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Chapter 1. Introduction. Types of Assets. Tangible Assets Value is based on physical properties Examples include buildings, land, machinery Intangible Assets Claim to future income generated (ultimately) by tangible asset(s) Examples include financial assets. Bank loans Government bonds

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Chapter 1

Chapter 1

Introduction


Types of assets
Types of Assets

  • Tangible Assets

    • Value is based on physical properties

    • Examples include buildings, land, machinery

  • Intangible Assets

    • Claim to future income generated (ultimately) by tangible asset(s)

    • Examples include financial assets


Types of financial assets

Bank loans

Government bonds

Corporate bonds

Municipal bonds

Foreign bond

Common stock

Preferred stock

Foreign stock

Types of Financial Assets


Debt vs equity
Debt vs. Equity

  • Debt Instruments

    • Fixed dollar payments (‘fixed income’)

    • Examples include loans, bonds

  • Equity Claims

    • Dollar payment is based on earnings

    • Residual (varying) claims

    • Examples include common stock, partnership share


Price of financial asset and risk
Price of Financial Asset and Risk

  • The price or value of a financial asset is equal to the present value of all expected future cash flows.

    • Expected rate of return

    • Risk of expected cash flow


Types of investment risks
Types of Investment Risks

  • Purchasing power risk = inflation risk

  • Default risk = credit risk (special case of PP risk)

  • Exchange rate risk = currency risk


Role of financial assets
Role of Financial Assets

  • Transfer funds from those with more money than projects to those with more projects than money.

  • Share unavoidable risk associated with cash flows.

    • Equity holders bear inflation risk

    • Debt holders bear default risk

    • Both may bear exchange rate risk


Role of financial markets
Role of (Financial) Markets

  • Provide liquidity: buyers and sellers all in one ‘place’.

  • price discovery  efficient resource allocation

  • Reduce transactions costs:

    • search costs

    • information costs (market efficiency)


Classification of financial markets
Classification of Financial Markets

  • Nature of asset: debt vs. equity markets

  • Maturity: money (short) vs. capital (long) markets

  • Seasoning: primary vs. secondary markets

  • Delivery: cash (= spot) vs. derivatives markets

  • Structure: auction vs. over-the-counter (OTC) vs. intermediated markets


Financial market participants
Financial Market Participants

  • Households

  • Business units

  • Federal, state, and local governments

  • Government agencies

  • Supranationals (= multilaterals)

  • Regulators (broader definition)


Globalization of financial markets
Globalization of Financial Markets

  • In general, easier for investors to move capital internationally

  • Causes:

    • Deregulation (liberalization) of financial markets (e.g. currency controls)

    • Technological advances

    • Increased role of institutional investors (economies of scale), inc. CalPERS


Classification of global financial markets
Classification of Global Financial Markets

External Market

(= international, offshore

or Euromarket): securities

offered outside single

jurisdiction to investors

in multiple countries

Internal Market

(= national market)

Domestic Market:

issuers domiciled

in the country

Foreign Market:

issuers domiciled

abroad


Motivation for using foreign markets and euromarkets
Motivation for Using Foreign Markets and Euromarkets

  • Limited fund availability in internal market (esp. in poorer countries)

  • Reduced cost of funds

  • Diversifying funding sources (portfolio reduces risk)


Derivatives market
Derivatives Market

  • Derivatives’ value depends on underlying (financial) asset

  • Futures/forward contracts: parties agree to buy/sell at an agreed price and date.

  • Options contracts: rights (not obligations) to buy (call) or sell (put) at an agreed price on/by an agreed date.


Role of derivative instruments
Role of Derivative Instruments

  • Buy/sell risk (e.g. purchasing power risk, interest rate risk, exchange rate risk)

  • `Zero sum’

  • However, there are still advantages:

    • May be lower transactions costs

    • Can be faster to transact than cash market

    • Greater liquidity

    • Allows great scope for financial innovation…


Chapter 2

Chapter 2

Financial Intermediaries and Financial Innovation


Services of financial institutions
Services of Financial Institutions

  • Financial intermediaries transform financial assets (then their liabilities): inc. deposits, insurance, pensions

  • Help create, launch financial assets (underwriter)

  • Trade financial assets for customers (broker)

  • Trade their own financial assets (dealer)

  • Provide investment advice


Role of financial intermediaries
Role of Financial Intermediaries

  • Obtain funds (their liabilities, e.g. deposits) & invest them (their assets, e.g. loans): transfer funds from savers to investors

  • Direct investment

    • e.g. bank buys corporate stocks or bonds

  • Indirect investment

    • e.g. individual deposits money in a bank that buys…


Intermediaries and asset transformation
Intermediaries and asset transformation

  • Maturity intermediation

    • Many short term deposits = a long term loan

    • Longer loan terms usually more expensive

  • Reducing risk by diversification

    • portfolio, covariance, marriage [?]

  • Specialization reduces costs: contracting and information processing, etc.

  • Enable non-cash payments (cheques, plastic)


Asset liability management
Asset/Liability Management

  • Spread and Non-Spread Businesses

    • buy/bid v. sell/ask spread (inc. insurance)

    • non-spread: fund management fees

  • Nature of Liabilities

    • contracts specify amount, timing of payment

    • see chart on next page

  • Liquidity: redeeming liabilities prematurely

  • Regulations and taxation



Categories of financial innovation economic council of canada
Categories of Financial Innovation (Economic Council of Canada)

  • Market-broadening instruments

    • attract new investors

  • Risk-management instruments

    • re-allocate risk

  • Arbitraging instruments and processes

    • facilitate arbitrage


Categories of financial innovation bis
Categories of Financial Innovation (BIS) Canada)

  • Price-risk-transferring innovations

    • for price/exchange rate risk

  • Credit-risk-transferring instruments

  • Liquidity-generating innovations

    • inc. by avoiding regulatory constraints

  • Credit-generating instruments (debt funds)

  • Equity-generating instruments (capital base)


Causes of financial innovation
Causes of Financial Innovation Canada)

  • Financial innovation is a form of innovation

  • Reasons to innovate:

    • improve products (e.g. cut costs, including taxes – v. ‘Rules in OECD Countries to Prevent Avoidance of Corporate Income Tax’, Thuronyi)

    • differentiate products

  • Explosion in financial products since 1980s:

    • theoretical developments (e.g. Black-Scholes)  more sophisticated market participants

    • technical developments: computers, IT

    • deregulation  greater competition by intermediaries

    • increased risk [?]: see chart on next page

  • Changing global patterns of financial wealth


Increased volatility
Increased volatility? Canada)

St Louis Fed: FRED II


Asset securitization
Asset Securitization Canada)

  • Securitization:

    • “homogenizing and packaging financial instruments into a new fungible [interchangeable] one” (Barkley International Inc.)

  • Many institutions instead of a single one:

    • bank A makes home mortgages

    • bank A hires bank B to issue securities backed by the mortgages

    • bank A buys credit risk insurance

    • bank A sells loan servicing right


Benefits to issuers
Benefits to Issuers Canada)

  • Specialization/out-source to focus on ‘core competences’: service fees (to collect & forward payments…)?

  • Diversification reduces risks, hence costs

  • Manage risk-based capital requirements

  • Manage interest rate volatility


Other benefits
Other Benefits Canada)

  • To Investors (buyers of securities)

    • greater liquidity

    • reduced credit risk

  • To Borrowers

    • lower lending rate spreads

  • Social Benefits

    • e.g. `viatical settlement’: trade life insurance benefits