ch1 fundamentals

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CHAPTER 01 WHY ARE FINANCIALCHAPTER 01 WHY ARE FINANCIAL

s angp ng sa

Spring 2013Master


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Preview

Suppose you invented the iRobot and you plan toproduce it.

http://resources.irobot.com/index.php/video/US/11305111

Walter inherited lots of funds

With financial markets,

you, Walter and the economy would all be better off.

General Structure and Operation of the Financial SystemGeneral Structure and Operation of the Financial System

is a good start!is a good start!

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verv ew

Direct Finance/Indirect Finance

Overview of the Financial System

Why are Financial Intermediaries (FIs) Special?They reduce

Transact on costs R s Asymmetr c In ormat on

How Asymmetric Information Influences the

Facts about Financial Structure/Tools to Solve the

Problem

Why Does the Financial System Receive SpecialRegulatory Attention?

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Direct Finance vs. Indirect Finance

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Function of Financial Markets

Channeling of funds (Fig 2.1) Also called securities markets

Why is this channeling of funds so

mpor an Because savers (lenders) entrepreneurs(borrowers)

ANDWithout financial markets, they may never get

to ether

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Structure of Financial Markets

It helps to define financial markets along a

mutually exclusive). For starters,

ur : r v . u y r Seasoning: Primary Market vs. Secondary

Secondary Markets: Exchanges vs. Over-the-

Original Maturity: Money Markets vs. Capital

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Nature

Short-Term (maturity < 1 year)

Debt Markets

Long-Term (maturity > 10 year)

Intermediate term (maturity in-between)

In U.S., total value was $52.4 trillion at the end of 2009

Equity Markets

Pay dividends, in theory forever

Represents an ownership claim in the firm

In U.S., total value was $20.5 trillion at the end of 2009 Disadvantage: residual claim

Advantage: share the extra profit of the firm

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Seasoning: A new issue or not

New security issues sold to initial buyers

Primary Market

offering

Previously-issued securities are resold (traded)

Secondary Market

o e: ssu ng rms ge any money rom e secon arymarket

Involves both brokers and dealers (do you know the

difference?) Classification of the secondary market

Functions of the secondary market

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Secondary Markets Classification

Exchanges

(e.g., New York Stock Exchange(NYSE), TaiwanStock Exchange (TWSE) )

Over-the-Counter (OTC) Markets

Dealers at different locations buy and sell.

(e.g., the market for Treasury securities,Foreign Exchange Markets).

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The Secondar MarketTwo Crucial Functions

Provide Liquidity

making it easy to buy and sell the securities ofthe companies

Establish a Price

for the securities in the Seasoned-Equity

Offerings (SEOs) note: n t a u c er ng

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Original Maturity

Money Market

Short-Term (maturity < 1 year)

Capital Market

Long-Term (maturity > 1 year)

Best known capital market securities Bonds & Stocks

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Without FIs: Direct Investment

E uit & Debt

CorporationsHouseholds

(net borrowers)(net savers)

as

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FIs Specialness

Without FIs: Low level of fund flows.

Information costs Economies of scale reduce costs for FIs to screen and

monitor borrowers

Substantial price risk

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With FIs

FI

Households Corporations(Brokers)

Cash E uit & DebtFI

(Asset

Transformers)epos s nsurance

Policies

as

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Functions of FIs

Brokerage

Direct Finance Asset Transformer

Direct Finance

Indirect Finance

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Functions of FIs- Brokerage

Brokers

Acting as an agent for investors e.g. Merrill Lynch, Charles Schwab

Reduce costs through economies of scale

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Functions of FIs- Asset Transformer

Purchase primary securities by selling

financial claims to households These secondary securities (financial claims

sold to households) often more marketable

Transformation of financial risk

Examples:

Banks: deposits Insurance Companies: insurance policies

Mutual Funds: mutual fund shares

19 Investment banks: Stocks and bonds


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Other Special Services

Maturity Intermediation

Banks: deposits vs. loans Denomination intermediation

Mutual funds vs. investments in bonds stocks

Payment Services, ,

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Direct Finance vs. Indirect Finance

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Indirect Finance is FAR MORE

IMPORTANTthan Direct Finance

.

WHY?

Transaction Costs

Ris aring Asset Trans ormation

As mmetric Information

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Sources of External Funds

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Transaction Costs

The loan contract

. ., ,

High costs freeze out individual lenders

Can anyone come to the rescue?

s can. y

Economies of scale: the reduction in transaction costs.

So the lender decides to obtain a deposit account ona y, s prov e qu y serv ces o cus omers.

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Risk Sharing (Asset Transformation)

Risk sharing

A benefit from low transaction costs

FIs help reduce the risk exposure of investors (e.g.,de ositors

Also called a sse t t r a n s f o r m a t i o n , In a sense, risky assets are turned into safer

.

Examples of risk sharing

Banks (deposits)

Insurance Companies (insurance policies)

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Asymmetric Information

Definition

The borrower has better in o about the investmentprojects (potential returns & risks) than the lenderdoes.

It creates two problems

Adverse selection

Moral hazard (conflict of interest)

to reduce information roblems

FIs have expertise

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Adverse Selection

e ore ransac on occurs

adverse outcome are ones most likely toseek a loan

Loan decisions to Conservative Aunt (Aunt C) vs. Get-rich- uick Aunt Aunt G

Similar problems occur with insurancew ere un ea y peop e wan e r nownmedical problems covered

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Moral Hazard

er ransac on occurs

The risk hazard that borrower hasincentives to engage in undesirable (immoral)activities making it more likely that wont pay

.

Again, with insurance, people may engage inr s y ac v es on y a er e ng nsure

Also called conflict of interest e.g., the borrower has incentive to act in his/her

own interest rather than the lenders interest

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FIs Help Reduce Asymmetric Information

FIs have expertise to produce information

from good ones (reduce loss from adverseselection)

Expertise in monitoring the borrowers (reduceloss from moral hazard

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3. How Asymmetric Information Influences


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Facts about Financial Structure

throughout the Worldv ence rom gure a e .

1. Stocks are not the most important source of external

financing2. Marketable securities are not the primary source of finance

3. Indirect finance is more important than direct finance

.

5. The financial system is heavily regulated

6. Only large, well-established firms have access to securities

markets7. Collateral is prevalent in debt contracts

8. Debt contracts have numerous restrictive covenants

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Sources of External Funds for Businesses

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Asymmetric Information: Adverse

Selection and Moral Hazard We will now use these ideas of adverse

selection and moral hazard to explain howthey influence financial structure.

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The Lemons Problem: How Adverse Selection

Influences Financial Structure (1/2)

Lemons Problem in Used Cars

1. If we can't distin uish between oodandbad (lemons) used cars, we are willing payonly an average of good and bad car values

2. Result: Good cars wont be sold, and theused car market will function inefficiently.

What helps us avoid this problem with

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The Lemons Problem: How Adverse Selection

Influences Financial Structure (2/2)

Lemons Problem in Securities Markets

1. If we can't distin uish between ood and badsecurities, willing pay only average of goodand bad securities value

2. Result: Good securities undervalued andfirms won't issue them; bad securitiesovervalued so too many issued

3. Investors won't bu bad securities somarket won't function well

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Tools to Help Solve Adverse Selection

(Lemons) Problems

Free-rider problem interferes with this solution

Private Production and Sale of Information

Increase the information available to investors

Government Regulation to Increase Information

.,

-

Financial Intermediation

buy stocks/bonds from the open market

Large firms (well-known corporations) are more likely to

use direct instead of indirect financin . WHY?

Collateral and Net Worth

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How Moral Hazard Affects the Choice

Between Debt and Equity Contracts (1/3)

Moral Hazard in Equity Contracts:

the Principal-Agent Problem1. Result of separation of ownership by

stockholders (principals) from control by

managers (agents)2. Mana ers act in own rather than

stockholders' interest

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Suppose you become a silent partner in an ice

n examp e: qu y

,($9,000). The other owner, Steve, provides theremaining $1,000 and will act as the manager. If

eve wor s ar , e s ore w ma e ,

after expenses, and you are entitled to $45,000of it.

However, Steve doesnt really value the $5,000(his part), so he goes to the beach, relaxes, and

even s ends some of the rofit on art for hisoffice.

How do you, as a 90% owner, give Steve the

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-(Equity)

Government Regulation to Increase Information

Financial Intermediation (e.g, venture capital)

e t ontracts

Explains why debt (rather than equity) is the mostimportant source of financing for business

However, e t s st su ect to mora azar . Infact, debt may create an incentive to take on veryrisky projects.

amount (interest), so the borrower can keep any cashflow above this amount.

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How Moral Hazard Influences Financial

Structure in Debt Markets (1/2)

An example: Debt

(requiring a 10% interest rate) he needs to setup his business. With your money, Steve may

cream (which is riskier) instead.

.

Success: you get 10%, but Steve get a lot more

Failure: you loss $9,000, but Steve losesnothing or $1,000 at most.

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How Moral Hazard Influences Financial

Structure in Debt Markets (2/2)

Net Worth

Tools to Help Solve Moral Hazard in Debt Contracts

Monitoring and Enforcement of Restrictive Covenants.Examples are covenants that

discoura e undesirable behavior

encourage desirable behavior keep collateral valuable

Financial Intermediationbanks and otherintermediaries have special advantages in monitoring

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A i I f i P bl d


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Asymmetric Information Problems and

Tools to Solve Them

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4. Why Does the Financial System Receive Special

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Regulation of the Financial System

Main reasons for regulation

Investor rotection Information Disclosure: Increase information

available to investors

Ensure the soundness of financialintermediaries

Information Disclosure

Restrictions on Entry

Deposit Insurance

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Reference Ant ony Saun ers an Marcia Mi on Conett, 2008, Financia

Institutions Management, 6th edition, Chapter 1.

Erederic S. Mishkin and Stanle G. Eakins 2012 FinancialMarkets and Institutions, 6th edition, Chapters 2 & 7

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