of the household sector (mortgages)
Role of collective investment schemes?
investment trusts, unit trusts, open-end investment companies (OEIC)
•Large and complex portfolios of financial assets
•Value of portfolio divided in units (unit trusts)/ shares(investment trusts/ OEIC)
role of specialist FIs
Arbitrageurs(perform fundamental analysis and check for deviations from fair price)
•Hedgersusing futures, options (derivatives securities) they minimize the risk of their positions, e.g.
•Share prices falling
•Debt obligations’ interest going up
•Adverse forexmovements
•Speculatorstake views on prices
Role of market-makers
do not act as agents between end-users but they buy and sell securities for their own account
What are securities?
a claim on some underlying asset (financial or physical)
Main ways securities are separated
Issuer Currency of denomination Ownership and participation rights Collateral Maturity Income Payments Predictability of capital value Degree of liquidity/ reversibility Tax treatment Derivatives or not Composite securities or not
Securities: maturity
- Short-term (<1 year), long-term
- Callables, puttables(redeemable at the option of the issuer/ holder)
- Perpetuities (current and deposit accounts, perpetual bonds, preference shares, equity)
Securities: income payments
- Fixed or variable
- Monthly, quarterly (certain deposit accounts), semi-annual (government and local authority bonds), annually (eurobonds, certificates of deposit), etc
- No explicit payments: Sell at discount to their face value (Treasury bills, zero-coupon bonds, etc.)
Securities: predictability of capital
•Deposits (value of principal=certain), bonds (at maturity, capital value=certain), shares ( capital value is never certain)
Securities: issuer
- Domestic, foreign governments: government bonds=gilts
* Domestic, foreign corporations: corporate bonds, stock
Securities: Currency of denomination
Currency of denomination
•Domestic bonds (£ denominated, issued in the UK)
•Bulldog bonds (£ denominated, issued by a foreign issuer)
•Eurobonds (traded in the UK, but denominated in currencies other than £)
Securities: Ownership and participation rights (both profit + decision making)
- Common stock –ownership and participation
- Preference stock –just ownership
- Debt –none
Securities: Collateral
- Debentures: debt instrument for medium/ long term borrowing, securedagainst specific assets of the firm (UK)
- Unsecured
Securities: Degree of liquidity and degree of reversibility
- Liquidity: time and/or cost of converting a security into cash
- Reversibility: possibility to move cash-asset-cash, without high costs (bid-offer spread)
Securities: Tax treatment
- Income from securities (dividends, interests…) subject to income/corporation tax
- Capital gains tax
Securities: Are they derivatives?
- Derivative: Delivers a security (underlying asset) at some future time
- Financial futures, options, etc.
Securities: Do they involve composite securities?
- Composite security: Mixture of 2 or more securities
* Convertible bonds, swaps, etc.
Types of markets for securities?
•Maturity of securities
–Money markets (<1 year) : Treasury bills, commercial bills, negotiable certificates of deposit
–Capital markets: bonds, shares
•Primary vssecondary market
–Primary: when security is first issued
•Initial Public Offering (IPO)
–Secondary: where existing securities are traded
•Exchange vs over-the-counter market
–Over-the-counter: off-exchange,trading directly between parties
Definition of a market?
A system/place through which securities
are created and transferred
9 Trading arrangements/ types of order?
- Market order:best possible price
- Buy Stop order:buy Xshares as soon as the price rises above P
- Sell Stop order: sell X shares as soon as the price drops below P
- Limit order:buy/sell at a specified price orbetter
- Stop limit order:sell 104 stop, 100 limit= executed if share price falls bellow 104, but not lower than 100
- Day order:order is cancelled if it is not executed on a particular day
- Open order:remains in effect until it is either executed or cancelled
- Fill-or-kill order: cancelled if it cannot be executed immediately
- Round lot order:buy/ sell in the standard trading unit for a stock exchange (ex: 1000 shares LSE)
Difference between a flat and effective rate?
Flat rate is the quoted level, e.g. 6% a year.
Effective rate = interest factor - 1.
If compounding takes place more than once a year, re > r.
re = (1+ r/m)^m - 1.
An annuity?
A regular stream of payments. discounting back:
P = F(1+r)^-t
Perpetuity?
An annuity that continues indefinitely.
Characteristics of money market securities
•Maturity less than a year
•Quoted on
–Yield basis: % of interest
–Discount basis: sold at a discount from the face-value
•UK: 365-day year
•Settlement day: first business day following purchase
•London Interbank Market
London interbank reference interest rates:
LIBID (London interbank bid rate)= rate at which one bank
bids for funds (accepts deposits from other banks)
“If you depositfunds in my bank for a week, I’ll giveyou an annual interest rate of 9%’’
•LIBOR (London interbank offered rate)= rate at which
one bank offers funds (lends to other banks)
“If you want to borrowfunds from my bank for a week, I’ll chargeyou an annual interest rate of 9.5%’’
MMDs
Money market deposits:
• Issued for overnight, 1 week, or 1, 2, 3, 4, 5, 6, 9
and 12 months, fixed term
• Not negotiable: Cannot be liquidated before maturity
• Referenced to LIBID (ex: LIBID - x%)
• Fixed-rate
• Interest and capital repaid at maturity (no intermediate payments)
• Thus, simple interest
CDs?
Negotiable Certificates of Deposit:
•Mostlyfixed-rate, but could be variable
•Referenced to LIBID
•Maturities mainlybetween 1-3 months
•Interest: computed as in the case of MMDs…
•…but if maturity > 1 year, interest paid annually
•Can be traded…so more liquid than MMDs
Clean price?
of CD: Principal = P - accrued interest
Name 5 other securities quoted on discount basis
•TreasuryBills:
– issued by the Government :3,6 months
•Bills of exchange
–similar to TBs but issued by companies against the sale of goods
• Banker’s acceptances
–Written promise by a borrower to a bank to repay borrowed funds
–tradable on asecondary market
-bank that first accepted is responsible in case of defaultt of future buyers
•Commercial paper
–promissory notes issued by large firms
–unsecured (nocollateral)
–firm must be listed with net assets > £50m
•These securities are sold at a discount to their par value (no interests)
Expectations Hypothesis?
The Expectations Hypothesis says that long-term rates
describe the future path of short rates i.e. long-term
rates are determined by the expected future short-rates.
• Rising curve: Investors expect future short term rates to rise
• Falling curve: Investors expect future short term rates to fall
• Humped
Liquidity preference theory?
Liquidity Preference Theory:As borrowers prefer to borrow for longer periods, while investors prefer to stay liquid, a liquidity premium is required by lenders to forgo liquidity. Premium increases with maturity
Preferred habitat theory?
Preferred Habitat Theorysays that supply and demand conditions determine the slope of the yield curve. Banks demand short maturities, pension funds demand long maturities, no particular group demands medium
