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

2. Economic Functions of Financial Markets
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

3. Financial Markets - Why & Who
Why - Intermediation
Who . . .
banks
credit unions
S&Ls
thrifts
savings banks
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, 2000-2012

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, 2012

9. Financial Institutions
Mutual Funds
Sell diversification to individual savers.
Government regulations limit risks.
8,000 mutual funds in the United States.
Hedge Funds
Raise money from wealthy people/institutions
Largely unregulated
Use leverage which magnifies gains/losses.
Trade in derivative instruments. 9 9

10. Brokers and Dealers Investment Banks
A broker buys and sells securities for others
May be “full service” or “discount.”
A dealer buys and sells for itself, making a market in these securities.
Investment Banks
Underwrites and advises companies on mergers and acquisitions.
Investment banks buy and sell securities and derivatives. 10

11. The End of Investment Banks?
1930s regulations
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.

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

13. “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 But, you only want to hold them until 2018.
Risk – If interest rates rise, the price will fall.
Hedge – execute a forward contract, promising to sell bonds in 2018 at a price yielding 5.1%.

14. “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.

15. Forward vs. Future Contract
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.

16. “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.

17. “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.

18. 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!!

19. Case: Barings Bank 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.

20. The Credit Default Swap
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).

21. The Credit Default Swap
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 . . .

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