Topic 1: FINANCIAL MARKETS AND THE ECONOMY

WHAT IS A FINANCIAL MARKET?

Financial markets refer broadly to any marketplace where the trading of

securities occurs, including the stock market, bond market, forex market, and
derivatives market, among others.

Financial markets are vital to the smooth operation of capitalist economies.

WHAT IS THE ROLE OF FINANCIAL MARKETS IN AN ECONOMY?

Financial assets and the markets in which they trade play several crucial roles in
developed economies.

The Informational Role of Financial Markets

Stock prices reflect investors’ collective assessment of a firm’s current
performance and future prospects. When the market is more optimistic about the
firm, its share price will rise. That higher price makes it easier for the firm to
raise capital and therefore encourages investment. In this manner, stock prices
play a major role in the allocation of capital in market economies, directing
capital to the firms and applications with the greatest perceived potential.

The stock market encourages allocation of capital to those firms that appear at
the time to have the best prospects. Many smart, well-trained, and well-paid
professionals analyze the prospects of firms whose shares trade on the stock
market. Stock prices reflect their collective judgment.

Consumption Timing
Some individuals in an economy are earning more than they currently wish to
spend.

Others, for example, retirees, spend more than they currently earn. How can you
shift your purchasing power from high-earnings periods to low-earnings periods
of life? One way is to “store” your wealth in financial assets. In high earnings
periods, you can invest your savings in financial assets such as stocks and bonds.
In low-earnings periods, you can sell these assets to provide funds for your
consumption needs. By so doing, you can “shift” your consumption over the
course of your lifetime, thereby allocating your consumption to periods that
provide the greatest satisfaction. Thus, financial markets allow individuals to
separate decisions concerning current consumption from constraints that
otherwise would be imposed by current earnings.
Allocation of Risk
Virtually all real assets involve some risk. When Ford builds its auto plants, for
example, it cannot know for sure what cash flows those plants will generate.
Financial markets and the diverse financial instruments traded in those markets
allow investors with the greatest taste for risk to bear that risk, while other, less
risk-tolerant individuals can, to a greater extent, stay on the sidelines. For
example, if Ford raises the funds to build its auto plant by selling both stocks and
bonds to the public, the more optimistic or risk-tolerant investors can buy shares
of its stock, while the more conservative ones can buy its bonds. Because the
bonds promise to provide a fixed payment, the stockholders bear most of the
business risk but reap potentially higher rewards. Thus, capital markets allow the
risk that is inherent to all investments to be borne by the investors most willing to
bear that risk.

This allocation of risk also benefits the firms that need to raise capital to finance
their investments. When investors are able to select security types with the risk-
return characteristics that best suit their preferences, each security can be sold for
the best possible price.

This facilitates the process of building the economy’s stock of real assets.

Separation of Ownership and Management

Many businesses are owned and managed by the same individual. This simple
organization is well suited to small businesses and, in fact, was the most common
form of business organization before the Industrial Revolution.

Today, however, with global markets and large-scale production, the size and
capital requirements of firms have skyrocketed. For example, in 2012 General
Electric listed on its balance sheet about $70 billion of property, plant, and
equipment, and total assets of $685 billion. Corporations of such size simply
cannot exist as owner-operated firms. GE actually has more than half a million
stockholders with an ownership stake in the firm proportional to their holdings of
shares.

Such a large group of individuals obviously cannot actively participate in the day-
today management of the firm. Instead, they elect a board of directors that in turn
hires and supervises the management of the firm.

This structure means that the owners and managers of the firm are different
parties. This gives the firm a stability that the owner-managed firm cannot
achieve. For example, if some stockholders decide they no longer wish to hold
shares in the firm, they can sell their shares to other investors, with no impact on
the management of the firm. Thus, financial assets and the ability to buy and sell
those assets in the financial markets allow for easy separation of ownership and
management.

Corporate Governance and Corporate Ethics

Financial markets can play an important role in facilitating the deployment of
capital resources to their most productive uses. But market signals will help to
allocate capital efficiently only if investors are acting on accurate information.

We say that markets need to be transparent for investors to make informed

decisions. If firms can mislead the public about their prospects, then much can go
wrong.

Background of Financial Market Scams

Despite the many mechanisms to align incentives of shareholders and managers, the
three years from 2000 through 2002 were filled with a seemingly unending series of
scandals that collectively signaled a crisis in corporate governance and ethics. For
example, the telecom firm WorldCom overstated its profits by at least $3.8 billion
by improperly classifying expenses as investments. When the true picture emerged,
it resulted in the largest bankruptcy in U.S. history, at least until Lehman Brothers
smashed that record in 2008. The next-largest U.S. bankruptcy was Enron, which
used its now-notorious “special-purpose entities” to move debt off its own books
and similarly present a misleading picture
of its financial status.

Unfortunately, these firms had plenty of company. Other firms such as Rite Aid,
HealthSouth, Global Crossing, and Qwest Communications also manipulated and
misstated their accounts to the tune of billions of dollars. And the scandals were
hardly limited to the United States. Parmalat, the Italian dairy firm, claimed to have
a $4.8 billion bank account that turned out not to exist. These episodes suggest that
agency and incentive problems are far from solved.

What are agency problems?

Do managers really attempt to maximize firm value? It is easy to see

how they might be tempted to engage in activities not in the best
interest of shareholders. For example, they might engage in empire
building or avoid risky projects to protect their own jobs or over-
consume luxuries such as corporate jets, reasoning that the cost of
such perquisites is largely borne by the shareholders. These potential
conflicts of interest are called agency problems because managers,
who are hired as agents of the shareholders, may pursue their own
interests instead.
Other scandals of that period included systematically misleading and overly
optimistic research reports put out by stock market analysts. (Their favorable
analysis was traded for the promise of future investment banking business, and
analysts were commonly compensated not for their accuracy or insight, but for
their role in garnering investment banking business for their firms.)

Additionally, initial public offerings were allocated to corporate executives as a

quid pro quo for personal favors or the promise to direct future business back to the
manager of the IPO.

What about the auditors who were supposed to be the watchdogs of the firms?

Here too, incentives were skewed. Recent changes in business practice had made
the consulting businesses of these firms more lucrative than the auditing function.
For example, Enron’s (now-defunct) auditor Arthur Andersen earned more money
consulting for Enron than by auditing it; given Arthur Andersen’s incentive to
protect its consulting profits, we should not be surprised that it, and other auditors,
were overly lenient in their auditing work.

In 2002, in response to the spate of ethics scandals, Congress passed the

Sarbanes-Oxley Act to tighten the rules of corporate governance. For example,
the act requires corporations to have more independent directors, that is, more
directors who are not themselves managers (or affiliated with managers). The act
also requires each CFO to personally vouch for the corporation’s accounting
statements, created an oversight board to oversee the auditing of public
companies, and prohibits auditors from providing various other services to
clients.

REAL ASSETS VERSUS FINANCIAL ASSETS

The material wealth of a society is ultimately determined by the productive

capacity of its economy, that is, the goods and services its members can create.

This capacity is a function of the real assets of the economy: the land, buildings,
machines, and knowledge that can be used to produce goods and services.
In contrast to real assets are financial assets such as stocks and bonds. Such
securities are no more than sheets of paper or, more likely, computer entries, and
they do not contribute directly to the productive capacity of the economy.

Instead, financial assets are the means by which individuals in well-developed

economies hold their claims on real assets.

Financial assets are claims to the income generated by real assets (or claims on
income from the government). If we cannot own our own auto plant (a real asset),
we can still buy shares in Ford or Toyota (financial assets) and thereby share in
the income derived from the production of automobiles.

While real assets generate net income to the economy, financial assets simply
define the allocation of income or wealth among investors.

Individuals can choose between consuming their wealth today or investing for the
future. If they choose to invest, they may place their wealth in financial assets by
purchasing various securities.

When investors buy these securities from companies, the firms use the money so
raised to pay for real assets, such as plant, equipment, technology, or inventory.
So investors’ returns on securities ultimately come from the income produced by
the real assets that were financed by the issuance of those securities.

Our focus almost exclusively on financial assets should not make us lose sight of
the fact that the successes or failures of the financial assets we choose to purchase
ultimately depend on the performance of the underlying real assets.

Financial Assets

Financial assets, also referred to as financial instruments or securities, are

intangible assets. They are often used to finance the ownership of tangible assets
as equipment and real estate.

Financial assets represent legal claims to future cash expected often at a defined
maturity. The counterparties involved in the agreement are the institution or
entity that will pay the future cash (issuer) and the investors. Some examples of
financial assets are: stocks, bonds, bank deposits, loans.

All these instruments can be classified in different categories according to the

features of the cash flow associated with them.
They can be classified as debt instruments or equity instruments.

It is also common to distinguish among three broad types of financial assets:

fixed income, equity, and derivatives.

Debt instruments as bonds or loans require a fixed amount payment; equity

instruments have an uncertain cash flow, based on the issuer’s earnings.

There are also fixed income instruments that can be paid only after claims on debt
instruments have been satisfied. This is the case of preferred stocks and
convertible bonds.

As already stated, Fixed-income or debt securities promise either a fixed stream

of income or a stream of income determined by a specified formula. For example,
a corporate bond (also called debenture) typically would promise that the
bondholder will receive a fixed amount of interest each year.

Other so-called floating-rate bonds promise payments that depend on current

interest rates. For example, a bond may pay an interest rate that is fixed at 2
percentage points above the rate paid on U.S. Treasury bills.

At one extreme, the money market refers to debt securities that are short term,
highly marketable, and generally of very low risk. Examples of money market
securities are U.S. Treasury bills or bank certificates of deposit (CDs).

In contrast, the fixed-income capital market includes long-term securities such as

Treasury bonds, as well as bonds issued by federal agencies, state and local
municipalities, and corporations. These bonds range from very safe in terms of
default risk (for example, Treasury securities) to relatively risky (for example,
high-yield or “junk” bonds). They also are designed with extremely diverse
provisions regarding payments provided to the investor and protection against the
bankruptcy of the issuer.

Equity instruments are also referred to as residual claims because the issuer can
satisfy these claims only after holders of debt instruments have been paid.
Unlike debt securities, common stock, or equity, in a firm represents an
ownership share in the corporation.

The performance of equity investments is tied directly to the success of the firm
and its real assets. For this reason, equity investments tend to be riskier than
investments in debt securities.

Finally, derivative securities such as options and futures contracts provide

payoffs that are determined by the prices of other assets such as bond or stock
prices. For example, a call option on a share of Intel stock might turn out to be
worthless if Intel’s share price remains below a threshold or exercise price such
as $20 a share, but it can be quite valuable if the stock price rises above that level.
Derivative securities are so named because their values derive from the prices of
other assets.

Derivatives have become an integral part of the investment environment. One use
of derivatives, perhaps the primary use, is to hedge risks or transfer them to other
parties.

Investors and corporations regularly encounter other financial markets as well.

Firms engaged in international trade regularly transfer money back and forth
between dollars and other currencies. Well more than a trillion dollars of
currency is traded each day in the market for foreign exchange, primarily through
a network of the largest international banks.

Investors also might invest directly in some real assets. For example, dozens of
commodities are traded on exchanges such as the New York Mercantile
Exchange or the Chicago Board of Trade. You can buy or sell corn, wheat,
natural gas, gold, silver, and so on.

Commodity and derivative markets allow firms to adjust their exposure to various
business risks. For example, a construction firm may lock in the price of copper
by buying copper futures contracts, thus eliminating the risk of a sudden jump in
the price of its raw materials. Wherever there is uncertainty, investors may be
interested in trading, either to speculate or to lay off their risks, and a market may
arise to meet that demand.

Properties of Financial Assets

In general, all financial assets present some typical properties. Financial assets
can be used as a medium of exchange or can be converted into money at little
cost or risk. This attractive property for investors is called moneyless.

Divisibility and Denomination refers to the minimum amount or size in which

assets can be traded. For instance, US bonds are generally sold in $ 1,000
denominations, commercial paper in $25,000 units and deposits are infinitely
divisible.

Another property of financial assets is reversibility, also referred to as turnaround

cost or round-trip cost. It indicates the cost of buying an asset and then re-selling
it.

The Cash Flow is the return associated to the investment on financial assets
corresponded in different forms according to the type of financial asset as
dividends and options of stocks or coupon payments on bonds.

Term to maturity is the length of the period until the final repayment date or the
date at which the owner can demand the asset liquidation. In different cases the
financial assets may terminate before the stated maturity (in presence of call
provisions, bankruptcy of the issuer...) or can be also increased or extended on
demand of both counterparties.

Convertibility relates to the possibility to convert the financial assets into another
type of asset. This is the case of convertible bonds and preferred stocks.

Currency refers to the currency in which the asset’s cash flow is denominated.
There are some assets denominated in one currency that allow to earn cash flow
in a different currency (dual currency securities), created to reduce the exchange
rate risk. For example, some types of Eurobonds can pay interest in one currency
and principal in a second currency.

Another property that characterizes financial assets is the Liquidity. The degree
of liquidity of an instrument can be determined either in the financial market or it
can be determined by means of contractual obligations. An example of agreement
that can determine the degree of liquidity of an instrument is the claim of a
private pension fund. In this case, the asset is clearly considered illiquid in that
the claim can be satisfied not before the retirement date.

Another basic property is the Risk/Return predictability, for which the riskiness
associated to an asset depends on the uncertainty about future interest rates and
future cash flow (nominal expected returns). In case the future cash flow is
known in advance, as contractually determined, the uncertainty may regard only
the solvency of the debtor.
A financial asset can be also regarded as a combination of two or more simpler
financial instruments whose value is the sum of the price of its component parts.
For instance, the price of a callable bond corresponds to the price of a similar
non-callable bond less the value of the option that allows the issuer to redeem the
bond early. This property is called Complexity.

Finally, the last property is the so-called Tax status which depends on the
governmental regulations applying to the asset. The tax treatment generally varies
according to the issuer and owner nature, the asset maturity, the country’s or
different territorial unit's legislation, and so on.

These properties are important to determine the pricing of the financial asset.

Basically, the true or correct price of a financial instrument is equal to the present
value of its expected cash flow. However, there are several theories on the pricing
of financial assets directly related to the notion of expected returns.

THE ROLE OF FINANCIAL ASSETS

Financial assets allow us to make the most of the economy’s real assets.

We stated earlier that real assets determine the wealth of an economy, while
financial assets merely represent claims on real assets.

In general, financial assets serve two main economic functions:

1. The first is to transfer funds from those who have surplus funds to invest to
those who need a source of financing tangible assets.
2. The second is to redistribute the risk associated to the investment in
tangible assets between different counterparties according to their
preferences and risk aversion.

USERS OF THE FINANCIAL SYSTEM

1. Borrowers - Firms are net demanders of capital

They raise capital now to pay for investments in plant and equipment. The
income generated by those real assets provides the returns to investors who
purchase the securities issued by the firm.
2. Lenders - Households typically are net suppliers of capital
They purchase the securities issued by firms that need to raise funds.

Governments can be borrowers or lenders

Depending on the relationship between tax revenue and government expenditures
government can be a lender or a borrower.

Since World War II, the U.S. government typically has run budget deficits,
meaning that its tax receipts have been less than its expenditures. The
government, therefore, has had to borrow funds to cover its budget deficit.
Issuance of Treasury bills, notes, and bonds is the major way that the government
borrows funds from the public. In contrast, in the latter part of the 1990s, the
government enjoyed a budget surplus and was able to retire some outstanding
debt.

3. Financial intermediaries
Corporations and governments do not sell all or even most of their securities
directly to individuals. For example, about half of all stock is held by large
financial institutions such as pension funds, mutual funds, insurance companies,
and banks. These financial institutions stand between the security issuer (the
firm) and the ultimate owner of the security (the individual investor). For this
reason, they are called financial intermediaries.

Similarly, corporations do not market their own securities to the public. Instead,
they hire agents, called investment bankers, to represent them to the investing
public. Let’s examine the roles of these intermediaries.

Households want desirable investments for their savings, yet the small (financial)
size of most households makes direct investment difficult. A small investor
seeking to lend money to businesses that need to finance investments doesn’t
advertise in the local newspaper to find a willing and desirable borrower.
Moreover, an individual lender would not be able to diversify across borrowers to
reduce risk. Finally, an individual lender is not equipped to assess and monitor
the credit risk of borrowers.

For these reasons, financial intermediaries have evolved to bring the suppliers of
capital (investors) together with the demanders of capital (primarily corporations
and the government). These financial intermediaries include banks, investment
companies, insurance companies, and credit unions. Financial intermediaries
issue their own securities to raise funds to purchase the securities of other
corporations.

For example, a bank raises funds by borrowing (taking deposits) and lending that
money to other borrowers. The spread between the interest rates paid to
depositors and the rates charged to borrowers is the source of the bank’s profit. In
this way, lenders and borrowers do not need to contact each other directly.

Instead, each goes to the bank, which acts as an intermediary between the two.

The problem of matching lenders with borrowers is solved when each comes
independently to the common intermediary.

Financial intermediaries are distinguished from other businesses in that both their
assets and their liabilities are overwhelmingly financial.

Investment companies , which pool and manage the money of many investors,
also arise out of economies of scale. Here, the problem is that most household
portfolios are not large enough to be spread across a wide variety of securities. In
terms of brokerage fees and research costs, purchasing one or two shares of many
different firms is very expensive.

Mutual funds have the advantage of large-scale trading and portfolio

management, while participating investors are assigned a prorated share of the
total funds according to the size of their investment. This system gives small
investors advantages they are willing to pay for via a management fee to the
mutual fund operator.

Investment companies also can design portfolios specifically for large investors
with particular goals. In contrast, mutual funds are sold in the retail market, and
their investment philosophies are differentiated mainly by strategies that are
likely to attract a large number of clients.
Like mutual funds, hedge funds also pool and invest the money of many clients.
But they are open only to institutional investors such as pension funds,
endowment funds, or wealthy individuals.

They are more likely to pursue complex and higher-risk strategies.

They typically keep a portion of trading profits as part of their fees, whereas
mutual funds charge a fixed percentage of assets under management.

Economies of scale also explain the proliferation of analytic services available to

investors. Newsletters, databases, and brokerage house research services all
engage in research to be sold to a large client base. This setup arises naturally.
Investors clearly want information, but with small portfolios to manage, they do
not find it economical to personally gather all of it. Hence, a profit opportunity
emerges: A firm can perform this service for many clients and charge for it.

Investment Bankers
Just as economies of scale and specialization create profit opportunities for
financial intermediaries, so do these economies create niches for firms that
perform specialized services for businesses. Firms raise much of their capital by
selling securities such as stocks and bonds to the public. Because these firms do
not do so frequently, however, investment bankers that specialize in such
activities can offer their services at a cost below that of maintaining an in-house
security issuance division. In this role, they are called underwriters.

Investment bankers advise the issuing corporation on the prices it can charge for
the securities issued, appropriate interest rates, and so forth. Ultimately, the
investment banking firm handles the marketing of the security in the primary
market , where new issues of securities are offered to the public. Later, investors
can trade previously issued securities among themselves in the so-called
secondary market .

Venture Capital and Private Equity

While large firms can raise funds directly from the stock and bond markets with
help from their investment bankers, smaller and younger firms that have not yet
issued securities to the public do not have that option.

Start-up companies rely instead on bank loans and investors who are willing to
invest in them in return for an ownership stake in the firm.

The equity investment in these young companies is called venture capital (VC).

Sources of venture capital are dedicated venture capital funds, wealthy

individuals known as angel investors, and institutions such as pension funds.
Most venture capital funds are set up as limited partnerships. A management
company starts with its own money and raises additional capital from limited
partners such as pension funds. That capital may then be invested in a variety of
start-up companies. The management company usually sits on the start-up
company’s board of directors, helps recruit senior managers, and provides
business advice. It charges a fee to the VC fund for overseeing the investments.

After some period of time, for example, 10 years, the fund is liquidated and
proceeds are distributed to the investors.
Venture capital investors commonly take an active role in the management of a
start-up firm. Other active investors may engage in similar hands-on management
but focus instead on firms that are in distress or firms that may be bought up,
“improved”, and sold for a profit. Collectively, these investments in firms that do
not trade on public stock exchanges are known as private equity investments.

Bibliography
Fabozzi F., Modigliani F., Jones F. (2010), Foundation of Financial Markets and
Institutions, Pearson International Edition.

Bodie, K, Marcus (2006), Investments. 5th Edition. CUP, New Delhi.