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Lecture 1 Financial Systems, Markets, Institutions, Instruments and Crisis.

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1 Lecture 1 Financial Systems, Markets, Institutions, Instruments and Crisis.

2 Introduction The international financial system exists to facilitate the design, sale, and exchange of a broad set of contracts with a very specific set of characteristics. We obtain financial resources through this system: Directly from markets, and Indirectly through institutions.

3 Introduction Indirect Finance: An institution stands between lender and borrower. We get a loan from a bank or finance company to buy a car. Direct Finance: Borrowers sell securities directly to lenders in the financial markets. Direct finance provides financing for governments and corporations. Asset: Something of value that you own. Liability: Something you owe.

4 The Balance Sheet The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time Assets are listed in order of decreasing liquidity Ease of conversion to cash without significant loss of value Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity Liquidity is a very important concept. Students tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without significant loss of value.” Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean that it is liquid. Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns. See the IM for a more complete discussion of this issue.

5 The left-hand side lists the assets of the firm
The left-hand side lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are direct results of management’s investment decisions. (Please emphasize that “investment decisions” are not limited to investments in financial assets.) Note that the balance sheet does not list some very valuable assets, such as the people who work for the firm. The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets – total liabilities. The portion of equity that can most easily fluctuate is retained earnings. The right-hand side of the balance sheet is a direct result of management’s financing decisions. Remember that shareholders’ equity consists of several components and that total equity includes all of these components, not just the “common stock” item. In particular, remind students that retained earnings belong to the shareholders.

6 U.S. Corporation Balance Sheet – Table 2.1
The first example computing cash flows has a link to the information in this table. The arrow in the corner is used to return you to the example. Here is an example of a simplified balance sheet. Some students might make it through business school without ever seeing an actual balance sheet, particularly if they are not majoring in finance or accounting. I encourage you to bring in some annual reports and let the students see the differences between the simplified statements they see in textbooks and the real thing. This is a good place to talk about some of the specific types of items that show up on a balance sheet and remind the students what accounts receivable, accounts payable, notes payable, etc. are.

7 Income Statement The income statement is more like a video of the firm’s operations for a specified period of time You generally report revenues first and then deduct any expenses for the period Matching principle – GAAP says to recognize revenue when it is fully earned and match expenses required to generate revenue to the period of recognition Matching principle – this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period.

8 U.S. Corporation Income Statement - Table 2.2
The first example computing cash flows has a link to the information in this table. The arrow in the corner is used to return you to the example. Remember that these are simplified income statements for illustrative purposes. Earnings before interest and taxes (EBIT) is often called operating income. COGS would include both the fixed costs and the variable costs needed to generate the revenues. Analysts often look at EBITDA (earnings before interest, taxes, depreciation, and amortization) as a measure of the operating cash flow of the firm. It is not true in the strictest sense because taxes are an operating cash flow as well, but it does provide a reasonable estimate for analysis purposes. The IM provides a discussion of Cendant and the problems that the company ran into when fraudulent accounting practices were discovered. It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statement. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the IRS. In this instance, the “life” of the asset for depreciation purposes may be very different from the useful life of the asset. Statements that are prepared for investors often use straight-line depreciation because it will tend to have a lower depreciation charge than MACRS early in the asset’s life. This reduces the “expense” and thus increases the firm’s reported EPS. This is a good illustration of why it is important to look at a firm’s cash flow and not just its EPS.

9 Financial Management Decisions
Capital budgeting What long-term investments or projects should the business take on? Capital structure How should we pay for our assets? Should we use debt or equity? Working capital management How do we manage the day-to-day finances of the firm? Provide some examples of capital budgeting decisions, such as what product or service the firm will sell, should old equipment be replaced with newer, more advanced, equipment, etc. Be sure to define debt and equity. Provide some examples of working capital management issues, such as: whom to grant credit, how much inventory should be carried, when should suppliers be paid, etc.

10 Forms of Business Organization
Three major forms in the United States Sole proprietorship Partnership General Limited Corporation S-Corp Limited liability company www: Clicking on the “Web surfer” will take you to a Web site that will provide a discussion about which form of business may be appropriate for an entrepreneur. The following pages will provide links to specific pages on the Web site that provide additional information about the legal aspects of each form of business, as well as a discussion of the advantages and disadvantages. The address is:

11 Goal Of Financial Management
What should be the goal of a corporation? Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s stock? Does this mean we should do anything and everything to maximize owner wealth? Sarbanes-Oxley Act Try to have the students discuss each of the goals above and the inherent problems of the first three goals: Maximize profit – Are we talking about long-run or short-run profits? Do we mean accounting profits or some measure of cash flow? Minimize costs – We can minimize costs today by not purchasing new equipment, or by delaying maintenance, but this may not be in the best interest of the firm or its owners. Maximize market share – This has been a strategy of many of the companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their Web sites. Even though many of the companies may have huge market share (i.e. Amazon) that still does not guarantee positive earnings, so their owners may not be happy. Maximize the current value of the company’s stock There is no short run vs. long run here. The stock price should incorporate expectations about the future of the company and consider the trade-off between short-run profits and long-run profits. The purpose of a for-profit business should be to make money for its owners. Maximizing the current stock price increases the wealth of the owners of the firm. This is analogous to maximizing owners’ equity for firms that do not have publicly traded stock. Not-for-profits can also follow the same principle, but their “owners” are the constituencies that they were created to help. The instructors manual provides a letter to stockholders that was written by former Coca-Cola CEO Roberto Goizueta. There is also a brief discussion of an article that appeared in Fortune magazine that discusses Coke vs. Pepsi and their different philosophies on business in the early 1990s. Ethics Note: See the instructor’s manual for a discussion of Dow-Corning, silicone breast implants, and the ethics involved with pursuing owners’ wealth at all costs.

12 The Agency Problem Agency relationship Agency problem
Principal hires an agent to represent its interests Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent Management goals and agency costs Video Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada. A common example of an agency relationship is a real estate broker – in particular, if you break it down between a buyer’s agent and a seller’s agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyer’s price range. Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the Sensor razor. Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint; monitoring costs. Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.

13 Financial system survey in three steps:
Financial instruments or securities Stocks, bonds, loans and insurance. What is their role in our economy? Financial Markets New York Stock Exchange, Nasdaq. Where investors trade financial instruments. Financial institutions What they are and what they do.

14 Financial Instruments
Financial Instruments: The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions. The enforceability of the obligation is important. Financial instruments obligate one party (person, company, or government) to transfer something to another party. Financial instruments specify payment will be made at some future date. Financial instruments specify certain conditions under which a payment will be made.

15 Uses of Financial Instruments
Three functions: Financial instruments act as a means of payment (like money). Employees take stock options as payment for working. Financial instruments act as stores of value (like money). Financial instruments generate increases in wealth that are larger than from holding money. Financial instruments can be used to transfer purchasing power into the future. Financial instruments allow for the transfer of risk (unlike money). Futures and insurance contracts allows one person to transfer risk to another.

16 Financial Markets Financial markets are places where financial instruments are bought and sold. These markets are the economy’s central nervous system. These markets enable both firms and individuals to find financing for their activities. These markets promote economic efficiency: They ensure resources are available to those who put them to their best use. They keep transactions costs low.

17 The Role of Financial Markets
Liquidity: Ensure owners can buy and sell financial instruments cheaply. Keeps transactions costs low. Information: Pool and communication information about issuers of financial instruments. Risk sharing: Provide individuals a place to buy and sell risk.

18 Primary versus Secondary Markets
A primary market is one in which a borrower obtains funds from a lender by selling newly issued securities. Occurs out of the public views. An investment bank determines the price, purchases the securities, and resells to clients. This is called underwriting and is usually very profitable.

19 Primary versus Secondary Markets
Secondary financial markets are those where people can buy and sell existing securities. Buying a share of IBM stock is not purchased from the company, but from another investor in a secondary market. These are the prices we hear about in the news.

20 ©McGraw-Hill Companies, 2010
Money Any generally accepted means of payment for delivery of goods or the settlement of debt Legal money notes and coins Customary money IOU money based on private debt of the individual e.g. bank deposit. ©McGraw-Hill Companies, 2010 20

21 Money and its functions
Medium of exchange money provides a medium for the exchange of goods and services which is more efficient than barter Unit of account a unit in which prices are quoted and accounts are kept Store of value money can be used to make purchases in the future Standard of deferred payment a unit of account over time: this enables borrowing and lending ©McGraw-Hill Companies, 2010 21

22 ©McGraw-Hill Companies, 2010
Modern banking A financial intermediary an institution that specialises in bringing lenders and borrowers together e.g. a commercial bank, which has a government licence to make loans and issue deposits including deposits against which cheques can be written Clearing system a set of arrangements in which debts between banks are settled ©McGraw-Hill Companies, 2010 22

23 A beginner’s guide to the financial markets
Financial asset a piece of paper entitling the owner to a specified stream of interest payments over a specified period Cash notes and coins, paying no interest the most liquid of all assets Bills Short-term financial assets paying no interest directly but with a known date of repurchase by the original borrower at a known price. highly liquid ©McGraw-Hill Companies, 2010 23

24 A beginner’s guide to the financial markets (2)
Bonds longer term financial assets – less liquid because there is more uncertainty about the future income stream Perpetuities an extreme form of bond, never repurchased by the original issuer, who pays interest forever e.g. Consols Gilt-edged securities government bonds in the UK Company shares (equities) entitlements to receive corporate dividends not very liquid ©McGraw-Hill Companies, 2010 24

25 Credit creation by banks
Commercial banks need to hold only a proportion of assets as cash reserves. This enables them to create credit by lending. Example: Assume banks use a reserve ratio of 10 per cent. Suppose, initially, the non-bank private sector has wealth of £1000 held in cash: ©McGraw-Hill Companies, 2010 25

26 ©McGraw-Hill Companies, 2010
Financial crises A financial panic is a self-fulfilling prophecy. Believing a bank will be unable to pay, people rush to get their money out. But this makes the bank go bankrupt. In a solvency crisis, an institution’s assets have become less than its liabilities. In a liquidity crisis, an institution is temporarily unable to meet immediate requests for payment. ©McGraw-Hill Companies, 2010 26

27 ©McGraw-Hill Companies, 2010
The subprime crisis A subprime mortgage is a housing loan to a low-income high-risk person. Most of these mortgages were at variable interest rates: although initially low and ‘affordable’, they could subsequently be raised US house prices peaked in As they then fell, lenders became worried and began to raise mortgage interest rates, driving many of the poor to default. Suddenly, these subprime mortgages were worth a lot less than had been thought. ©McGraw-Hill Companies, 2010 27

28 ©McGraw-Hill Companies, 2010
Securitisation Securitisation transformed this into a global problem. Financiers had bundled lots of individual subprime mortgages into large bundles and sold them on to new buyers in London, Frankfurt and Mumbai. The market was convinced that although one poor subprime household might default, they would not all do so together. However buyers of securitized mortgages had miscalculated. ©McGraw-Hill Companies, 2010 28

29 ©McGraw-Hill Companies, 2010
The Credit Crisis It was quite likely that circumstances could arise in which all subprime borrowers got into trouble at the same time. And so they did. As US house prices fell sharply, banks found their assets worth much less than they had thought.   As the solvency of banks came into question, people became reluctant to lend to banks, and banks themselves became reluctant to lend to anyone else ©McGraw-Hill Companies, 2010 29

30 Top World’s Biggest Financial Crises Ever
Panic of 1819, a U.S. recession with bank failures; culmination of U.S.'s first boom-to-bust economic cycle Panic of 1825, a pervasive British recession in which many banks failed, nearly including the Bank of England Panic of 1837, a U.S. recession with bank failures, followed by a 5-year depression Panic of 1847, United Kingdom Panic of 1857, a U.S. recession with bank failures Panic of 1866, Europe Panic of 1873, a U.S. recession with bank failures, followed by a 4-year depression Panic of 1884, United States and Europe Panic of 1890, mainly affecting the United Kingdom and Argentina Panic of 1893, a U.S. recession with bank failures Black Monday (stock crashes 22% 1987) Credit Crisis of 1772 1907 Banker's Panic

31 Top World’s Biggest Financial Crises Ever
German Hyperinflation, OPEC Oil Price Shock (1973) Wall Street Crash The Great Depression 1998 Russian Crises 1997 Asian Crises Japan’s "Lost Decade," Financial crises of 2008 Subprime mortgage crisis in the U.S. starting in 2007 2008 United Kingdom bank rescue package 2009 United Kingdom bank rescue package 2008–2009 Belgian financial crisis 2008–2012 Icelandic financial crisis 2008–2009 Russian financial crisis 2008–2009 Ukrainian financial crisis 2008–2012 Spanish financial crisis 2008–2011 Irish banking crisis European Sovereign Debt Crisis, 2009 onward

32 Black Monday In the finance world, The Black Monday refers to the time of October 19, During that day, there was a widespread stock market crash all around the world. The beginning of this crash originated in Honk Kong and eventually spread to Europe. Ultimately, the United States was affected as well. The Dow Jones dropped by 22.1%, and it took almost 2 years to reach even the previous high of 1987

33 1907 Banker's Panic The Panic of 1907 saw the Dow drop almost 50% from the high of the previous year. It was triggered by the usual suspects: over-expansion and poor speculation. The stock market crashed in March, and a second crash in October led to a run on banks and every trust in New York, notably causing the massive National Bank of North America to fail.

34 Credit Crisis 1770 This crisis originated in London and spread to other parts of Europe, such as Netherlands. Ironically, it had been preceded by a period of great prosperity for Britain. The mid 1760s and 1770s saw a credit boom which spurred greater manufacturing and industrial activity. The period of 1770 to 1772 was politically very stable for Britain and its colony, America. However, there was a deeper systemic problem that prevailed under the surface of this prosperity. Speculative practices thrived to generate more credit, and this led to a false feeling of optimism in the market. On June 8, 1772, the fleeing of one of the partners of the Banking House “Neal, James, Fordyce and Down” due to failure to repay debts led to panic.

35 Japan’s "Lost Decade," The collapse of the Japanese asset bubble in 1991 led to a prolonged period of low growth, which has since been extended to incorporate the decade since the year The original lost decade was caused by an unsustainable level of speculation, large amounts of credit and low interest rates (sound familiar?). When the government stepped in to control this, credit became much harder to obtain, and capital investment dropped significantly.

36 Dot-Com Bubble This speculative bubble related to internet based companies saw massive rises in equity stock values of industrialized nations from This bubble began because of easy credit availability in These start-up companies wanted to establish a high market share by establishing more coverage. This meant that many of the services were freely provided, and large operational losses were actually occurring. They wanted to establish a brand and then charge profitable rates. The phrase “Get large or get lost” operated in the minds of company founders. 

37 European Sovereign Debt Crisis, 2009 onward
This is the most recent of the crises on our list, and no one is yet certain about when, or how, it is going to end. Markets have grown increasingly concerned about the ability of nations, particularly Greece, Ireland, Spain, Portugal, and Italy, to pay their debts, and the exposure of international banks to these potentially toxic debts has played a large part in the enormous market falls of recent days — some of the worst on record.

38 Financial crises of 2008 This crises was considered the worst one since the Great Depression itself. This easy availability of credit propelled greater demand for housing and a bubble started. However, once this ended, there was a big crash in housing prices. Mortgage values now exceeded the values of houses bought. A great level of lending to less credit worthy borrowers had also prevailed, called sub-prime lending. The existence of financial instruments like Collateralized Mortgage obligations (CMOs) allowed the effect to spread to the entire financial market. Financial innovations led to far greater risk taking appetite. However, the eventual collapse of trust in the market froze lending activity.

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