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Financial Markets

Basics

Financial markets
Exchange of securities, commodities and other fungible goods Functions:
Connect savers and investors (transfer of K) Transfer of risk (derivatives) Facilitate international trade (currencies) Transfer of liquidity (money markets)

Financial markets
commodities
Financial markets

f/x
derivatives

Capital market Stocks Bonds

Money market

certificates of deposit Repos Commerical bills ect. Interbank market

Capital market
Exchange of long-term securities (debt = bonds) or equity (stocks) Stocks
Equity. Owner of capital goods. -> Titles to K goods
Business cycle

residual assets of the company after discharging of all secured (collateralized, collateral and borrower) and unsecured debts (uncollateralized, only borrower -> higher i)
Senior claims = debt that takes priority vs. junior claims, subordinated debt such as ABS or CDO (tranches)

It has often been maintained that a failing price level injures business firms because it aggravates the burden of fixed monetary debt. However, the creditors of a firm are just as much its owners as are the equity shareholders. The equity shareholders have less equity in the business to the extent of its debts. Bond holders (long-term creditors) are just different types of owners, very much as preferred and common stock holders exercise their ownership rights differently. Creditors save money and invest it in an enterprise, just as do stockholders. Therefore, no change in price level by itself helps or hampers a business; creditorowners and debt-owners (Rothbard 2000: 51, n. 16).

Capital market
Bonds
Creditor Debt security Normally negotiable (traded in secondary markets) form of loan or IOU (informal document) Longer term than certificates of deposit or commercial paper
Principal (or nominal), Maturity (pay back principal), Coupon (interest rate), Yield (current return or internal rate of return held to maturity)

Commodity markets
Fungible Metalls Agricultural products Traded for instance in Chicago Board of Trade

Foreign exchange markets


Exchange of international currencies As of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion Types:
Spot (settles next day) Forward (exchange occurs at agreed rate in the future, for instance 100 for $140 in 3 months), -> eliminate f/x risk Swap:
spot foreign exchange transaction (today borrow $128and lend 100) forward foreign exchange transaction reversing (1 year get 100 back and give back $135 (dollar expected to depreciate))

Future: standardized forward contracts. Traded on future exchanges Option: Derivative: Right but not obligation to exchange currencies at a fixed ratio at a certain date

Derivatives
Contract between two parties on payments that are made between them Used for risk management (hedging) or speculation Value is derived from underlying performance of underlying assets
Currencies Interest rates Stocks Bonds Commodities Forwards Futures Options: right but no obligation (long-dated options are called warrents Swaps: exchange of cash flows based on interest rates (e.g. fixed variable), f/x rates, commodities

Types:

Derivatives
Credit default swaps A credit-default swap may be described as an insurance that investors buy to compensate for a loss if a particular debtor defaults on its obligation.
Imagine that an investor holds a million-dollar bond issued by Citigroup. If the insurance premium (CDS spread) is 25 basis points, or 0.25 percent, the investor can insure himself against a default by paying an annual fee of 0.25 percent of one million, i.e. $2,500. CDS spreads indicate the insurance premium and the confidence in the underlying bond. If Citigroup defaults on its bond, the investor receives one million dollars in exchange for the bond.

An intriguing aspect of CDSs is that you can buy them even if you do not own any debt from the company that they refer to. These are the infamous naked credit-default swaps. By buying a CDSs on Citigroup without owning the corresponding bond, you can bet that Citigroup will default on its obligations. By just paying $2,500, a hedge fund could make a gross profit of $1,000,000 when Citigroup defaults on its obligations.

Derivatives
CDS continued
From a free-market point of view, betting on defaults of financial institutions is as legitimate as betting against a certain soccer team in the World Cup. Yet, there is one important difference: in the case of financial institutions the betting can become self-validating For instance, investment funds bet on the downfall of Icelandic banks during the financial crisis by buying CDS on obligations of Icelandic banks. It was in the fund's interest to undermine people's confidence and, thereby, promote their own investments. But why did investors start to bet against Icelandic banks in the first place? Icelandic banks were highly dependent on wholesale short-term funding. Once international liquidity evaporated, they could not roll over their short-term liabilities. Moreover, their size made them too big to be bailed out by the Icelandic government. The Icelandic financial system was the perfect target. How could this bet then become self-validating? As the demand to buy protection on Icelandic banks increased, the price of the insurance increased in CDS markets and spreads on the banks rose. The rising spreads indicated distrust in the banks. Consequently, Icelandic banks had to pay higher interest rates on the market to attract new funds. The rising spreads spurred further demand for insurance, leading to even higher spreads, and so on until the distrust in the banks reached a point where banks could not receive further funding and failed. CDSs are powerful corrective instruments that discipline banks. CDSs are not weapons of mass destruction but instruments of providing discipline and order. It is possible that without rising CDSs spreads, Icelandic banks would have survived longer. They would have had time to cause additional distortions and make the collapse even more disastrous. CDS may be used as bets that can make unsound financial institutions and reckless governments fall sooner than they otherwise would. Therefore, they are feared by governments and socially useful.

Derivatives
Size often critized
$1,200 Trillion Dollars 20 Times Larger than the Global Economy and seen as unproductive

However:
Useful to reduce risk and discipline actors Prices as orientation for action Many derivatives result of government intervention
CDS on gov. Default All f/x futures, and swaps would not exist in a world wide gold standard and did not exist in 19th century

Money market
Market for short term loans (1 year or less) Types:
Treasury bills Commercial paper
Unsecured (no collateral), promissory note (promise to pay amount in the future, not only acknowledging debt like IOU), maybe negotiable (saleable) or not

Bankersacceptance
A promises to pay to B 100 in 6 months writing a so-called time draft. A has in his bank account 1000. The bank accepts (guarantees) the payment to the holder of the draft (now person B). B can sell the draft discounting it.

Money Market
Types (continued):
Time deposits Certificate of deposits (US product), type of federally insured time deposit Real bills
Secured promissory note, backed by the goods being sold on the market. Winery that has produced bottles of wine that will be sold within 3 months for approximately 1000. Wine has to be transported to super market. To finance transport, the Winery issues a real bill backed with the wine payable in 3 months and pays transport agency Real bills doctrine, self-liquidating. Needs of trade. Very liquid. Bank can sell it easily.
Problem: Effect on prices, credit markets communicating tubes, frees up liquidity often invested long term.

Money Market
Types (continued):
Repurchase agreement
Sell security with the agreement to repurchase it back at a later time. Example: Sell Spanish government bond for 100 to bank, and agree to buy it back in a year for 105. Interest rate: 5%.

Short term Asset backed securities


Morgages or student or auto loans Value and income payments derived from and collaterlized by pool of underlying assets.
For instance pool of mortgages that pay on average 5% interest. Pooling is called securitization and often occurs in special purpose vehicles.

CDO is a special case of ABS. Different tranches are paid. 3 different types. If payments doesnt flow, first the lowest, highest risk and interest tranch loses.

Interest rates on the money market


Short term loans Intertemporal coordination Banks, Central banks, private investors, hedge funds, money market funds (invest in shortterm commercial paper and Treasury bills), etc.

Interbank market is key part of money market


Loans from banks to other banks (unsecured) <1 week, mostly overnight (Exchange: reserves at the CB) Reserves that are necessary to maintain legal reserve ratio FFR (EEUU) [overnight, w/o colateral, Exchange: reserves FED, targeted rate by Fed] LIBOR (UK) [no target, average estimated interest rate charged overnight in London] EURIBOR: Euro interbank offered rate [average interest rate interbank market, unsecured EUONIA= weighted average of all overnight interbank loans]
Differences:
EURIBOR not only overnight, also short term interbanks loans EURIBOR eliminates 15% higher and lowest quotes. EUONIA based on overnight assets created on the interbank market

Monetary policy and interest rates


CB Bank reserves

Relatively: In normal times positiv Cred. ex.

i money market arbitrage i capital market

i interbank