Financial Institutions and Markets

PART 1: INTRODUCTION

1. Why study Financial Markets and Institutions?

 Preview
o Why Study Financial Markets?
o Why Study Financial Institutions?
o Applied Managerial Perspective
o How Will We Study Financial Markets and Institutions
 Why study financial markets?
 crucial in our economy
o Channel funds from saver to investors, promoting economic efficiency
o Market activity affects:
 Personal wealth
 Business firms
 Economy
o Well-functioning financial markets are key factors in producing high
economic growth

 Debt markets & interest rates

o Debt markets allow governments, corporations, and individuals to borrow
o Borrowers issue a security, called a bond, offering interest and principal over
time
o The interest rate = the cost of borrowing
o Many types of market interest rates:
 Mortgage rates
 Mortgage = lening op onroerende goederen (vastgoed)
 Car loan rates
 Credit card rates
o The level of these rates are important
 E.g. mortgage rates in the early part of 1983 exceeded 13%
o Understanding the history of interest rates is beneficial
o Bond market & interest rates
 The stock market
o What? – the markets where (common) stock are traded
o Companies initially sell stock (in the primary market) to raise money. After
that, he stock is traded among investors.
o The stock market receives the most attention from the media
o Preview (Stock prices as measured by the Dow Jones Industrial Average,
1950-2013):

o Companies, not just individuals, also watch the market

 Often seeking additional funding
 The success of SEOs (Secondary Equity Offerings) is dependent on the
company’s stock

 The foreign exchange market

o What? – where international currencies trade and exchange rates are set
o Although most people know little about this market, it has a daily volume
nearing $3 trillion
o Preview (Exchange rate of the USD, 1970-2013):
o These fluctuations matter
 Until a couple of years ago, US consumers have found that
vacationing in Europe is expensive, due to a weakening dollar relative
to the Euro
 In recent years, the dollar strengthened, leading to a drop of foreign
purchase of US goods

 Why study Financial Institutions?

o Financial institutions – the corporations, organizations, and networks that
operate the so-called “marketplaces”
o Structure of course?
1) Structure of the financial system
 Helps funds move from savers to investors
2) Financial crises
 The “Great Recession” of 2007-2009 was the worst financial
crisis since the Great Depression (why?)
3) Central banks and the conduit of monetary policy
 The role of the Fed, and foreign counterparts, in the
management of interest rates and the money supply
4) The international financial system
 Capital flows between countries impacts domestic economies
 Need to understand exchange rates, capital controls, and the
role of agencies such as the IMF
5) Banks and other financial institutions
 Includes the role of insurance companies, mutual funds,
pension funds, etc.
6) Financial innovation
 Focusing on improvements in technology and the impact on
financial product delivery
7) Managing risk in financial institutions
 Focusing on risk management in the financial institution

 Applied managerial perspective

o Financial institutions are among the largest employers in the US and often
pay high salaries
o Knowing how financial institutions are managed may help you better deal
with them
 Exploring the Web
o Web exercise
 Finding historical interest rates from the Fed and save information
 To analyze interest rates, you must collect market interest-rate
data. One metric commonly used is US Treasury data.
 The Fed website maintains historical data on US Treasury
yields

 Importing the data into Excel

 Many websites are designed so that the data can be easily
imported into Excel for further data analysis
 Preview (Excel Spreadsheet with interest-rate data):
 Examining the information using an Excel chart
 Powerful tools in spreadsheet programs allow you to graph
data, run regressions, and conduct scenario analysis
 Preview (Excel graph of interest-data):

CHAPTER SUMMARY
 Why study Financial Markets?
o The 3 primary markets:
 Bond markets
 Stock markets
 Foreign exchange markets
 Why study Financial Institutions?
o The markets, institutions, and key changes affecting the institutions
 Applied managerial perspective
o Presentation of material to better understand how actual managers use the
information in daily operations
2. Overview of the Financial System
 Preview
o The importance of financial markets and financial intermediaries in our
economy
o Acquisition of an understanding of their general structure and operation
before we can appreciate their role in our economy
o Examination of the role of the financial system in an advanced economy. We
study the effects of financial markets and institutions on the economy, and
look at their general structure and operations.
Topics include:
 Function of Financial Markets
 Structure of Financial Markets
 Internationalization of Financial Markets
 Function of Financial Intermediaries: Indirect Finance
 Types of Financial Intermediaries
 Regulation of the Financial System
 Functions of financial markets
o Channels funds from person or business without investment opportunities
(i.e., “Lender-Savers”) to one who has them (i.e., “Borrower-Spenders”)
o Improves economic efficiency
o Flows of Funds Through the Financial System

 Financial Markets Funds Transferees

Lender-Savers Borrower-Spenders
1) Households 1) Business firms
2) Business firms 2) Government
3) Government 3) Households
4) Foreigners 4) foreigners
 Segments of Financial Markets
o Direct Finance
 Borrowers borrow directly from lenders in financial markets by selling
financial instruments which are claims on the borrower’s future
income or assets
o Indirect Finance
 Borrowers borrow indirectly from lender via financial intermediaries
(established to source both loanable funds and loan opportunities) by
issuing financial instruments which are claims on the borrower’s
future income or assets

 The importance of Financial Markets

o The is important. For example, if you save $1000, but there are no financial
markets, then you can earn no return on this – might as well put the money
under your mattress
However, if a carpenter could use that money to buy a new saw (increasing
her productivity), then she is willing to pay you some interest for the use of
the funds
o Financial Markets are critical for producing an efficient allocation of capital,
allowing funds to move from people who lack productive investment
opportunities to people who have them
o Financial markets also improve the well-being of consumers, allowing them
to time their purchases better.

 Structure of Financial Markets

o It helps to define financial markets along a variety of dimensions (not
necessarily mutually exclusive). For starters…
1. Debt markets
 Short-term (maturity < 1year)
 Long-term (maturity > 10 years)
 Intermediate term (maturity in-between)
 Represented $38,2 trillion at the end of 2012
2. Equity markets
 Pay dividends, in theory forever
 Represents an ownership claim in the firm
 Total value of all US equity was $18,7 trillion at the end of 2012
1. Primary market
 New security issues sold to initial buyers
 Typically involves an investment bank who underwrites the offering
2. Secondary market
 Securities previously issued are bought and sold
 Examples include the NYSE and Nasdaq
 Involves both brokers and dealers
 Difference between brokers and dealers?
o When a firm is acting as a broker, it is acting as the
customer’s agent and is merely executing the
customer’s order for a fee known as a commission. The
role of the broker is simply to find someone willing to
buy the investor’s securities if the customer is selling or
to find someone willing to sell them the securities if
they are buyers.
o The firm acts as a dealer when it participates in the
transaction by taking the opposite side of the trade.
For example, the firm may fill a customer’s buy order
by selling the securities to the customer from the firm’s
own account or the dealer may fill the customer’s sell
order by buying the securities for their own account.
o Even though firms don’t get any money, per se, from the secondary market, it
serves two important functions:
 Provides liquidity, making it easy to buy and sell the securities of the
companies
 Establishes a price for the securities (useful for company valuation)
o 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
o We can also classify markets by the maturity of the securities:
 Money market:
 Short-term (maturity < 1 year)
 Capital market:
 Long-term (maturity > 1 year) plus equities (no maturity)
 Internationalization of Financial Markets
o The internationalization of markets is an important trend. The US no longer
dominates the world stage
o The international Bond Market & Eurobonds
 Foreign bonds
 Denominated in a foreign currency
 Targeted at a foreign market
 Eurobonds
 Denominated in one currency, but sold in a different market
 Now larger than US corporate bond market
 Over 80% of new bonds are Eurobonds
 Eurocurrency market
 Foreign currency deposited outside of home country
 Eurodollars are US dollars deposited, say, London
 Gives US borrows an alternative source for dollars
 World Stock Markets
 US stock markets are no longer always the largest – at one
point, Japan’s was larger

o The number of international stock markets indexes is quite large. For many of
us, the level of the Dow or the S&P 500 is known.
How about the Nikkei 225? Or the FTSE 100? Do you know what countries
these represent?

 Global Perspective: Relative Decline of US Capital Markets

o The US has lost its dominance in many industries: automobiles and consumer
electronics, to name a few
o A similar trend appears at work for US financial markets, as London and Hong
Kong compete. Indeed, many US firms use these markets over the US
o WHY?
 New technology in foreign exchanges
 9-11 made US regulations tighter
 greater risk of lawsuit in the US
 Sarbanes-Oxley has increased the cost of being a US-listed public
company
 Function of Financial Intermediaries: Indirect Finance
We now turn our attention to the top part of the figure – indirect finance

o Instead of savers lending/ investing directly with borrowers, a financial

intermediary (such as a bank) plays as the middleman:
 The intermediary obtains funds from savers
 The intermediary then makes loans/ investments with borrowers
o This process, called financial intermediation, is actually the primary means of
moving funds from lenders to borrowers
o More important source of finance than securities markets (such as stocks)
o Needed because of transactions costs, risk sharing, and asymmetric
information
o Transaction costs
 Financial intermediaries make profits by reducing transactions costs
 Reduce transactions costs developing expertise and taking advantage
of economies of scale
o A financial intermediary’s low transaction costs mean that it can provide its
customers with liquidity services, services that make it easier for customers
to conduct transactions
 Banks provide depositors with checking accounts that enable them to
pay their bills easily
 Depositors can earn interest on checking and saving accounts and yet
still convert them into goods and services whenever necessary
o Another benefit made possible by the FI’s low transaction costs is that they
can help reduce the exposure of investors to risk, through a process known as
risk sharing
 FIs create and sell assets with lesser risk to one party in order to buy
assets with greater risk from another party
 This process is referred to as asset transformation, because in a sense
risky assets are turned into safer assets for investors
o Financial intermediaries also help by providing the means for individuals and
businesses to diversify their asset holdings
o Low transaction costs allow them to buy a range of assets, pool them, and
then sell rights to the diversified pool to individuals
o Another reason FIs exist is to reduce the impact of asymmetric information
o One party lacks crucial information about another party, impacting decision-
making
o We usually discuss this problem along 2 fronts: adverse selection and moral
hazard

 Asymmetric information: adverse selection and moral hazard

Adverse selection Moral hazard

- Before transaction occurs - After transaction occurs
- Potential borrowers most - Hazard that borrower has
likely to produce adverse incentives to engage in
outcome are ones most undesirable (immoral)
likely to seek a loan activities making it more
- Similar problems occur with likely that won’t pay loan
insurance where unhealthy back
people want their known - Again, with insurance,
medical problems covered people may engage in risky
activities only after being
insured
- Another view is a conflict of
interest

o Financial intermediaries reduce adverse selection and moral hazard

problems, enabling them to make profits.

 Global: the importance of financial intermediaries relative to securities markets

o Studies show that firms in the US, Canada, the UK, and other developed
nations usually obtain funds from financial intermediaries, not directly from
capital markets
o In Germany and Japan, financing from financial intermediaries exceeds
capital market financing 10-fold
o However, the relative use of bonds versus equity does differ by country

 Economic of scope and conflicts of interest

o FIs are able to lower the production cost of information by using the
information for multiple services: bank accounts, loans, auto insurance,
retirement savings, etc.
This is called economies of scope
o But, providing multiple services may lead to conflicts of interest, perhaps
causing one area of the FI to hide or conceal information from another area
(or the economy as a whole).
This may actually make financial markets less efficient!

 Types of financial intermediaries

o Primary assets and liabilities of financial intermediaries

o Principal financial intermediaries and value of their assets

o Depository Institutions (banks): accept deposits and make loans

These include commercial banks and thrifts
o Commercial banks (11,343 at end of 2012)
 Raise funds primarily by issuing checkable, savings, and time deposits
which are used to make commercial, consumer and mortgage loans
 Collectively, these banks compromise the largest financial
intermediary and have the most diversified asset portfolios

o Thrifts: S&Ls and Mutual Saving Banks (918) and Credit Unions (905)
 Raise funds primarily by issuing savings, time, and checkable deposits
which are most often used to make mortgage and consumer loans,
with commercial loans also becoming more prevalent at S&Ls and
Mutual Saving Banks
 Mutual saving banks and credit unions issue deposits as shares and
are owned collectively by their depositors, most of which at credit
unions belong to a particular group, e.g., a company’s corkers

o Types:
 Finance Companies
 Sell commercial paper (a short-term debt instrument)
 Issue bonds and stocks to raise funds to lend to consumers to
buy durable goods, and to small businesses for operations
 Mutual Funds
 Acquire funds by selling shares to individual investors (many of
whose shares are held in retirement accounts)
 Use the proceeds to purchase large, diversified portfolios of
stocks and bonds
 Money Market Mutual Funds
 Acquire funds by selling checkable deposit-like shares to
individual investors
 Use the proceeds to purchase highly liquid and safe short-term
money market instruments
 Investment Banks
 Advise companies on securities to issue
 Underwriting security offerings
 Offer M&A assistance
 Act as dealers in security markets

 Contractual Savings Institutions (CSIs)

o All CSIs acquire funds from clients at periodic intervals on a contractual basis
and have fairly predictable future payout requirements

 Life Insurance Companies receive funds from policy premiums, can

invest in less liquid corporate securities and mortgages, since actual
benefit pay outs are close to those predicted by actuarial analysis
 Fire and Casualty Insurance Companies receive funds from policy
premiums, must incest most in liquid government and corporate
securities, since loss events are harder to predict
 Pension and Government Retirement Funds hosted by corporations
and state and local governments acquire funds through employee and
employer payroll contributions, invest in corporate securities, and
provide retirement income via annuities

 Regulatory agencies
o Principal regulatory agencies of the US financial system

 Regulation of financial markets

o Main reasons for regulation
1) Increase information to investors
2) Ensure the soundness of financial intermediaries

 Regulation reason: increase investor information

o Asymmetric information in financial markets = investors may be subject to
adverse selection and moral hazard problems
 consequences:
 may hinder the efficient operation of financial markets
 may keep investors away from financial markets
o The Securities and Exchange Commission (SEC) requires corporations issuing
securities to disclose certain information about their sales, assets, and
earnings to the public
Also restricts trading by the largest stockholders (known as insiders) in the
corporation

o Consequences of such government regulation:

 can reduce adverse selection and moral hazard problems in financial
markets
 can increase their efficiency by increasing the amount of information
available to investors
 Indeed, the SEC has been particularly active recently in pursuing illegal
insider trading

 Regulation reason: ensure soundness of financial intermediaries

o Providers of funds (depositors) to financial intermediaries may not be able to
assess whether the institutions holding their funds are sound or not
o If they have doubts about the overall health of financial intermediaries, they
may want to pull their funds out of both sound and unsound institutions
 can lead to a financial panic
 Such panics produces large losses for the public and causes serious
damage to the economy
o To protect the public and the economy from financial panics, the government
has implanted six types of regulations:
 Restrictions on Entry
 Disclosure
 Restrictions on Assets and Activities
 Deposit Insurance
 Limits on Competition
 Restrictions on Interest Rates

Restriction on entry
o Regulators have created tight regulations as to who is allowed to set up a
financial intermediary
o Individuals or groups that want to establish a financial intermediary, such as
bank or an insurance company, must obtain a charter from the state or the
federal government
o Only if they are upstanding citizens with impeccable credentials and a large
amount of initial funds will they be given a charter

Disclosure
o There are stringent reporting requirements for financial intermediaries
 Their bookkeeping must follow certain strict principles
 Their books are subject to periodic inspection
 They must make certain information available to the public

Restriction on assets and activities

o There are restrictions on what financial intermediaries are allowed to do and
what assets they can hold
o Before you put your funds into a bank or some other similar institution, you
want to know that your funds are safe and that the financial intermediary will
be able to meet its obligations to you

HOW TO DO THIS?
 Restrict the financial intermediary from engaging in certain risky
activities
 Restrict financial intermediaries from holding certain risky assets, or
at least from holding a greater quantity of these risky assets than is
prudent

Deposit insurance
o The government can insure people’s deposits to a financial intermediary from
any financial loss if the financial intermediary should fail
o The Federal Deposit Insurance Corporation (FDIC) insures each depositor at a
commercial bank or mutual savings bank up to a loss of $250 per account
o Similar governments agencies exist for other depository institutions:
 The National Credit Union Share Insurance Fund (NCUSIF) provides
insurance for credit unions

Limits on competition
o Evidence is weak showing that competition among financial intermediaries
promotes failures that will harm public.
However, such evidence has not stopped the state and federal governments
from imposing many restrictive regulations
o In the past, banks were not allowed to open branches in other states, and in
some states banks were restricted from opening additional locations

Restrictions on interest rates

o Competition has also been inhibited by regulations that impose restrictions
on interest rates that can be paid on deposits
o These regulations were instituted because of the widespread belief that
unrestricted interest-rate competition helped encourage bank failures during
the Great Depression
o Later evidence did not support this view, and restrictions on interest rates
have been abolished

 Regulation reason: improve monetary control

o Because banks play a very important role in determining the supply of money
(which in turn affects many aspects of the economy), regulation of these
financial intermediaries is intended to improve control over the money
supply
o Ex.: reserve requirements
 Make it obligatory for all depository institutions to keep a certain
fraction of their deposits in accounts with the Federal Reserve System
(the Fed), the central bank in the US
Reserve requirements help the Fed exercise more precise control over the
money supply

 Financial regulation abroad

o Those countries with similar economic systems also implement financial
regulation consistent with the US model: Japan, Canada, and Western Europe
 Financial reporting for corporations is required
 Financial intermediaries are heavily regulated
o However, US banks are more regulated along dimensions of branching and
services than their foreign counterparts

CHAPTER SUMMARY
 Function of financial markets:
o We examined the flow of funds through the financial system and the role of
intermediaries in this process
 Structure of financial markets:
o We examined market structure from several perspectives, including types of
instruments, purpose, organization, and time horizon
 Internationalization of financial markets:
o We briefly examined how debt and equity markets have expand in the
international setting
 Function of financial intermediaries:
o We examined the roles of intermediaries in reducing transaction costs,
sharing risk, and reducing information problems
 Types of financial intermediaries:
o We outlined the numerous types of financial intermediaries to be further
examined
 Regulation of the financial system:
o We outlined some of the agencies charged with the oversight of various
institutions and markets
3. What do interest rates mean and what is their role in valuation?
 Preview
o Interest rates are among the most closely watched variables in the economy
It is imperative that what exactly is meant by the phrase interest rates is
understood
o Any description of interest rates entails an understanding of certain
definitions, most of which will not only pertain directly to interest rates but
will also be vital to understanding many other foundational concepts

 Present value
o Different debt instruments have very different streams of cash payments to
the holder (known as cash flows), with very different timing
o All else being equal, debt instruments are evaluated against one another
based on the amount of each cash flow and the timing of each cash flow
o This evaluation, where the analysis of the amount and timing of a debt
instrument’s cash flows lead to its yield to maturity or interest rate, is called
present value analysis
o The concepts of present value (or present discounted value) is based on the
commonsense notion that a dollar of cash flow paid to you one your from
now is less valuable to you than a dollar paid to you today.
This notion is true because you could invest the dollar in a saving account
that earns interest and have more than a dollar in one year
o The term present value (PV) can be extended to mean the PV of a single cash
flow or the sum of a sequence or group of cash flows
o Loan principal:
 the amount of funds the lender provides to the borrower
o Maturity date:
 The date the loan must be repaid
 The Loan Term is from initiation to the maturity
o Interest payment:
 The cash amount that the borrower must pay the lender for the use of
the loan principal
o Simple interest rate:
 The interest payment divided by the loan principal
 The percentage of principal that must be paid as interest to the lender
 Convention is to express on an annual basis, irrespective of the loan
term
 Present value: Simple Loan
S im p le lo a n o f $ 1 0 0
Y e a r: 0 1 2 3 n
$100 $110 $121 $133 1 0 0 ×( 1 + i ) n

o This example reinforces the concept that $100 today is preferable to $100 a
year from now since today’s $100 could be lent out (or deposited) at 10%
interest to be worth $110 one year from now, or $121 in two years or $133 in
three years.

 Yield to maturity
Loans
o Yield to maturity = interest rate that equates today’s value with present
value of all future payments
 Simple Loan Interest Rate ( i = 10%)

Bonds
o Coupon Bond (Coupon rate = 10% = C/F)

o Fixed coupon payments of $C

o One-Year Discount Bond

(P = $900, F= $1000)
 Relationship between price and yield to maturity
o 3 interesting facts
 When bond is at par, yield equals coupon rate
 Price and yield are negatively related
 Yield greater than coupon rate when bond price is below par value

o It’s also straight-forward to show that the value of a bond (price) and yield to
maturity (YTM) are negatively related.
If i increases, the PV of any given cash flow is lower;
Hence, the price of the bond must be lower

 Global perspective
o Now, we notice some yields on government bonds are negative!
Investors are willing to pay more than they would receive in the future
o Best explanation is that investors find the convenience of the bills worth
something – more convenient than cash.
But that can only go so far – the rates are only slightly negative
 Distinction between real and nominal interest rates
o Real interest rate
 Interest rate that is adjusted for expected changes in the price level
i r=i −π e
 Real interest rate more accurately reflects true cost of borrowing
 When the real rate is low, there are greater incentives to borrow and
less to lend
 We usually refer to this rate as the ex ante real rate of interest
because it is adjusted for the expected level of inflation.
After the fact, we can calculate the ex post real rate based on the
observed level of inflation
 If i = 5% and π e= 0% then i r= 5% - 0% = 5%
If i = 10% and π e= 20% then i r= 10% - 20% = -10%
o US real and nominal interest rates
 Distinction between interest rates and returns
o Rate of return: we can decompose returns into 2 pieces:

 Key facts about the relationship between rates and returns

 Maturity and the volatility of bond returns

o Key findings from TABLE 3.2.
 Only bond whose return = yield is one with maturity = holding period
 For bonds with maturity > holding period
 i increases, P decreases implying capital loss
 The longer is maturity, greater is price change associated with interest
rate change
 The longer the maturity, the more return changes with change in
interest rate
 Bond with high initial interest rate can still have negative return if i
increases
 conclusion from this analysis:
 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
o Occurs if you hold a series of short bonds over a long holding period
o i at which you reinvest is uncertain
o As an investor, you gain when i increase, you lose when i decreases

4. Why do interest rates change?

 Preview

Early 1950s 1981 2003 2007 2008

Short-term The yields rose The yields Rates jumped Rates fell back
Treasury bills to 15% and dropped back up to 5% to near zero
were yielding higher to 1%
about 1%

o Examination of the forces that move interest rates and the theories behind
those movements.
 Determination Asset Demand
 Supply and demand in the bond market
 Changes in equilibrium interest rates

 Determinants of asset demand (1)

o Asset = piece of property that is a store of value
Facing the question of whether to buy and hold an asset or whether to buy
an asset rather than another, an individual must consider the following
factors:
 Wealth, the total resources owned by the individual, including all
assets
 Expected return (the return expected over the next period) on one
asset relative to alternative assets
 Risk (the degree of uncertainty associated with the return) on one
asset relative to alternative assets
 Liquidity (the ease and speed with which an asset can be turned into
cash) relative to alternative assets
o Example 1: expected return
o Example 2: Standard Deviation (a)
 Consider following 2 companies and their forecasted returns for the
upcoming year:

o Example 2: Standard Deviation (b)

 What is the standard deviation of the returns on the Fly-by-Night
Airlines and Feet-on-the-Ground Bus Company, with the return
outcomes and probabilities described on the previous slide? Of these
2 stocks, which is riskier?

o Example 2: Standard Deviation (e)

Fly-by-Night Airlines Feet-on-the-Ground

Bus Company
Standard deviation 5% 0%
of returns

 Fly-by-Night Airlines is a riskier stock BECAUSE stdev of retruns of 5% > 0%

stdev of returns for Feet-on-the-Ground Bus Company, which has a
certain return

 A risk-averse person prefers stock in the Feet-on-the-Ground (the sure

thing) to Fly-by-Night stock (the riskier asset), even though the stocks
have the same expected return, 10%. By contrast, a person who
prefers risk is a risk preferrer or risk lover. We assume people are risk-
averse, especially in their financial decisions.

 Determinants of asset demand (2)

o The quantity demanded of an asset differs by factor
 Wealth: holding everything else constant, an increase in wealth raises
the quantity demanded of an asset
 Expected return: 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: holding everything else constant, if an asset’s risk rises relative
to that of alternative assets, its quantity demanded will fall
 Liquidity: the more liquid an asset is relative to alternative assets,
holding everything else unchanged, the more desirable it is, and the
greater will be the quantity demanded

 Determinants of asset demand (3)

o Response of the quantity of an asset demanded to changes in wealth,
expected returns, risk, and liquidity

 Supply and demand in the bond market

o The mechanics f interest rates
o Examination of how interest rates are determined – from a demand and
supply perspective
These forces act differently in different bond markets
 Current supply/ demand conditions in the corporate bond market are
not necessarily the same as, say, in the mortgage market
o However, because rates tend to move together, we will proceed as if there is
one interest rate for the entire economy

The demand curve

o Let’s consider a one-year discount bond with a face value of $1000. In this
case, the return on this bond is entirely determined by its price. The return is,
then, the bond’s yield to maturity

o Derivation of demand curve:

Point A: if the bond was selling for $950

Point B: if the bond was selling for $900

 How do we know the demand ( Bd ) at point A is 100 and at point V is

200?
Well we are just making-up those numbers. But we are applying basic
economics – more people (investors) will want (demand) the bonds if
the expected return is higher

To continue…

Point C: P = $850 i = 17,6% Bd = 300

Point D: P = $800 i = 25,0% Bd = 400
Point E: P = $750 i = 33,0% Bd = 500
Demand curve Bd which connects points A, B, C, D, E. (has usual downward
slope)

 Supply and demand for bonds (figure 4.1.)

The supply curve
o Derivation of supply curve:
 In the last figure  the supply curve = snuck in – the line connecting
point F, G, C, H, and I.
 The derivation follows the same idea as the demand curve

Point F: P = $750 i = 33,0% Bs = 100

Point G: P = $800 i = 25,0% Bs = 200
Point C: P = $850 i = 17,6% Bs = 300
Point H: P = $900 i = 11,1% Bs = 400
Point I: P = $950 i = 5,3% Bs = 500
Supply curve is Bs that connects points F, G, C, H, I, and has an upward slope

 How do we know the supply ( Bs ) at point F is 100 and at point G is 200?

Again, like the demand curve, we are just making-up those numbers. But
we are applying basic economics – more people (investors) will offer
(supply) the bonds if the expected return (cost) is lower

 Market equilibrium
o The equilibrium follows what we know from supply-demand analysis:
 Occurs when Bd = Bs , at P*= 850, i* = 17,6%
 When P = $950, i = 5,3%, Bs > Bd
(excess supply): P decreases to P*, i increases to i*
 When P = $750, i = 33,0 %, Bd ¿ Bs
(excess demand): P increases to P*, i decreases to i*
 Market conditions
o Market equilibrium occurs when the amount that people are willing to buy
(demand) equals the amount that people are willing to sell (supply) at a given
price
o Excess supply occurs when the amount that people are willing to sell (supply)
is greater than the amount people are willing to buy (demand) at a given
price
o Excess demand occurs when the amount that people are willing to buy
(demand) is greater than the amount that people are willing to sell (supply)
at a given price

 Supply and demand analysis

o We used 2 different vertical axes – one with price, which is high-to-low
starting from the top, and one with interest rates, which is low-to-high
starting from the top
o This just illustrates what we already know: bond prices and interest rates are
inversely related
o Note: this analysis is an asset market approach based on the stock of bonds.
Another way to do this is to examine the flows. However, the flows approach
is tricky, especially with inflation in the mix
Focus?  stock approach
 Changes in equilibrium interest rates
o Focus? Changes in interest rate, actual shifts in the curves
o Remember: movements along the curve will be due to price changes alone

 Factors that shift demand curve (a)

Factors that shift demand curve (b)

o How factors shift the demand curve

1) Wealth/ saving
 Economy increases, wealth increases
 Bd increases, Bd shifts out to right

OR
 Economy decreases, wealth decreases
 Bd increases, Bd shifts out to right
2) Expected returns on bonds
 i decreases in future, Re for long-term bonds increases
 Bd shifts out to right

OR
 π edecreases, relative Re increases
 Bd shifts out to right
…and expected returns on other assets
 ER on other asset (stock) increases
 Re for long-term bonds decreases
 Bd shifts out to left
these are closely tied to expected interest rate and expected inflation
3) Risk
 Risk of bonds that decrease, Bd increases
 Bd shifts out to right

OR

 Risk of other assets that increase, Bd increases

 Bd shifts out to right
4) Liquidity
 Liquidity of bonds that increase, Bd increases
 Bd shifts out to right

OR

 liquidity of other assets that decrease, Bd increases

 Bd shifts out to right

 Summary of shifts in the demand for bonds

o Wealth: in a business cycle expansion with growing wealth, the demand for
bonds rises, conversely, in a recession, when income and wealth are falling,
the demand for bonds falls
o Expected returns: higher expected interest rates in the future decrease the
demand for long-term bonds, conversely lower expected interest rates in the
future increase the demand for long-term bonds
o Risk: an increase in the riskiness of bonds causes the demand for bonds to
fall, conversely, an increase in the riskiness of alternative assets (like stocks)
causes the demand for bonds to rise
o Liquidity: increased liquidity of the bond market results in an increased
demand for bonds, conversely, increased liquidity of alternative asset
markets (like the stock market) lowers the demand for bonds

 Factors that shift supply curve

o Shifts in the supply curve

1) Profitability of investment opportunities
 Business cycle expansion
 Investment opportunities increase, Bs increases
 Bs shifts out to right
2) Expected inflation
 π edecreases, Bs increases
 Bs shifts out to right
3) Government activities
 Deficits increase, Bs increases
 Bs shifts out to right
 Summary of shifts in the supply of bonds
o Expected profitability of investment opportunities: in a business cycle
expansion, the supply of bonds increases. Conversely, in a recession, when
there are far fewer expected profitable investment opportunities, the supply
of bonds falls
o Expected inflation: an increase in expected inflation causes the supply of
bonds to increase
o Government activities: higher government deficits increase the supply of
bonds. Conversely, government surpluses decrease the supply of bonds

 Case: Fisher Effect

o Recall that rates are composed of several components: a real rate, an
inflation premium, and various risk premiums
o What if there is only a change in expected inflation?
o Changes in π e :the Fisher Effect
 If π eincreases…
 Relative Re decreases, Bd shifts in to left
 Bs increases, Bs shifts out to right
 P decreases, i increases
 Response to a change in expected inflation
 Evidence on the Fisher Effect in the US – expected inflation and
interest rates (three-month treasury bills), 1953-2013

o Summary of the Fisher Effect

 If expected inflation rises from 5% to 10%, the expected return on
bonds relative to real assets falls and, as a result, the demand for
bonds falls
 The rise in expected inflation also means that the real cost of
borrowing has declined, causing the quantity of bonds supplied to
increase
 When the demand for bonds falls and the quantity of bonds supplied
increases, the equilibrium bond price falls
 Since the bond price is negatively related to the interest rate, this
means that the interest rate will rise

 Case: business cycle expansion

o Another good thing to examine is an expansionary business cycle. Here, the
amount of goods and services for the country is increasing, so national
income is increasing.
o What is the expected effect on interest rates?
Business Cycle Expansion
 Wealth increases, Bd increases, Bd shifts out to right
 Investment increases, Bs increases, Bs shifts out to right
 If Bs shifts more than Bd … then P decreases, i increases
 Response to a Business Cycle Expansion
 Evidence on Business Cycles and Interest Rates – business cycle and
interest rates (three-month treasury bills), 1951-2013

 Case: Low Japanese Interest Rates

o In November 1998, Japanese interest rates on six-month Treasury bills turns
slightly negative
o How can we explain that?
 Negative inflation lead to an increase of Bd
– Bd shifts out to right
 Negative inflation lead to a decrease in real rates
– Bs shifts out to left
 Net effect was an increase in bond prices (falling interest rates)
 Business cycle contraction lead to a decrease in interest rates
– Bs shifts out to left
– Bd shifts out to left

But the shift in Bd is less significant than the shift in Bs , so the net
effect was also an increase in bond prices

 The Practicing Manager

o Many firms have economists or hire consultants to forecast interest rates.
o Although this can be difficult to get right, it is important to understand what
to do with a given interest rate forecast
 Profiting from interest-rate forecasts
o Methods for forecasting
a. Supply and demand for bonds: use Flow of Funds Accounts
and judgement
b. Econometric Models: large in scale, use interlocking
equations that assume past financial relationships will hold
in the future
o Make decisions about assets to hold
 Forecast a decrease in i, buy long bonds
 Forecast an increase in i, buy short bonds
o Make decisions about how to borrow
 Forecast a decrease in i, borrow short
 Forecast an increase in i, borrow long
 Forecasting interest rates
o Financial economists are hired (sometimes for high salaries) to forecast
interest rates
o These predictions help forecast the strength of the economy, profitability of
investments, expected inflation, etc.

CHAPTER SUMMARY
 Determining asset demand: examination of the forces that affect the demand and
supply of assets
 Supply and demand in the bond market: we examine those forces in the context of
bonds, and examined the impact on interest rates
 Changes in equilibrium interest rates: examination of the dynamics of changes in
supply and demand in the bond market, and the corresponding effect on bond prices
and interest rates
5. How do risk and term structure affect interest rates?
 Preview
o Chapter 4: why do interest rates change?  a big assumption – there is only
one economy-wide interest rate
Of course that isn’t really the case
o Examination of the different rates that we observe for financial products
o Examination of the bonds that offer similar payment streams but differ in
price
o The price differences are due to the risk structure of interest rates
o Examination of what this risk structure looks like and ways to examine it
o Different rates required on bonds with different maturities
o We typically observe higher rates on longer-term bonds  known as the
term structure of interest rates
o Treasury bonds to minimize the impact of other risk factors

 Examination of how the individual risk of a bond affects its required rate.
 Exploration of how the general level of interest rates varies with the maturity
of the debt instruments.
 Risk structure of interest rates
 Term structure of interest rates

 Risk structure of interest rates

o First, examination of the yields for several categories of long-term bonds over
the last 90 years
o Aspects regarding these rates, related to different bond categories and how
this has changed through time
 Risk structure of long bonds in the US
o 2 important features of interest-rate behavior of bonds
 rates on different bond categories change form one year to the next
 spreads on different bond categories change from one year to the
next

 Factors affecting risk structure of interest rates

o Specific risk factors
 Default risk
 Liquidity
 Income tax considerations
Default Risk Factor
 One attribute of a bond that influences its interest rate is its risk of default,
which occurs when the issuer of the bond is unable or unwilling to make
interest payments when promised
 US Treasury bonds have usually been considered to have “no default risk”
because the federal government can always increase taxes to pay off its
obligations (or just print money). Bonds like these with no default risk are
called “default-free bonds”
 But are these bonds truly default-free bonds? During the budget negotiations
in Congress in 1995-1996, and then again in 2011-2013, the Republicans
threatened to let Treasury bonds default, and this had an impact on the bond
market. If these bonds were truly “default-free”, we should not have seen
any reaction

 The spread between the interest rates on bonds with default risk and default-
free bonds, called the risk premium, indicates how much additional interest
people must earn in order to be willing to hold that risky bond
 A bond with default risk will always have a positive risk premium, and an
increase in its default risk will raise the risk premium
 Default risk is an important component of the size of the risk premium
Because of this, bond investors would like to know as much as possible about
the default probability of a bond

 One way to do this is to use the measures provided by credit-rating agencies

 Examples: Moody’s, Fitch and S&P
 Bond ratings by Moody’s and Standard and Poor’s
(figure 5.1)

Increase in default risk on corporate bonds – Response to an increase in default risk on

corporate bonds

 Analysis:

 Corporate bond market

o Re on corporate bonds ¯, Dc ¯, Dc shifts left
o Risk of corporate bonds , Dc ¯, Dc shifts left
o Pc ¯, ic
 Treasury bond market
o Relative Re on Treasury bonds , DT , DT shifts right
o Relative risk of Treasury bonds ¯, DT , DT shifts right PT , iT ¯
 Outcome
o Risk premium, ic - iT, rises

 Case: the Global Financial Crisis and the Baa-Treasury Spread

o Starting in 2007, the subprime mortgage market collapsed, leading to large
losses for financial institutions
o Because of the questions raised about the quality of Baa bonds, the demand
for lower-credit bonds fell, and a “flight-to-quality” followed ‘demand for T-
securities increased)
o Result: Baa-Treasury spread increased from 185 bps to 545 bps

Liquidity Factor
 Another attribute of a bond that influences its interest rate is its liquidity; a
liquid asset is one that can be quickly and cheaply converted into cash if the
need arises. The more liquid an asset is, the more desirable it is (higher
demand), holding everything else constant
 The differences between interest rates on corporate bonds and treasury
bonds (that is, the risk premiums) reflect not only the corporate bond’s
default risk but its liquidity too. This is why a risk premium is sometimes
called a risk and liquid premium
Corporate bond becomes less liquid

 Corporate bond market

o Liquidity of corporate bonds ¯, Dc ¯, Dc shifts left
o Pc ¯, ic
 Treasury bond market
o Relatively more liquid Treasury bonds, DT , DT shifts right
o PT , i T ¯
 Outcome
o Risk premium, ic - iT, rises
 Risk premium reflects not only corporate bonds’ default risk but also lower
liquidity

Income Taxes Factor

 An odd feature of figure 5.1 is that municipal bonds tend to have a lower rate
the Treasuries. WHY?
 Munis certainly can default. Orange County (CA) is a recent example form the
early 1990s
 Munis are not as liquid a Treasuries
 However, interest payments on municipal bonds are exempt from federal
income taxes, a factor that has the same effect on the demand for municipal
bonds as an increase in their expected return
 Treasury bonds are exempt from state and local income taxes, while interest
payments from corporate bonds are fully taxable
 For example, suppose you are in the 35% tax bracket. From a 10%-coupon
Treasury bond, you only get $65 of the coupon payment because of taxes
 However, from an 8%-coupon muni, you get the full $80. For the higher
return, you are willing to hold a riskier muni (to a point)
Tax advantages of municipal bonds – Interest rates on municipal and treasury bonds

 Analysis:

 Municipal bond market

o Tax exemption raises relative Re on municipal bonds, Dm , Dm shifts
right
o Pm
 Treasury bond market
o Relative Re on Treasury bonds ¯, DT ¯, DT shifts left
o PT ¯
 Outcome
o im < iT

 Case: Bush Tax Cut and Obama Repeal on Bond Interest Rates
o The 2001 tax cut called for a reduction in the top tax bracket, from 39% to
35% over a 10-year period
o This reduces the advantage of municipal debt over T-securities since the
interest on T-securities is now taxed at a lower rate
o The Bush tax cuts were repealed under President Obama. Our analysis is
reversed. The advantage of municipal debt increased relative to T-securities,
since the interest on T-securities is taxed at a higher rate
 Term structure of interest rates
o Another important influence on interest rates (besides risk, liquidity, and
taxes) – maturity
Bonds with different maturities tend to have different required rates, all else
equal
o Following the news: e.g., [Link] publishes a plot of the yield curve (rates
at different maturities) for Treasury securities
 Yield curves
 Facts to be explained
o Besides explaining the shape of the yield curve, a good theory must explain
why:
 (1) Interest rates for different maturities (maturity bonds) move
together.
 Movements over time of interest rates on US Government
bonds with different maturities

 (2) Yield curves tend to have steep upward slope when short rates are
low and a downward slope when short rate are high
 (3) Yield curve is typically upward sloping

 Three theories of term structure

1) Expectations Theory
 Pure expectations theory explains 1 and 2, but not 3
 pure expectations theory explains fact (1) – that short and long
rates move together
 explains fact 2 – that yield curves tend to have steep slope
when short rates are low and downward slope when short
rates are high
 when short rates are low, they are expected to rise to
normal level, and long rate = average of future short-
rate; yield curve will have steep upward slope
 when short rates are high, they will be expected to fall
in future, and long rate will be below current short
rate; yield curve will have downward slope
 doesn’t explain fact 3 – that yield curve usually has upward
slope
 short rates are as likely to fall in future as rise, so
average of expected future short rates will not usually
be higher than current short rate: therefore, yield
curve will not usually slope upward

2) Market Segmentation Theory

 Market segmentation theory explains 3, but not 1 and 2
 Explains fact 3 – that yield curve is usually upward sloping
 People typically prefer short holding periods and thus
have higher demand for short-term bonds, which have
higher prices and lower interest rates than long bonds
3) Liquidity Premium Theory
 Solution: combine features of both Pure Expectations Theory and
Market Segmentation Theory to get Liquidity Premium Theory and
explain all facts
 Explains all 3 facts
 Explains fact 3 – that usual upward sloped yield curve
by liquidity premium for long-term bonds
 Explains fact 1 and fact 2 using same expectations as
pure expectations theory because it has average of
future short rates as determinant of long rate

Expectations Theory Market Liquidity Premium

Segmentation Theory
Theory
Key Assumptions Bonds of different Bonds of different Bonds of different
maturities are maturities are not maturities are
perfect substitutes substitutes at all substitutes, but are
not perfect
substitutes
Implication Re on bonds of Markets are Modifies Pure
different maturities completely Expectations Theory
are equal segmented with features of
Interest rate at each Market
maturity are Segmentation Theory
determined
separately

 Expectations Theory
o To illustrate what this means, consider 2 alternative investment strategies for
a 2-year time horizon
 Buy $1 of one-year bond, and when it measures, buy another one-
year bond with your money
 Buy $1 of 2-year bond and hold it
o The important point of this theory is that if the expectations theory is correct,
your expected wealth is the same (at the start) for both strategies. Of course,
your actual wealth may differ, if rates change unexpectedly after a year

o More generally for n-period bond…


Don’t let this seem complicated. Equation simply states that the
interest rate on a long-term bond equals the average of short rates
expected to occur over life of the long-term bond
 Numerical example
 One-year interest rate over the next 5 years are expected to
be 5%, 6%, 7%, 8% and 9%
 Interest rate on 2-year bond today:
 (5% + 6%)/2 = 5,5%
 interest rate for 5-year bond today:
 (5%+ 6%+ 7%+ 8%+ 9%)/ 5 = 7%
 interest rate for one- to five-year bonds today:
 5%, 5.5%, 6%, 6.5% and 7%
o expectations theory and term structure facts
 explains why yield curve has different slopes
 when short rates are expected to rise in future, average of
future short rates = int is above today’s short rate; therefore
yield curve is upward sloping
 when short rates expected to stay same in future, average of
future short rates same as today’s, and yield curve is flat
 only when short rates expected to fall will yield curve be
downward sloping
 Market Segmentation Theory
 Liquidity Premium Theory
o Investors prefer short-term rather than long-term bonds. This implies that
investors must be paid positive liquidity premium, int , to hold long term
bonds
o Results in following modification of Expectation Theory, where lnt is the
liquidity premium
o
o the relationship between the liquidity premium and expectations theories:

o numerical example:
 1-year interest rate over the next 5 years: 5%, 6%, 7%, 8%, and 9%
 investors’ preferences for holding short-term bonds so liquidity
premium for one- to five-year bonds: 0%, 0.25%, 0.5%, 0.75%, and 1%
 Interest rate on 2-year bond:
 0.25% + (5%+ 6%)/ 2= 5.75%
 interest rate on 5-year bond:
 1% + (5% + 6% + 7% + 8% + 9%)/ 5 = 8%
 interest rate on one- to five-year bonds:
 5%, 5.75%, 6.5%, 7.25% and 8%
 comparing with those for the pure expectations theory, liquidity
premium theory produces yield curves more steeply upward sloped

 market predictions of future short rates

o yield curves and the market’s expectations of future short-term interest rates
according to the liquidity premium theory

 evidence on the term structure

o initial research (early 1980s) found little useful information in the yield curve
for predicting future interest rates
o recently, more discriminating tests show that the yield curve has a lot of
information about very short-term and long-term rates, but says little about
medium-term rates
 case: interpreting yield curves
o the picture on the next slide illustrates several yield curves that we have
observed for US Treasury securities in recent years
o what do they tell us about the public’s expectations of future rates?
o Interpreting yield curves, 1980-2013
 Yield curves for US Government Bonds
o The steep downward curve in 1981 suggested that short-term rates were
expected to decline in the near future. This played-out, with rates dropping
by 300 bps in 3 months
o The upward curve in 1985 and 2013 suggested a rate increase in the near
future
o The moderately upward slopes in 1980 and 1997 suggest that short term
rates were not expected to rise or fall in the near term
o The steep upward slope in 2013 suggests short term rates in the future will
rise
 Mini-case: the term structure as a forecasting tool
o The yield curve does have information about future interest rates, and so it
should also help forecast inflation and real output production
 Rising (falling) rates are associated with economic booms (recessions)
 Rates are composed of both real rates and inflation expectations

CHAPTER SUMMARY
 Risk Structure of Interest Rates: examination of the key components of risk in debt:
default, liquidity, and taxes
 Term Structure of Interest Rates: examination of the various shapes the yield curve
can take, theories to explain this, and predictions of future interest rates based on
the theories
6. Are Financial Markets Efficient?
 Preview
o Expectations are very important in out financial system
 Expectations of returns, risk, and liquidity impact asset demand
 Inflationary expectations impact bond prices
 Expectations not only affect our understanding of markets, but also
ho<n financial institutions operate
o To better understand expectations?  examination of the efficient markets
hypothesis
 Framework for understanding what information is useful and what is
not
 However, we need to validate the hypothesis with real market data.
The results are mixed, but generally supportive of the idea
o The basic reasoning behind the efficient market hypothesis. Also:
examination of the empirical evidence examining this idea.
 The Efficient Market Hypothesis (EMH)
 Evidence on the Efficient Market Hypothesis
 Why the EMH does not imply that financial markets are efficient
 Behavioral finance
 Efficient Market Hypothesis
o Recall from chapter 3 that the rate of return for any position is the sum of the
capital gains ((Pt+1 – Pt) plus an cash payments (C):

o At the start of a period, the unknown element is the future price: Pt+1
But, investors do have some expectation of that price, thus giving us an
expected rate of return

o The EMH views the expectations as equal to optimal forecasts using all
available information:

o Assuming the market is in equilibrium:

Re = R*
o Put these ideas together: efficient market hypothesis

Rof = R*
Rof = R*
o This equation tells us that 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
o Financial economists state it more simply: a security’s price fully reflects all
available information in an efficient market

 Example of the EMH

 Rationale behind the hypothesis

o When an unexploited profit opportunity arises on a security (so-called
because, on average, people would be earning more than they should, given
the characteristics of that security), investors will rush to buy until the price
rises to the point that the returns are normal again
o In an efficient market, all unexploited profit opportunities will be eliminated
o Not every investor need be aware of every security and situation. As long as a
few keep their eyes open for unexploited profit opportunities, they will
eliminate the profit opportunities that appear because in so doing, they make
profit
o Why EMH makes sense
 If Rof > R* → Pt ↑ → Rof ↓
If Rof < R* → Pt ↓ → Rof ↑
Until Rof = R*
o All unexploited profit opportunities eliminated
o Efficient market condition holds even if there are uninformed, irrational
participants in market
 Evidence on EMH
o Favorable evidence
 Investment analysts and mutual funds don’t beat the market (note:
insider trading!)
 Stock prices reflect publicly available info: anticipated announcements
don’t affect price
 Stock prices and exchange rates close to random walk; unpredictable
 Technical analysis does not outperform market
 Evidence in favor of market efficiency
o Performance of investment analysts and mutual funds should not be able to
consistently beat the market
 The “Investment Dartboard” often beats investment managers
 Mutual funds not only do not outperform the market on average, but
when they are separated into groups according to whether they had
the highest or lowest profits in a chosen period, the mutual funds that
did well in the first period do not beat the market in the second
period
 Investment strategies using inside information is the only “proven
method” to beat the market In the US, it is illegal to trade on such
information, but that is not true in all countries
 ‘Legal insider trading’ by ‘insiders’
o do stock prices reflect publicly available information as the EMH predicts they
will?
 If information is already publicly available, a positive announcement
about a company will not, on average, raise the price of its stock
because this information is already reflected in the stock price
 Early empirical evidence confirms: favorable earnings announcements
or announcements of stock splits (a division of a share of stock into
multiple shares, which is usually followed by higher earnings) do not,
on average, cause stock prices to rise
o Random-walk behavior of stock prices that is, future changes in stock prices
should, for all practical purposes, be unpredictable
 If stock is predicted to rise, people will buy to equilibrium level; if
stock is predicted to fall, people will sell to equilibrium level (both in
concert with EMH)
 Thus, if stock prices were predictable, thereby causing the above
behavior, price changes would be near zero, which has not been the
case historically
o Technical analysis is the study past stock price data, searching for patterns
such as trends and regular cycles, suggesting rules for when to buy and sell
stocks
 The EMH suggests that technical analysis is a waste of time
 The simplest way to understand why is to use the random-walk result
that holds that past stock price data cannot help predict changes
 Therefore, technical analysis, which relies on such data to produce its
forecasts, cannot successfully predict changes in stock prices
 Mini-case: Raj Rajaratnam
o In the mid-2000s, Mr. Rajaratnam of Galleon Group made millions of dollars
for himself and his investors by investing in firms on which he allegedly
received inside information. His strategy shows that you can profit from
information that the market does not have. But that strategy landed him in
jail for insider trading
 Case: foreign exchange rates
o Could you make a bundle if you could predict FX rates?  Of course.
o EMH predicts, then, that FX rates should be unpredictable
o Oddly enough, that is exactly what empirical tests show – FX rates are not
very predictable
 Evidence against market efficiency
o Unfavorable evidence
 Small-firm effect: small firms have abnormally high returns
 The Small-Firm Effect is an anomaly. Many empirical studies
have shown that small firms have earned abnormally high
returns over long periods of time, even when the greater risk
for these firms has been considered
 The smell-firm effect seems to have diminished in recent years
but is still a challenge to the theory of efficient markets
 Various theories have been developed to explain the small-
firm effect, suggesting that it may be due to rebalancing of
portfolios by institutional investors, tax issues, low liquidity of
small firm stocks, large information costs in evaluating small
firms, or an inappropriate measurement of risk for small-frim
stocks
 January effect: high returns in January
 The January Effect is the tendency of stock prices to
experience an abnormal positive return in the month of
January that s predictable and, hence, inconsistent with
random-walk behavior
 Investors have an incentive to sell stocks before the end of the
year in December because they can then take capital losses on
their tax return and reduce their tax liability.
Then when the new year starts in January, they can
repurchase the stocks, driving up their prices and producing
abnormally high returns
 Although this explanation seems sensible, it does not explain
why institutional investors such as private pension funds,
which are not subject to income taxes, do not take advantage
of the abnormal returns in January and buy stocks in
December, thus bidding up their prices and eliminating the
abnormal returns
 Market overreaction
 Recent research suggests that stock prices may overreact to
news announcements and that the pricing errors are corrected
only slowly
 When corporations announce a major change in
earning, say a large decline, the stock price may
overshoot, and after an initial large decline, it may rise
back to more normal levels over a period of several
weeks
 This violates the EMH because an investor could earn
abnormally high returns, on average, by buying a stock
immediately after a poor earnings announcement and
then selling it after a couple of weeks when it has risen
back to normal levels
 Excessive volatility
 The stock market appears to display excessive volatility; that
is, fluctuations in stock prices may be much greater than is
warranted by fluctuations in their fundamental value
 Researchers have found that fluctuations in the S&P
500 stock index could not be justified by the
subsequent fluctuations in the dividends of the stocks
making up this index
 Other research finds that there are smaller fluctuations
in stock prices when stock markets are closed, which
has produced a consensus that stock market prices
appear to be driven by factors other than
fundamentals
 Mean reversion
 Some researchers have found that stocks with low returns
today tend to have high returns in the future, and vice versa
 Hence stocks that have done poorly in the past are
more likely to do well in the future because mean
reversion indicates that there will be a predictable
positive change in the future price, suggesting that
stock prices are not a random walk
 Newer data is less conclusive; nevertheless, mean
reversion remains controversial

 New information is not always immediately incorporated into stock

prices
 Although generally true, recent evidence suggests that,
inconsistent with the efficient market hypothesis, stock prices
do not instantaneously adjust to profit announcements
 Instead, on average stock prices continue to rise for some time
after the announcement of unexpectedly high profits, and they
continue to fall after surprisingly low profit announcements
 The practicing manager: implications for investing
o How valuable are published reports by investment advisors?
o Should you be skeptical of hot tips?
 YES. The EMH indicates that you should be skeptical of hot tips since,
if the stock market is efficient, it has already priced the hot tip stock
so that its expected return will equal the equilibrium return
 Thus, the hot tip is not particularly valuable and will not enable you to
earn an abnormally high return
 As soon as the information hits the street, the unexploited profit
opportunity it creates will be quickly eliminated
 The stock’s price will already reflect the information, and you should
expect to realize only the equilibrium return
o Do stock prices always rise when there is good news?
 NO. in an efficient market, stock prices will respond to
announcements only when the information being announced is new
and unexpected
 So, if good news was expected (or as good as expected), there will be
no stock price response
 And, if good news was unexpected (or not as good as expected), there
will be a stock price response

o Efficient markets prescription for investor

 Investors should not try to outguess the market by constantly buying
and selling securities. This process does nothing but incur
commissions costs on each trade
 Instead, the investor should pursue a “buy and hold” strategy –
purchase stocks and hold them for long periods of time. This will lead
to the same returns, on average, but the investor’s net profits will be
higher because fewer brokerage commissions will have to be paid
 It is frequently a sensible strategy for a small investor, whose costs of
managing a portfolio may be high relative to its size, to buy into a
mutual fund or tracker rather than individual stocks. Because the
EMH indicates that no mutual fund can consistently outperform the
market, an investor should not buy into one that has high
management fees or that pays sales commissions to brokers but
rather should purchase a no-load (commission-free) mutual fund that
has low management fees
 Why the EMH does not imply that financial markets are efficient
o A strong view of EMH states that (1) expectations are rational, and (2) prices
are always correct and reflect market fundamentals
o This has 3 important implications:
 One investment is just as good as any other (stock picking is pointless)
 Prices reflect all information
 Cost of capital can be determined from security prices, assisting in
capital budgeting decisions
 Case: What do stock market crashes tell us about the efficient market hypothesis?
o Does any version of Efficient Markets Hypothesis (EMH) hold in light of
sudden or dramatic market declines?
o Strong version EMH?
o Weaker version EMH?
o A bubble is a situation in which the price of an asset differs from its
fundamental market value
 Can bubbles be rational?
o Role of behavioral finance
 Behavioral Finance
o Dissatisfaction with using the EMH to explain events like 1987’s Black
Monday gave rise to the new field of behavioral finance, in which concepts
from psychology, sociology, and other social sciences are applied to
understand the behavior of securities prices
o EMH suggests that “smart” money would engage in short sales to combat
overpriced securities, yet short sale volume is low, leading to behavioral
theories about “loss aversion”
o Other behavioral analysis points to investor overconfidence as perpetuating
stock price bubbles
CHAPTER SUMMARY
 The Efficient Market Hypothesis: examination of the theory of how both old and new
information are expected to be incorporated into current stock prices
 Evidence on the Efficient Market Hypothesis: evidence for various tests of the
hypothesis and how well the hypothesis holds
 EMH does not imply efficient markets: the EMH only implies that prices are
unpredictable, which is not as strong as stating that prices are correct
 Behavioral Finance: examination of another area of research to explain how stock
prices are formed based on psychological factors affecting investors.

PART 3: FUNDAMENTAL OF FINANCIAL INSTITUTIONS

7. Are Financial Markets Efficient?
 Preview
o A vibrant economy requires a financial system that moves funds from savers
to borrowers. But how does it ensure that your hard-earned dollars are used
by those with the best productive investment opportunities?
o Why do financial institutions exit and how do they promote economic
efficiency
 Basic facts about financial structure throughout the world
 Transaction costs
 Asymmetric information: adverse selection and moral hazard
o The Lemons problem: how adverse selection influences financial structure
o How moral hazard affects the choice between debt and equity contracts
o How moral hazard influences financial structure in debt markets
o Conflicts of interest
 Basic facts about financial structure throughout the world
o The financial system is a complex structure including many different financial
institutions: banks, insurance companies, mutual funds, stock and bonds
markets, etc.
o This chart shows how nonfinancial business attain external funding in the US,
Germany, Japan, and Canada. Notice that, although many aspects of these
countries are quite different, the sources of financing are somewhat
consistent, with the US being different in its focus on debt

o Sources of foreign external finance  sources of external funds for

nonfinancial businesses…

 Facts of financial structure

1) Stocks are not the most important source of external financing for
businesses
2) Issuing marketable debt and equity securities is not the primary way
in which businesses finance their operations
3) Indirect finance, which involves the activities of financial
intermediaries, is many times more important than direct finance, in
which businesses raise funds directly from lenders in financial markets
4) Financial intermediaries, particularly banks, are the most important
source of external funds used to finance businesses
5) The financial system is among the most heavily regulated sectors of
economy
6) Only large, well-established corporations have easy access to
securities markets to finance their activities.
7) Collateral is a prevalent feature of debt contracts for both households
and businesses
8) Debt contracts are typically extremely complicated legal documents
that place substantial restrictions on the behavior of the borrowers

 Transaction costs
o Transactions costs influence financial structure
 E.g., a $5 000 investment only allows you to purchase 100 shares @
$50/ share (equity)
 No diversification
 Bonds even worse – most have a $1 000 size
o In sum, transactions costs can hider flow of funds to people with productive
investment opportunities
o Financial intermediaries make profits by reducing transactions costs
 Take advantage of economies of scale (ex.: mutual funds)
 Develop expertise to lower transactions costs
 Also provides investors with liquidity, which explains fact #3

 Asymmetric information: adverse selection and moral hazard

o In introductory finance course: assumption of a world of symmetric
information – the case where all parties to a transaction or contract have the
same information
o In many situations, this is not the case. We refer to this as asymmetric
information
o Asymmetric information can take on many forms, and is quite complicated.
However, to begin to understand the implications of asymmetric information
 focus:
 Adverse selection
 Occurs when one party in a transaction has better information
than the other party
 Before transaction occurs
 Potential borrowers most likely to produce adverse outcome
are ones most likely to seek loan and be selected
 Moral hazard
 Occurs when one party has an incentive to behave differently
once an agreement is made between parties
 After transaction occurs
 Hazard (danger) that borrower has incentives to engage in
undesirable (immoral) activities making it more likely that
won’t pay loan back
o The analysis of how asymmetric information problems affect behavior is
known as agency theory
o Ideas of adverse selection and moral hazard to explain how they influence
financial structure
 The Lemons problem: how adverse selection influences financial structure
o Lemons Problem in used cars
 If we can’t distinguish between “good” and “bad” (lemons) used cars,
we are willing pay only an average of good and bad car values
 Result: good cars won’t be sold, and the used car market will function
inefficiently
o What helps us avoid this problem with used cars?
o Lemons problem in securities markets
 If we can’t distinguish between good and bad securities, willing to pay
only average of good and bad securities’ value
 Result: good securities undervalued and firms won’t issue them; bad
securities overvalued so too many issued
 Investors don’t want to buy bad securities, so markets don’t function
well
 Explains fact #1 and #2
 Also explains fact #6: less asymmetric info for well known firms, so
smaller lemons problems
 Tools to help solve adverse selection (Lemons) problems
o Private production and sale of information
 Free-rider problem interferes with this solution
o Government regulation to increase information (fact #5)
 For example, annual audits of public corporations (although Enron is a
shining example of why this does not eliminate the problem – we’ll
discuss that briefly)
o Financial intermediation
 Analogy to solution to lemons problem provided by used car dealers
 Avoid free-rider problem by making private loans (explains fact #3 and
#4)
 Also explains fact #6 – large firms are more likely to use direct instead
of indirect financing
o Collateral and net worth
 Explains fact #7
 The Enron Implosion
o Up to 2001, Enron appeared to be a very successful firm engaged in energy
trading
o However, that the firm had severe financial problems, and hid many of its
problems in complex financial structures that allowed Enron to not report
them
o Even though Enron regularly filed records with the SEC, the problem was not
prevented
o Even worse, its auditor Arthur Andersen eventually plead guilty to
obstruction of justice charges. With that plea, one of the largest and trusted
auditors closed its doors forever
 How moral hazard affects the choice between debt and equity contracts
o Moral hazard in equity contracts: the principal –agent problem
 Result of separation of ownership by stockholder (principals) from
control by managers (agents)
 Managers act in own rather than stockholders’ interest
o An example of this problem is useful. Suppose you become a silent partner in
an ice cream store, providing 90% of the equity capital ($9 000). The other
owner, Steve, provides the remaining $1 000 and will act as the manager. If
Steve works hard, the store will make $50 000 after expenses, and you are
entitles to $45 000 of it
o However, Steve doesn’t really value the $5 000 (his part), so he goes to the
beach, relaxes, and eve, spends some of the “profit” on art for his office. How
do you, as 90% owner, give Steve the proper incentives to work hard?
o Tolls to help solve the principal-agent problem
1) Production of information: monitoring
2) Government regulation to increase information
3) Financial intermediation (e.g. venture capital)
4) Debt contracts
o Explains fact #1: why debt is used more than equity
 How moral hazard influences financial structure in debt markets
o Even with the advantages just described, debt is still subject to moral hazard.
In fact, debt may create an incentive to take on very risky projects. This is
important to understand.
o Example: most debt contracts require the borrower to pay a fixed amount
(interest) and keep any cash flow above this amount
For example, what if a firm owes $100 in interest, but only has $90? It is
essentially bankrupt. The firm “has nothing to lose” by looking for “risky”
projects to raise the needed cash
o Tools to help solve moral hazard in debt contracts
 Net worth and collateral
 Monitoring and enforcement of restrictive covenants
Examples are covenants that…
 Discourage undesirable behavior
 Encourage desirable behavior
 Keep collateral valuable
 Provide information
 Financial intermediation – banks and other intermediaries have
special advantages in monitoring
o Explains facts #1-4

 Asymmetric information problems and tools to solve them

 Case: financial development and economic growth
o Financial repression leads to low growth
o Why?
 Poor legal system
 Weak accounting standards
 Government directs credit (state-owned banks)
 Financial institutions nationalized
 Inadequate government regulation
o Financial crises
 Mini-case: should we kill all the lawyers?
o Lawyers are an easy target as a cause of problems.
Shakespeare’s character Dick the Butcher quips, “… let’s kill all the lawyers.”
Is he right?
o Most legal work is about contract enforcement:
 Establish and maintain important property rights
 Without such rights, limited Investments
 The US has more lawyers/ capita than any nation. Arguably the richest
as well. Coincidence?
 Financial crises and aggregate economic activity
o Our analysis of the effects of adverse selection and moral hazard can also
assist us in understanding financial crises, major disruptions in financial
markets. The end result of most financial crises in the inability of markets to
channel funds from savers to productive investment opportunities
 Is China a Counter-example?
o Even with its booming economy, China’s financial development is still in an
early stage
o Per capital income is around $10 000, but savings are around 40%, allowing
China to build up capital stocks as labor moves out of subsistence agriculture
o However, this is unlikely to work for long
o Russia in the 1950s had a similar economy, and few would argue that modern
Russia is a success story
o To continue its growth, China needs to allocate capital more efficiently. Many
of the financial repression problems we outlined are being addressed by
Chinese authorities today
 Conflicts of interest
o Conflicts of interest are a type of moral hazard that occurs when a person or
institution has multiple interests, and serving one interest is detrimental to
the other
o 3 classic conflicts developed in financial institutions. Looking at these closely
offers insight in avoiding these conflicts in the future
Underwriting and research in investment banking
o investment banks may not research companies with public securities, as well
as underwrite securities for companies for sale to the public
o research is expected to be unbiased and accurate, reflecting the facts about
the firm. It is used by the public to form investment choices
o underwriters will have an easier time if research is positive. Underwriters can
better serve the firm going public if the firm’s outlook is optimistic
o an investment bank acting as both a researcher and underwriter of securities
for companies clearly has a conflict – serve the interest of the issuing firm or
the public?
o During the tech boom, research reports were clearly distorted to please
issuers. Firms with no hope of ever earning a profit received favorable
research
o This also lead to spinning, where underpriced equity was allocated to
executives who would promise future business to the investment bank
Auditing and consulting in accounting firms
o Auditors check the assets and books of a firm for the quality and accuracy of
the information. The objective in an unbiased opinion of the firm’s financial
health
o Consultants, for a fee, help firms with variety of managerial, strategic, and
operational projects
o An auditor acting as both an auditor and consultant for a firm clearly is not
objective, especially if the consulting fees exceed the auditing fees
o The case of Arthur Andersen, of course epitomizes this conflict. A myriad of
conflicts with its client Enron resulted in the eventual demise of Arthur
Andersen when Enron collapsed.
Credit assessment and consulting in rating agencies
o Rating agencies assign a credit rating to a security issuance of a firm based on
projected cash flow, asset pledged, etc.
The rating helps determine the riskiness of a security
o Consultants, for a fee, help firms with variety of managerial, strategic, and
operational projects
o A rating agency as both a rater and consultant for a firm clearly is not
objective, especially if the consulting fees exceed the rating fees
o Rating agencies, such as Moody’s and Standard and Poor, were caught in this
game during the housing bubble. Firms asked the rater to help structure debt
offerings to attain the highest rating possible. When the debt subsequently
defaulted, it was difficult for the agency to justify the original high rating.
Perhaps it was just error. But few believe that – most see the rating agencies
as being blinded by high consulting fees.
o In short, the SEC stepped in and proposed new regulation. For example, a
rating agency can no longer rate a security that they helped structure. But
the steps go further, creating a real regulatory reporting hassle for these
firms
(Mini-cases)
 Remedies?
o Aside from the 2 mini-cases, has much been done to remedy conflicts? YES
o Sarbanes-Oxley Act of 2002
 Established an oversight board to supervise accounting firms
 Increased the SEC’s budget for supervisory activities
 Limited consulting relationships between auditors and firms
 Enhanced criminal charges for obstruction
 Improved the quality of the financial statements and board
o Global Legal Settlement of 2002
 Required investment banks to sever links between research and
underwriting
 Spinning is explicitly banned
 Imposed a $1.4 billion fine on accused investment banks
 Added additional requirement to ensure independence and
objectivity of research reports
o Will these work?
 It’s too early to determine yet
 However, there is much criticism over the cost involved with these
separations. In other words, financial institutions can no longer take
advantage of the economies of scope gained from relationships
 Some have argued that Sarbanes-Oxley has negatively impacted the
value of US Capital markets. The details that follow:
 Mini-case: has SOX led to a decline in US capital markets?
o The cost of implementing Sarbanes-Oxley is not trivial. For companies with
less than $100 million in sales, it’s estimated to be around 1% of sales
o During the same period, European countries have made it easier for firms to
go public
o Both equity issuances and bond issuances are growing faster now in Europe
than in the US. It is time to revisit this bill to determine if the beneifts
outweigh the costs?
CHAPTER SUMMARY
 Basic facts about financial structure throughout the world: review of 8 basic facts
concerning the structure of the financial system
 Transaction costs: examination of how transaction costs can hinder capital flow and
the role financial institutions play in reducing transaction costs
 Asymmetric information: adverse selection and moral hazard
o Definition of asymmetric information along with 2 categories of asymmetric
information – adverse selection and moral hazard
 The lemons problem: how adverse selection influences financial structure
o Discussion of how adverse selection effects the flow of capital and tools to
reduce this problem
 How moral hazard affects the choice between debt and equity contracts: review of
the principal-agent problem and how moral hazard influences the use of more debt
than equity
 How moral hazard influences financial structure in debt markets: discussion of how
moral hazard and debt may lead to increased risk-taking, and tools to reduce this
problem
 Conflicts of interest: review of several examples of conflicts in our economy, many of
which ended badly.
Can we address these in the future before they lead to severe problems?
8. Why do financial crises occur and why are they so damaging to the
economy?
 Preview
o Financial crises are major disruptions in financial markets characterized by
sharp declines in asset prices and frim failures.
Binning in August 2007, the US entered into a crises that was described as a
“once-in-a-century credit tsunami”
o Why did this financial crisis occur? Why have financial crises been so
prevalent throughout US history, as well as in so many other countries, and
what insights do they provide on the current crisis? Why are financial crises
almost always followed by severe contractions in economy activity?
o Chapter 8: development of a framework to understand the dynamics of
financial crises
 What is financial crises?
 Dynamics of financial crises in advanced economies
 What is a financial crises?
o A functioning financial system is critical to a robust economy
o However, both moral hazard and adverse selection are still present. The
study of these problems (agency theory) is the basis for understanding and
defining a financial crisis
o Asymmetric information creates barriers between savers and firms with
productive investment opportunities
o A financial crisis occurs when information flows in financial markets
experience a particularly large disruption. Financial markets may stop
functioning completely
 Dynamics of financial crises in advanced economies
o Financial crises hit countries like the US every so often, and each event helps
economists gain insights into present-day turmoil
o These crises usually proceed in 2 or 3 stages:
 Sequence of events in (US) financial crises in advanced economies
Stage 1: initiation
Financial crisis can begin in several ways:
 Credit boom and bust
 Asset-price boom and bust
 Increase in uncertainty

o The seeds of a financial crises can begin with mismanagement of financial

liberalization or innovation:
 Elimination of restrictions
 Introduction of new types of loans or other financial products
o Either can lead to a credit boom, where risk management is lacking
 Government safety nets weaken incentives for risk management.
Depositors ignore bank risk-taking
 Eventually, loan losses accrue, and asset values fall, leading to a
reduction in capital
 Financial institutions cut back in lending, a process called
deleveraging. Banking funding falls as well
 As FIs cut back on lending, no one is left to evaluate firms. The
financial system losses its primary institution to address adverse
selection and moral hazard
 Economic spending contracts as loans become scarce
o A financial crisis can also begin with an asset-price boom and bust:
 A pricing bubble starts, where asset values exceed their fundamental
values
 When the bubble bursts and prices fall, corporate net worth falls as
well. Moral hazard increases as firms have little to lose
 FIs also see a fall in their assets, leading again to deleveraging
o Finally, a financial crisis can begin with an increase in uncertainty:
 Periods of high uncertainty can lead to crisis, such as stock market
crashes or the failure of a major financial institution
 Examples:
 1857, when Ohio Life Insurance & Trust Company failed
 2008, when AIG, Bear Sterns, and Lehman Bros. failed
 with information hard to come by, moral hazard and adverse
selection problems increase, reducing lending and economic activity
Stage 2: banking crisis
o deteriorating balance sheets lead financial institutions into insolvency. If
severe enough, these factors can lead to a bank panic & bank run
 panics occur when depositors are unsure which banks are insolvent,
causing all depositors to withdraw all funds immediately
 as cash balances fall, FIs must sell assets quickly, further deteriorating
their balance sheet
 adverse selection and moral hazard become severe – it takes years for
full recovery
Stage 3: debt deflation
o consider a frim in 2015 with assets of $100 million (in 2015 dollars), $90
million of long-term liabilities, and so $10 million in net worth
o price levels fall by 10% in 2016. Real value of assets (in 2015 dollars) remains
the same
o real value of liabilities rise to $99 million (in 2015 dollars), and so net worth
falls to just $1 million!
o If the crisis also leads to a sharp decline in prices, debt deflation can occur,
where asset prices fall, but debt levels do not adjust, increasing debt burdens
 This leads to an increase in adverse selection and moral hazard, which
is followed by decreased lending
 Economic activity remains depressed for a long time
 Cases
o Examination of several cases which highlight various financial crises, focusing
on how they started and the impact they had:
 The Great Depression
 The Global Financial Crisis of 2007-2009

Case: The Great Depression

o In 1928 and 1929, stock prices doubled in the US. The Fed tried to curb this
period of excessive speculation with a tight monetary policy. But this lead to
a stock market collapse of more than 20% in October of 1929, and losing an
additional 20% by the end of 1929.
The decline continued for several years
o Stock market prices during the Great Depression:

o We might have been a normal recession turned into something far worse,
when severe droughts in 1930 in the Midwest led to a sharp decline in
agricultural production
o Between 1930 and 1933, one-third of US banks went out of business as these
agricultural shocks led to bank failures
o For more than 2 years, the Fed sat idly by through one bank panic after
another
o Adverse selection and moral hazard in credit markets became severe. Firms
with productive uses of funds were unable to get financing. As seen in the
next slide, credit spreads increased from 2% to nearly 8% during the height of
the Depression in 1932

o Credit spreads during the great depression:

o The deflation during the period lead to a 25% decline in price levels
o The prolonged economic contraction lead to an unemployment rate around
25%
o The Depression was the worst financial crisis ever in the US. It explains why
the economic contraction was also the most severe ever experienced by the
nation
o Bank panics in the US spread to the rest of the world, and the contraction of
the US economy decreased demand for foreign goods
o The worldwide depression caused great hardship, and the resulting
discontent led to the rise of fascism and WWII
Case: The Global Financial Crisis of 2007-2009
o We begin our look at the 2007-2009 financial crisis by examining three
central factors:
 Financial innovation in mortgage markets
 Agency problems in mortgage markets
 The role of asymmetric information in the credit rating process
o Financial innovation in mortgage markets developed along a few lines:
 Less-than-credit worthy borrowers found the ability to purchase
homes through subprime lending, a practice almost nonexistent until
the 2000s
 Financial engineering developed new financial products to further
enhance and distribute risk from mortgage lending
o Agency problems in mortgage markets also reached new levels:
 Mortgage originators did not hold the actual mortgage, but sold the
note in the secondary market
 Mortgage originators earned fees from the volume of the loans
produced, not the quality
 In the extreme, unqualified borrowers bought houses they could not
afford through either creative mortgage products or outright fraud
(such as inflated income)
 Finally the rating agencies didn’t help:
 Agencies consulted with firms on structuring products to
achieve the highest rating, creating a clear conflict
 Further, the rating system was hardly designed to address the
complex nature of the structured debt designs
 The result was meaningless ratings that investors had relied on
to assess the quality of their investments
o Many suffered as a result of the 2007-2009 financial crisis.  5 areas:
 US residential housing
 FIs balance sheets
 The “shadow” banking system
 Global financial markets
 The failure of major financial firms
o Initially, the housing boom was lauded by economics and politicians. The
housing boom helped stimulate growth in the subprime market as well
o However, underwriting standard fell. People were clearly buying houses they
could not afford, except for the ability to sell the house for a higher price
o Lending standards also allowed for near 100% financing, so owners had little
to lose by defaulting when the housing bubble burst
o The rise and fall of housing prices in the US. The number of defaults
continues to plague the US banking system
 Housing prices and the financial crisis of 2007-2009

 Was the Fed to blame for the housing price bubble?

 Some argue that low interest rates from 2003 to 2006 fueled the housing bubble
(the Taylor rule)
 In early 2010, Mr. Bernanke rebutted this argument. He argued rates were
appropriate
 He also pointed to new mortgage products, relaxed lending standards, and
capital inflows as more likely causes
 Bernanke’s speech was very controversial, and the debate over whether
monetary policy was to blame for the housing price bubble continues to this day

o As mortgage defaults rose, banks and other FIs saw the value of their assets
fall. This was further complicated by the complexity of mortgages, CDOs,
defaults swaps, and other difficult-to-value-assets
o Banks began the deleveraging process, selling assets and restricting credit,
further depressing the struggling economy
o The shadow banking system also experienced a run. These are the hedge
funds, investment banks, and other liquidity providers in our financial system.
When the short-term debt markets seized, so did the availability of credit to
this system. This lead to further “fire” sales of assets to meet higher credit
standards
o The fall in stock market and the rise in credit spread further weakened both
firm and household balance sheets
o Both consumption and real investment fell, causing a sharp contraction in the
economy
 stock priced and the financial crisis of 2007-2009

 credit spreads and the 2007-2009 financial crisis

o Europe was actually first to raise the alarm in the crisis. With the downgrade
of $10 billion in mortgage related products, short term money markets froze,
and in August 2007, a French investment house suspended redemption of
some of its money market funds. Banks and firms began to horde cash
o The end of credit lead to several bank failures
o In September 2007, Northern Rock was one of the first, relying on short-term
credit markets for funding. Others soon followed
o By most standards, Europe experienced a more severe downturn that the US

o Finally, the collapse of several high-profile US investment firms only further

deteriorated confidence in the US
 March 2008: Bear Sterns fails and is sold to JP Morgan for 5% of its
value only 1 year ago
 September 2008: both Freddie Mac and Fannie May put into
conservatorship after heaving subprime losses
 September 2008: Lehman Brothers files for bankruptcy. Merrill Lynch
sold to Bank of America at “fire” sale prices. AIG also experiences a
liquidity crisis
The crisis and impaired credit markets have caused the worst economic
contraction since WWII
o The crisis peaked in September of 2008
o Congress passed a bailout package, but the stock market continued to
decline, and credit spreads reached over 500 bps.
o The fall in reals GDP and increase in unemployment to over 10% in 2009
impacted almost everyone
o The recession that started in December 2007 became the worst economic
contraction in the US since WWII, and is now called the “Great Recession”
o Starting in March 2009, a bull market in stock got under way and credit
spreads began to fall
o Unfortunately, the pace of the recovery has been slow

 GLOBAL: The European Sovereign Debt Crisis

o Up until 2007, all the countries that had adopted the euro found their
interest rates converging to very low levels
o At the same time, several of these countries were hit very hard:
 Lower tax revenue from economic contraction
 High outlays for FI bailouts
 Fear of gov’t default cause rates to surge
o Greece was the first domino to fall
 In September 2008, government projected a 6% deficit and debt-to-
GDP of 100%
 In October, with newly elected officials, numbers were shown to be
far worse
 Dear of default caused rates on Greek debt to peak near 40%
 Debt-to-GDP rose to 160% in 2012
 Greece was forced to write-down its debt (partial default)
 Civil unrest broke out as unemployment rates climbed
 The prime minister was eventually forced to resign

o Ireland, Portugal, Spain, and Italy followed

 Governments forced to embrace austerity measures to shore up their
public finances
 Interest rates climbed to double-digit levels
 Severe recessions resulted, despite assurances from the ECB to help
 Unemployment rate rose to double-digits (25% in Spain)
o Will the Euro survive?

 Mini-case: CDOs
o Collateralized Debt Obligations (CDO) – their role in the crisis
 A special purpose vehicle (SPV) is created to buy assets, create
securities from those assets, and then sell those securities to investors
 in a CDO, the securities (or tranches) are created based on default
priorities. The first defaults go to the lowest rated tranches. The
highest rated tranches suffer defaults if most of the assets default
o there are many, many tranches in a CDO, each with different exposure to
defaults:
 the highest rated tranches are called super senior tranches
 the next bucket is known as the senior tranche – it has a little more
risk and pays a higher interest rate
 the next tranche is the mezzanine tranche – it bears more risk and has
an even higher interest
 the lowest tranche is the equity tranche – this is the first tranche that
suffers losses from defaults
o it can be difficult to determine exactly what they are worth and who has the
rights to what cash flows
o in a speech in the middle of the crisis, Ben Bernanke, the chairman of the
Federal Reserve, joked that he “would like to know what those damn things
are worth”
o bottom line – increased complexity of structured products can actually
reduce the amount of information in financial markets.

CHAPTER SUMMARY
 what is a financial crisis: review of the ideas of embodied in agency theory as a
framework for the examination of what a financial crisis is.
 dynamics of financial crises in advanced economies: examination of the stages of a
crisis in an advanced economy. Further… examination of the 2007-2009 US financial
crisis

[Link] Bond Market

 Preview
o Focus on the long-term securities: bonds
 Bonds are like money market instruments, but they have maturities
that exceed one year
 These include Treasury bonds, corporate bonds, mortgages, and the
like
o Important terms and notions
 Purpose of the Capital Market
 Capital Market Participants
 Capital Market Trading
 Types of Bonds
 Treasury Notes and Bonds
 Municipal Bonds
 Corporate Bonds
 Financial Guarantees for Bonds
 Current Yield Calculation
 Finding the Value of Coupon Bonds
 Investing in Bonds

 Purpose of the Capital Market

o Original maturity is greater than 1 year, typically for long-term financing or
investments
o Best known capital market securities:
 stocks and bonds
 Capital Market Participants
o Issuers of securities:
 Federal and local governments: debt issuers
 Corporations: equity and debt issuers
o Largest purchasers of securities:
 You and me (everyone)
 Capital Market Trading
o Primary market for initial sale (IPO)
o Secondary market
 Over-the-counter (bonds)
 Organized exchanges (i.e., NYSE) (stocks)

 Types of Bonds
o Bonds are securities that represent debt owed by the issuer to the investor,
and typically have specified payments on specific dates
o Types of bonds:
 long-term government bonds (T-bonds)
 municipal bonds
 corporate bonds
 sample corporate bond  Hamilton/ BP Corporate Bond

 Treasury Notes and Bonds

o The US Treasury issues notes and bonds to finance its operations
o The following table summarizes the maturity differences among the various
Treasury securities
o Treasury securities:
o Treasury bond interest rates
 “No default risk” since Treasury can print money to payoff the debt
 very low interest rates, often considered the “risk-free rate” (although
inflation risk is still present)
 interest rate on Treasury Bonds and the inflation rate, 1973-2013
(January of each year)

 bills vs. bonds

 interest rate on Treasury bills and treasury bonds, 1974-2013
(January of each year)
o recent innovation:
 treasury inflation-indexed securities:
 the principal amount is tied to the current rate of inflation to
protect investor purchasing power
 treasury strips
 the coupon and principal payments are “stripped” from a T-
bond and sold as individual zero-coupon bonds

o agency debt:
 Although not technically Treasury securities, agency bonds are issued
by government-sponsored entities, such as GNMA, FNMA, and FHLMC
 The debt gas an “implicit” guarantee that the US government will not
let the debt default. This “guarantee” was clear during the 2008
bailout…
The 2007-2009 Financial Crisis: bailout of Fannie and Freddie
o Both Fannie May and Freddie Mac managed their political situation
effectively, allowing them to engage in risky activities, despite concerns
raised
o By 2008, the 2 had purchased or guaranteed over $5 trillion in mortgages or
mortgage-backed securities
o Part of this growth was driven by their Congressional mission to support
affordable housing. They did this by purchasing subprime mortgages
o As these mortgages defaulted large losses mounted for both agencies
o In 2013, Fannie May repaid $59,4 billion of its $117 billion in bailout
o Freddie Mac has paid back about $37 billion of the $72 billion it received

 Municipal Bonds
o Issued by local, county, and state governments
o Used to finance public interest projects
o Tax-free municipal interest rate = taxable interest rate x (1 – marginal tax
rate)
o Example:
 Suppose the rate on a corporate bond is 9% and the rate on a
municipal bond is 6,75%
Which should you choose?
Answer: find the marginal tax rate:
 6,75% = 9% x (1 – MTR), or MTR= 25%
if you are in a marginal tax rate above 25%, the municipal bond offers
a higher after-tax cash flow
 suppose the rate on a corporate bond is 5% and the rate on a
municipal bond is 3,5%
Which should you choose? Your marginal tax rate is 28%
Find the equivalent tax-free rate (ETFR):
 ETFR= 5% x (1 – MTR) = 5% x (1 – 0,28)
The ETFR = 3,36%
If the actual muni-rate is above this (it is), choose the muni
o Two types
 General obligation bonds
 Revenue bonds

o NOT default-free (e.g., Orange County California)

 Defaults in 1990 amounted to $1,4 billion in this market
o Comparing revenue and general obligation bonds
 Issuance of revenue and general obligation bonds, 1984-2012

 Corporate bonds
o Typically have a face value of $1000, although some have a face value of
$5000 or $10 000
o Pay interest semi-annually (USD) or annually (EUR)
o Cannot be redeemed anytime the issuer wishes, unless a specific clause
states this (call option)
o Degree of risk varies with each bond, even from the same issuer. Following
suite, the required interest rate varies with level of risk
o The degree of risk ranges from low-risk (AAA) to higher risk (BBB). Any bonds
rated below BBB are considered sub-investment grade debt
o Interest rates:

o Characteristics of corporate bonds

 Conversion
 Some debt may be converted to equity
 Similar to a stock option, but usually more limited
 Convertible bonds
 E.g.: $1000 face value
 Share price at issue of convertible = $20
 Conversion price = $25
 Conversion premium = 25%
 Conversion period = 5 year
 Investor will convert bonds in shares if shares trade at $25 or
higher
 Conversion will typically only happen near maturity of the
bonds
 Secured bonds
 Mortgage bonds
 Equipment trust certificates
 Unsecured bonds
 Debentures
 Subordinated debentures
 Variable-rate bonds
 Junk bonds
 Debt that is rated below BBB
 Often, trusts and insurance companies are not permitted to
invest in junk debt
 Michael Milken developed this market in the mid-1980s,
although he was subsequently convicted of insider trading

 Debt ratings – descriptions:

 Financial Guarantees for Bonds
o Some debt issuers purchase financial guarantees to lower the risk of their
debt
o The guarantee provides for timely payment of interest and principal, and are
usually backed by large insurance companies
o As it turns out, not all guarantees actually make sense
 In 1995, JPMorgan created the credit default swap (CDS) a type of
insurance on bonds
 In 2000, Congress removed CDSs from any oversight
 By 2008, the CDS market was over $62 trillion
 2008 losses on mortgage lead to huge payouts on this insurance
 Bond (Current) Yield Calculation
o Bond yields are quoted using a variety of conventions, depending on both the
type of issue and the market
o Focus: the current yield calculation that is commonly used for long-term debt
o What is the current yield for a bond with a face value of $1000 a current price
of $921,01 and a coupon rate of 10,95%?
Answer: i c = C/P = $109,50 / $921,01 = 11,89%
Note: C (coupon) = 10,95% x $1000 = $109,50
 Finding the Value of Coupon Bonds
o Bond pricing is, in theory, no different than pricing any set of known cash
flows
o Once the cash flows have been identified, they should be discounted to time
zero at an appropriate discount rate
o Bond terminology:

o Let’s use a simple example to illustrate the bond pricing idea

What is the price of two-year, 10% coupon bond (semi-annual coupon
payments) with a face value of $1000 and a required rate of 12%?
SOLUTION:
 Identify the cash flows
 $50 is received every six months in interest
 $1000 is received in two years as principal repayment
 Find the present value of the cash flows (calculator solution):
 N=4, FV= 1000, PMT= 50, I=6
 Computer the PV  PV= 965,35
 Investing in Bonds
o Bonds are the most popular alternative to stocks for long-term investing
o Even though the bonds of a corporation are less risky than its equity,
investors still have risk: price risk and interest rate risk
o Bonds and stocks issued

CHAPTER SUMMARY
 Purpose of the capital market: provide financing for long-term capital assets
 Capital market participants: governments and corporations issue bond, and we buy
them
 Capital market trading: primary and secondary markets exist for most securities of
governments and corporations
 Types of bonds: includes Treasury, municipal, and corporate bonds
 Treasury Notes and Bonds: issued and backed by the full faith and credit of the US
federal government
 Municipal bonds: issued by state and local governments, tax-exempt, defaultable
 Corporate bonds: issued by corporations and have a wide range of features and risk
 Financial guarantees for bonds: bond “insurance” should the issuer default
 Bond current yield calculation: how to calculate the current yield for a bond
 Finding the value of coupon bonds: determining the cash flows and discounting back
to the present at an appropriate discount rate
 Investing in bonds: most popular alternative to investing in the stock market for
long-term investments
[Link] Stock Market
 Preview
o In August of 2004, GOOGLE went public, auctioning its shares in an unusual
IPO format.
The shares originally sold for $85/ share, and closed at over $100 on the first
day
In 2014, Google announced a two-for-one stock split
In 2015, Google changed its name to Alphabet
On May 15th 2017, the shares of Alphabet are trading on Nasdaq at over
$960/share

Go o g le ( Alp h a b e t ) P ric e Gra p h

Copyright ©2015 Pearson Education, Inc. All rights reserved. 13-2

N a s d a q : N o t a lw a y s s u c c e s s fu ll

Copyright ©2015 Pearson Education, Inc. All rights reserved. 13-5

o Topics addressed
 Stock market indexes
 Buying foreign stocks
 Regulation of the stock market
 Investing in stocks
 Computing the price of common stock
 How the market sets security prices
 Errors in valuation
 Investing in stocks
1) Represents ownership in a firm
2) Earn a return in 2 ways
 Price of the stock rises over time
 Dividends are paid to the stockholder
3) Stockholders have claim on all assets
4) Right to vote for directors and on certain issues
5) Two types
 Common stock
 Right to vote
 Receive dividends
 Preferred stock
 Receive a fixed dividend
 Do not usually vote
 Sample corporate stock certificate
 Sapir consolidated airlines stock
o How stocks are sold
 Organized exchanges
 NYSE is best known, with daily volume around 4 billion shares,
with peaks at 7 billion
 “organized” used to imply a specific trading location. But
computer systems (ECNs) have replaced this idea
 others include Euronext (BE-NL-FR-PORT), Nikkei, LSE, DAX
 listing requirements exclude small firms
 over-the-counter markets
 best example is NASDAQ
 dealers stand ready to make a market
 today, about 3000 different securities are listed on NASDAQ
 other include the dealing/ trading rooms of banks
 important market for thinly-traded securities – securities that
don’t trade very often
Without a dealer, ready to make a market, the equity would
be difficult to trade
o organized vs. OTC
 organized exchanges (e.g., NYSE)
 auction markets with floor specialists (floor traders)
 25% of trades are filled directly by specialist
 remaining trades are filled through SuperDOT
 over-the-counter markets (e.g., NASDAQ)
 multiple market makers set bid and ask prices
 multiple dealers for any given security
o ECNs
 ECNs (electronic communication networks) allow broker and traders
to trade without the need of the middleman
They provide:
 Transparency: everyone can see unfilled orders
 Cost reduction: smaller spreads
 Faster execution
 After-hours trading
 However, ECNs are not without their drawbacks:
 Don’t work as well with thinly-traded stocks
 Many ECNs competing for volume, which can be confusing
 Major exchanges are fighting ECNs, with an uncertain outcome
o ETFs
 Exchange Traded Funds are a recent innovation to help keep
transaction costs down while offering diversification
 Represent a basket of securities or an index (e.g. the S&P 500°
 Exact content of basket is known: valuation is certain
 Traded on a major exchange
 Management fees are low (although commissions still apply)
 “ETF” and “index fund” are not synonyms!!!

 Computing the price of common stock

o Valuing common stock is, in theory, no different from valuing debt securities:
 Determine the cash flows
 Discount them to the present
o Review of 4 different methods for valuing stock, each with advantages and
drawbacks
The One-Period Valuation Model
o Simplest model, just taking using the expected dividend and price over the
next year

o
o what is the price for a stock with an expected dividend and price next year of
$0,16 and $60, respectively?  use a 12% discount rate

answer:

The Generalized Dividend Valuation Model

o most general model but the infinite sum may not converge

o
o rather than worry about computational problems, we use a simpler version,
known as the Gordon growth model
The Gordon Growth Model
o same as the generalized dividend valuation model, but it assumes that
dividend grow at a constant rate, g.
That is
The Price Earnings Valuation Method
o the price earnings ratio (PE) is a widely watched measure of much the market
is willing to pay for $1,00 of earnings from the firms

o
o if the industry PE ratio for a firm is 16, what is the current stock price for a
firm with earnings for $1,13/share?
Answer: Price= 16 x $1,13 = $18,08
 How the market sets security prices
o Generally speaking, prices are set in competitive markets as the price set by
the buyer willing to pay the most for an item
o The buyer willing to pay the most for an asset is usually the buyer who can
make the best use of the asset
o Superior information can play an important role
o Consider the following 3 valuations for a stock with certain dividends but
different perceived risk:

o Bud, who perceives the lowest risk, is willing to pay the most and will
determine the “market” price
 Errors in valuation
o Although the pricing models are useful, market participants frequently
encounter problems in using them. Any of these can have a significant impact
on price in the Gordon model
 Problems with estimating growth
 Problems with estimating risk
 Problems with forecasting dividends
o Dividend growth rates:
 Stock prices for a security with D0 = $2.00, ke = 15%, and Constant
Growth Rates as Listed
o Required returns
 Stock prices for a security with D0 = $2.00, g = 5%, and Required
Returns as Listed

 security valuation is not an exact science! – considering different growth rates,

required rates, etc., is important in determining if a stock is a good value as an
investment
 Case: The 2007-2009 financial crisis and the stock market
o The financial crisis, which started in August 2007, was the start of one of the
worst bear markets
o The crisis lowered “g” in the Gordon Growth model – driving down prices
o Also impacts ke – higher uncertainty increases this value, again lowering
prices
o The expectations were still optimistic at the start of the crisis. But, as the
reality of the severity of the crisis was understood, prices plummeted
 Case: 9/11, Enron and the market
o Both 9/11 and the Enron scandal were events in 2001
o Both should lower “g” in the Gordon Growth model – driving down prices
o Also impacts ke – higher uncertainty increases this value, again lowering
prices
o In both cases, prices in the market fell. And subsequently rebounded as
confidence in US markets returned
 Stock market indexes
o Stock market indexes are frequently used to monitor the behavior of a
groups of stocks
o Major indexes include the Dow Jones Industrial Average, the S&P 500, and
the NASDAQ composite
o Dow Jones Industrial Average
 The thirty companies that make up the Dow Jones Industrial Average
o $1,00 invested in the DJIA back in 1980 (DJIA was around 800) would have
grown to about $16,40 in 2012 (Dow closed year at 13,104).
This represented an annual growth rate around 8,8%
o DJIA
 Dow Jones Industrial Averages, 1980-2013

 Buying foreign stocks

o Buying foreign stocks is useful form a diversification perspective. However,
the purchase may be complicated if the shares are not traded in the US
o American depository receipts (ADRs) allow foreign firms to trade on US
exchanges, facilitating their purchase.
US banks buy foreign shares and issue receipts against the shares in US
markets
 Regulation of the stock market
o The primary mission of the SEC is “… to protect investors and maintain the
integrity of the securities markets”
o The SEC brings around 500 actions against individuals and firms each year
toward this effort. This is accomplished through the joint efforts of four
divisions
o Divisions of the SEC:
 Division of corporate finance
 Responsible for collecting, reviewing, and making available all
of the documents corporations and individuals are required to
file
 Division of market regulation
 Establishes and maintains rules for orderly and efficient
markets
 Division of investment management
 Oversees and regulates the investment management industry
 Division of enforcement
 Investigates violations of the rules and regulations established
by the other divisions

CHAPTER SUMMARY
 Investing in stocks: development of an understanding of the structure of the various
trading systems, including exchanges and OTC markets
 Computing the price of common stock: various techniques for valuing dividends and
earnings were presented
 How the market sets security prices: review of the basic idea that prices are set by
the “highest bidder”
 Errors in valuation: difficulties in determining dividends, growth rates, and/or
required returns can have a significant impact in the pricing models
 Stock market indexes: a way to track changes in calculation for a broad group of
stocks
 Buying foreign stocks: potential benefits for diversifications, simplified by the use of
ADRs
 Regulation of the stock market: the primary function of the securities and exchange
commission