Professional Documents
Culture Documents
(IF1204)
Dr Angela Gallo
Angela.gallo.1@city.ac.uk
www.cass.city.ac.uk/cassexec
Topic 5: Non-bank financial intermediaries
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Objectives
• To understand the crucial role of non-bank financial
intermediaries in the financial system
• To examine their activities and business models
• To understand recent trends in the industry
• To discuss their role in pre- and post- crisis economy
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Outline
I. Finance Companies and Securities Firms
II. Mutual Funds and Hedge Funds
III. Insurance and Pension Funds
IV. Shadow Banking
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II. Mutual Funds and Hedge Funds
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Institutional investors
Institutional investors are specialised financial institutions that
manage collectively savings of small investors and invest in
diversified portfolios of assets.
They are well placed to perform the key functions of trade,
manage, and diversify risk, and reduce information and trading
costs.
üMutual funds, pension funds and life insurance companies
are the main types of institutional investors in Europe.
üMost countries in southern Europe are characterized by low
institutional savings, while the role of institutional investors in
northwestern Europe is more important.
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Institutional investors
• Institutional investors are pooling funds from individual
households. Due to economies of scale, they are able to invest
these funds more efficiently than individuals (lower transaction
costs and commissions).
• Moreover, they are able to invest in assets that are indivisible
(such as property) and therefore often not available to small
investors.
• Having access to a larger investment opportunity set than
individuals, they provide diversified portfolios at low cost to
households.
• Costs of asset management are low, as they are shared among
many households, so that the risk-return profile is more
attractive than other investment.
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Classification of Institutional investors
Short term Long term
PFs DB
PFs DC
Life
Insurance
Mutual
Funds
Hedge
funds
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Institutional investors
The role of institutional investors in the financial markets:
• Because of their policy to hedge exposures and to diversify
their investments, they increase the demand for risk-
management tools (as derivatives).
• Because of their active trading policies, they enhance the
liquidity in the markets, leading to higher efficiency and lower
transaction costs.
• They are often important shareholders in companies and can
influence or be active players in the corporate governance,
having more “bargaining power” than individual investors.
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Institutional investors
Institutional investors have made banks less important as
intermediaries of financial assets, also in countries with a
bank-dominated financial system (France, Germany, Italy).
• Both in the EU and in the US, they have increased
enormously over the last two decades.
• Nevertheless, the largest EU countries are still mainly bank-
oriented.
• In the US, institutional claims are twice as large as bank
claims.
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Institutional investors
However, the turmoil on the global financial markets revealed
their vulnerability (i.e. large investments in equities and ABS)
to downward market pressure.
Theoretically, they are viewed as long-term investors that tend
to keep their holdings during stressed market conditions until
the market recovers, thus helping stabilise the markets.
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Institutional investors
(Assets as % of GDP,) in 2012
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Mutual funds
Mutual funds have been major market-share winners over the
past 40 years. The mutual fund industry is among the most
successful financial innovations (Khorana et al. 2005).
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Open-end Mutual Funds
Funds that operate on very different rules.
The shares are continuously liquidated and augmented by a
specialised management company that offers shares for
cash, and cash for shares at the Net Asset Value (NAV).
NAV is the estimated liquidation or market value of the fund’s
assets divided by the number of shares the fund has
outstanding.
Thus, unlike closed-end fund shares, the prices of open-end
fund shares cannot deviate from the value of underlying
assets.
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Long-term Funds
• Bond funds (comprised of fixed income securities with a
maturity of over one year)
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Net asset value
The fund managers calculate the current value of each mutual
fund share by computing the daily market value of the fund’s
total asset portfolio and then dividing this amount by the
number of mutual fund shares outstanding.
This is the price the investor gets when selling shares back to
the fund that day or buying any new shares in the fund on that
day.
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NAV – Example (1)
Suppose a mutual fund contains 1,000 shares of Apple trading at
$105, 2,000 shares of Microsoft currently trading at $53 and
1,500 shares of Citigroup currently trading at $42.
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NAV – Example (2)
If next month, Apple shares increase to $107, Microsoft shares
increase to $55 and Citigroup shares increase to $45, the NAV
(assuming the same number of shares outstanding) would
increase to:
NAV = [(1,000 X $107) + (2,000 X $57) + (1,500 X $45)] /15,000
= $19.24
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NAV - Example
The shares outstanding can change in open-end mutual funds
with the amount of share redemption and new purchases. In
other words, investors can buy and sell shares from and to the
mutual fund company.
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Net Asset Value
Closed-end funds have a fixed number of shares outstanding
at any given time. Therefore, the NAV of the funds’ shares is
determined not only by the value of the underlying shares, but
also by the demand for the funds’ shares themselves.
• When the demand is high, the shares can trade at more than
the NAV of the securities held in the fund (trading at a
premium).
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Short-term funds - MMMFs
Introduced in the 1960s, they have gained popularity since the
1970s, when the high inflation and interest rates reduced the
attractiveness of traditional bank deposits.
MMMFs are managed conservatively, and in some case are
restricted to holding direct debt of the US government.
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Short-term funds - MMMFs
Despite the competitive disadvantage of operating without a
government guarantee, money market funds offered a
compelling package of substitutes for them:
• low-risk investment strategies;;
• higher yields than deposits;;
• implicit guarantee of reputable management companies;;
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Hedge funds
It is a private investment pool subject to the terms of an
investment agreement between the sponsor of the fund and its
(wealthy) individuals and other investors (e.g. commercial
banks).
In contrast to mutual funds, hedge funds are actively managed
funds that pursue nontraditional investment strategies.
They take both long and short positions in a variety of financial
instruments – equities, fixed-income securities, currencies,
etc.- to achieve the highest return commensurate to the fund’s
objective.
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Hedge funds
• Fund managers have incentives to limit disclosure to their
investors in order to reduce the likelihood that their
proprietary strategies can be identified and replicated.
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Classification of Hedge funds
• Market directional: HFs that seek high returns using
leverage, typically investing based on anticipated events.
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Hedge funds
• Although the hedge fund industry has traditionally been far
less regulated than mutual funds, the gap is partially closed
now in the US and Europe.
• Less regulation is justified by the expectation that these
types of investors are able to make more informed decisions
and take on a higher level of risk.
• HFs grew in popularity in 1990s as investors saw returns of
over 40% after management fees (often more than 25%). But
then one of the largest hedge fund nearly collapsed in the
1998 (LTCM).
• Since then, hedge funds are often blamed to create financial
instability.
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Hedge funds vs Mutual Funds
• MFs are restricted in their ability to leverage against the
value of securities in their portfolio, whereas leveraging and
other higher-risk investment strategies are commonplace for
hedge funds.
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Revision Questions
•Discuss the role that institutional investors play in financial
markets.
•What is the rationale for the existence of Mutual funds?
•What is the rationale for the existence of Hedge funds?
•Discuss agency problems in the mutual funds’ operations.
•Discuss agency problems in the hedge funds’ operations.
•What is NAV?
•How are money market funds competing with banks?
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Essential Readings for Topic 5
SC Chapter 5
******
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