Appunti Financial Markets, Credit and Banking

Chapter 1: Why studying financial markets and institutions?

For an economy to reach its potential growth rate, mechanisms must exist to effectively allocate capital (which is a scarce resource) to the best possible use, while evaluating the riskiness of the opportunities available. Markets and institutions have been created to facilitate transfers of funds from economic agents with excess funds to economic agents in need of such funds. For an economy to maximise its growth potential, it must create methods to attract savers' excess funds and to allocate those funds to the best uses possible. The funds transfer must occur at the lowest cost possible, to ensure maximum economic growth, and to allow the growth of individual and social wealth.

Savers and spenders

Financial markets and institutions allow transfer of funds from persons or business without investment opportunities, i.e. lenders-savers (households, business firms, government, foreigners), to ones with investment opportunities, i.e. borrowers-spenders (business firms, government, households, foreigners). There are 4 economic categories, which can be savers and spenders at the same time. Households savings flow to financial markets (such as banks and other financial institutions that link savers and borrowers).

Institutional sectors and financial balances

Starting from the left, we can see where a saver can invest: pension funds, different deposits, stocks, bonds, securities, insurances etc. All these instruments are then invested directly or indirectly into the economy in terms of loans, shown on the right: large and small business, venture capital, construction, investment etc.

Six parts of the financial system

• Money: to pay for purchases and store wealth; it has changed from gold/silver coins to paper currency to eventually electronic funds. Today, cash can be obtained from an ATM anywhere in the world and bills are paid and transactions are checked online.
• Financial instruments: to transfer resources from savers to investors and to transfer risk to those best equipped to bear it (risk and information are key in the financial market). They have been created along with the financial markets to let the economic agents with surplus funds to enter into direct contracts with economic agents in need of funds, buying and selling bonds or stock. At first, the possibility was open just to wealthy people, but today the possibility is open to everyone thanks to online systems. The finance is much more democratic today than in the past.
• Financial markets: to buy and sell financial instruments; they are organizations that facilitate the trade of financial securities. At first, they were all physical (like the NYSE), while today they are mostly automated (like NASDAQ).
• Financial institutions: to provide access to financial markets, collect information and provide services; they are corporations that provide services as intermediaries of a financial market. There are three major types: depository institutions (that manage deposits and make loans, including banks, mortgage loans companies etc); contractual institutions (insurance companies etc); and investment institutions (brokerage firms etc.)
• Regulatory agencies: to provide oversight for financial system; they have been introduced by the federal government after 1929, at first to analyse and supervise the safety and stability of financial institutions; then performing consumers protection functions with the FDIC (federal deposit insurance corporation) and the SEC (security and exchange commission). Similar institutions exist in the EU as well (ex. CONSOB in Italy).
• Central banks: to monitor financial institutions and stabilize the economy. The FED is responsible for influencing liquidity and overall credit conditions. Its primary monetary policy tool is the possibility of open market operations, that control the buying and selling of US treasury and federal agency securities. Such purchases and sales determine the federal fund rates and alter the level of reserves available. The federal reserve board is responsible for regulating and supervising the US banking system, which is intended to provide financial stability in the US. The same goes for the ECB.

Five core principles of money and banking

1. Time has value: Interest is paid to compensate the lenders for the time the borrowers have their money. Every financial transaction is based on this.
2. Risk requires compensation: The higher the risk, the higher the compensation.
3. Information is the basis for decisions: The more important the decision, the more information we gather. The collection and processing of information is the foundation of the financial system.
4. Markets determine prices and allocation resources: They are the core of the economic systems because they channel resources and minimize the costs of gathering information and making transactions. The better developed the financial market, the faster the country will grow.
5. Stability improves welfare: A stable economy reduces risks and improves welfare, while instability triggers downturns.

Methods of funds transfer

• Direct financing: Borrowers borrow directly from lenders in financial markets by selling financial instruments, which are claims on the borrowers' future income or assets, without the help of an intermediary. In such case, society relies on primary market to initially price the issue, and then secondary markets to update the prices and provide liquidity.
• Indirect financing: Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower's future income or assets. The intermediary and the borrower negotiate the terms and costs. The intermediary is usually responsible for monitoring the contractual conditions or updating the costs.

Function of financial systems

All trades on the goods market involve both the real sector and the financial sector. The financial sector is important to macroeconomics because of its role in channelling savings back into the circular flow that we see described in the picture: Savings are returned to the circular flow in the form of consumer loans, business loans and loans to government or foreigners. Savings are channelled into the financial sector when individuals buy financial assets such as stocks or bonds or others and channelled back into the spending stream as investments. For every financial asset there is a corresponding financial liability.

The financial system links the savers with the spenders. It helps immobilizing and allocating the savings efficiently and effectively and plays a crucial role in economic development through saving/investment process, called capital formation. It helps monitor corporate performance and provides mechanism for managing uncertainty and controlling risk, for the transfer of resources across geographical boundaries, it offers portfolio adjustment facilities provided by financial markets and intermediaries, it helps lowering the transaction costs and increase returns, that will motivate people to save more. It helps promoting the process of financial deepening (increasing financial assets as percentage of GDP) and broadening (building an increasing number and variety of participants and instruments). A financial system contributes to the acceleration of economic development.

Financial market

It refers to any marketplace where the trading of securities occurs, including bond market, stock markets etc. Financial markets are vital to the operation of capitalist economy by allocating resources and creating liquidity for businesses and entrepreneurs. The markets make it easy for buyers and sellers to trade their financial holdings. Financial markets create securities products that provide a return for those who have excess funds (investors or lenders) and make these funds available to those who need money (borrowers).

There are different types of taxonomies: on one side there are:

• The regulated markets, covered by special rules and supervisions
• The over-the-counter markets, where participants trade stocks, commodities, currencies or other instruments directly between two parties and without a central exchange or broker.

There are:

• The restricted markets
• The open to the public markets.

The markets can be distinguished with respect to the mode of trading:

• Markets quote driven: where the prices are determined by bid and ask quotations, made by market makers, dealers or specialists; in such market, also known as price driven market, dealers fill orders from their own inventory or by matching them with other orders.
• Order driven market: a financial market where all buyers and sellers display the prices at which they wish to buy or sell a security, as well as the amount of the security desired to be bought or sold.
• Hybrid: where the participants have the option to choose between human brokers who execute transactions, or automated electronic exchange system. For example, investors placing large orders, might want to avoid their investment becoming public knowledge.

Primary and secondary markets

• Primary markets: Markets in which users of funds raise funds through new issues of financial instruments such as stocks and bonds. New issues of financial instruments are sold in exchange for funds (money) that the issuer needs. Most primary market transactions in the United States are arranged through financial institutions called investment banks. For these public offerings, the investment bank provides the issuer with advice on the securities issue (such as the offer price and number of securities to issue) and attracts the initial public purchasers of the securities. These first-time issues are usually referred to as initial public offerings (IPOs). Seasoned offerings are the offerings a public company makes after the first one.
• Secondary markets: Once financial instruments such as stocks are issued in primary markets, they are then traded in secondary markets. They provide a centralized marketplace where economic agents know they can transact quickly and efficiently. Secondary markets offer buyers and sellers liquidity—the ability to turn an asset into cash quickly at its fair market value—as well as information about the prices or the value of their investments. Increased liquidity makes it more desirable and easier for the issuing firm to sell a security initially in the primary market. Further, the existence of centralized markets for buying and selling financial instruments allows investors to trade these instruments at low transaction costs.

Money market and capital market

• Money markets: Markets that trade debt securities or instruments with maturities of one year or less. The short-term nature of these instruments means that fluctuations in their prices are usually quite small, and they grant a low return. Most money markets are over the counter, which means they don’t operate in a physical location, rather via telephone, wire transfers and computer trading.
• Capital markets: Markets that trade equity (stocks) and debt (bonds) instruments with maturities of more than one year. Given their longer maturity, these instruments experience wider price fluctuations and higher returns.

Foreign exchange markets

The FX market is an over-the-counter marketplace for the trading of currencies, where every country can exchange its currencies for others. It determines the exchange rate for global currencies. It is the largest financial market in the world, in terms of volume of exchanges.

There are two kinds of foreign exchanges:

• Spot FX: It is the immediate exchange of currencies at current exchange rates, where the settlement is usually two business days after the trade.
• Forward FX: The exchange of currencies happens in the future at a specific date and at a pre-specified exchange rate.

Derivative security markets

The derivative security is a contract which derives its value from some underlying assets or market conditions. It means they have no personal value, but they depend on the asset they are connected to. The main purpose of derivative markets is to transfer risk between market participants. On the market, there are two kinds of figures:

• Hedgers: Professionals who use derivative securities to limit risk exposure.
• Speculators: Professional gamblers who use derivatives to obtain high returns.

The two main types of derivative markets are the markets for exchange-traded derivatives and the OTC derivatives markets. Exchange-traded derivatives are liquid and involve no counterparty risk whereas OTC contracts are custom contracts negotiated between two counterparties and have default risk. OTC derivatives are forward contracts, forward rate agreements and swaps. Derivatives have been blamed for the financial crisis of 2008.

Market efficiency: different meanings

• Completeness efficiency: In economics, a complete market has the following conditions: transaction costs are negligible, and every asset in every state of the world has a price. (Arrow-Debreu)
• Information efficiency: The degree to which market prices reflect all available relevant information. If markets are efficient then the info is already incorporated into prices, so there is no way to outperform the market because there are no overvalued or undervalued securities available (Fama). Forms of efficiency are weak, semi-weak, strong. Weak-form tests study the information contained in historical prices. Semi-strong form tests study information (beyond historical prices) which is publicly available. Strong-form tests regard private information.
• Fundamental efficiency: The prices that are formed are the economic foundations of the value of financial assets. The prices are derived from a discounting of future cash flows (dividends, cash flow, etc.). Fundamental Value does not mean objective value but simply the value that expresses the expected future cash flows and rates of return required. In the short term, the fundamental value FV may differ from market price.

Requirements for market efficiency

• Width: Have large order volumes
• Thickness: Have a thick price distribution with a lot of buyers and sellers at different price levels
• Elasticity: For a small change in price, there will be a reactivity in terms of orders.

Price discovery should be considered the central function in any marketplace. The market brings sellers and buyers together, each one having different reasons for trading. By allowing these counterparties to interact, a consensus price is established. Price discovery is influenced by a wide variety of factors, among which there are structure, security type, info available in the market; the parties with the freshest information have an advantage on others. When new info arrives, it can change the prices. Too much transparency can be detrimental to a market.

Types of brokerage services

• Brokers: Who work exclusively for third parties by facilitating the search for trade partners and making it possible to cross between supply and demand. They can offer information services. They act as intermediaries for buyers and sellers for a fee or a commission.
• Dealers: Who operate on their own account and perform the function of making liquid the market of particular financial assets, ensuring the continuity of trades. They hold their own portfolio of financial assets they use to respond promptly to the trading needs of other operators, expressing the purchase price and the selling prices.
• Market makers: Operators acting on their own account and who are committed to make public pricing conditions at which they are willing to negotiate: quoting prices at which they wish to purchase and sell minimum lots of financial assets. They are committed to make a market. They typically are large banks or financial institutions. They help to ensure there's enough liquidity in the market.

The activities of the financial intermediaries in the markets: the provision of investment services

Under Security Market Law (art. 1) "Investment services and activities" we mean the following tasks when pertaining to financial instruments:

• Proprietary trading: A firm or bank that invests for direct market gain rather than earning commissions by trading on behalf of others. It may involve the trading of stocks, bonds, commodities etc.
• Execution of orders on behalf of clients: Conclude agreements to buy and sell financial instruments on behalf of clients (broker).
• Underwriting and placement on a firm commitment or with residual commitment to issuers (dealer).
• Portfolio management
• Reception and transmission of orders
• Advice on investments to educate and inform an investor.
• Management of Multilateral Trading Facilities (MTFs): Self-regulated financial trading venue. These are alternatives to the traditional stock exchanges where a market is made in securities, typically using electronic systems.

Depository and non-depository financial institutions

• A depository institution is a financial institution such as a savings bank, commercial bank, etc., that is legally allowed to accept deposits from consumers.
• A non-depository institution (insurance company, investment trust, etc.) serves as intermediary between savers and borrowers but doesn't accept deposits. Both are supervised and authorized agents.

The structure of the financial system: The savers are linked to the spenders through either the depository institutions (banks) and finance companies (credit intermediaries), or through the institutional investors (such as mutual funds or insurances), that pass through the markets (such as money market, capital market, FX market and derivative market).

Financial institutions exist because of

1. Economies of scale on transaction costs, such as search, screening, production, monitoring costs.
2. Provision of liquidity services
3. Risk sharing provision (which grants asset transformation and portfolio diversification)
4. Asymmetric information (screening and monitoring aimed to minimize informational asymmetries)