There is more or less a pattern of expansion
(recovery) and contraction (recession) in
economic activity around the path of trend
At cyclical peak- economic activity is high
relative to trend.
At cyclical trough ??
Over time what causes the trend line to change ?
Factors not fully employed all the time.
What is inflation ?
Why worry about inflation instead of unempmt.?
What are they ??
What makes a good market ??
Can we name some “bad” markets ??
FINANCIAL MARKETS & INSTITUTIONS
I. Financial markets exist to aid in the most
efficient allocation of capital
II. Financial Institutions facilitate this
allocation of capital.
The players in the market are households,
businesses and governments. How they play and
what motivates them to play is critical to the
well being of economies.
TYPES OF MARKETS
Primary – New fund raising
Secondary – Trading
There are specialized markets for fund raising
and trading. The most important of these are:
Money Markets – Maturities < 1 yr.
Capital Markets – Maturities > 1 yr.
FLOW OF FUNDS
Who are the players?
Rest of the World
All act at one point in time or another as
borrowers and providers.
Funds arrive directly or indirectly
What is the role of Financial Intermediaries ?
To lower transaction costs
To lower risk
To provide better market information
Intermediaries also incur risks………
Credit or default risk
What about Foreign Mkts & Intermediaries ?
Provide for borrowing or investing abroad
Important source of diversification
What is an interest rate ?
Compensation for lending or giving up one’s
abilitiy to spend today.
Can be a measuring guideline governing
Why do we care about interest rates ?
They influence the allocation of capital.
They impact the economy and decision
How do we look at interest rates and time ?
Concept of Present Value
Present value allows you to place a value on
future funds. What might $10 today be worth 10
years from now ?
The Present Value calculation converts cash
flows received in the future to a value
assuming receipt today (the PRESENT ).
How much is $3000 received in two years
worth today if the interest rate is 4% ?
How much is $2000 next year and $3000 the
year after worth today if the interest rate is
Where do you hear the concept of Present
Value applied quite often ?
U.S. Savings Bonds
Winning the lottery
Back to our first example :
PV of $3000 received in 2 years @ 4% =
If the i/r is 2%....is PV higher or lower ?
If the i/r is 6%.... is PV higher or lower ?
WHAT DETERMINES THE LEVEL OF I/R
AT ANY GIVEN POINT IN TIME ?
The supply and demand of loanable funds.
Same concept as the supply and demand of
goods and services you studied in Economics.
So there is a supply and demand curve here as
What might the supply and demand curve look
What might cause the curves to shift ?
Near term spending needs
Restrictiveness of nonprice conditions.
What are the factors that can affect the i/r for
an individual security ?
Begin with the “real interest rate “
Direct correlation between inflation & i/r..
U.S. Treasuries become the benchmark..
What factors influence nominal i/r ?
Term to Maturity
Ubiased Expectations Theory
Liquidity Premium Theory
Market Segmentation Theory
What does the yield curve tell us ?
What exactly are bonds ?
Debt instruments – Secured/Unsecured
Coupon or Zero
PV = Face Value = Par
PV> Face Value= Premium
PV < Face Value = Discount
These reflect the price of bonds. How does
that relate to Yield….
Price and yield are inversely related. Why ?
Duration – measure of the weighted average
time to maturity. That is, it takes into account
the timing of payments. Any received before
maturity will result in a shorter duration that
the maturity date…..
Higher interest rates shorten duration. Why ?
THE FEDERAL RESERVE SYSTEM
Moderate long-term i/r
Maintain high level of employment
Conduct monetary policy
Supervise/regulate depository institutions
Maintain stability of financial system
Provide payments services for governments
Also check clearing & wire transfers
Independent of Executive Branch
Oversight by Congress
Chairman/Vice Chair appointed by President
12 Regional Banks
7 Member Board of Governors
5 of Regional Bank Presidents + Board of
Governors comprise the Federal Open
Market Committee (FOMC)
The objectives shown above are their job….
What is important is how they do it….
What is it and how does it affect us ?
In essence it is an attempt to influence the
amount of reserves that remain in the banking
system….which in turn affects i/r and the
availability of credit…which ultimately affects
the levels of employment, output, and prices and
inflation. In other words the money supply.
MONETARY POLICY TOOLS
Open Market Operations
The FOMC impacts the economy thru its
practice of buying and selling government
securities in the open market. In so doing they
are either adding money (expanding) to the
existing supply or taking it out (contracting).
Discount rate – Rate Fed. Charges bank to
borrow from it….In reality is only used as a
signal to the market as to which way the Fed
wants to see rates go. The discount rate was
lowered 11 time in 2001 in an attempt to
stimulate the economy.
Required – currently 10%
How do these tools help expand the money
How do these tools help contract the money
Definitions of the money supply
The FED selects a target and uses Monetary
Policy to get to that target.
Most popular targets:
Short term debt instruments < 1 year
Active secondary market/ very liquid
Capital markets > 1 year
Characteristics of money market instruments:
Large – usually $1 mil. +
Low default risk
Maturity of 1 year or less
Corporates and governments usually sell
money market instruments to meet short term
Default risk free
Benchmark for other securities pricing
Refinancing debt/govt. deficit/tax timing
Sold at auction weekly
Shortest maturity is 13 weeks.
Sold at a discount
Suppose you buy a 26 week T-bill for $9500
whose face value is $10,000. What is the
discount yield ?
i = 10000-9500/10000 x 360/182 = 9.89%
Primarily overnight loans between banks.
One of the uses of their excess reserves.
FED sets the lending rate.
For all practical purposes are just lending cash
between two banks.
REPURCHASE AGREEMENTS (REPOS)
Actual sale of securities between two parties
with agreement to repurchase at set date and
Is collaterized most often with govt.
Normally 1-14 days but can go 90.
More secure than Fed Funds so has lower
yield…often as much as 25 basis points.
COMMERCIAL PAPER (CP)
An unsecured promissory note issued by
Corporates with good credit can often
borrow cheaper in the cp mkt. than from their
banks. (see chart on page 135)…comparing cp
rates to prime rate.
Normally held to maturity….up to 270 days.
Lower rated corporates can issue cp backed
by LOC’s or bank lines of credit. Expensive
by effective….better than issuing long term if
Purchasers get internal approval on a credit
and return again again.
Cp usually sold thru dealers like Goldman
Sachs…agree to repurchase in event of
Rates are quoted on a discount basis
Bank issued promissory notes. Specific
maturity and rate. Trade in secondary market
at negotiated price.
Normal maturities are 14-360 days.
Unsecured issuance so yield is higher.
A draft for payment backing a LOC issued
against imported goods.
Importer gets LOC guaranteeing payment to
exporter. BA allows them to draw down
money before delivery. Importer then
reimburses the bank.
There is a secondary market for BA’s.
MONEY MARKET PARTICIPANTS
T-bills Treasury Fed/Banks/Cor
Fed Funds Banks Banks
Repos Fed/Banks Fed/Banks/Cor
Cp Banks/Corps Corps/FI’s
Neg. CD Banks FI’s/Corps
BA’s Banks Banks/Corps
Where are there secondary markets ?
Where are yields the highest/lowest ?
Who are the important FI’s ?
Summary – Money markets are important to:
The Fed – for controlling the money supply.
Banks – to meet reserve requirement and as a
place to use excess reserves.
Broker-Dealers – Keep the market moving
Corporations - source of short term funding and
as a place to invest short term cash.
Other FI’s – A place to maintain liquidity.
INTERNATIONAL MONEY MARKETS
Foreigners are major investors in Treasuries
Diversification and default free
Keep deposits in foreign countries to facilitate
exhange into $.
LIBOR is major lending rate.
Now major rate measurement for all types of
loans, not just foreign.
Borrowing is usually quoted as a spread over
LIBOR…might be 350, 30 or 3…depending
on the risk associated with the borrower.
THE BOND MARKET
Bonds are capital market instruments with
maturities of greater than one year.
Typically fixed income ….offering interest a
set time periods and the return of principal at
maturity. A bond with a coupon of 8% would
normally pay interest every six months, 4% at
Treasury notes >1<10 years
Treasury bonds >10 <31 years
They comprise about 26% of total bond
Both pay semi-annual interest and are sold at
auction..but are sold at par unlike T-bills.
Treasury also issues inflation adjusted bonds
They also sell STRIPS where each coupon
payment is sold separately.
The secondary market in Treasury issues is
huge. If a bond is sold between coupon
payments the seller must pay the buyer the
accrued interest..or discount the price to
account for it.
Debt instruments issued by state and local
governments. About 17% of all bonds o/s.
Interest not taxed by feds or state investor
lives in for bonds issued in that state.
Tax exemption lowers cost of bonds issuance
for the governments because investors take a
General obligation – backed by taxing power
Revenue bonds – backed by revenue of a
project. General tax receipts cannot be used to
pay off a revenue bond…thus is riskier.
Industrial development bonds – normally for
How are municipal bonds sold ?
Underwritten/best efforts/negotiated basis
Secondary market very thin.
Comprise about 57% of o/s bonds.
Normally issued to fund long term obligations.
Rating agency comments are critical to price.
Debentures – no collateral
Subordinated debentures – junior in status
Convertible bonds – debt that converts to
equity at some point in time if certain things
Moody’s/S & P / Fitch
Who are buyers of the various types of bonds?
Which bonds likely carry the highest and
lowest yields ?
INTERNATIONAL BOND MARKETS
Eurobonds – Sold outside the country of the
currency in which they are issued. Could be
dollar denominated bonds sold in Japan.
Foreign bonds – Bonds issued outside the
home country but denominated in the host
country currency…Samurai bonds are dollar
denominated bonds issued by Japanese
borrowers in the U.S.
Brady bonds – bonds substituted in a
restructuring of a less developed country’s
debt. Longer term and lower rates. Backed by
the U.S. Treasury
Sovereign bonds – specific country issued .
Loans to purchase real property such as a
home, land or building.
75% of mortgages are for single family
Characteristics of a mortgage:
Size, term, i/r, collateral
Qualifications – fairly standard, income to
value ratio (can you make the payments)
Down payment – reduces default risk
Conventional vs. Insured.
Maturity – 15/30 yr….. balloon payment
I/R – Fixed vs. ARM
Greenspan ARM quotes.
Refinancing depending upon rate cycle.
Originate with FI’s most of whom do not
continue to carry them on their balance sheet.
Sold off in secondary market thru
securitization. Allows FI to enhance their
liquidity and reduce i/r and credit risk.
What is securitization and how does it
Why securitize ?
Mortgage market very cyclical. Govt.
subsidies are key to role housing plays in the
robustness of the economy. Home building
may suffer as rates go up…
What is stock anyway ?
How does one make a return from stock ownership ?
Limited liability of ownership
IPO’s /Seasoned offerings
Primary vs. secondary markets.
SEC/Registration/Red Herring/Shelf registration
How does trading occur on each market ?
DOW / S & P 500 / Wilshire 5000
What causes prices to change on the Market ?
Efficient market theory / Random walk
Global trade requires that we exchange currencies.
The foreign exchange rate is the ratio of one
currency to another. How yen equal one dollar ?
Initially had fixed currency rates. And Gold !!
Eventually floating. Now the Euro !!
Can use spot or forward markets to make exchange
rate more predictable.
What causes exchange rate differentials between
Economic flows between countries are measured by
the balance of payments.
Merchandise trade balance
Capital Account :
Financial instruments tailored to change where risk
Swaps, caps, floors, etc. are examples of these.
Most deal with the i/r or credit markets.
Spot contracts - discussed in FX context. Is a given
price today….a guarantee. When investing using
spot contracts you are investing looking for
Forwards are contracts to buy something at a given
price in the future at a price determined today.
Hedging future price change by locking in today.
Example: Airlines buying fuel for their fleets.
Locking in a mortgage rate could involve a forward
Futures contracts are like forward buy are traded on
a formal exchange. No default risk versus total with
forwards. Futures are revalued every day.
Futures are generally in 3 areas:
Can hold contracts to maturity or trade….most
liquidate before maturity.If hold to maturity you take
possession of the underlying asset.
So in each of these markets you are betting on
Options are a contract giving you the right but not
the obligation to buy or sell something within a
specific period of time.
Call options give you the right to buy (call away
from the seller)..a security at a predetermined price.
This is the exercise or strike price.
Selling an option…you write a call option.
You can buy stock options on many of the major
companies in the world on the NYSE or NASD.
Cheap way to invest..
What happened to markets after 9-11 ?
What would have happened to your options ?
You can purchase indices made up of the major
stocks….Dow/ S & P 500, etc. You can use these to
hedge (as a derivative) other stocks you own.
SWAPS – the most used derivative…great fun !!
Two parties agree to swap cash flows some time in
the future based upon some underlying asset.
Terrific tool for companies to manage i/r risk,
currency risk and credit risk.
Sold bond last year - $100 mil. 10yr – 7% coupon.
Now I think rates are going to trend down. What can
I do about it now ?
Nothing changes with the underlying assets…only
the cash flows tied to them.
Currency swaps – evening out exposure
Swap markets –
Caps (ceilings) – limit the upside exposure.
Floors – protect the bottom
Collars – give up a little to establish a range of risk.
Serve as principal channel for government monetary
Loans are assets/Deposits are liabilities. How then
do banks make a profit when their chief assets and
liabilities are just pieces of paper ??
Loans – A promise to repay – Approx. 60% of
Loans to whom ?
Business – 25% of total
Revolving lines of credit
Fixed – collateralized
Real Estate – 46% of total
Commercial and residential
Mortgages/equity lines of credit
Consumer credit – 16%
Fixed rate lending
Mismatch of maturities
Keys to successful asset management:
Lend to good customers
Invest in low risk securities
THERE IS A FINE LINE BETWEEN
PROFITABILITY AND SAFETY.
Why are deposits liabilities ?
Deposits represent aout 2/3 of total bank funding.
Generally checking, savings and CD’s.
The remainder of funding comes from direct bond
issuance, discount window and fed funds
Shorter term and more liquid than assets
Regulators mandate a minimum level of
equity(capital) to assets.. Today this number is about
9%. So banks are really highly levered.
Capital is primarily common stock and retained
earnings. It also includes reserves for losses.
Serves as a cushion against a drop in assets. What
happens when liabilities exceed assets ?
Japan banking crisis
What happens in a recession to bank business ?
Banks frequently have lots of business off their
balance sheets. Swaps, derivative contracts, some
loan commitments, foreign exchange contracts, etc.
Why would they do this ?
Commercial bank companies have been growing
because of the change in the law allowing branching.
This has brought on major merger/acquisition
More income coming from non-interest/fee based
Commercial banking – International
U.S. banks going abroad:
Follow their customers
Risks are higher – As are returns
Banking around the World
Historically small institutions serving specialized
needs of local groups.
Savings assoc. (formerly S & L’s)…population has
declined by 75% over last 20 years. Now about
Traditionally made long term fixed rate mortgages to
individuals funded by short term deposits.
Problems of the 1970’s / Regulation Q
Garn-St. Germain Act of 1982 / NOW-MMDA
Oil collapse / Regulators failed / New regulators
Assets: Mortgages and mortg. Backed sec. 73%
Comm. Loans – 3%
What happens in an economic downturn ?
Over 60% is small deposits.
Fed. Home Loan Bank borrowings = 22%
Equity (capital) = 8.2 %
What happens in an economic downturn ?
Essentially S & L or Savings Assoc. in the NE.
Less than 400 exist.
Balance sheets similar to Savings Assoc. except that
are more highly capitalized.
Evolved from employer owned institutions.
Are now nonprofits owned by their depositors.
Customers must have a common bond.
Consumer loans make up 37% of assets with
mortgages at 29%.
Portfolio is more liquid and has lower default risk
than that of banks and SA’s.
Credit Union Liabilities:
Member deposits = 89%
Primarily savings, CD’s, and NOW accts.
Equity (capital) is in excess of 9%
Should be able to offer better rates to customers and
make a higher ROA because of tax status.
REGULATION OF THRIFTS;
Office of Thrift Supervision (part of Treasury)
FDIC provides insurance
State assoc. are regulated by states.
Natl. Credit Union Admin. Board charters and
Insures credit unions.
Will these institutions exist 10 years from now ?
Life insurance – allows individual to protect
themselves and their benefactors against the loss of
income from death.
Insures pool risks – why /
What happens if they are wrong ?
Types of life insurance:
Accident and Health
What do the balance sheets of Insurers look like ?
Premiums are assets – long lived
Policies are liabilities
Regulation is at state level. Business getting more
competitive with brokerages, banks entering.
Property & Casualty:
Premiums are assets / claims are liabilities
How do these companies ever lose money ?
SECURITIES FIRMS & INVESTMENT
Research……the scandals…tying arrgmts.
SEC / Spitzer
Lenders to consumers, businesses, mortgages.
How are they different from Banks ?
1. Sales Finance Institutions
2. Personal Credit
3. Business Credit
Asset makeup / Liabilities
How do they fund their business ?
How much equity capital do they employ ?
Why do they even exist ?
MUTUAL FUNDS & HEDGE FUNDS
Financial instruments that pool funds.
Various funds have different objectives:
Growth, international, bond, etc.
How do you make money in a mutual fund ?
How do mutual fund companies make money ?
Savings plans through which participants
accumulate tax deferred savings for retirement.
Defined benefit plan
Defined contribution plan
State & local
REGULATION OF DEPOSITORY INSTITUTIONS
Crucial – Confidence in FI’s key for domestic and
Safety & Soundness
Entry & Chartering
Reg. of Product & Geographic Expansion
Prior to crash
Glass – Stegall
Glass – Stegall repeal
Unit/restricted branching/interstate branching
Why did problems of the 1980’s arise ?
Balance Sheet Regulations:
Focus on leverage
Capital to assets ratios become triggers:
>5% all the way to <2%
On balance sheet versus including off balance sheet
What is history of foreign banks ?
Social Security problems / solutions
FINANCIAL INSTITUTION RISKS
Credit – Bad investments/ Bad loans
Firm specific risk
Liquidity – High withdrawals/ “run”
Interest Rate – Mismatching
Market – Trading
Off Balance Sheet - draw downs/derivatives
Technology – Operational
MANAGING CREDIT RISK
Have had bouts of bad credit …..
1980’s – thrifts/real estate
1990’s – junk bonds/credit cards
2000 – telecom’s/tech/sovereign debt
What is the best way for a FI to lessen its risk of
extending bad credit ?
Real estate lending:
Ability to pay
Ability to pay:
How long have you lived somewhere /
Credit scoring also used. Compares your situation to
others like you. If you look like those who have
defaulted then assumption is you will also.
Collateral : Perfect security interest/lien
Default and they foreclose.
Non-mortgage consumer loans just based on ability
Small business lending looks at cash flow of the
Mid-market focuses more on the business
itself….cash flow/customer book/cyclicality
In the end, how predictable is the cash flow /
Credit analysis of the smaller firms is critical.
The 5 C’s….
Tougher sell for the FI. More options.
Information is better.
Once you have decided to make the loan how do you
decide what to charge for it ? In other words, how do
you make money at this game ?
How much is a relationship worth ?
MANAGING LIQUIDITY RISK
I WANT MY MONEY NOW !!!
Can purchase liquidity or use stored liquidity.
Runs and panics
Fed Discount Window
Life Insurance Co. liquidity risk
Property and Casulty liquidity risk
Mutual Funds liquidity risk
INTEREST RATE & INSOLVENCY RISK
Measuring the Risk…..
Rate Sensitive Assets and Liabilities
The Repricing Gap
The Duration Model
What is Capital and how is it Valued ??
MANAGING DERIVATIVE RISKS
Spot / Forwards / Futures
Hedging with Contracts
Accounting Rules / Bank Regulations
Options / Swaps
LOAN SALES AND SECURITIZATION
What are Loan Sales ? Why did they come to be ?
Participations / Assignments
What is the Market ? Who are the Players ?
What drives the Market ?
How is Loan Securitization different from Loan