An Overview of the Financial System

1. An Overview of the Financial System

2. Characteristics of a Good Financial System • Diversifies Risk

3. 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 can’t state anything with certainty, only with degrees of probability. “There is a 45% chance that it will be 35 degrees tomorrow”

4. 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.

5. 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

6. 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

7. 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 You’ve lowered your risk by 20% (At a cost of $7)

8. Diversification & Correlation • Adding uncorrelated (Corr = 0) variables to a portfolio lowers the risk attached to that portfolio

9. Diversification & Correlation • Negative correlations (Corr < 0) enhance the power of diversification

10. Stock Market Diversification • B Solnik, “Why Not Diversify Internationally”, Financial Analysts Journal

11. Characteristics of a Good Financial System • Diversifies Risk • Creates Liquidity

12. 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?

13. Enron: Sinner or Saint? • Enron’s core business was to become the “middleman” in energy markets – this helped manage risk and improved liquidity.

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

15. Asymmetric Information • Adverse Selection • Prior to a transaction taking place, one party is missing vital information about the other party (can’t tell the good eggs from the bad eggs!) • Moral Hazard • After the transaction takes place, one party can’t observe the other’s actions (the good eggs might become bad eggs!)

16. 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 can’t distinguish lemons from good cars) Solution: Signaling or Regulation!

17. 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?

18. Project A (Safe) Bondholders: $100 Stockholders: $0 With certainty Project B (Risky) Bondholders: 50% chance of $0, 50% chance of $100 E(B) = .5(100) + .5(0) =$50 Stockholders: 50% chance of $0 50% chance of $100 E(S) = (.5)(100) + .5(0) =$50 A Moral Hazard Example

19. A Moral Hazard Example • As a bondholder, you can’t 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

20. 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

21. 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) “Black Tuesday”

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

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

24. “Black Monday” • On Monday, October 19,1987 The Dow fell from $2246 to $1738 – 22.6% of its value

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

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

27. 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

28. 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

29. 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

30. Government Institutions ($3T) • Provision of Liquidity • Fannie Mae • Freddie Mac • Ginnie Mae • Sallie Fae • Regulation and Oversight • Federal Reserve • SEC • FDIC

31. 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

32. Evolution of the Financial System • Financial Innovation • Integration and Globalization • Regulation • Competition