Financial Markets, Institutions & Derivative Instruments

1. Financial Markets, Institutions & Derivative Instruments ECO 473 – Money & Banking – Dr. D. Foster

2. Economic Functions of Financial Markets • Match saversand investors • Savers want to  wealth • Investors want to create wealth • Spread/share risk. • Successful strategy - diversification • Savers seek out mutual funds • Savers seek out financial intermediaries • Investors seek OPM

3. Financial Markets - Why & Who • banks • credit unions • S&Ls • thrifts • savings banks • Why - Intermediation • Who . . . • pension funds • Insurance companies • mutual funds • mortgage brokers • investment bankers • finance companies

4. Financial Markets - New & Used • New - Primary Markets • stocks (IPO), bonds, mortgages, other. • Used - Secondary Markets • exchange of ownership. • Where: NYSE,NASDAQ,OTC . . .

5. Financial Markets - Short & Long • Short - Money Markets • A financial instrument that matures w/in one year. • Used to facilitate liquidity demands. • Need funds soon. • Have excess cash. • Fed’l funds • Repurchase agreements • Bankers’ acceptances • Euro$ funds • 3 mo. & 6 mo. T-Bills • Commercial paper • Bank CDs

6. Money Market Instruments Outstanding, April 2005

7. Financial Markets - Short & Long • Long - Capital Markets • Maturities of more than one year. • Used for capital purchases (investment). • Less liquid & more risk than MM. • Other U.S. & Munis • Mortgages • Comm./Con. loans • Corporate stock • Corporate bonds • U.S. Treasury bonds

8. Capital Market Instruments Outstanding, April 2005

9. Federal Financing Bank Banks for Cooperatives Federal Intermediate Credit Banks Federal Land Banks Federal National Mortgage Association (FNMA, or “Fannie Mae”) Government Players • General National Mortgage Association • (GNMA, or “Ginnie Mae”) • Federal Home Loan Banks (FHLBs) • Federal Home Loan Mortgage Corporation • (FHLMC, or “Freddie Mac”)

10. Sell diversification to individual savers. Government regulations limit risks. 8,000 mutual funds in the United States. Financial Institutions Mutual Funds Hedge Funds • Raise money from wealthy people/institutions • Largely unregulated • Use leverage which magnifies gains/losses. • Trade in derivative instruments.

11. A brokerbuys and sells securities for others May be “full service” or “discount.” Adealerbuys and sells for itself, making a market in these securities. Brokers and Dealers Investment Banks • Underwrites and advises companies on mergers and acquisitions. • Investment banks buy and sell securities and derivatives.

12. The End of Investment Banks? • 1930s Regs/diversification option? • 2008 - collapse of the MBS market. • Bear Stearns - couldn’t roll over debt. • Lehman Brothers - $639 bill. in assets. • Merrill Lynch - sold to BoA • Goldman Sachs & Morgan Stanley- converted to commercial banks.

13. Case - Google IPO • Google structured IPO as a “Dutch” auction. • Google saved on investment bank services. • Presumption is Google earned more $$. • Had touted a price of $135 earlier. • Ended up with a price of $85. • Earned $1.67 billion on sale. • Conclusion: Investment underwriters are not biased!

14. Case - Google IPO After After After After 8/2012 trading Aug. 20, trading Aug. 20, trading IPO, IPO, IPO, IPO, At peak, traded at At peak, traded at At peak, traded at At peak, traded at at about $460 at about $542 at about $460 traded traded traded traded almost $715 almost $715 almost $715 almost $715 at $106 at $106 at $106 at $106 4/2014; stock split: As of 10/9/2014GOOG $562– GOOGL $572

15. Derivative Financial Instruments • Forward contracts • Future contracts • Options • Swaps Derivatives in . . . • Interest rates • Currency • Stock • Commodities • Weather

16. “Purpose” of a Derivative • Hedging/Insuring against adverse changes … You have $10 million in U.S. Treasuries,nominal yield is 5% and maturity date is 2022.But, you only want to hold them until 2019. Risk – If interest rates rise, the price will fall. Hedge – execute a forward contract, promising to sell bonds in 2019 at a price yielding 5.1%.

17. “Purpose” of a Derivative • Hedging/Insuring against adverse changes … You need to buy €5 million in 6 months,the current exchange rate is $1.33/ €. But, you think the dollar will depreciate by then. Risk – If the dollar falls, it costs more to buy €. Hedge – go “long” and agree to buy €, through a futures contract, at $1.36 each.

18. Forward vs. Future Contract • Forward: • Variable in content. • Settled at maturity date. • Matching participants. • Future: • Standardized amounts and terms. • Ongoing settlement cash flows. • Active, liquid market. • Default can’t hurt other party.

19. “Purpose” of a Derivative • Hedging/Insuring against adverse changes … You need to buy €5 million in 6 months,the current exchange rate is $1.33/ €.But, you think the dollar will depreciate by then. Risk – If the dollar falls, it costs more to buy €. Alternative Hedge – buy a call option to purchase Euros at $1.40 each; exercise only if the rate moves higher than that.

20. “Purpose” of a Derivative • Hedging/Insuring against adverse changes … You pay a variable return on $25 million worth of outstanding bonds. Risk – If interest rates rise, so do your costs. Hedge – execute an interest rate swap, to gain a fixed payment schedule, and reducing your exposure to interest rate changes.

21. Derivatives as speculative • Bank agrees to buy bonds in one year at a price that earns 5% . . . thinking rates will fall. • Buy/sell currency futures if you expect rates to move contrary to market. • Buy options to leverage your investment. Actions raise market liquidity for non-speculators!!

22. Case: Barings Bank - 1762 to 1995 • 1992 – Nick Leeson becomes a trading manager at Baring Securities in Singapore. • Charged with executing client option orders and arbitraging price differences between SIMEX and Osaka exchanges. • Took “speculative positions” in futures linked to Nikkei 225 and Japanese gov’t. bonds. • Hid losses in an unused error account:$400 m. – 1994 and $1.4 b. – 1995 • Fled Singapore; arrested in Germany.

23. The Credit Swap Derivative • Hedging against adverse changes.. You own $25 million worth of outstanding bonds. Risk – If the firm goes bankrupt . . . Hedge – buy a credit default swap, and make a fixed payment (insurance). If firm goes bust, the seller owes you for the bond (difference).

24. The Credit Swap Derivative • First one in 1995 (J.P. Morgan) • By 2008, $45 trillion in value. • As speculation – buy & sell to manage risk. • You don’t need to own bond! • Done OTC. • Party-to-party transaction. • Settlement/liquidity issues. • Build a virtual bond portfolio. • Insider trading issue . . .

25. Financial Markets, Institutions & Derivative Instruments ECO 473 – Money & Banking – Dr. D. Foster