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

 Match savers and 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

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

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

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

Money Market Instruments Outstanding,

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

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

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

 1930s Regs/diversification option?  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.

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

 Hedging/Insuring against adverse changes … You have $10 million in U.S. Treasuries, nominal yield is 5% and maturity date is 3 years from now. But, you only want to hold them for one more year. Risk – If interest rates rise, the price will fall. Hedge – execute a forward contract, promising to sell bonds in 2009 at a price yielding 5.1%. “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. “Purpose” of a Derivative

 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. Forward vs. Future Contract

 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. “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. “Purpose” of a Derivative

 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!! Derivatives as speculative

 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. Case: Barings Bank to 1995

 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). The Credit Swap Derivative

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

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