Chapter 1

Introduction
 Types of Assets

Tangible Assets
Value is based on physical properties
Examples include buildings, land, machinery
Intangible Assets
Claim to future income generated
(ultimately) by tangible asset(s)
Examples include financial assets
 Types of Financial Assets

Bank loans Common stock

Government bonds Preferred stock
Corporate bonds Foreign stock
Municipal bonds
Foreign bond
 Debt vs. Equity

Debt Instruments
Fixed dollar payments (‘fixed income’)
Examples include loans, bonds
Equity Claims
Dollar payment is based on earnings
Residual (varying) claims
Examples include common stock, partnership
share
 Price of Financial Asset
and Risk

The price or value of a financial asset is

equal to the present value of all expected
future cash flows.
Expected rate of return
Risk of expected cash flow
 Types of Investment Risks

Purchasing power risk = inflation risk

Default risk = credit risk (special case of

PP risk)

Exchange rate risk = currency risk

 Role of Financial Assets

Transfer funds from those with more

money than projects to those with more
projects than money.
Share unavoidable risk associated with
cash flows.
Equity holders bear inflation risk
Debt holders bear default risk
Both may bear exchange rate risk
Role of (Financial) Markets

Provide liquidity: buyers and sellers all in

one ‘place’.
price discovery  efficient resource
allocation
Reduce transactions costs:
search costs
information costs (market efficiency)
 Classification of Financial
Markets

Nature of asset: debt vs. equity markets

Maturity: money (short) vs. capital (long)
markets
Seasoning: primary vs. secondary markets
Delivery: cash (= spot) vs. derivatives
markets
Structure: auction vs. over-the-counter
(OTC) vs. intermediated markets
 Financial Market
Participants

Households
Business units
Federal, state, and local governments
Government agencies
Supranationals (= multilaterals)
Regulators (broader definition)
 Globalization of Financial
Markets

In general, easier for investors to move

capital internationally
Causes:
Deregulation (liberalization) of financial
markets (e.g. currency controls)
Technological advances
Increased role of institutional investors
(economies of scale), inc. CalPERS
 Classification of Global
Financial Markets

Internal Market External Market

(= national market) (= international, offshore
or Euromarket): securities
offered outside single
jurisdiction to investors
in multiple countries

Domestic Market: Foreign Market:

issuers domiciled issuers domiciled
in the country abroad
 Motivation for Using Foreign
Markets and Euromarkets

Limited fund availability in internal market

(esp. in poorer countries)
Reduced cost of funds
Diversifying funding sources (portfolio
reduces risk)
 Derivatives Market

Derivatives’ value depends on underlying

(financial) asset
Futures/forward contracts: parties agree
to buy/sell at an agreed price and date.
Options contracts: rights (not obligations)
to buy (call) or sell (put) at an agreed
price on/by an agreed date.
 Role of Derivative
Instruments

Buy/sell risk (e.g. purchasing power risk,

interest rate risk, exchange rate risk)
`Zero sum’
However, there are still advantages:
May be lower transactions costs
Can be faster to transact than cash market
Greater liquidity
Allows great scope for financial innovation…
Chapter 2

Financial
Intermediaries
and Financial
Innovation
 Services of Financial
Institutions
Financial intermediaries transform
financial assets (then their liabilities): inc.
deposits, insurance, pensions
Help create, launch financial assets
(underwriter)
Trade financial assets for customers
(broker)
Trade their own financial assets (dealer)
Provide investment advice
 Role of Financial
Intermediaries

Obtain funds (their liabilities, e.g.

deposits) & invest them (their assets, e.g.
loans): transfer funds from savers to
investors
Direct investment
e.g. bank buys corporate stocks or bonds
Indirect investment
e.g. individual deposits money in a bank that buys…
 Intermediaries and asset
transformation

Maturity intermediation
Many short term deposits = a long term loan
Longer loan terms usually more expensive
Reducing risk by diversification
portfolio, covariance, marriage [?]
Specialization reduces costs: contracting
and information processing, etc.
Enable non-cash payments (cheques,
plastic)
 Asset/Liability
Management

Spread and Non-Spread Businesses

buy/bid v. sell/ask spread (inc. insurance)
non-spread: fund management fees
Nature of Liabilities
contracts specify amount, timing of payment
see chart on next page
Liquidity: redeeming liabilities prematurely
Regulations and taxation
 Nature of Liabilities of
Financial Institutions
Amount of Cash Timing of Cash Example
Outlay Outlay

Fixed Fixed fixed interest mortgage

Fixed Variable life insurance policy

floating-rate certificate
Variable Fixed of deposit

Variable Variable car insurance

 Categories of Financial
Innovation (Economic Council
of Canada)
Market-broadening instruments
attract new investors
Risk-management instruments
re-allocate risk
Arbitraging instruments and
processes
facilitate arbitrage
 Categories of Financial
Innovation (BIS)

Price-risk-transferring innovations
for price/exchange rate risk
Credit-risk-transferring instruments
Liquidity-generating innovations
inc. by avoiding regulatory constraints
Credit-generating instruments (debt funds)
Equity-generating instruments (capital base)
 Causes of Financial
Innovation
Financial innovation is a form of innovation
Reasons to innovate:
improve products (e.g. cut costs, including taxes – v.
‘Rules in OECD Countries to Prevent Avoidance of
Corporate Income Tax’, Thuronyi)
differentiate products
Explosion in financial products since 1980s:
theoretical developments (e.g. Black-Scholes)  more
sophisticated market participants
technical developments: computers, IT
deregulation  greater competition by intermediaries
increased risk [?]: see chart on next page
Changing global patterns of financial wealth
 Increased volatility?

0.8

0.6

0.4

0.2

0
1900 1920 1940 1960 1980 2000

-0.2

-0.4

-0.6

GBP/USD UK RPI 2.5% consol FT all share

-0.8
St Louis Fed: FRED II
 Asset Securitization

Securitization:
“homogenizing and packaging financial instruments
into a new fungible [interchangeable] one” (Barkley
International Inc.)
Many institutions instead of a single one:
bank A makes home mortgages
bank A hires bank B to issue securities backed by the
mortgages
bank A buys credit risk insurance
bank A sells loan servicing right
 Benefits to Issuers

Specialization/out-source to focus on ‘core

competences’: service fees (to collect &
forward payments…)?
Diversification reduces risks, hence costs
Manage risk-based capital requirements
Manage interest rate volatility
 Other Benefits

To Investors (buyers of securities)

greater liquidity
reduced credit risk
To Borrowers
lower lending rate spreads
Social Benefits
e.g. `viatical settlement’: trade life insurance
benefits