An Overview of the Financial System

Characteristics of a Good Financial System

Diversifies Risk

Defining Risk

In a world with no uncertainty, we could make the following statement:

Tomorrow, the temperature will be 35 degrees

In an uncertain worlds, we cant state anything with certainty, only with degrees of probability.
There is a 45% chance that it will be 35 degrees tomorrow

Probability Distributions

More generally, uncertainty is characterized by a probability distribution Expected value (mu) refers to the most likely event. Standard Deviation (sigma) refers to the spread of possible events. It is equal to the expected value of squared differences from the mean.

Statistics

Expected value is equal to the sum of each possible event multiplied by its probability. Prob(35) = .45 Prob(25) = .55 E(Temperature) = .45(35) + .55(25) = 29.5 Variance is equal to the expected value of squared differences from the mean. Variance (Temp) = .45(35 29.5)^2 + .55(25-29.5)^2 = 24.75 Standard Dev. (Temp) = SQRT(24.75) = 4.97

Diversification

Suppose the chance of a cold winter is 40% (the chance of a warm winter is 60%). You own an oil company. In a cold winter, you earn $100 in profit. In a warm winter, you lose $50.

E(Profit) = .40($100) + .60(-$50) = $10 Variance (Profit) = .4(100-10)^2 + .6(-50 10)^2 = 5,400 Standard Deviation = 73.5

Diversification

Now, suppose you buy stock in Disney. If its warm, your stock appreciates by $20. If its cold, Disney stock falls by $10. You pay $15 for the stock. E(Profit) = .4($100 - $10 - $15) + .6(-$50 + $20 - $15) = $3 Variance (Profit) = .4(75 - 3)^2 + .6(-45 - 3)^2 = 3,455 Standard Deviation = 58.8

Youve lowered your risk by 20%

(At a cost of $7)

Diversification & Correlation

0.7
Standard Deviation

0.6 0.5 0.4 0.3 0.2 0.1 0 1 2 3 4 5 6 7 # of variables

Adding uncorrelated (Corr = 0) variables to a portfolio lowers the risk attached to that portfolio

Diversification & Correlation

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 0.5 0 -0.5 Correlation (three variables) Std. Dev.

Negative correlations (Corr < 0) enhance the power of diversification

Stock Market Diversification

100 90 80 70 60 Portfolio 50 Variance 40 30 20 10 0 1 3 5 10 20 30 40 50 Number of Stocks

US Stocks International

B Solnik, Why Not Diversify Internationally, Financial Analysts Journal

Characteristics of a Good Financial System Diversifies Risk Creates Liquidity

Enron: Sinner or Saint?

In Dec. December 2001, Enron declared bankruptcy one of the largest corporate failures in history. While Enron did a lot of things wrong, what did it do right?

Enron: Sinner or Saint?

Enrons core business was to become the middleman in energy markets this helped manage risk and improved liquidity.

Characteristics of a Good Financial System Diversifies Risk Creates Liquidity Provides/Communicates Information

Asymmetric Information

Adverse Selection

Prior to a transaction taking place, one party is missing vital information about the other party (cant tell the good eggs from the bad eggs!)
After the transaction takes place, one party cant observe the others actions (the good eggs might become bad eggs!)

Moral Hazard

An Adverse Selection Example

Suppose you are shopping for a new car. There are 10 cars on the lot. 8 Cars are good (P = $1000) 2 Cars are Lemons (P = $100) What price do you offer? (You cant distinguish lemons from good cars) Solution: Signaling or Regulation!

A Moral Hazard Example

Suppose a company has one bondholder ($100) and one stockholder. The company has two possible projects to invest in:

Project A: $100 profit with certainty Project B: 50% chance of $0 profit, 50% chance of $200 profit.

Which project should the company invest in?

A Moral Hazard Example

Project A (Safe)
Bondholders: $100 Stockholders: $0 With certainty
Stockholders: 50% chance of $0 50% chance of $100 E(S) = (.5)(100) + .5(0) =$50

Project B (Risky)
Bondholders: 50% chance of $0, 50% chance of $100 E(B) = .5(100) + .5(0) =$50

A Moral Hazard Example

As a bondholder, you cant always observe the stockholder actions, but you would prefer the stockholder to only take on low risk projects. How do you do this?

Monitoring Optimal Contracting

Why Do We Care?

With a financial system, your consumption expenditures are no longer restricted to equal your income (i.e., the financial system efficiently transfers income between households) Financial Markets Transfer Savings from households to firms for the purpose of financing investment projects S = I + (G-T) + NX

Black Tuesday

On Tuesday, October 29,1929, the Dow Jones Closed at $230 Down 23% from its opening of $299 with huge volume (16,410,030 shares)

The October 29th drop was only the beginning of a 89.7% collapse over the next 714 days.

The Dow make it back to its pre 1929 highs until 1954.

Black Monday

On Monday, October 19,1987 The Dow fell from $2246 to $1738 22.6% of its value

However, unlike the 1929 crash, the market quickly recovered by September 1989, the Dow returned to its pre-1987 levels

The Players
Securities Market Institutions Contractual Savings Institutions (40%) Investment Institutions (25%) Government Institutions (10%) Depository Institutions (25%) _______________________________ $30 Trillion in Debt and Equities

Securities Market Institutions

Securities market institutions match up buyers with sellers. (provide liquidity) Securities market institutions also provide information and analysis to help buyers and sellers of assets Primary Markets Secondary Markets Investment Banking Brokers Dealers Exchanges

Contractual Savings

Contractual Savings Institutions are by far the biggest participant in financial markets ($12 Trillion in assets) Specialize in writing contracts to protect policyholders from financial loss associated from specific events.
Insurance

Companies

Property/Casualty ($1T) vs. Life($3T) Mutual vs. Stock

Pension

Funds

Defined Benefit vs. Defined Contribution

Investment Institutions ($8T)

Investment Institutions represent the fastest growing segment of financial markets The key service provided is low cost diversification Mutual Funds Money Market Funds Hedge Funds (LTCM) Venture Capital Funds

Government Institutions ($3T)

Provision of Liquidity

Fannie Mae Freddie Mac Ginnie Mae Sallie Fae

Federal Reserve SEC FDIC

Regulation and Oversight

Depository Institutions ($8T)

The distinguishing characteristic of a depository institutions is the acceptance of deposits and the creation of loans.
Commercial

Banks Savings & Loans (Thrifts) Credit Unions Savings Banks

Evolution of the Financial System Financial Innovation Integration and Globalization Regulation Competition