Financial Services and the new Financial World

Lecture 1: Course Overview:

1) Role of the Financial System and an Overview of the Marketsa. Transfer Funds from those that have money to those that need moneyb. Provide for Capital Formation

c. Services Provided: Risk sharing, liquidity, and information collectiond. Differentiate Money Markets and Capital Marketse. Identify competition within the system

2) Valuation of Instruments

a. Fixed Income (Bonds and Loans)

b. Equity (Stock)3) Interest Rate Determination and Financial Costs of Funds

a. How Interest Rates are Determined

b. Examine the effects of bond supply and demand

c. Factors influencing Premia and Term Structured. Discuss Types Risk and how its measurede. Examine theories and evidence related to Term Structure4) Market Structure and Factors influencing Financial Market Efficiency /Costs

a. Various theories: Rational Expectations, Efficient Markets Hypothesis

b. Evidence of Efficiency / Inefficiency; Implications for you (the investor)c. Obstacles to Efficiency: Transaction Costs, Asymmetric Information, Adverse Selection, Moral Hazardd. Implications for Firm and Market Structure

e. Discuss market solutions5) Examine Financial Institutionsa. Different types: e.g. Commercial Banks, Investment Banks, Funds, etc.

b. Their mechanical function

c. Their role in the Financial System e.g. reduce transaction costsd. How they Make Money and Manage Risk6) Origins of the Financial Industry

a. History of Crisesb. Regulation and Response to Crises

c. How these factors have influenced the Current Structured. The current regulatory structure US and Abroad7) Derivatives and Risk Management

a. Provide an Overview of the Financial Derivatives Market

b. Study the theory behind financial options and derivativesc. Review simple contracts: Forwards, Futures, Calls, and Puts

d. Discuss their use in Risk Management, and other Risk Management Techniques

e. Discuss fundamental investment strategies using options

f. Provide Managerial Insight how to use these financial contracts and discuss the risk involvedFinancial System Overview:1) What is the purpose of a financial system?

a. Connect Savers & Borrowers

b. Facilitate Capital Formationthe ability to raise needed funds

c. Financial System ( Transfers funds from savers (investors) to borrowersd. Do this via two channels Financial Markets and Intermediaries

2) Types Markets

a. Equity versus Debt

b. Primary versus Secondary

c. Money versus Capital (Short-term versus Long Term)

d. Cash versus Forward/Futures

3) Debt and Equity Markets, Key Instruments:

a. DebtFinancial Claims: Bonds

b. EquityOwnership: Stocks

4) Debt Markets

a. Bonds (effectively loansthat have been securitized)b. Pays Interesta contractual cash-flowc. Value dependent on interest paid and risk involved

d. Interest rate associated with level of risk

e. Contracts have fixed lives at which point principle is returned

5) Equity Markets (Stocks)a. Shares represent Fractional Ownership

b. Pays Dividendsan uncertain cash-flow

c. Cash-flows are Residual to Expenses or Claims (Debt)

d. Infinitely lived

6) Definitions for Debt and Equity:

a. Principle (Debt)

b. Interest (Debt)

c. Default (Debtwhy? Why not equity?)

d. Dividends (Equity)

e. Capital Gains (Both)

7) Primary Markets:

a. Original Issues of Debt and Equityb. Where the borrowers generate fundsc. Composed of Big PlayersInstitutions, Fundsd. Trades are in Large Blocks for Investment or Resale on Secondary Markete. Firms trading in Primary Market make money two ways:i. Buying and Holdinginvesting and speculationii. Spread or Premia from Resale to smaller investors on Secondary Market

8) Secondary Market

a. RESALE of EXISTING SECURITY ISSUES

b. Trades conducted in Exchanges or Over-the-Counter

c. This is where you can buy stocks or bonds d. Market Providesi. Information (prices impound information)

ii. Liquidity (Standardized assets can be Liquidated easily)iii. Risk Sharing (ability to diversify investments by purchasing a portfolio)

e. This is the market where prices are determined and is the reason that our financial system works.

f. Without it, you would have no way to dispose of financial assets efficientlyyou could not sell your stocks or bonds.

9) Types of Secondary Markets:a. AuctionExchange (Competitive bidding)

b. OTCyou take price as postedc. In OTC markets, dealers maintain an inventory and are willing to sell at their posted price. It remains competitive, because the dealers are aware of other dealers prices.

10) Money versus Capital Markets

a. Short term debt instrumentshighly liquid/low riskb. Longer term debt and equityused for Capital Projects

11) Cash Markets vs. Forwards and Futures

a. Cash PAY NOW (Current Settlement) Stock and Bond Marketsb. Futures and Forwards AGREE TO PAY LATER12) Intermediaries (go-betweens) between Saver and Borrower

a. Commercial Banks, S&Ls, Credit Unions

b. Mutual Funds

c. Insurance Companies and Pension Funds d. Finance Companies: e.g. Ford Motor Credit, GMACe. Other Financial Institutions THAT RAISE AND SUPPLY FUNDS

13) What do INTERMEDIARIES DO?

a. Pooling of funds for a loan portfolio ( Risk Sharing or Diversification

b. Pooling allows withdrawals ( Liquidity

c. Collect and Process information about Borrowers ( Info. Services

14) Institution Types: How they do it.a. DepositoryCommercial Banks

b. Contractual SavingsInsurance Companies, Pension Funds

c. Investment IntermediaryMutual funds, Finance Companies

15) Other Institutions:

a. Investment Banks

b. Brokers/Dealers

c. Mutual Funds

d. Venture Capitalists

16) Key Issues:

a. Risk Sharing (Diversification of risk)b. Liquidity (Ease of which these assets can be liquidated into cash)

c. Information (Credit of the borrower)

d. Asymmetric Information (What the Borrower knows and you dont)

e. EACH OF THESE INSTITUTIONS PROVIDES ONE OF THESE FUNCTIONS.

17) Why do we Study the Institutions?a. Components Make it Function and form a Complex Structureb. Provides: Capital Raising, Risk-sharing, Information, and Liquidity

c. Financial Market composed of:i. Central Bank (FED)establishes interest rates, controls the money supply, and influences inflationii. Financial Intermediariesraise and lend funds

iii. Firms that create and trade financial securities (Investment Banks and Brokerages)

Money Markets:

1) Short Term/Low Risk/Liquid

a. Investments have lives less than a yearb. Can be liquidated quickly (sold) at market value

c. Risk to Principle is Very Low

d. These are secure investments because they invest in Short-term securities that are relatively insensitive to interest rates, and have low risk of default

e. Examples: T-bills, CDs, Repos

2) Purpose of the Money Markets

a. Facilitate Short-Term Loans/Investmentsb. Permit temporary warehousing of funds

c. Provide Higher Returns than available from Demand Deposits at Banks (Savings)this is because banks must set aside loss reserves

3) Characteristics

a. Large Denominations: $50-100 Million

b. Low Default Risk

c. Maturities of less than one year

4) Chief Instruments and Sourcesa. T-bills:i. Bullet payment in 3, 6, or 12 months

ii. Sold at Auction to highest bidder(s)

iii. Also sold via non-competitive bidding where US Treasury charges weighted average of accepted bid prices

iv. Sold on secondary market on a discount basis (highly liquid)

v. Whats the Default Risk?

b. Certificates of Deposit (CDs)

i. Term securities (unlike savings accountsdemand deposits)

ii. Traded on secondary market in round lots of $1 Million

iii. Rates and Risk slightly higher than T-bills (Why?)

iv. Created to compete against T-bills

c. Repurchase Agreements (Repos)

i. Effectively a Secured Loanii. Bank/Firms sells a security to another Bank/Firm, and agrees to Repurchase the security at a Predetermined date/price

iii. Also traded on the secondary market

d. Commercial Paper (CP)

i. Promissory Note maturing in less than 270 days

ii. Unsecured. Only sold by credit-worthy institutions

iii. Sold on secondary market on a discount basis like T-bills

e. Bankers Acceptances (Letters of Credit)i. Bank guarantees the payment of a firmii. Charges firm a fee for the guarantee

iii. Widely used in International Trade and is traded in the secondary markets

f. EurodollarOffshore Markets

i. Dollar denominated loans/deposits overseas

ii. Available in deposits and CDs

iii. Has become a reference rate more widely used then the Treasuries http://www.marketprices.ft.com/markets/currencies/internationalg. Fed Funds Rate

i. Loan rate between banks

ii. Overnight borrowing to cover Reserve Shortfalls (Not traded)

5) Money Market Participants

a. Treasury issuing T-bills

b. FED buying and selling bills (FED is the banker for the federal government)

c. Commercial Banks, Firms, Securities Firms, Finance Co.s, Insurance Co.s, Pension funds, etc.

6) Money Market Mutual Funds

a. Established to give Small Investors access to the Money Markets

b. Aggregates Deposits from Investors to purchase large block securities

c. Makes profits on spreadno fees charged for investing

d. Looks like a Demand Deposit, requires a Minimum Investment

Capital Markets:1) Longer Term Financing/Greater Returns/Greater Riska. Purpose is to provide Long-term capital financing to Governments and Corporations

b. Reduces risk to those firms of having to roll-over short term debt at higher rates

c. Riskier to Investors because of greater default and interest rate risk

d. Provided via Bonds, Stocks, and Mortgages

2) Market Participants

a. Federal, State, and Local Governments (Debt)

b. Corporations (Debt and Equity)

c. Property Owners (Mortgages)participation is indirect, mortgages securitized by various providers

3) Markets

a. PrimarySale of Initial Public Offerings (IPOs) to major finance firms (mutual funds, insurance companies, pension funds, etc.)

b. Secondarywhere most trading occurs: Exchanges and OTC

4) Exchanges

a. National: NYSE, American, Foreign (DAX, Nikkei) etc.

b. Regional: Pacific, Philadelphia

c. Have listing requirements; most stringent is NYSE, can list on multiple exchanges

5) Over the Counter Markets (OTC)

a. Nasdaq (Nation Association of Securities Dealers Automated Quotation System)

b. Other regional marketsInstruments:

6) Bonds

a. Securitized Debt (effectively a loan from the issuer)

b. Always pays interest, however, interest may be accumulated until the bond matures

c. Coupon Bonds pay interest each year (usually semi-annually)

d. Face Value is the principle amount paid on maturity

7) Federal Bonds

a. T-bonds

i. Semi-annual interest payments

ii. Quoted as a percentage of $100 face valueiii. Credit is Federal Government

b. Strips

i. Principle and Interest payments sold separately

ii. Principle Only (PO)

iii. Interest Only (IO)

c. Agency Bonds

i. GNMA, FNMA, SLMA

ii. Used to supply funds for home loans and student loans iii. Sell at a premium to treasuries (higher interest rate), why?

8) Municipal Bonds

a. State and Local Bonds

b. General ObligationClaim on revenues to general fund

c. Revenue Bondswhole slew of types, basically these have some revenue stream pledged as collateral. Examples:

i. Sewer Bondsclaims on sewer system revenues

ii. Golf Course Bondsclaim on revenues from Municipal Golf Courses

iii. Assessment Districtsclaim on the assessments from a specific district

iv. Lease Obligationclaim on the revenue stream from municipal lease, uses leased property as collateral

d. Bonds may be rated or non-rated (why wouldnt you want a bond rated?)

9) Corporate Bonds

a. Usually, $1000 denominations, paying interest semi-annually

b. Bearer Bondsrarely issued, bearer has right to payments

c. Registered Bondsregistered in owners name

d. Callable Bondsmay be called in by issuer after some date

e. Convertiblescan be converted to stock by purchaser if the stock price reaches a threshold level (after some date)f. Can be Unsecured or Secured with Property (collateralized)

g. Investment grade or Junk (speculative)

10) Equities

a. Common Stockfractional ownership of a firm with voting rights

b. Preferred Stocki. Fixed Dividend paid prior to payment of normal dividends

ii. No voting rights

iii. Claim residual to that of bond-holders

c. Valuation should reflect the present value of expected future cash-flows, also known as dividendsthis valuation method is known as the Dividend Discount Model

d. American Depository Receipts (ADRs)i. Provides claim on foreign stocks not traded on US exchanges

ii. Traded like stocks on US exchanges

Can this cost you?

Financial Markets:

Exchanges

OTC Market

Stocks, Bonds, Futures

Really Important!

Financial Intermediaries:

Banks (loans)

Finance Co.s

Insurers

Lenders/Savers/Investors

Borrowers/Firms