Financial Markets

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Why banks are better than individual lenders

- Individuals can't demand money back at a moments notice with interest. Individuals have to wait til the investment yields profits. Moreover, you can't easily sell your loan to others - While banks also can't get their money back quicker, they have many other depositors, so when one wants money back the bank can come up with it. They also don't invest all the money that is deposited with them. They keep liquid the amount necessary to recover the normal amount of withdrawls (Thus everyone can make deposits that are backed by illiquid investments yet have their individual deposits remain highly liquid - The system is still vulnerable to bank runs. But even then and even if there is no deposit insurance, the govt. allows banks to suspend liquidity temporarily and depositors will likely get paid most of what they are owed - Bank regulators in modern times attempt to further reduce the problem of bank runs by demanding that banks maintain an adequate amount of reserves (cash in the vault or deposits at other banks to make good on immediate withdrawls) and of capital (the total cushion of assets, after subtracting liabilities to make good on promises to depositors). This way the govt. should not in theory have to bail them out - Explicit reserve requirements date back to 1917 and Capital requirements for banks began to be enforced by banks in 82. - In addition to providing liquidity, banks address the moral hazard problem. If individuals invest directly in companies by lending money to them or buying securities, they may in effect be robbed by the people with whom they invest. Banks on the other hand have a reputation to protect. Thus many reputable banks will be ensured above the statutory limit. Moreover, even when banks do a make a bad call they are so diversified it likely has little effect. There is the public perception banks are better at sniffing out bad investments. - Banks also solve another problem for less- skilled investors. Banks solve the selection bias problem. Low skill investors are more likely to pick lemons while skilled investors snatch up the better ones. Banks do not discriminate against depositors and all investments go in to one pot in essence - Also banks solve the problem that there are not entirely effective ways for individuals to evaluate the trustworthiness of businesses for which they may want to invest. Even the reports available to the public that are valuable create a free rider problem. That is, tips are spread quickly and the value to those that come across them is minimized. - While some companies issue debt directly to the public, and people in theory can avoid banks by buying it directly from them at perhaps a better interest rate, a company is more likely to fail on a debt obligation than a bank is a deposit - A bank also has local branches that invest in local communities. The lenders at these branches will know the detailed information about what is really going on with each investment, down to evaluating who is running a given company. There is no free-rider associated with bank research because the bank does not publish it. - Also banks make short term renewable investments in to companies and demand regular reporting from the companies with which they lend. In turn the companies know they better maintain a good relation if the loans are not to be called.

- Classification of debt and equity is important for two reasons

1. In the case of bankruptcy of the issuer, investors in debt instruments have a priority claim on the issuer over equity investors 2. In U.S. tax treatment, the payments by the issuer differs depending on the type of class. Specifically, interest payments made on debt instruments are tax deductible to the issuer whereas dividends are not

Why of securities

1. It enables firms to specialize in particular aspects of a complex buissiness in which it might have a special advantage rather than participating in all areas of the business. 2. Selling assets to investors allows the issuers of loans to diversify their risk portfolio 3. Allows issuers of loans to raise more capital in order to accommodate requirements or lend more 4. The sale of securitized assets creates publicly available prices, which can be good if the underlying asset is difficult to obtain price discovery on

Flow Complexity and financial markets

The more complex the flow path the larger the market . You can get double triple quadruple, etc. counting •Ultimately flows into real assets •Larger market - more competition •Larger market - more backups •Larger market - more opportunities

Net Interest Margins

(Interest earned on loans and investment)4 - (Interest paid on deposits and borrowings) 1 4-1 =3, 3/100 = 3% Interest earning assets are 100 (bond and loan) So net interest margin is 3/100 which comes out at .03 or 3%. - 3- 4.5 % is typical for commercial banks - Net interest margin is a good way to evaluate the health of the bank

Future of banking according to Shiller

- Recession was not due to failures in traditional banking models but in new certain kinds of business models in which loans made to homeowners were not retained on the books and mortagage originators but bundled together in to securities and sold to other banks, thereby reintroducing the very moral hazard problem that banks were suppose to solve - Also regulators in the US have been increasingly permissive of alternative forms of banking. - They have allowed shadow banks to develop which are not subject to the same oversight as commercial banks - Shadow banks are finance institutions that escape banking regulations be designing themselves so they don't fit the traditional definition because they don't accept deposits but instead get their money in other slightly different ways - Examples of shadow banks include Bear Stearns and Lehman brothers, which were called investment banks but because they did not take deposits were not regulated like commercial banks - They then began to act like banks thus becoming shadow banks - Another example is structured investment vehicles - Shadow Banks may obtain commercially securitized loans or mortgages and enter into repurchase agreements with institutional investors, using those securities as collateral. That business creates liquid investment for commercial investors shich resemble depositors - In this way the shadow banks are in effect creating money as well. Thus their activities may involve a risk of collapse of the entire economic system, just as with commercial banks - A banks business which may have "charter value" (value created by excluding others) is adversely affected by these new shadow banks. Thus, in an effort to compete banks may try and branch out thereby creating new kinds of unregulated securities like the subprime loans that caused the recession. - Dodd-Frank are designed to put many of these shadow banking activities under stronger regulation to help prevent a similar crisis. However, it will be difficult to design regulation to keep pace

Investment Advisors Acts

- Regulates private investment fund managers, mainly imposition of fiduciary duty and some disclosure requirements - If assets under management >100 million must register - If AUM < 100 million, not allowed to register - Registered advisers must file Form ADV annually Ownership of firm, past violations, current or past litigations - Subject to SEC audit every 3-5 years What is an SEC audit of a PIF like? Limited notice, request for files, interviews, focus on different things different years (marketing of returns is most important), prepare audit letter

improvin inequality

- Progressive consumption taxes - one is taxed not based on what they earn but what they spend (like a sumptuary tax). However, this will also encourage people to withhold spending their income - Book argues the most effective way to help inequality is to aggressively pursue estate taxes. Most agree it should land around 1/3 though and people are neither completely for it or against it in most cases - Progressive tax structures, already in employ is another effective way to combat inequality. However, our tax system is not designed to tackle inequality per se - Earned income tax credit: Gives low owners a negative income tax on their wages - Shiller argues countries should index their tax system to inequality thereby tying tax rates to inequality in society. A indexed income tax on inequality system could raise more taxes to reverse inequality or simply work to keep inequality at its current level so as to prevent worsening inequality - As a society we are bad are considering taxes holistically. One side sees taxes as a net loss and others see it only as a net good. We are bad at looking at taxes as something that has positive attributes and negatives - Shiller argues we must build systems that plan in advance against increasing inequality because as the class of wealthy increases, it becomes harder for the rest to counter their political clout - Technological advancement can make pay paying more automatic, responsive, and nuanced, all qualities that can help battle inequality

Volatility straddle

- Purchase an out of the money call and an out of the money put - If Apple is at $160, purchase a three month $170 calll and a three month $150 put. - Short volatility by writing at the money call and put: - Example: is apple is at 160, write a three month 170 call and a three month 150 put - Implied volatility exceeds actual volatility 85% of the time

Quantitative easing

- Purchases by Federal reserve of federal securities back from financial institutions (banks, pensions plans, mutual funds, etc.) - Increases supply of capital into financial markets (bc they're paying cash) and lowering interest rates - For periods when the tool was used, starting in 2009 - During periods of purchasing is when the tool has the largest effect... so you don't want to be consistently purchasing because the punch will be lessened

High frequency traders

- Rapid fire electronic trading helps fuel the fire to rapid and devastating sell offs - They can cause flash crashes based on nothing more than algorithmic data - The bigger change that electronics have brought to trading has been more in the organization of information that the speed at which trading is carried out. - Computers allow people to collect, collate, and store information about investments - Speed trading is necessary to maintain competitiveness, but does not change the general activities of the participants because they are not serving clients who think in milliseconds Put another way, HFT helps traders do the same job faster

Supplemental bond notes

- Real yields what you get out of U.S. govt. bonds after inflation - 10 year treasury yields are negative at the moment - Low treasury yields encourage investors to purchase corporate bonds, therby allowing those corporations to continue paying their employees and making investments - Stocks too are bolstered by negative real yields - Real yields decline bring a dollar decline with them - Theory for why interest rates are so low: Rising life expectancy increases desired savings. - New technology also reduces the need for capital and are becoming cheaper, cutting the demand for investment - Negative bond interest rates are designed to revive growth by drving investors to corporate bonds and equities - Bond prices rise as yield drops. Why would someone buy your bond yielding 2% if current bonds yields are 5%.... the rise in current yields drops the value of lower yielding existing bonds. Alternatively, as yields drop from say 4%-2%, those 4 percent yields are more valuable. - Why would people buy at a negative yield? Expectations yields will rise and you will be able to sell to someone later on

Depository receipts

- A way for firms to tap foreign capital markets without directly listing their shares abroad - Come in two varieties: Sponsored ist set up at the behaest of the share issuer which deposits the desired number of its own shares with a bank in the country where the receipts are to be traded. The receipts themselves are technically securities issued by the bank giving the holder a claim on the earnings and price appreciation of the shares the bank holds - An unsponsored is set up on the initiative of an outside party such as an IB. - The main difference between them is that the owners of unsponsored receipts may have more difficulty obtaining financial reports and other information from the share issuer because the issuer has not sought the receipts

Issues of private fund management

- Allocation among various funds within a fund - Pricing of illiquid investments - Strategic drift - Transparency - "Agency cross transactions" trades between managed funds

CEO pay

- Anger of CEO pay accounts for much of the hostility regarding financial capitalism in general - But high compensation is the only way to attract the talent needed to do the hardest jobs and because of competitors willing to pay the same, pay may be easily justified - Growth in high salaries may be more attributable to improvements in our capitalistic situation that now better recognize the importance of strong leadership over arbitrary pay conventions

attidudes toward businessman

- Attitudes toward businesspeople are often negative but negative stereotypes are not universal - Research suggest that perceptions of sleaziness were higher in countries with no legal business people. It would appear that part of any countries process of becoming financially advanced involves getting over the exaggerated perception of sleaziness - 20-40 of Americans hold businesspeople in poor regard - However, we have to accept some level of less than high minded behavior may be product of a system that is good overall

Measurement of stock

- Average tracks value of certain stocks, essentially a sum of prices. - Index adjusts for market cap of the component stocks - DIJA most common Average Consists of 30 stocks that are meant to represent US economy. Now a measure for the stock market - Every $1 movement in component = 6.78 points - Average trackss value of certain stocks, essentially a sum of prices; index adjusts for market cap of the component stocks - S&P 500 most common index Price movements of components are weighted by proportionate market cap - S&P 500 is an investment vehicle in of in itself because of the diversity it can provide the causal investor

Example of Bank Risk weighting Assets

- Bank of UST - Customer deposits $100. The bank has $100 in assets and $100 in liabilities - Reserve requirement with the federal reserve $10. $90 left in cash - Need to raise capital by issuing stock. Investors purchase $20 of bank assets. - Contribution of capital for stock does not create a reserve requirement - We now have $110 in cash and 120 in liabilities - Put $50 in Fannie Mae bonds and 50 in commercial loans (still assets on the books) - 10% risk weight for bond and 100% for commercial loan - In order to meet capital requirement for bond and loan we need to back it up with .70 cents for bond and 3.50 for loan - Earn 2%interest on bond and 6% on loan. Make $1 on loan and $3 on bond. Must pay 1 to shareholders. So a total of 3 dollars was made - Now have 13 in cash assets

Democratization of banking

- Banking is generally a great business models and its proponents try and broaden its application to benefit not only the wealthy - In this way is stands as an example of being a societal steward - Today banks provide microfinance loans: Microfinance loans allow individual investors to lend small sums via microfinance institutions to individual entrepreneurs in poorer regions and through the power of the internet deal one on one with the people who benefit from their loans - Democratization is advanced by tech advances but is far from complete - A 2007 study revealed that 25% of families in the bottom 1/5 of wealth had no transactions at all. This makes it difficult to save, send their children to college, and plan for the future. - Govt. proposed to expand the democratization of banking by including explicit incentives to banks to provide services to low income people and the automatic openings of banks accounts for tax refunds and welfare payments - Democratization of banking can also be a great way to deal with hostility towards bankers

Moral Hazard and differed compensation

- Reason for the Govt. to interevene in the process of determining CEO salaries: Mitigate the specific moral hazard that played a substantial role in causing the recession - the incentive to take extraordinary risk - Many CEOs believe their companies are too big or important to fail and will be rescued if they do, so the upside to extreme risk is not held in check by the supposed mitigated downside - A CEO with a stock option based compensation has an incentive to manipulate the flow of information out of the company or to even doctor financial reports or to delay bad information until after his bonus has been paid - Sqaum Lake Group idea for CEO pay: Deliver a significant amount of compensation until an extended period of time down the road (5 years) and don't pay any if there is a bailout of the company - Dodd Frank requires CEOs to return erroneously awarded compensation as a result of material noncompliance with any SEC reporting requirements

- Bankruptcy section 548© defense - Transfer value - must be investment principal not profits - In good faith - two part tests 2nd circuit decisions - Presence of information that put transferee on inquiry notice - Objectivity test - should they have reasonably perieced red flags - Transferee on inquiry notice must conduct reasonable diligent investigation - In re Bayou Group LLC cases have court examine whether diligent inquiry would have recovered fraud more than just "asking the transferor about suspicious circumstances"

- Receivership is a state law remedy and is generally less expensive and more efficient and speedier than bankruptcy (10-15% goes back in 5 - 10 years) - Federal Bankruptcy filing More legal rules and structure, closely presided over a bankruptcy judge, assets can be sold free and clear of liens, efficient multi-state jurisdiction

Shiller on Bankers

- Banks are fundamental to the economic environment - Most notably, they provide transaction services and contribute to the money supply, which both facilitate the economy - There is great hostility towards bankers (bailouts and high compensation). - Govt. uses regulations and laws to prevent instability. However, banks evolve and with them so to must stability measures - Bankers aren't criticized for beating the market even though they are in much of the same business. However, bankers generally stay out of more volatile markets - Bankers also are not criticized the way investment bankers are because they engage in a long time honored tradition, one that has provided societal goods all enjoy such as liquidity, moral hazard and selection bias, and transaction services - The reason for ire at bankers seems to be their presumptive pursuit of money above all else, as well as their power. Also whenever there is a banking crisis the banks are helped while others are left to fend - The public also has a sense of centrality, sobriety and safety in banks. They should know that the successful management of banks has a great effect on the economy and that bank managers play a great park in community guidance and management - Banking is a pillar of communities and there is some extra monetary reward for those who go in to it at times

Bond ratings

- Before being issued, ratings agencies will rate bonds. All measure the probability of default. - Bonds with lower ratings should have a higher yield

A margin of security

- Before buying or selling a futures contract an investor is required to deposit a down payment known as a performance bond or initial margin. - If the futures commission merchant is a clearing member of the exchange it must in turn place a variation margin or settlement variation on deposit with the clearing house.. if not, the futures commission merchant must maintain an account with a clearing member which takes financial responisbility for its trade - Minimum initial margins are set by the exchange and will vary depend on if the investor is a hedger, speculator, or has bought and sold the contract before - The idea is that the investor should always have sufficient margin on deposit to cover potential losses

Institutional trading

- Block trades - selling large amount of stock - Basket trades - trading shares in several different companies as part of one transaction - Algorithmic trades - initiated buy computers that are identify to trade shares better in line with predicted options or futures of those shares - Short sales - transaction in which an investor borrows shares for a specified period and then sells them at the current market price in the expectation that the price will be lower than when he borrowed those shares

Educators

- Book claims that the efficient market theory was oversold to students and helped contribute to the recession because it left students with the impression that markets were more efficient than they were. This led students to believe it did not matter if they acted unethically becyse no one could ever disturb the equilibrium in the market - Educators are also responsible for the acceleration of financial sophistication in financial markets in recent decades

CEO

- CEO stands for an idea, a way of thinking that defines the companies activity and employees, and connects the company to the outside world - Responsible for short-run goals and embodies the purpose of the company - Teams are prone to conflict and sidetracking. Groups are less adept at being strategic or purposeful. A leader must coordinate and control groups to avoid these shortfalls

Option terms

- Call option - gives its owner the right to buy shares of a specific stock at a specified exercise price on or before a specific maturity date - Put option - gives to owner the right to sell shares of a specific stock at a specified exercise price on or before a specified maturity date - Contract - option with respect to 100 shares - Buy option - to buy an option and this hold the right to buy or sell shares to another party - Write option - to sell an option to another patty and be responsible to deliver shares or cash upon its possible execution

Cronyism and the boardroom

- Causes of unduly high salary: Fraud driven out of personal curtesy or class sympathy, or even repayment later on - Boards have economic and personal incentives to pay high CEO salary. The arms length bargaining power dynamic is not always practiced - The issue with CEO and board cronyism pay thus may not be as much a result of some aspect of financial capitalism but how boards are elected, take shape, and are replaced - Lessons learned from Venture Capital Funds re. CEOs: Talent and dedication make a huge difference. Moreover, dedication and talent are not exclusive to older professionals who demand higher salaries - VCs also play an important role in regulating crony boards. They often demand a seat on the board and do not care about the incentives to overpay CEOs that may be held by board members. Moreover, they are more likely than angel investors to replace the CEO when things do not go well - Unfortunately VCs are not always long-term and often simply leave when their investment has succeeded - The late 20th century was the era of the charismatic CEO, one who was overvalued by the public and incentivized to take excessive risks to perform mireacles to justify his or her salary. This bubble in CEO salaries mirrored that on home and stock prices.

Some unfortunate incentives to sleaziness inherent in finance

- Certain finance related fields are among those that often put people in positions offering more than the usual temptation to be manipulative. Some are aware of this and some suffer from cognitive dissonance that may push them to defend their self-esteem and justify such behavior - Finance may seem corrupt because of the astronomically high returns in some cases or because the management of information is central to finance and that means there are opportunities for providing misinformation to others - Setting high maximum bets, advertising rich people as gamblers, serving alcohol are all ways that casinos entice gambling even though the law of averages demands the house always wins

Traders and market makers

- Classic ex. of a trader is the specialist who has a position on a trading floor and buys and sells from his own inventory - Proprietary traders - who trade on their account to profit from short run price movements, including doing arbitrage (profiting from price descrepencies across markets) - Execution traders - make transactions at good prices without disturbing the market - Traders draw a lot of ire from society because they are not seen as helping the market in any way... rather they just buy and sell to make money for themselves. Their actions also remind people of gambling - Traders risk horizon is very short term unlike portfolio managers - Traders are adept at taking advantage of other people and the terms of deals while protecting themselves from being taken from - We need traders as they facilitate market movement - Trading is a necessary activity and so there should be a return on that expertise, even if part of that expertise is taking advantage of others (and understanding market forces)

Shareholder primacy

- Commitment to stakeholders (community, employees, etc) is counterposed to idea of shareholder primacy (primary goal is to create value for shareholders) - What does that mean in practice? Executives can run the business as they see fit Management is ultimately accountable to shareholders

Commodities

- Commodities are physical goods but not all physical goods are commodities. Commodities have particular characteristics that make it feasible to trade them in markets: 1) Stored for long periods 2) Value depends heavily on measurable physical attributes and on the physical location of commodities 3) Commodities with the same physical attributes and the same location are fungible.

Market for Corporate Control

- Control premium - governance control is worth more than a sum of minority economic interests - Tender offer can be made directly to public shareholders. - TO allows shareholders to receive control premium and higher evaluation - Possible check on self-interested management - Securities law regulation under 1934 exchange act - best price rule: all shareholders, not just some receive a control premium of 20-40% premium... also you must pay highest price stock trades at

Off- Market trading

- Dark pool: a dark pool receives buy and sell orders from institutional investors who chose to join them without disclosing the existence of the orders to any parties (useful if you want to large a large amount of shares but not disturb the market) - Other form is known as "internlisation": In this cases a retail broker receives an order to by 1000 shares of a particular stock. The order may then be sent to a wholesale brokers that makes a small payment to the retail broker, and then fill the order with its own shares it owns or buys for the purpose rather then sending the order to an exchange, earning a small commission for its role

hedge fund performance

- Data shows recently hedge funds underperformed the SAP stock index - Result of Buffett Seides bet - Buffet compounded annual return was 7.1% compaired to 2.1 percent for Seides hedge fund investment. Even taking out fees and assessing the gross return, Buffet SAP index fund beat Seides fund of funds investment Buffett's Reasons for Hedge Fund underperformance - Great majority of managers not skilled enough to outperform SAP 500 - A good record attracts a torrent of money and it becomes harder to find places to put that money productively - Huge sums invariably act as an anchor on investment performance - Most managers will nevertheless seek new money because of their personal equation - namely, the more funds they have under management, the more their fees - Crowded trades

Guest Speaker (Jay Kanive) on High Yield and Leveraged Loans:

- Debt market dwarfs equity market 3:1 ratio - Rating agencies could be easily, junk bonds were stretched to fit parameters of investment grade - 60% of investment grade bonds are in lowest end of investment grade - Impact that affect credit ratings: 1) asset value 2) Industry 3) Size of business and market share 4) Externalities (political headshots like United) 5) Credit support linked to issued debt - parent guarantees, security etc.

securities regulation and bonds

- Definition of security under federal law: Investment of money A common enterprise with expectations of Profits from efforts of other - Corporate bonds are a security, leveraged loans are not - Why? Bond holders are passive whereas leveraged loans have much fewer holders and actively negotiate loans - Has implication for disclosure (securities have to be disclosed and registered)(Loans do not) - Bonds also trade in semi-liquid market because bonds are sold in 10k increments

Discount Rate

- Discount rate: Charged to banks at Federal Feserve "discount window". Currently at 0.25% or (25 basis points, one one-hundreth of 1%), current cycle high was 250 and an all-time high of 625 in 2006. Referred to easing (lowering) and tightening (higher)

security

- Either "secured" or "unsecured" Security can be granted in specific assets like property plant and equipment inventory or accounts receivable. Security is not the same as "ranking". However, security can be divided like rankings using 1st, 2nd, 3rd liens on certain assets - You can have senior secured debt or senior unsecured debt - If you trade a bond in the US within 15 minutes you have to post the trade - High yield market has exploded in growth since recession - Bonds are standardized unlike loans - Leveraged loan market is as large as high yield bond market

Factors affecting option prices

- Elements of Back Scholes pricing model - Intrinsic value - extent to which option is "in the money" (share price v. exercise price) - Time value - length of time remaining to exercise option (today's date v. maturity date) "everyday options are dying" - Volatility - frequency and magnitude of change in the price of the underlying stock (if volatility is high, greater probability of greater intrinsic value). Volatility is good for long options buying

The roles banks play

- Equilibrium of deposits, withdrawals, and loans in theory because of size - Solve adverse selection problem by employing credit analysts who know the community - Solve moral hazard problem that individuals will use funds for reason they said they would. The bank has experts who can evaluate actions of borrowers and thereby mitigate losses Liquidity is the consequence. Access for borrowers to receive loans and depositors to invest

Equity markets

- Equity = ownership - Industrial revolution made it necessary to raise a large amount of capital to build faculty and infrastructure - Two ways to raise capital, loans or issuing securities - Disadvantage of dividing equity and having shareholders is that shareholders may value short term earnings over long term promise - Venture capital: Usually short-term investorts who take an active role in the companies they've invested

Corporate stock market returns

- Equity = shares of stock = ownership = claim of profits = future dividends - Corporation = limited liabilities

Over the counter

- Estimated 25k firms in the US trade OTC. - OTC requires a brokerage firm to match a prospective seller and a prospective by at a price acceptable to both - A brokerage firm may sell or buy their own shares in this process - If a firm wishes to raise large amounts of capital it will seek to list its shares on a stock exchange

performance of managers

- Evidence in academic finance literatures shows that actively managed funds actually do worse than passive investment strategy - Investment managers are not particularly good at mamanaging their own investments research shows - Actively mananged funds have grown immensely - Taken to its logical extreme, efficient market trading would result in no market trades. However markets are not completely efficient - As professional investors increase it is actually the average professional investor who is the average investor - Smarter investment managers (those who went to elite schools) tend to do better - Persistence is measuring how well an investor does after a point in time - Competition drives down returns as does portfolio growth because an investor may run out of opportunities - Investment managers themselves have bubbles and bursts in their line of work... sometimes there are too few and sometimes to many

currency futures

- Exchange rate contracts are the oldest financial futures but their popularity has remained modest - This is because much of currency hedging is now done with derivatives and exchange rates have stabilized with the creation of a single euro currency

How the Fed tools work

- Expand and contract supply of money, inflation and deflation - Directly, but much more indirectly impact interest rates - Indirectly affect currency, stock, and fixed income markets (liquid markets) - Alter market psychology, consumers, investors, bankers

Impulse for conventionality and familiarity

- Finance is complex and people think they will be taken advantage of by people who understand it better so some hold on rigidly to the norms they see as protecting them - Part of draw to traditionality is liquidity. People want to be in markets with many other people so they have less difficulty selling - Negatives to an approach being exposed down the road, regulators who may feel restricted by bureaucratic structures and the perceived need to respect past law, free rider problem, all discourage anything but conventionality - Progress in finance has been very slow - People tend to prefer contracts denominated in currency despite the fact that currency could swing wildly - Non monetary units of account indexed to inflation would be better units to base our contracts off of but we as a society are inevitably linked to the money unit in contracts - It is counterintuitive to put rates like rent in currency units because as inflation progresses the amount you are paying the landlord actually decreases while the value increases - Non-monetary units linked to inflation would make more sense in many contracts - Language and its relation to conventionality matters because people may be averse to taking on debt for example but not mortgages - Debt is almost always fixed in currency units but instead it should be fixed on a variety of economic factors. Instead we are overly reliant on the traditional contractual terms and language even if it doesn't make much practical sense - Inflation flexibility and more work outs in cases of certain economic events such as home price drops could have help avoid the 08 crisis - However, new forms of debt structures are often seen a odd or not liquid

ESG

- Finance will create impact because it is a 300 trillion industry - Finance is a more important system than govt. itself - The products are now available to everyone - Likely already involved in ESG whether you know it or not - Myths about industry performance are just that - ESG funds are cheaper rn because many firms are taking losses to capture the market

Debt and fixed income

- Fixed income investments are generally capped in value - Advantage for corporations to issue fixed income: Do not lose any ownership or governance rights, interest payments are tax deductible - Negative for corporations in issuing fixed income: Become restricted due to covenants

Accountants and auditors

- For an economic organization to function, it must have its own memories and its own way of storing accesing and communicating those memories - Accountants manage the repositories of financial memories - Auditors evaluate and interpret the work of accountants - Employees may be good at remembering their own contracts and numbers relating to their work but not the company's - CEOs are like the prefrontal cortex of the brain whereas accountants are like the hippocampus, where short term memories are converted into long term memories. - Accountants have to determine which numbers to remember, document, and publish - Accountants are upholders of consistent moral standards since the consistency of standards is essential to remember commitments and details - Accounts often face moral challenges because they will be pressured by those who behave as dishonestly as possibly within constraint

Oil Futures Trading Dynamics

- Futures roll: Speculators and some hedgers enter into offsetting trades on contract before expiry and open new positions - Pandemic demand shock in 2020 makes forecasting very difficult - Price discovery from futueres prices informs decision making; and represents huge increase in transparency and open markets - Contango encourages the storage of oil - Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity - When you don't have a futures exchange in commodities it's a way less transparent market - Backwardation - downward price sloping over time - Theoretical futures contact price = spot + storage cost + cost of capital (money could be invested elsewhere) - Backwardation and cotango look to the future not past - Dynamics created by oil futures market is ultimately self-correcting. For example, cotango will drive more production which will dampen contango

Costs of false positives and Fed policy

- Given how hard it is to slow down price increases when a bubble is forming (as discussed earlier), I assume the monetary policy response would need to be large enough to risk putting the economy into recession to stop a bubble. - Not all asset busts are so costly. When the tech bubble burst in 2000, equity investors lost money, but it led to only a mild, fairly short recession. - It seems to me that the Fed was right to not try to slow down equity markets in the late 1990s. The cost of prevention by raising interest rates may have exceeded the cost of the correction. - Similarly, I mentioned oil price spikes and falls in the last decade. No doubt these swings were painful for the oil sector, including North Dakota, which is in my Federal Reserve District, but the costs to the economy overall have been small. - As with the tech bubble, had the Fed tried to use interest rates to prevent oil prices from rising, the cost of prevention would likely have exceeded the cost of the correction.

Distinctions between Hedge funds and Private investment funds

- Hedge Funds Investments: Liquid - stocks, bonds, options, futures, derivatives Duration: Evergreen (perpetual) Capital Contributions: All up front subscriptions Redemptions: Periodic redemptions permitted with gate Distributions: Typically none, Liquidity through redemptions Manager Compensation: Management fee is percentage of net asset value. Incentive Fee on unrealized gains with clawback

High-scope trading

- High scope trading refers to the broadening of assets that can be traded - More important development the HFT - Ex. prediction markets trade for example contracts that pay out amounts based on who receives a certain popular vote share - Many prediction markets have not yet achieved liquidity and there is little volume of trade. (significant market institutions do not deal in them) - Until recently there was no derivatives market for residential real estate prices. - Had there been the suprime mortage bubble may not have formed because the the market would have revealed how people felt about future home prices - Again, the problem with prediction markets is a lack of liquidity. Currently the big players can't play in them because any bet worth making would move the market drastically and set them up for a potential catastrophic loss - Also there is a problem that the public doesn't believe there is a need for new markets and creating such just opens up more avenues for bad behavior. But trading is not inherently bad or good so why should trading stocks be treated as any different than derivatives of home prices - People also have a complex to return to their moral roots after a crisis. They believe that correct or not returning to a traditional way of trading is the proper way of doing things. (Don't often run a flee-flciker twice) - Expanding the scope of our financial system is in essence a route to democratizing finance by making financial markets more responsive to our needs

Some difficulties for EMH

- How to account for the stock crash of October 87 crash - 1981 Paper and subsequent research by Shiller demonstrates excess volatility in the aggregate US stock market, less so for individual stocks - In retrospect, major market movements seem exaggerated - Movements of S&P500 is more attenuated than individual stocks - Alpha - the performance of an investment against an index. Used as a measurement of a portfolio manager's performance - Beta - the volatility of an asset compared to the overall market. Used as a measure of risk - Need more sophisticated modeling than normal distribution curves to accurately asses risk

sub-zero oil

- In late april WTI futures trade at lowest -40 - Pandemic demand shock results in huge increase in stored oil in Cushing. Cushing was 76% full and the rest had already been leased out - Futures roll traders long may 20 WTI in last two days- can't take delivery casue no storage; don't want to do offset short trade at plunging price - don't want to go long June 20 on roll because price could also collapse - Spot WTI prices were also negative these two days in April but substantially less negative, physical delivery keeps future honest; result of many futures roll speculators as well

ponzi schemes

- Inherently fraudulent arrangement under which the schemer must utilize after-acquired investment funds to pay off previous investors in order to forestall disclosure of the fraud - Warning signs 1. Promises of high returns with little or no risk 2. Track record of overly consistent returns 3. Secretive or complex strategies 4. Vague or inappropriate paperwork 5. Difficulty receiving distributions

clearing and settlement of futures

- Initiating a futures transaction requires two parties a buyer and a seller. Once a bargain has been struck the parties have no further responsibility to eachother - The exchange itself acts in place of the buyer and every seller for all buyers. - This facilitates trading in two important ways 1)either party to the original transaction is free to terminate its obligations by taking an offsetting position with the consent of the other party 2) No investor needs to worry about the reliability or solvency of any investor - The exchange gurauntees that those who contracts gain in value receive their money and collect the sums owed by owners of money-losing positions. This work is handled in the exchange clearing house - The first step in the clearing house's work is the process of determining what trades have occurred - Once the clearing process has been completed the clearing house and the banking system can proceed with settlement, the process of matching payments with futures market positions. Settlement is far more complex a process on futures exchanges than on stock markets because of the exchanges role in ensuring that market participants live up to their commitments

Marketing a PIF

- Intensive focused one on one marketing - Private offering requirements under securities law Must be at least accredited investors Cannot advertise Presentation of returns highly scrutinized - Typically takes 1-2 years for a new PIF manager to raise a fund 6-9 months for an established manager - Intensive due diligence processed focused on the people (professional references, background checks, resume verification, net worth)

yield curve

- Interest rate lends rewire of any borrower will depend on this - Drawn on two axes, vertical showing yield and horizontal showing term of years - Positively shaped in that lower yields will coinside with shorter terms and vice versa

yield curve

- Interest rate lends rewuire of any borrower will depend on this - Drawn on two axes, vertical showing yield and horizontal showing term of years - Positively shaped in that lower yields will coinside with shorter terms and vice versa

Inflation and bond returns

- Interest rates on bonds have two components 1) Change in prices that is expected to occur during the term of borrowing 2) Re-compensation for inflation

inflation and bond returns

- Interest rates on bonds have two components 1) Change in prices that is expected to occur during the term of borrowing 2) Recompensation for inflation

Market v. intrinsic value

- Intrinsic value is the fundamental value of the firm: present value of unknown future cash flows - Market value is the current price of the firm, based on current shares prices and debt values - Market value represent price discovery function of markets

Value of a firm

- Intuitive, what the firm could be sold for right now - Measures of value: Book value (historical value) Liquidation value (value if all assets were liquidated) Market value (current price/share * shares outstanding + debt - cash) Intrinsic value (present value of future cash flows)

Investment bankers

- Investment Bankers help people sell new securities. They do this by helping companies issue shares to investors - IPO - first time new shares are sold to a company - Seasoned offering - When companies try and offer more shares to the public - IBs differ from banks in that they do not accept deposits and do not make loans - IB's facilitate the acquisition of capital by the company, divide the company up in to shares, and help manage risk - IB specialize in underwriting securities such as new shares - They perform due diligence on the issuing company, design the terms of the issue, place shares with long term investors, put their own reputation behind new issue - IBs do not usually elicit as much public ire because they act almost invisibly - IBs are responsible for the origin of securities markets (including stock) - Perks of the stock market: Allow companies to sell shares to the public, allow people to indulge their naturally adventurous spirit in to exposure of riskier investment, decentralizes the allocation of capital, and in the course of corporate transactions it allows companies to take control of an enterprise. - Newspapers played a major role in disseminating news about fluctuations in stock prices and made investment bankers more important

Professional Money Managers

- Investment managers determine the composition of portfolios of investments on behalf of their clients buy and hold those portfolios for those clients - Investment managers diversify, record keep, reduce tax exposure, safekeep securities - They also deal with investors special concerns like green investing or liquidity - Investment managers face hostility because they can make obscene income and from a sense they cant do what they claim to be able to do (efficient market)

futures trading strategies

- Investors in the futures markets oftern pursue complex strategies involving the trading of different futures contracts simultaneously 1) Basis Trading - Also known as an exchange of futurees for physicals, this involves the simultaneous purchase of the asset underlying a futures contract and the sale of an offsetting contract in the futures contract or vice versa - An investor who has bought the physicals and osld the futures is said to be the long basis - One who has bought the futurees and sold the physicals is the short basis. - The aim of the strategy is to profit from changes in the relationship between the spot price of the physicals and the price of the futures contracts 2) Dynamic Hedging - This involves constant changes in a futures position in response to changes in the price of the underlying asset and the rate at which the price of the underlying asset is changing 3) Index arbitrage - When someone seeks to capitalize on moment to moment changes in the price relationship between a shre and the futures contract on that index, by simultaneously buying the shares in the index and selling the futures, or vice versa 4) Spreads - A spread is a position constructed in the expectation that the relationship between two prices will change - An intra-commodity spread involves contracts in different commodities with approximately the same delivery date and could be used to speculate that a certain commodity price will rise more quickly than another commodity price over the next three months 5) Straddles - Straddle is a type of spread that invlolves purchasing a contract for one delivery motnh while selling a contract for another delivery month of the same commodity, thereby betting on a change in the relationship between short-term and long -term prices - A bear spread is a straddle arranged with the intention of profiting from an unexpected profit decline but limiting the potential loss if the expectation is wrong. This is accomplished by selling a nearby delivery month and buying a more distant month - A bull spread is the reverse operation, designed to profit from a rise in prices while limiting the potential loss by buying contracts for a nearby delivery month and selling a more distant month 6) Strips - A strip, also called a calender strip, is the simultaneous purchase or sale of futures positions in consecutive months

How investment banking keeps incentives up to date

- Issuing shares dilutes ownership of companies - The process of issuing new shares in a company that unevenly dilutes shares of ownership stakes of existing shareholders can become fierce battles - Ultimately investment bankers lead to more productive companies by acting as diplomats in negotiating and understanding between contentious powers - Investment bankers are keepers of peace and promoters of getting the business to get on with progress

Thesis of Kashakari's Fed piece

- Job growth, wage growth, inflation and inflation expectations are all likely somewhat lower than they would have been had the FOMC not removed accommodation over the past three years. - Allowing inflation expectations to slip further will mean that we will have less powerful tools to respond to a future economic downturn. I believe these are significant costs that we must consider as we contemplate the future path of policy.

Lawyers and financial advisers

- Lawyers are critical to financial capitalism because they provide information tailored to their clients needs - Law is expert thinking and complex communication - For the foreseeable future, no computer will fully replace developed human intelligence in helping other humans with their financial needs - The people behind automated financial advisors may lack integrity so those machines may too - The value of human financial service is so essential that the provisions of such services to those modest incomes need to be encouraged and subsidized - Every stock, bond, future, and option is a long legal contract - Lawyers are the engineers who construct financial devices - U.s. has one lawyer for every 255 people, Isreal has the most. Depends on complexity of the legal systems in large part - More and better legal advice could have prevented many recession problems such as those related to the purchases of mortgages one couldn't afford - Shiller argues we need to subsidize financial advice to some degree so the benefits of financial capitalism can be felt by all - Subsidization of financial advice could prevent even more costly bubbles like in 2008 - Subsidization financial advisors for the poor could also help prevent them from being taken advantage of from scrupulous money managers

Legal Structure

- Legal structure standardly used is a Delaware Limited Partnership Limited Liability General partnership control Taxed on pass-through basis - Limited Partnership Agreement is governing document Heavily negotiated by initial anchor investors Terms include management and incentive fees; diversification and investment limits; replacement of manager - Supplemented by many side letters Most favored nation arrangements (seeing side letters) by time and size Investor-specific preferences and requirements ESG requests or distribution of cash over security

Fed D. 9

- Lender of last resort - Guarantees bank deposits. Insures bank accts. up to increased to 250k. As part of the2008 bailout, no depositor in any bank lost money because the Fed guaranteed bank deposits - Keepers of the gate - sues position of central bank to promote economic stability - Two goals 1)"Full" employment; 2) price stability of commercial goods Don't want significant inflation or deflation, both of which could harm economy. Economically impossible to have full employment, but likely around 4 or 5%. - Neel Kaskarri is the District Fed President for District 9 - known for being a dove. Aerospace engineer, Goldman Sachs, ran for governor of California, oversaw 2008 banking bailout

Benefits of stock exchanges to listing firms

- Liquidity (ability to sell/buy easily reduces risk of stock) - Currency for employee compensation - Recognition (analyst followings reduce information asymmetry problems, also creates prestige value) - Certification (standards for exchange listing, mandatory disclosure regime)

trading terms

- Long: Buyers position or ownership position in futures contract (right to recieve delivery) - Short: sellers position in futures contract. Short position not traded before delivery makes the short seller liable to deliver the actual goods - Market order: To be executed immediately regardless of price - Limit order: To be executed only at specified price - Open position: Established trade not yet closed out with offsetting trade - Offset a position: Make equal and opposite futures trade which eliminates both an open position and a delivery obligation

Even with additional tools, bubbles can be exceptionally difficult to slow down

- Looking at other countries' experiences in trying to deal with potential asset bubbles shows how difficult it can be to slow down rapid increases in asset prices. As powerful as those tools appear to be in theory, they have not been very effective in slowing down price appreciation. · Given fast increases in housing prices in Sweden, in October 2010, the Finansinspektionen (FSA) applied an LTV limit of 85 percent to any new mortgage or extensions to existing mortgages that used a home as collateral. Prior to this policy, the average LTV ratio on new loans was over 70 percent, with more than 33 percent of these loans having an LTV ratio above 85 percent. In November 2014, the FSA introduced a mandatory amortization of mortgages for those with an LTV ratio higher than 50 percent. Home prices in Sweden have continued to increase despite these policy actions. · Authorities in Vancouver have been concerned about increasing home prices for a number of years. The price appreciation seems to be driven by foreign buyers who are looking for safe, offshore investments, which has made buying homes unaffordable for many Vancouver residents. In August 2016, local authorities passed a 15 percent tax on home purchases by foreign buyers. This was a very targeted and, in theory, very powerful policy tool to curb further price appreciation. Price growth in Vancouver did slow for a time, but appears to be climbing again. And prices in Toronto, which does not have such a tax, now seem to be climbing even faster. · when asset prices are climbing rapidly, they can be very difficult to slow down, even with policy tools that are targeted squarely at the asset class. That suggests to me that if central bankers were to try to use monetary policy to slow those bubbles down, the rate increases necessary to be effective would likely be large, resulting in high economic cost to the rest of the economy.

share price futures

- Many stock exchanges trade futures contracts on the prices of individual shares - Although many contracts exist, few are notably successful as in most cases trading the underlying equity is not lively enough to sustain interest in a futures contract

margin calls

- Margin calls allow for every participant in trading at the exchange to recognize all gains or losses after each days trading. - The trading house, in theory, is protected from losses because each clearing member is responsible for keeping its own customers accounts in balance. - The initial margin keeps an individual investor from running up large unrecognized losses and then defaulting on payment - If the amount in a customers account falls below the maintenance margin, the futures commission merchant issues a margin call, demanding that the investor immediately deposit enough funds to meet the initial margin - The futures commission merchant will liquidate the investors contracts if the funds are not forthcoming. - On the other hand. If the account rises above the initial margin, the investor may withdraw the excess

Mark to market

- Mark to market - bonds trade at value fluctuating value. As mark to market evaluating follows fluctuations in the market, the banks assets fluctuate too. - This can provide an honest up to date evaluation of bank health - Hazard - can make a bank deposit look worse than it actually is. This is because a bank mark to market asset may be fluctuating down but the bank doesn't have to sell it at that price - Fed govt. made money on bank bailouts because banks paid back TARP (Troubled Asset Reserve Program) with interests in 8 years

Market designer and financial engineers

- Market designers sometimes called mechanism designers start with a problem and then design a market and associated contracts to solve the problem - This is a way of humanizing finance - Cap and trade emissions forces producers of CO2 emissions to buy permits to emit measured in certified emission reduction units on an open market. Thus, a price is set on emissions and those producers that can most easily sell will do just that, transferring their permits to those that need them more for profit. - Govts. that do not encourage entrepenurial enterprises that actively look for problems to solve wont be very helpful - Problem in dating is that peoples social circles do not offer them a number of potential matches not that people desire to be celibate. Dating services are an example of a market driven social good. Not knowing the availability of potential good matches is another theory (people do not know they're likely success rate so they overestimate when lower levels of compatibility may be more suitable - Social policy bonds - people buy the bonds and the bonds pay out when an objective is complete thereby incentivizing people to solve the selected problem

Market designers and financial engineers

Trading shares

- Market order: contact a broker and tell him to buy shares at the best possible price - A limit order requires the broker to complete the transaction only at the specified price or at one better - A stop order instructs a broker to buy and sell shares once a specified price is reach

Inequality and injustice

- Modest inequality is good for stimulation and motivation that it comes with - Public awareness of inequality does not seem to be strongly associated with overt signs of anger such as terrorism or antisocial acts - The greatest resentment is reserved for the social classes who focus their attention on amassing fortunes and keeping them from the eyes of the tax collector year upon year and generation after generation - Only about a quarter of the forbes 400 is directly involved in finance. Most runs businesses with selling a specialized nonfinancial product - The wealthiest in society are often not well known and those who provide society with the most good, nobel winning scientists for example, never make the lost - Finance is a powerful tool because it has the ability to amass capital, pool information, and coordinate and incentivize people - Wealthy people obtain wealth not only though their own ability, but often from their ability to form and lead huge effective organizations composed of many other talented people - Financial salaries have increased dramatically on a comparative basis, but financial salaries go in ebbs and flows and we may be at the top - Only about a third of family businesses are continued by children - Studies show that those that inherit large amounts of wealth feel higher degrees of meaningless in life

The Long aftermath Article

- Most of the major Ponzi schemes that were revealed in 2008 are still being unwound - Trustees have to balance repaying investors quickly what they can and saving money for larger lawsuits - Trsutees are court appointed - 300 mil. Recovered of total 5 billion Petters fraud - In rare cases trustees will arrange payouts based on need - Trustees say they often wait to pay investors so there is money left to pursue lawsuits as the scheme continues to be unwound or so they can have money left if new victims come forward

Dervitive basics

- Option - the right to take some sort of action during some time period - The choice itself has value before the decision is finalized - Option in FM - An option is a contract which gives the option buyer the right, but not the obligation, to buy or sell shares of a specific stock at a specified exercise prive on or before a specified date - Like future contracts, options contracts trade on exchanges - Like future contracts, option contracts can be settled by exercise, similar to physical delivery, or by off-setting trade - Like future contracts many ways to hedge and speculate with options - Stock option are like rocket fuel because they can huge price movements

Robinhood article

- Option trading has skyrocketed during the pandemic - Known for offering free trades - Robinhood users don't actually trade more than those of othe brokerage firms - - Robinhood is making increasing amounts of money from order flow from other market makers - Robinhood depends heavily on trading revenue, more so than its peers - Payment for order flow, the money given to robinhood from other market makers accounts for more than half it's revenue

Over/under valuation

- Overvaluation: Market value > intrinsic value Equity is relatively overpriced - Undervaluation: market value< intrinsic value Equity is cheap These opportunities are what value investors are looking for

Obtaining share price info

- PE is the company's price to earnings ratio P/E by using the companies earnings per share over a 12 month period - Many newspapers and websites report share performance on a daily basis

Risk taking

- People savor the possibility of future rewards and put themselves in a position where such possibility is real - Mere presence of uncertainty in a positive direction creates a pleasurable sensation and so the reward system creates an incentive to take on risk positive bets - Sensation seeking personality: restless people who want excitement in the lives they seek excitement in their lives they seek excitement per se rather than pleasure. They want novelty for novelty sake. They are more prone to alcohol and drug abuse and to be engaging in unsafe sex with multiple partners - As a society we encourage risk so long as it is not anti social - Modern society allows us to sort ourselves into occupations according to our own self assessments and this self-sorting is one of the reasons for the success of financial capitalism - Inequality is an outcome of risk taking but inequality, so long as it is not crushing, is not inherently bad

regulators

- Regulators work for the advantage of all. - Milton Freidman's take was that regulators and in particular occupational licensing, was just a ploy to limit the supply of services so as to keep process high. This caused many to believe that regulators purpose was to deny entry to competitors - 28% of the labor force is occupationally licensed. As unionization declined occupational licensing rose - Regulators in the US today are civil servants - Some argue that a great deal of financial fraud exposed in the recession was due to the fact that regulators went after the small crooks and were captive to the large companies that engaged in fraud - Overall regulators are well meaning and substantially more effective then people realize - FINRA is a nongovernmental slef-regulatory agency funded by the securities industry that works to promote professional standards and encourage ethical behavior. - To sell securities one must pass licensing exams. - Selling dividends: convincing someone to buy a stock so as to not miss a dividend payment even though the value of the stock usually drops after the payment is made - Front running: buying shares on ones own account before filling a large customer order - Churning: Deliberately advising a client to make moves in order to generate fees

investment Company Act of 1940

- Section 3 ©(1) held by 100 investors or less - Section 3 ©(7) - held by qualified purchasers and knowledgeable employees - Qualified purchasers - individual or family officers with $5 milion or more in investments - Knowledgable employees - officers, directors, involvement in investment activities of manager, are in house counsel knowledgeable employee? Over time the answer is yes

Credit defaults swaps

- Seller receives a premium from the buyer - Sell will compensate buyer if credit event occurs - Credit event is usually monetary default or bankruptcy - Compensation is difference between full face value of reference bond and market price at invterval occurrence of credit event

Democratization of Investment banking

- Shareholders are never liable for the debts of corporation (limited liability) - Prior to limited liability no one could hold a diversified portfolio because of the risk from any company that would open them up to possible liability - Bill to Encourage the Manufacture of Woolen Cloth, Cotton, Hemp, and Flax, and for other purposes - those other purposes would change the world - The bill clarified limited liability and is an example of a crisis leading to financial innovation - Underlying the concept of free incorporation and unrestrained trading of shares created the result of applying capital to new ideas and new business directions - Recent development such as "crowd funding" are wrinkles in the model that started with investment banking - It is false to conclude season shares are not important to a company. They can go towards satisfying the needs of an endless arrays of company needs by providing increased liquidity

History of real estate market

- Pre-depression Typical way to finance real estate was through 2-5 year mortgages, interest only with balloon payment (almost entire amount due at principal). Because many could not pay at maturity, bank could reassess credit risk every few years - Federal Housing Admin 1934 on - Federal insurance of mortgages. Mandatory minimum term of 15 years. Banned interest only mortgages. Strongly encouraged 30 year fixed interest rates which lowered rates. Considered conventional mortgage. - Structure of conventional mortgage 30 yr. amoritization of debt. Fixed monthly. Down payment of 5-20%. Fixed interest rate set with reference to US treasury yields. Floating with annual adjustments linked to index treasury yields. Fixed/floating become adjustable after 3 or 5 years "teaser rates" with caps and floors - Federal National Mortgage Assicoation (Fannie Mae) Govt. Agency created to buy mortgages. Contracted out servicing. Standards for appraisal (loan to value) and creditworthiness assessment. Clear stanards that FM used gave investors confidence that every individual mortgage within a security complied with standards First issued mortgage backed security in 1960s. Fannie Mae privatized in 1968. Freddie Mac created in 1970 to emulate Fannie for lower income borrowers and privatized in 89. Controlled 46% of US home loan market in 46%. Even though they were privatized investors believed they were too big to fail

Semi-strong form efficiency

- Prices reflect all public information about the asset - When the 10-k is released the information in the 10k is immediately priced in - Arbitrage eliminates market abnormalities (taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance) - Active management fallacy - actively managing stock traders will not be able to beat it

Two types of stock market

- Primary market where the firm first sells new shares Functions: providing capital for firm, provides and initial valuation for firm, allows general public to buy shares, primary cash out method for existing investors - Secondary market where the firms issued shares are tracked Allow an exchange of existing ownership of a firm, provides liquidity for investors, constant updating of firm value. Stock market transactions

Mortgage Lenders and Securitizers

- Society regards subsidizing home ownership as beneficial and sees public good in promoting it - Efficient matching between the ultimate lender, home buyer, and government is a problem that can benefit from financial innovation - Mortgage origination: when a local lender works directly with the home buyer to arrange the terms of the loan and get the contracts signed - The mortgage originator then sells the mortgage to a mortgage securitize who in turn bundles a large group of mortgages into a residential mortgages backed security, which can then be sold to investors - Mortgage origination is the point in the mortgage process where the least sophisticated parts negotiates with sophisticated professionals, so opportunity for abuse is high. However, mortgage originators reputation is built on integrity so that should curb abuse - Cause 1 of the 2007 crisis: Borrowers getting mortgages they couldn't afford - Home Ownership and Equity Protection Act established standards for mortgage lending... However, this did little. Brokers could still convince borrowers to lend for homes they could not afford by saying they could get an adjustable rate mortgage. However, more times than not those rates only went up - Now, mortgage brokers are licensed and Dodd Frank forbids mortgage companies from incentivizing their officers to steer borrowers toward profitable mortgages that were not right for them. Dodd Frank also requires mortgage originators to verify their borrower's ability to repay

Mortgage lenders and securitzers

cross marging

- Some exchanges have begun to allow cross-margining in which investors effectively allowed to use a single account to trade on more than one exchange - Gains in contracts in one exchange may then be used to offset losses on another exchange in determining the amount of margin required, generally reducing the amount of money the investor needs to keep in deposit - The ability to cross margin is one of the main factors encouraging mergers and cooperative agreements

active management fallacy

- Some level of persistence in performance of managers... those who do well do well more consistently - Without active management there would be no efficient markets - Passive strategies are 60%of US equity assets - Anecdotally hard working and skilled - Most important: identification of inefficient markets - Private equity fund - all fees are back end loaded meaning they are assessed on profits

Significance of financial speculation

- Speculation is essential to market efficiency - Competition among many intelligent parties push prices to be at their most efficient levels - Price changes in US markets have been more accurately linked to changes in moods or attitudes of something else rather than the mood of the underlying value to which changes are constantly being ascribed - Much of the data supports that th crash in '29 was a huge overreaction. No Dow 30 companies went bankrupt - Excess volatility in US markets can be treated as fact - Our animal spirits drive action. When we are presented with news we have an impulse to act irrespective of careful deliberate calculation... we want to act - Any model of stock value is simply an opinion and the model is always subject to change - Countries with highest numbers of immigrants (US and Canada) have highest numbers of people with mental disorders or hypomanic people. Hypomanic people are naturally prone to self select emigration and become entrepeneurial - Modern society makes it even easier for people to emigrate and heightens the selection effect - Limited liability law was a legal construct intended to entice people to express their animal spirit and engage in a risky market place - Limited liability facilitated the playful excitement that encourage participation in the stock market - With increases in limited liability we may see decreases in integrity because people reputation and skin in the game is less on the line at public companies - In partnerships without limited liability, you are forced to fix problems because they will destroy you and the business if you don't.. there is good in that - Difficulty in partnership structure is the ability for the firm to grow - Increase in growth prior to the recession can be in part attributed to rise in limited liability and decrease in partnership. Scale was emphasized perhaps too much - The problems with bubbles in financial markets is more of a people problem then a market problem

Speculative bubles

- Speculative bubble equals = a situation in which news of price increses spur investor enthusiasm, which spreads by psychologically contagion from person to person , in the process amplifying stores that might justify the proce increases and bringing in larger and larger class of investors who, despite doubts about the real value, are drawn to it partly because of envy of others success and partly through the gambler's own excitement - Negative bubbles operate much the same way.. negative stories feed negative demand which encourages selling so more negative stories feed more public attention on the lack of demand and continue to push selling

Pension funds - Defined benefit funds

- Started in 1950s by general motors in 2009, contributed to its bankruptcy - Structured to define a benefit to employees and employer obligated to fund plan to meet benefits - Pension Benefit Guaranty corporation currently guarantees annual benefit of $67,295 - However, very difficult to project benefits - PBGC projected insolvency by 2025, 2020 budget proposes one- time infusion - Problem of people living longer and low interest rates. It's hard for a pension fund manager to find those safe investments that deliver a good return in a low interest rate market

Types of bonds

- Straight bonds: Also known as debentures, basically a fixed income investment. Holder gets paid interest annually or semi annually and issuer has to redeem the bond at face value (par value) on a specific date - Callable bonds: The issuer may reserve the right to clal the bonds at a particular date. A call obliges the owner to sell the bond to the issuer for a price, specified when the bond was issued, that usually exceeds the current market price - Non-refundable bonds: These bonds may be called only if the issuer is able to generate the funds internally from sales or taxes. This prohibits the issuer from selling new bonds at a lower interest rate and using the proceeds to call bonds that bear a higher interest rate - Putuable bonds: These give an investor the right to sell the bond back to the issuer at par value on designated dates. This benefits the investor if interest rates rise, so a putable bond is worth more than an identical bond that is not putable - Perpetual debentures: Bonds that last forever unless the holder agrees to sell them back to the issuer - Zero coupon bonds: Issued at less than par value and redeemed at par value. No interest paid. Thus, nothing to reinvest until the bond matures - Convertible bonds: Under specified conditions and strictly at the bondholders option, convertible bonds may be exchanged for another security (usually common shares)

types of bonds

- Straight bonds: Also known as debentures, basically a fixed income investment. Holder gets paid interest annually or semi annually and issuer has to redeem the bond at face value (par value) on a specific date - Callable bonds: The issuer may reserve the right to clal the bonds at a particular date. A call obliges the owner to sell the bond to the issuer for a price, specified when the bond was issued, that usually exceeds the current market price - Non-refundable bonds: These bonds may be called only if the issuer is able to generate the funds internally from sales or taxes. This prohibits the issuer from selling new bonds at a lower interet rate and using the proceeds to call bonds that bear a higher interest rate - Putuable bonds: These give an investor the right to sell the bond back to the issuer at par value on designated dates. This benefits the investor if interest rates rise, so a putable bond is worth more than an identical bond that is not putable - Perpatual debentures: Bonds that last forever unless the holder agrees to sell them back to the issuer - Zero coupon bonds: Issued at less than par value and redeemed at par value. No interest paid. Thus, nothing to reinvest until the bond matures - Convertible bonds: Under speceifed conditions and strictly at the bondholders option, convertible bonds may be exchanged for another security (usually common shares)

CEO sucession

- Successful corps have no life span but individuals do. Thus they must set goals that will outlive their tenure. - BC a CEO likely only serves for a few years, a reward system is needed to focus them on the long term. - Ego: The ego of the CEO is most naturally satisfied if he is the founder. He will become a legend if the company endures - Foundation myth: A story that everyone in a given society knows, one that describes their orgins. Typically humanized by the identity of the founder, he or she becomes a major part of the myth for a company - The modern CEO is expected to be a visionary who can reinvent the company in response to new information and market demand - Share price is the CEOs report card - Tying the CEO's salary to share price is a way of aligning the CEO incentives with the companies. - Also, unlike CEOs themselves stock has no end date. Thus, the wealth of the CEO is largely tied to their positioning of the company in the long run and not just the short - Stock is likely a better incentive than bonuses for meeting profit marks etc. because bonuses are paid immediately while stock is an investment in the future

how futures are traded

- TO buy or sell futures contracts an investor must deal with a registered broker, also known as a futures commission merchant. Many futures commission merchants are owned by large banks or securities companies that are active in other financial markets - Specific directions given 1) Market orders will be executed immediately 2) A limited order is to be executed only at a specified price 3) A market if touched order is to be executed as soon as the market has reached a specified price, but the actual trade may be at a lower or higher price 4) All or none order must be filled in its entirety or not at all 5) A fill or kill order must be filled immediatly in its entirety or the order is cancelled. - The buyer who agrees to receive the contract for commodities is said to be in the long position - Whereas the seller has agreed to deliver commodities at a specific price and quantity at the expiration of the contract and is in the short position - With an options contract, either party may separately terminate its contract at any point by arranging an offset without affecting the other party's position - An offset is made by the supplier purchasing the same number of contracts that he previously sold and the two sets of contracts would cancel eachother out - If the price at offset is greater than when the supplier sold, he will have lost money. If the price is lower now the supplier will have made money off the offset - A commodity supplier cares not about the futures market profit but about the amount he will receive for his crop. If he sells his commodity for a good price, he is likely to regard any loss in the futures market as a sort of insurance premium that bought him protection had prices fallen.

Basic Overview of Debt Capital Markets

- Tenor: Length of time until maturity (5-7 yrs for high yield bonds) - Par: Stated face amount of the bond - Coupon: Rate of annual interest on a bond... can be fixed or floating rate - Call and put structure: Refers to the ability of an issuer to "call" or repay a bond prior to maturity or for holders to "put" or require company to repay bonds prior to maturity - Optional redemption: typically a non-call period of a few years followed by calls at Par + ½ coupon, par+1/4 coupon then par - Equity claw back: Right of issuer to claw back bonds during non-call period for equity issuances... typically priced at Par + coupon Yield - return on a bond at a given price to a specified date at a specified price Ranking - priority of repayment of the bonds in a bankruptcy or winding up of a business - Senior: highest ranking for a bond. First in payment priority - Senior subordinated: subordinated in right until all senior debts have been paid - Junior: All senior debt, including senior subordinated debt must be paid in full until junior debt recovers payments

The Fed's policy tools to slow down asset price increases are limited

- The Fed's primary policy tool is setting short-term interest rates. - When inflation is lower than our 2 percent target and unemployment is high, we lower interest rates to try to stimulate economic activity by reducing borrowing costs. - When inflation is high and unemployment low, we raise rates to try to prevent the economy from overheating. - We set the overnight interest rate, and it then affects rates all across the country, across different asset classes. That's one of the biggest challenges in trying to use monetary policy to change asset prices. For example, if we see a bubble forming in commercial real estate, raising interest rates won't affect just the commercial real estate market, but also housing, automobiles, consumer borrowing and capital-intensive industries, among others. - The Fed also has regulatory and supervisory tools that it can use to change the behavior of the financial institutions it supervises. - Ensuring that banks lend appropriately in this market, this supervisory activity could affect the price of high-yield bonds and related investments.

Managers falling short of expectations

- The benefit of financial managers, accountning for their costs, is hard to quantify - In finance, the Sharpe ratio measures the performance of an investment compared to a risk-free asset, after adjusting for its risk. It is defined as the difference between the returns of the investment and the risk-free return, divided by the standard deviation of the investment. - Tail risks, when one invests in very risky strategies and experiences high returns only to attribute losses to unforeseeable events (emerging markets and dictator overthrows) - Allocating funds to those with the highest returns may not be a good strategy because risks of how those funds were managed may not be accounted for - Securities laws in the US prohibit companies from failing to state a material fact if such a fact or omission would make their report of past returns misleading. However, this is imperfect because some risks simply cannot be accounted for - Especially hard to beat the market in large cap stocks because there is so much information and so much trading

Issuing bonds

- The govt. can curtail when bonds are issued in order to not conflict with their borrowing needs - Offer document - lays out terms of the bond - Issuers of bonds use IB's to underwrite their bonds (syndicate if many are used) - Interest rate for bonds can be set by the IB or at auction - Selling direct - the internet has made it possible for bond issuers to sell directly to purchasers (good way to reduce middle man fees) - There is now a substantial bond trading market

Debt and leverage

- The impulse toward risk taking encourages people to take on too much debt and the impulse for conventionality can lead people to not mitigate risk when they do take on debt - When inflation increases the real value of fixed debt goes up - Business selling shares in themselves is a good idea to reduce debt intake - Debt overhang - when debt is such that it inhibits any positive action - Savings rate prior to the recession was near zero - The boom in home prices leading up to crises was largely tied to increased indebtness - On the eve of the crisis each person in the us had on average five credit cards compared to 33 persons to one in china - Politicians generally do not want to focus on high indebtness in stable times because they will be criticized in that they are supposedly harming businesses - Europe had zero capital requirements on banks holding euro govt. debt because had the it would have signaled weakness in the govts. Thus, govt. defaults could bring down banks - Leverage cycle - over leverage in boom times and underleverage in bust - There is a clear role in the govt. managing leverage - Odious debt: a term for actors or govts. that use debt to prey on the weak - Odious debt especially owed to the govt. should not have to be repaid. New govts. that overthrow corrupt govts. that took odious debts from there people should not require it be paid - Salubricpus debt is good debt and provides healthy incentives to borrowers or other relevant parties - U.s loans to Europe after WW2 is an example of salubricous debt because it helped create a unified Europe that was to the benefit of all - Improving debt flexibility is an essential to salubricous debt... Rigidity in debt serves no ones interest

FM and philanthropy

- The moral calculus of accumulating large sums of money over a lifetime and dispensing near the end of that life is extrememely opaque for that period because one cannot experience the purpose of such accumulation until it is over - There is little public interest in the good deeds of the wealthy, rather the bad deeds become magnified. - The book argues Philanthropy is egotistical and altruistic yet, few outsiders care about the philanthropy of others. - Even if the wealthy plan to give away their wealth, that is not always known or guaranteed and thus people are naturally suspicious of those intentions. Therefore, such suspicion may express itself in a tendency to brand all the rich as sleezy

Pricing securities

- The price of a fixed rate asset backed security is usually expressed as an interest rate yield compared with the yield of an appropriate benchmark, most often govt. bonds - Floating rate asset backed securities are usually priced from a widely used floating rate - The difference between the yield of an asset backed security and it's benchmark varies greatly, dependant on: 1. Credit risk: When an economy is strong borrowers are expected to have little difficulty, meeting their obligations and the premium required by investors of asset backed securities will be small. Vice versa in bad economies 2. Rating: Consider the strength of any firm or govt. that purports to back the security. High ratings will lead securities to trade closer to benchmark 3. Asset characteristics: avg. maturity, delinquency risk, 4. Prepayment risk: When interest rates fall investors will be able to pay back earlier devaluing the asset for investors 5. Extension risk: When interest rates rise investors will be seek extensions ultimately paying more and the asset for investors will rise in value 6. Underwriting risk: Some banks that originate asset backed securities are known to make scrupulus loans. These will have lower yields 7. Servicing risk: Servicing is the collection of principal and interest payments from individual borrowers. The service provider takes a fee for collecting each payments and passes the remained to the trustee to pay to investors. Some servicers are more effective than others

Entitlements

- The rights of man are laid out in financially oncosistent ways - The word right has great weight in human discourse and can trump and other words of societal advantage or compromise - As a society we accept rights such as education or a certain standard of living with relative disregard for how that will be paid for. - Often rights are rigid in that they do not allow for compromise or flexibity - SS for example is employed without regard for the working segments of society that has to pay for it - Author argues govt. pensions should be indexed to some the taxpayers ability to pay, such as GDP but this is rarely done. Doing so woud promote intergenerational risk sharing instead of one segment of the population burdening it for the rest - Universal rights are often not a fair compromise because they do not cost all populations of society equally - We need to evolve the language of our contracts to make more economic sense

Debt pricing

- There is an active market for trading bonds by Bloomberg and brokers - Price of 100 is equal to outstanding principal amount - Qouted in cents on the dollar of principal - Can be above or below 100 - Amount paid = quoted priced + accrued interest for days /180

Debt pricing - bonds

exchanges

- There is intense competition among exchanges to develop new contrats and to cut costs to make existing contracts more attractive. - All futures and options and options trades are subject to brokerage commissions, teaxes, and fees levied by the exchange itself. - Thus, since many trading strategies aim to exploit small price differences among contracts, even a minor change in cost structure can have a significant effect on the volume of trading - An exchange may discontinue trading an established contract if there is insufficient interest

Trading on bubbles

- Trading on bubbles is nearly impossible as they have not been really enough to study them and have been caused by different reasons... bubbles cannot be easily quantified because so much of their build is social and psychological - Bubbles are social epidemics - Bubbles occur not only in capitalist systems - The presence of free markets, analysts, balance sheets, and income statement limit the magnitude of financial disasters but those are not present in communist regimes. Thus the bubbles go from recession to widespread famine - Bubbles can also occur in war, such as WWI where a relatively minor event spurred many many larger feedbacks - G20 was designed in part to avoid the recreation of asset bubbles and the re-emergence of unsustainable global financial flows - Speculation's value: even though the fluctuating level of aggregate stock market price over the past century has generally discovered little more than changing market psychology, stock prices still mean something. Notably, individual stock prices clearly carry useful information - The market is macro inefficient and micro efficient meaningful is easier to predict future growth of decline of overall stocks than market wide trends. This is because although large movements in stock prices, say 10-20% is considered volatile, it is uncommon and in some regards more foreseeable. Whereas the same level of volatility in the macro market is less foreseeable in that there has never been much genuine information predicting as much. Thus, economy wide bubbles will continue to dominate. - A substantial fraction of the variation in individual stock prices is not perfect, and a substantial fraction of the variation in individual stock prices is not explainable in terms of anything that makes good economic sense. However, enough of the the variability in individual stock prices does make sense that the market remains an extremely important source of information for directing resources - Takeaways: Macro bubbles are caused by a lack of genuine information that can be useful at all in predicting when they happen (driving blind). Micro-bubbles or bubbles in individual stocks occur via a dangerous mix of valuable information and tainted social driven speculation feedback loops. Yet, understanding market information, although imperfect, is worthwhile because there is enough real information out there that can provide some level of predictability, even if very imprecise. Being imprecise by a larger margin is still better than being imprecise by an even larger margin if you were to participate in financial markets at random

Trustees and nonprofit managers

- Trusts make long term goals achievable because they can outlive individuals - Trusts are the best mechanism to make ones life goals immortal - Nonprofits represent the third sector of the economy, aside from for profit and government - Benefit corporation - possible fourth sector where it is for profit but the board is not legally obligated to achieve high returns rather a broader cause is pursued. Investors can't sue if the board pursues the cause to the detriment of the shareholder - The jobs performed by trustees are essential because they extend economic powers beyond the immediate consumption and do so in individualistic and democratic ways

Leveraged loans - loans extended to commercial borrowers by groups of banks

- Typically secured by pledge of all assets - Leverage loan is senior to corporate bonds - Floating interest rate - spread to LIBOR, adjusted monthly or quarterly - Interest paid monthly

Corporate Bonds - loans in the form of debt securities issued by commercial borrowers with principal, rate, and maturity

- Typically unsecured - Fixed interest rate (set at the issuance and referenced to treasury rates). Will be slightly higher than treasury rate so investors choose the corporate bond despite it's higher risk of default - Interest rate also determined in part on credit rating and risk - NCAA bond - Bond that defaults before a single interest payment has been made

Fiduciary duties of money managers

- Under investment advisers act of 1940, fidduciery duty to investors - Must act in interest of owners of assets - Managers of pension assets under ERISA must act as prudent man in like circumstances in like position with like aims - DOL fiduciary rule - imposes fiduciary duty on mgmt. of retirement assets, vacted by fifth circuit in March 2018

Efficient market hypothesis

- Views the markets as giant sophisticated voting machines - Eficiency in any market is about information processing - In an efficient market, the price of the asett reflects material information about the asset - As new information arrives, the price wil change - In efficient markets prices will reflect all public information about the asset Arbitrage eliminates market abnormalities

Clearing and settlement

- When brokers have executed a trade on exchange they report the details to the exchange . The exchanges clearing house reconciles the reports of all brokers involved to make sure that those parties are in agreement as to the price and number of shares to be traded. - Settlement then involves the transfer of shares and money - Settlement must occur within a time limit established by regulators (usually within two business days here).

Niel Kashakari

- When the Fed wants to stimulate the economy they try to lower the expected future path of interest rates and when they want to slow the economy they raise the expected future path

Cognitive dissonance

- a negative emotional response, a feeling of psychological pain when something conflicts with ones stated beliefs. Put another way, an emotional response when one persons actions are to be revealed to be inconsistent with certain beliefs, he or she often conveniently changes those beliefs - Hypocrisy is one particular manifestation of cognitive dissonance, in which a person espouses opinions out of convenience and to justify certain actions, while at some level actually believing them - The brain is fundamentally geared toward cognitive dissonance - "Home prices can never fail" was an example of cognitive dissonance that led to tremendous economic fallout - Another example would be European bank regulators putting zero capital requirements on euro dominated govt. debt.... The decision had already been made the end to the euro was unthinkable, hence later decisions that recognized the risk of exactly that were thought to be hypocritical and thus the stage was set for disaster in the banking sector - Financial managers benefit society because they go against politically correct or conventional thinking in pursuit of being right to justify their own dissonance - One problem with the attractiveness of financial dealings is for the genuinely sleazy has been that they discredit the entire profession even those who are honest. At one extreme is the inherent risk, that even for the most ethical will be indicted for crimes and misdemeanors they themselves did not commit and suffer permanent loss of reputation - Those in finance and business management acquire genuine power and power to mak things happen perhaps only they want to have happen. Power can be limitless and unchecked in business - For males this also means power over other males and females which creates a sort of resentment. In some parts of the world this power and status brings with it the ability to command multiple wives at the expense of some men who will have no wives

Public awareness matters when considering potential policy responses

- it's the Fed's job to put the brakes on the economy before it overheats, which almost by definition will be unpopular with many people. - the Fed must make tough, sometimes unpopular choices, but the ability of the Fed to impose and sustain steep costs on the economy and Main Street is limited by the willingness of the people to accept those costs. - The most famous example of the Fed imposing steep costs on Main Street for the long-term health of the economy is the Volcker Fed dramatically raising interest rates to crush inflation in the early 1980s. - The costs were large — a deep recession and unemployment reaching 10 percent, the same as the peak unemployment rate in the Great Recession. - But a key factor that enabled the Fed to impose such painful medicine was that the American people hated inflation. - inflation was ranked as the number one economic issue on voters' minds. - Imagine if Chairman Greenspan declared war on housing prices in 2004, when many Americans were enjoying homeownership for the first time. I suspect many Americans, members of Congress, homebuilders, realtors, banks (and many others) would have been outraged that the Fed was depriving people of participating in the American dream for a problem that they didn't believe was real. - Imagine if the Fed decided to raise rates to prevent housing prices from climbing. Given how painful the Great Recession was, this may have in fact been a better choice than what the Fed actually did, which was basically nothing - It can be very hard for a sole regulator to stand up against a national belief that home prices only go up and say: "We know better than all of you."

The Fed has stronger tools to mitigate the damage from bubbles than to prevent them

- there is something we can do that does not require us to identify bubbles in the first place. - We can make sure our financial institutions are sound and can withstand the shock of asset price corrections. - Without question, one of the key factors that magnified the intensity and costs of the 2008 financial crisis was the undercapitalization of the nation's largest banks. They amplified the shock rather than dampened it. - If we make sure the largest banks are highly capitalized (the Minneapolis Fed's estimate is that they need roughly double the equity capital they currently have), the financial system will be much more resilient against asset price corrections in the future. - In addition, if we identified an asset class that appeared richly valued to which banks had a lot of exposure, we could use existing tools to respond. - This is the essence of the current stress test. The Fed tests how a decline in asset values in a weak economy would affect the solvency of a bank. And banks that have insufficient capital to withstand such losses can face reductions to their dividends and share buybacks to ensure that they build adequate capital to withstand a correction

Styles of HF management

-Long/short - trading public equities and options based on views of equity market as a whole, economic sectors and individual stocks -Long/ short fixed income- trading fixed income securities based on views of intrest rates and yields as well as credit quality in different sectors -Event driven - trading equity, options and fixed income in anticipation of mergers and acquisitions as well as political and legal developments -Global macro - trading equity and fixed income based on views relative economic conditions around the world as well as policy actions of fiscal monetary authorities -Commodities - trading futures based on views of suplly and demand, political and economic risk and weather

Four main categories of commodities futures

1) Ag Products Ag products have many varieites and demand several contract for each generic commodity. In other words the speciality of ag products have opened the door to specialty contracts. 2) Metals futures Genrally more volatile in nature, futures markets provide a means to hedge risk that the value of these stocks will fall. Gold is the most unique in regards to metals futures because it is used as a store of value in times of inflation. Less contracts then Ag products because there is less variation in how metals are extracted and processed 3) Energy futures Future contracts on petroleum and petroleum products is popular. The price competition in wholesale electricity markets has led to the creation of futures contracts on electricity but the volume of trading individual contracts is small because each is tied to the price of power delivered to a specific location Environmental futures are tradable allowances of sulfur dioxide. This encourages firms to reduce CO2 emissions in the least costly way and to use the allowances for pollution sources that would be the most costly to mitigate. Some govts. want to establish similar tradable permits for other categories of air emissions particularly CO2 4) Commodity related futures As the delivered price of physicals depend greatly upn the cost of transport there is demand to hedge freight rates. Thus freight futures are now readily tradeable. There is also a market for non-physical contracts such as temperature, which is useful for hedging ag or energy prices

Implications of maturity intermediation

1) Borrowers have more alternatives for the length of their debt obligations and Lenders and investors have more choices with respect to the maturity for the financial instruments in which they invest 2) Financial intermediary like a commercial bank is willing to take a lower interest rate for a loan than individual investors because they have access to successive funding sources over a long period of time (successive deposits)

Definition of a security

1) Investment of money in 2) a common enterprise with expectations of 3) profits from efforts of others

how futures prices are set

1) The quoted price Not the price of the contract but the specfified unit (multiplied by the number of units per contract) 2) Price movements Investors in commodities futures must pay close attention to information that could affect the price of the underlying commodity. Copper prices will be sensitive to construction activity information for example 3) Limits on price movements For some contracts the contract specifications limit the emaount that the price may rise or fall on a given day. When this happens the market is deemed to have been locked 4) Spot price The reference price for any futures contract is the spot price, otherwise understood as the amount required to go out and purchase those items today The difference between the spot price of an asset and the price of a futures contract for the nearest delivery moth is the basis or the swap rate. As a contract approaches its delivery date its prices normally converges with the spot price 5) Term factor Most of the time the price of a contract rises as the delivery month becomes more distant. This reflects both the greater risk of big price changes over the life of a long term contract and the fact that the buyer of that contract has money tied up over a long period of time. If this relationship exists with each delivery date for a particular contract having a higher price than the previous delivery date for a particular contract, the market is called a normal market. 6) Obtaining price info The current price of a futures contract is simply the most recent price at which a contract was exchanged. Active traders and investors can subscribe to private info services. In general though, exchanges provide up to the minute data about prices and orders as valuable information and supply it as part of the exchange fee

Interest rate options

1. Bond options are based on the price of a govt. bond, which moves inveserly with interest rates. Their nominal value is set equal to the current market value of bonds with a specified par value.. 2. Yield options are based on an interest rate itself, but because interest rates are typically low, the nominal value of a yield option is often set by deducting the interest rate from 100 3. Interest rate options offer a less costly way to speculate interest rate movement than the purchase of bonds. An investor who owns bonds can use interest rate options to protect against a loss in value, and one who has chosen not to buy bonds can use options to avoid forgoing profits should bond prices rise Currency options are very popular

Option hedging strategies

1. Covering yourself is a risk minimizing strategy. Covered means that the writer of the options already owns the underlying 1. To write a covered put, the writer would have to short a position in the underlying. 2. Baring all - Naked means that a writer has neither a short nor long position in the underlying 2. Naked options offer the potential for higher returns than the covered options as the writer is spared the expense of investing in the underlying 3. The potential for loss in the writer for a naked call is unlimited 3. Straddling - a straddle positions the investor to benefit either from high price volatility or low price volatility. A buyer who is said to have a long straddle simultaneously takes put and call options expiring at the same time at the same strike price 4. Spread - a spread position involves two options on the same underlying, similar to a straddle, except that the put and the call expire at different time or have different strike prices 5. Turbo charging - a turbo option involves the purchase of two options with different strike prices on the same side of the market 6. Dynamic hedging - continuously relaligning a hedge as the price of the underlying changes 7. Clearing and settlement - once a trade has been completed, exchange rules normally require the buyer to deposit enough money with an options broker to pay the entire premium, the writer will recieve the premium payment through its broker 4. Each broker has an account with the clearing house and must have enough money on deposit at the end of each day to cover the cost of the transactions it has handled 5. No risk of not getting paid 6. Most common ways to terminate an option is to buy the opposite or exercise it

Factors affecting share price

1. Earnings (revenue over expense) 2. Cash flow 3. Dividends 4. Asset value 5. Analyst recommendations 6. Inclusion in an index 7. Interest rates 8. Bond returns 9. Economic conditions 10. Fads 11. Stock splits 12. Market efficiency 13. Key financial information 14. Price to earnings ration 15. Beta 16. Return on equity 17. Return on capital 18. Value added 19. ROI

Derivatives

1. Fastest growing part of financial markets has been the over the counter derivative market 2. Forwards: are contracts that a set price for something to be delivered in the future 3. Options: are contracts that allow but do not require one or both parties to obtain certain benefits under certain conditions. 4. OTC derivatives are often customized to meet an ivnestors requirements. This provides flexibility with respect to the underlying , the size of the contract, and the expiration date, which is not available with exchange traded products

Fed Strategy

1. Identifying bubbles on the way up is extremely difficult, and it will be rare indeed when we make such an identification with any confidence. - What we should do now is make sure the financial system is resilient and can withstand a future correction. That means we should force the large banks to raise a lot more capital now, when markets are strong. 2. Second, given how costly some asset bubbles can be when they burst, even though it is difficult, we must remain on alert, always looking for signs of a new bubble forming. If, however unlikely, we do spot a potential bubble, then we must try to assess how damaging a correction would be. - If we think it's not likely to be very damaging, then we shouldn't do anything, because the cost of false positives is high. - However, in those cases where debt is fueling the asset value increase, a correction could trigger financial instability, because banks might take huge losses and potentially fail. - The worry is not the high asset values themselves, but the exposure of market participants to those assets. - In those cases, we should consider a number of options: - (1) Speak out to raise awareness of the potential bubble, but not just one mention of "irrational exuberance." If we really think we see an iceberg ahead, we should be speaking out until people take the risk seriously. - (2) Use what nonmonetary tools we have to try to make sure the financial system is positioned to withstand the coming correction (by limiting bank dividends, for example). - (3) Ask Congress for new authorities to make the financial system more resilient, which admittedly might take too long to be useful. - (4) I would say as a last resort, if we are confident that the potential bubble poses grave danger, consider raising interest rates to try to slow it down.

Three examples of well-intentioned government officials trying unsuccessfully to accurately identify bubbles and potential crises.:

1. In 1996, then-Fed Chairman Alan Greenspan gave his famous "irrational exuberance" speech, where he said the stock market was overvalued. Essentially, Greenspan was warning that a bubble was forming and that investors needed to be careful because a correction was coming. At the time, the S&P 500 had a price-to-earnings ratio of 17.8. The stock market did end up correcting in the early 2000s, after the P/E ratio reached 26.9 by the end of 1999. The P/E ratio fell below 16 by mid-2002. Was Greenspan right when he called a bubble in 1996? Should the Fed have raised interest rates in response? Of course, it is impossible to know what would have happened if Greenspan had used monetary policy to act on his irrational exuberance call. But given how the stock market has climbed in the following 20 years, I would say that this was a "false positive" — identifying a bubble far too early, or seeing one where it didn't exist. 2. When I went to Treasury in July 2006, then-Treasury Secretary Henry Paulson declared to his staff that the U.S. economy was due for some form of crisis. He didn't know where it would come from but, because markets had been stable for some time, history suggested something would happen. So he tasked his staff (including me) to work with the Federal Reserve and Securities and Exchange Commission to look for signs of trouble. We looked at a variety of scenarios, from an individual large bank running into trouble to a hedge fund blowing up. Sadly (and embarrassingly), we never considered a nationwide housing downturn. We missed it, and we were looking. It seems obvious now. This was clearly a "false negative." 3. Finally, in the wake of the 2008 financial crisis, all regulators were on alert for potential economic shocks. We had all learned our lessons and weren't going to make the same mistake again. Yet I don't know anyone who predicted oil prices climbing to over $100 per barrel and then falling to $26. That is an enormous price decline, and we all missed it. Was oil at $100 a bubble? Should the Fed have raised interest rates when oil started its climb?

Two primary regulatory requirements of banks

1. Reserve - A percent of transaction amounts which must be held in federal reserve (checking type accounts). Reserve requirement is 10%. - No reserve requirements for savings type accounts 2. Capital Requirments - Capital requirements provided for a minimum ratio of shareholder equity / Risk weighted assets - Shareholder equity is initial contributed capital then total assets (total assets - total liabilities) - Insolvent banks are when liabilities exceed assets - Risk weighted assets (RWA) Divided in to categories 0% - Govt. bonds (certain country's bonds) 20% - Local, state got. Bonds, Fannie Mae, Freddie Mac 50% - residential mortgages 100% - Commercial loans - Banks with higher risk weighted assets will need more capital to support - Capital requirements under Basel III require shareholder equity must be 4.5% of RWAs plus 2.5% of RWAs as capita conservation buffer in order to pay dividends So shareholder equity must be 7% of RWAs

Motive for options trading

1. Risk management 2. Hedging - eliminate the risk that an underlying asset will lose too much value 3. Leveraged speculation - allows a speculator make bigger bets with a given amount of money. 1k in an index fund will produce smaller losses and profits than a 1k option could 4. Arbitrage - seeking to profit from discrepancies in prices from different market. Options arbitragers watch for changes in an options premium or in the price of the underlining and buy when one seems out of line. Price discrepancies are short-lived so an arbitrageur may open a position by purchasing an option and then close the position by selling the option within a matter of minutes 5. Income -Many large investors write options that are covered by holdings in their portfolios to obtain additional income. For example an investor in DB valued at 47 a share might write DB 55 calls. If the bank shares do not reach the strike price, the investor pays a premium, if they do reach the strike price, the investor must sell shares on which it has written option but will still receive an 8 per share price appreciation plus the premium

Impact investing

= finance goals + impact goals. Knowing what your money does and why Five Phases of impact investing - Pre 70's: Faith based organizations and race movements lead to conscious investment - 80's: Basic ESG themes develop - 90's: Ratings agencies pop up that evaluate how companies operate investing - 2000s: Biggest investors get involved - Now: Everyone engaged in the field Why do people do ESG: - Values - Performance

Repo

A combination of two transactions. The first is when a securities dealer, such as a bank, sells securities it owns to an investor, agreeing to repurchase the securities at a specific higher price at a future date. The second transaction, days or months later, is the repo and is when the dealer buys back the securities from the investor. For the investor the repo offers a profitable short-term use for unneeded cash.

Asset

A resource that we expect can provide future benefits

- Assets that support medium term and long-term securities can also be used to back commercial paper, a security with a maturity of less than 270 days - The paper is issued by a trust or special purpose vehicle which uses the proceeds to purchase assets such as recieveables - Asset backed commercial paper was created to meet investor demand in the face of limited commercial issuance

Asset backed commercial paper

- Issues when selling private funds:

Can't advertise Careful what you promise to investors Have to have a preexisting relationship with an investor in order to pitch them Only can recruit qualified investors Have to build relationships one conversation at a time - Post 2008 investors due diligence in investing in a company is extreme. Investors are much more sophisticated - 2-3 years to land a commitment - Have to be solutions oriented in order to be a lawyer in the private equity field (can't be an obstructionist)

Capital requirements

Capital requirement is shareholder equity / risk weighted assets (ratio) Equity = Assets - liabilities Risk weighted assets: Gvot. bonds (weighted 0%) Local bonds (weighted 20%) Residential Mortgages (50%) Commercial loans (100%) Shareholder equity must be 4.5% of risk weighted assets Plus 2.5% of RWA as capital conservation bufffer in order to pay dividends SO shareholders equity must be 7% of RWA For every $1 of shareholder equity a bank could hold $71 Fannie bonds or $14 of commercial loans .... $1/0.2x.0.07 = SE/RW x Capital reserve requirement

- Cash contract: The purchase and sale of a specified commodity for an immediate delivery.... Direct transaction between producer and consumer - Spot market: place for simple cash transactions. Quality based on test results. Qualified bidders bid by specifying "basis" spread to futures in action for this specific delivery of grain - Allows for many possible grades/ qualities of wheat to be traded

Cash v. Futures Trading

Types of stock

Common stock: Those who hold common stock get to vote. They only have s claim on the firms income and assets after all creditors and prefferred stockholders have received payment Preffered stock Offers specified payments on specific dates. It is appealing because the dividend remains constant. The issuer of preferred stock is obliged to pay dividends to preferred shareholders before common shareholders IPO When a firm first sells its shares to the public. IPOs have decreased in numbers and dominated by VC firms. Even govt. firms can be spun off in IPOs Private offering Only available to financial firms or wealthy individuals, a private offering is a way to sell shares with disclosures about the risks found in public offerings. Private offerings sell common stock Secondary offering When a firms whose shares are already traded publicly offers more shares

Protecting a bond investment

Covenants - Legally bidning promise made at a time a bond is issued. Ex. limiting the amount of debt a company may take on in the future - Bond insurance - Frequently sought by issuers with unimpressive credit ratings. An issuer pays a premium to the insurance agency that ensures the bondholders will be paid on time. The issuer can then sell bonds at a lower rate to more satisfied prospective shareholders - Sinking funds - ensure that the issuer arranges to retire some of its debt on a prearranged schedule prior to maturity

financial intermediaries

Create more favorable transaction terms than could be realized by lenders/investors and borrowers/sponsors dealing directly with eachother in the financial market Smooth the edges Ex. Commercial bank loans - Knowledge for credit risk - Scale for size maturity rate, monitoring - Get paid for value they bring in arranging loans Ex. Mutual funds - Expertise in selection, monitoring and managing - Scale for diversification - Handle the complexity of investing the retail investors may not have time for

Why regulators played a part in the failure of the system

Ever since Basel 1 banks around the world have been limited in their speculation through asset risk weighting. Essentially, risk weighting forces banks to hold back capital and be judicious about who they lend to. Mortgages were generally given a high risk weighting, which acted as a natural drag on the number of mortgages banks could give out. However, with the securitization of mortgages, banks could bundle them up and sell them. With these mortgages sold off they could actually in fact go out and buy bundles themselves, with the assumption they are nearly riskless, and end up holding essentially the same mortgages they started out with. However, these bundled securitized mortgages were given lower risk weighting then the mortgages themselves. So now the banks held mortgages with much lower risk weightings that allowed them to go off and lend for more mortgages. For example, a securitized bundle of mortgages rated AAA was risk weighted at 20% as opposed to an individual mortgage risk weighting of 50%

Purpose of FM

Finance is not about "making money" per se. It is a "functional" science in that it exists to support other goals - those of society

- Consist of securities issued by private lenders - Specifically intended to give loans to families of modest means - Each GNMA mortgage is guaranteed by some govt. agency - The lender groups the mortages to form a pool having similar payment structures and then GNMA issues securities based on these mortgages - The lender is responsible for collecting interest and payments for the loan but the govt. gives full faith and credit the investor will receive all that is due

Ginnie MAE's

Why are financial regulations justified

Importance of FM to broader society

Most people viewed that anyone selling them investment directly would not be selling them a good investment, because why wouldn't they keep that for themselves? If all the buyers assume the market is only the bad stuff they will only pay the lowest prices meaning the seller won't even put out the good stuff and thus the marketplace becomes a repository for bad products. However, when mortgages are securitized, bundled and rated by independent agencies, specialists are providing a service to weed out lemons and which lowers the risks for investors and thereby entices them into investment. Investors should have been able to trust the high tranche CDIs more than any pool of mortgages or any share in a complex and difficult to understand mortgage lending institution

In theory what id mortgage securitization do

- Private investment funds

Investment: Private company stock, distressed debt, real estate Duration: Limited life (8-10 years) plus possible extensions Capital contributions: Called in installments (to make investments and pay fees) Severe default penalties. Subscription agreements Redemptions: NO - "lock-up funds" Distributions: Investment realizations proceeds distributed Manager compensation: Management fee is percentage of committed capital. Incentive fee back ended on realized gains

- Credit enhancements Senior and subordinate cash flow priority Over collateralize Insurance wrapper where an investor may insure security notes - Prepayment risk Financial assets being paid off early decreases interest payments Can create principal only or interest only classes - Bankruptcy of sponsor Could the assets in trust become part of bankruptcy estate Could be used to pay other creditors Automatic stay could halt debt service payments Bankruptcy plan could alter terms of securitization Bankruptcy Remoteness Transfer of assets to trust not controlled by sponsor Independent direct consent to bankruptcy filing "True sale" legal opinion required to ensure it is not a fraudulent payment Each securitization transaction is completely separate

Investor risks to securitization

Recourse garuantees

Investors in an asset backed trust benefit from certain guarantees. With asset backed securities the recourse guarantees is the trust reimbursement from the lender for any recovery the lender recieves if the loan defaults

Distressed Debt Investing

Leveraged loans - Syndicated bank loans to commercial and industrial borrowers - Total US market size of 1.2 trillion High yield bonds - Typically unsecured debt securities trading in secondary market - Total US peak market size of 1.4 trillion -Requires Substantial legal analysis Terms of bank loan documents and bond indentures Operation of rights under bankruptcy code Mergers and acqusitions to sell investments Requires substantial cedit analysis - Valuation of financially distressed enterprsies - Selection of fulcrum securities (legal too) - Identification of exit strategies

- After mortgages have been secured the mortgage originators sell their individual mortgages to a mortgage securitizer - Theses securitizer then bundle them into a form that will allow them to be placed in investor portfolios . - The bundled mortgages (RMBs) will then in turn be placed into a trust to allow a set of collateralized debt obligations, (CDOs) to be issued based on the mortgage pool - CDIs are divided up into pieces known as tranches according to the perceived repayment ability of the holders - Senior tranche, in case of default will be paid off first and so on and so forth until you get to the last tranche or the toxic waste tranche - The toxic waste tranche does not get paid unless very few of the underlying mortgages default - The higher level tranches were easy to sell to investors - However, over time, rating agencies began giving out to high of grades so the highest rated tranches were in fact filled with lower rated mortgages - When in reality very few of the highest rated tranches had defaults, news account of a few AAA subprime securities suffering major, the significance of the losses in the lower rated tranches, and the major market price decline sin general left people with a faulty impression of the failures of the tranching system - Why did the system crash so terribly? Most people assume homes prices would never decline significantly. Thus, if you believed this then you saw mortgage backed securities as a safe investment. In the cases where people failed on their mortgage the lender could simply foreclose on the home and sell it to recover the balance. In most cases the homeowner would sell themselves when they could not pay

Mortgage securitization

Value of firm 3 (multiple)

Multiple (future growth) of cash flow (assets) is the *primary method of calculating the value of the firm The value of the firm is derived as a multiple of either last twelve months or projected EBITDA Market Value (Current price/share * Shares outstanding (this is market capitalization)) + debt-cash Market value = (LTM EBITDA * multiple)

Industry Level Regulation

New York Stock Exchange - Standards for listed companies - Governance rules required shareholder votes - Licensing of traders Financial Industry Regulatory Authority - Self-regulatory organization for brokers and dealers formed in 1939 with 3400 employees in 20 offices - Licensing for brokers (Series 7 exam for example) - Power to supervise and levy financial fines against members State level regulation - Blue sky laws - Not very important Federal level regulation - SEC Adopts and enforces rules, monitors disclosure, EDGAR system(allows easy access to all securities filings), Market surveillance - Financial Accounting standards board - Investment advisors act of 1940 Registration requirement for private fund managers Fiducuary standard for registered advisers Permitted to register if 25-100 mil in assets. Must register if 100 mil or over in assets. Registered private fund managers can be audited

Money Market Funds:

Pools money market securities, allowing investors to diversify risk among the various company and government securities held by the fund. Normally required by law or regulation to invest only in cash equivalents, securities whose safety and liquidation make them almost as good as cash.

Option downside protection

Purchase stock and pit options with strike price at same level as stock purchase price (cost of put options is cost of insurance)

Puts v. calls

Puts - a put option allows the buyer of an option to sell the underlying at an agreed price, known as a strike price, for a specific period of time. The buyer of a put expects the price of the underlying to fall. The writer, who is short the put thinks the price of the underlying will not fall or will not fall that much Call - a call option gives the buyer the right to purchase the underlying at the strike price. The buyer of a call anticipates the price of the underlying will rise above the strike price and the writer thinks it will not

Money Markets

Refers to the network of corporations, financial institutions, investors and governments, which deal with the flow of short-term capital. · It's the buying and selling of debt instruments maturing in one year or less. · Money market investors tend to be highly risk averse, that is, they value the absolute safety of their funds more than the higher return they would receive for taking risks. · Because money market instruments by nature are short term, their prices are much less volatile than the prices of longer-term instruments.

Mutual Savings Bank

Take deposits and make mortgage and consumer loans, income tax 374 billion in assets No direct ownership

Professional "stocks and bonds"

Terms they use are equity and fixed income stock market = equity market bond markets = fixed income market

1. Letter of credit example - Letter of credit is where banks guaranteed payment for the delivery of certain goods 2. Letter of credit market collapsed because banks were highly exposed to step in payments and when the market decreased panic ensued that these banks were over exposed 3. 75 years of home increases followed by 40% drop form 2006 -10 4. Overheated fixed income market 5. Federal housing policy that encouraged home ownership and relaxed underwriting standards. Securitization market as a whole consisted of subprime mortgages and mortgage securitizers mislabeled sub prime mortgage %

Uniqueness of 2008 crisis

- Offering Circular or prospectus: Document sent to investors setting forth information about the company and proposed bonds - Indenture: For all intents and purposes the substantially similar to description of notes in OC. Indenture sets the forth the terms of the bonds for both the issuer and the holders. Typical terms include: No maintenance covenants Change of control Debt incurrence Restricted payments - Difficult to buy high yield bonds as an individual, but can buy baksets of them through an ETF - Can't call defaults on bonds

basis of high yield bond

Arbitrage

the purchase of securities in one market for immediate resale in another to profit from a price discrepancy (eventually doing so will even out prices as supply demand reflect what is going on but in the meantime profits can be made

- Risk of price and supply changes - Futures reduce risk of future price movements by allowing individuals to hedge on future prices - Hedge + entering in to a financial markets transaction that can reduce losses with certain price movements and reduce exposure - Futures provide price discovery by telling us what the price is now and what it may be in the future - Price discovery (what should I should produce and how should I produce it?)... difficult to make investment when future price is difficult to know

why commodities futures?

Syndicated bank loan

A bank loan where a group of banks provide funds to a borrower they would not be able to themselves because of the credit risk and exposure.

Flow variable (Economic indicator)

Measure over a period of time (personal income)

Types of Debt securities

- 1) bonds 2) notes 3) medium term notes 4) asset backed securities

Repurchasing shares

A firm may wish to repurchase sahres to become a private organization again, boost a sagging price, return excess capital to shareholders, use for employee compensation programs

Price in context of FM

Aggregate information collected by all market participants

Financial gambling

BC of lack of sports, more FM gambling? FM are not a casino, but similar

First Central Bank

Bank of England (similar to Federal Reserve)

Yahoo Finance

Best free finance tool

- Sell the option before the maturity date - Exercise the option (American style at any time it is in the money) - Options exchanges force exercise of the option at maturity date if it is in the money - Let it expire valueless out of the money

How you terminate an option

2 goals of Fed Reserve

Employment and price stability (inflation)

Market differentiation

High differentiation this year compared to last 10-20 (tech v. cyclicals)

Efficiency

Market is transparent and liquid

A money market mutual fund is a type of fixed income mutual fund that invests in debt securities characterized by their short maturities and minimal credit risk. Money market mutual funds are among the lowest-volatility types of investments.

Money Market Mutual Funds

Importance of banks

Most important source of capital for non-public businesses

Difference between Bond and a note

Note has a maturity of 10 years or less. Bond has a maturity greater than 10 years.

Single biggest one day decline

Oct. 19 1987 (Black Monday) Declined 508 pt. decline (20% decline) SEC created a mechanism to halt trading in emergencies (used in 2001)

Debt pricing - Zero Coupon Bond

Pays zero interest. Sells at a discount to amount paid at maturity Price = 100/(1+r)^t r = interest rate t = time to maturity Ex. pay 90.7 today and 100 at issuance, but no yield paid along the way

Reserve (D-Reserve) Requirements of Banks. Reserve v. Capital requirements.

Percentage of transactions accounts that must be held in reserve (transaction=checking, not savings) 10% reserve requirements of transaction account has to be held with fed reserve

- Basic good in commerce - Functionally interchangeable - Meets specified minimum standards Crude oil, hard red spring wheat, pork, OJ

What is a commodity

Purpose of Fed Reserve

Price stability and lender of last resort

Most important source in financial markets

Savings. Pension, 401k, bank deposits etc. All allow financial markets to grow

- Very complex sector - Cost/benefit relationship - Moral hazard of implicit government backing

Some difficulties of financial market regulations

Financial Assets

Stocks and Bonds

Flow and Inventory playing off eachother

These two concepts can create eachother. Flow can create inventory (savings). Alternatively, financial markets (bonds, stock, etc.) may pay out as income - Flow contributes to creating inventory - Inventory assets can produce flow

Ex. of RWA

UST Bank 100 deposit (creates $100 asset and $100 liability) Give 10 to Fed Reserve for reserve requirement $20 more comes in as shareholder equity 2 more has to go to reserve 108 (120) in assets and 120 in liabilities Keep 10 in cash (RW 0)--------- Put 10 in Fed bonds (RW 0)------- 50 in stadium bonds (RW 20)--------- RWA 10 (50X.2) 50 in commercial (RW 100)--------------- RWA (50X1) 60 in RWA x .07 (capital requirement) = $4.20 needed to support investments

- Governed by a contracts (trust indenture, administered by indenture trustee) - Interest calculated simple not compounded, so half the stated interest rate paid as coupon every six months in arrears - At issuance, stated interest rate and initial offering price are set - Zero coupon = bonds sold at initial discount and no interest payments - 100% of principal paid at maturity. Interest between issuance and maturity - Typically five to seven year maturities but some sovereign bonds are 100 years - Indenture contains restrictive covenants - Importance of credit ratings

bond enforcement

the ploy to attract the opposite sex. Underlying the desire for wealth is a sexual and social status impulse. The hostility felt toward the rich is partly recognition of that power.

conspicuous consumption

- No promised benefit rather preferential savings vehicle, most common example is 401k - Pret-tax obligations grow tax free, only taxed on withdrawal - 2020 annual contribution limit is 19500 or 26000 for employees over 50 - Behavioral finance point - recent change allows automatic enrollment rather than opt in - Early withdrawal penalty of 10% - Advice - contribute if possible

defined contribution plan

- Cash contract for a delivery in the future - Terms negotiated between buyer and seller (consumer and producer) - Ends in physical delivery or deliveries - Frequently used between producer and consumer of a commodity

forward

- When world economic growth is strong there is greater demand for metals, timber, petroleum, and other products used in construction or manufacturing - One investors profit from having purchased a contract will be offset by another investors loss from having sold the contract

futures performance

Algorithmic trading

high-frequency trading has increased dramatically as a result of increased computing power and AI

- Trading interest rate futures account for over 90% of all financial futures trading - Contracts on short term interest rates now account for more than half of all trading in interest rate futures

interest rate for futures

- Regulated by investment company act of 1940 - Traded once daily at Net asset valaue - Expense ratio typically 1.0-3.0% for act and 15-25 bp for passive - Taxation - must distribute capital gains annually - No suitability requirements -anyone can buy - Restriction on activities, need cash for redemption - Can be purchased once a day -

mutual funds

Driving force behind financial markets is the desire of investors to earn a return on their assets. Return has two distinct components:

o Yield: income the investor receives while owning an investment o Capital gains: increases in the value of the investment itself, and are often not available to the owner until the investment is sold

- An asset backed security is a type of bond offering less security than a traditional bond. Rather, repayment is dependent on the the mortgage holders repaying their loans and there is no guarantee this happens. - However, asset backed securities receive higher payments than loans and are more readily available - Securitization accounts for 30% of financial investment down from 40% before 07' - Mortgage securities account for 80% of asset backed securities.

securitization

Swap derivative

standardized contract

federal funds rate

the interest rate at which banks make overnight loans to one another

quantitative easing (QE)

the purchase of long term government and private mortgage-backed securities by central banks to make credit available in hopes of stimulating aggregate demand

Transaction costs

what it takes to sell illiquid assets

Option gains and losses

1. One parties gain is necesarilly another parties loss 2. The premium represents the max loss for the buyer and the maximum gain for the writer 3. A put owners maximum gain and the writers maximum loss occurs when the underlying loses all value. 4. There is theoretically no limit to the potential profit of a call owner or the loss of the call writer, as the price of the underlying can increase without limit 5. To limit their losses, some investors prefer to write calls only when they already own the underlying security (covered calls v. naked calls)

Financial markets engineering

Combination of law, mathematics, psychology, economics

Financial Markets Role

Essential to a healthy society With problems that need to be addressed Regulation is not silver bullet Central market's biggest problem is 'access' so their benefits can be more broadly realized

Commercial Banks

Take deposits, make mortgages, consumer and business loans, income taxed Total assets of 20 trillion (continue to grow even as number of banks decrease) Income taxed and owned by shareholders. Some are private some are public

Treasury Bills

Securities with a maturity of one year or less, issued by national governments.

current status of the bond market

- Judging return on a bond will depend on future interest rates - Benchmark- tracks the performance of a bond issue that is deemed an appropriate benchmark for an entire category of bonds (particularly useful for sovereign bonds - Weighted - measures the total return of an identifiable group of bonds. The importance of any bond in the index is based on the size of the issue compared with the size of all issues included in the index.

contract terms

- Standardization is an important feature of futures markets as it makes contracts interchangeable, freeing traders and investors from the need to worry about unusual provisions (and lawyers?) - Futures contracts contain the following standard provisions 1) Size (how much of the asset is to be delivered) 2) Quality standards 3) Delivery date 4) Price limits 5) Position limits 6) Settlement

Credit Unions

Growing in assets but consolidating Total assets of 1.66 trillion Owned by depositors but not for profit Can restrict and select customers and don't have access to capital markets

Markets

Mechanism to trade financial assets Characteristics: 1. Aggregation of buyers and sellers 2. Prices in that market are set by supply and demand

Components of an efficient market (semi strong efficiency idea)

1. Many intelligent speculators required 2. Individual stock prices reflect all historical/public news and expectations - prices accurately reflect available information 3. Stock price is good estimate of its intrinsic value - "prices reflect true underlying value of assets" - If this is how the market operates, it must be very very difficult to beat the market - Large cap funds usually underperform the S&P500

Long-run trends of increased financial market activity

o Lower inflation o Pensions o Stock and bond market performance o Risk management

Basic Market Functions

o Price setting o Asset valuation o Arbitrage o Raising capitals (shares, bonds) o Commercial transactions o Investing (stock, bond and money market) o Risk management (futures, options)

Forces of market change

o Technology o Deregulation o Liberalization o Consolidation o Globalization

Private investment funds v. mutual funds

- PIFs are highly regulated, no investment Company act rules - As a result, PIFs have suitability requirements and high minimum investments - PIFs typically have higher fees than mutual funds/ETF's (2 and 20...... 1.5 and 18?) - Volatility of annual returns - Should they be more widely available? DOL information letter June 2020 indicates 401k plans may offer private equity investments to participant - Theory is higher fees than public equity is for higher returns

Strong Form Market Efficiency

- Prices reflect all public and private information about the asset - Private infroamtion are things like the CEO plans to retire soon or a plant director just found out about a critical supply shortage - There is no way for private info to be included in the stock price except insider trading

Money

Backed by full faith and credit of U.S. Govt. and rule of law

- Price of oil in general reporting does not report the spot price but the nearby contract - For U.S. it is WTI, which is light sweet crude oil. Sweet vs. sour refers for sulfur content. - Contracts for WTI deliver to Cushing OK. Contracts our in monthly windows - If you hold short for WTI contract you must physically deliver to Cushing OK with a storage ticket - Brent Oil trades in London on a futures oil there. Not as light and sweet as WTI. Used more for diesel fuels, shipping, industrial. - WTI is less expensive to extract with fracking tech

Cushing pipeline

- Yield to maturity is the rate of return an investor earns who purchases the bond today at a given price and holds the bonds to maturity (assuming no default) - Price > 100 YTM rate > stated coupon rate - Price < 100 mean YTM rate < stated coupon rate - Current yield = annual stated coupon payment/price - Two different forces driving bond price 1. Market interest rate 2. Risk of default

Debt pricing of conventional bonds

- CAPE

CYCLICALLY Adjusted price to earnings ration - current stock price of S&P 5000 divided by the average earnings over the last ten years, adjusted for inflation - Year end CAPE levels avg. around 30. Below means the market is cool and the above means that market is maybe overheated

Returning value to shareholders

Cash dividends: provides cash flow to shareholders, taxable at income tax rates, non-voluntary, non-dilutive Stock buybacks: provides cash flow to shareholders, taxable at capital gains rates (15%), voluntary, anti-dilutive

3 types of offering

1. Underwriting - this is where an IB buys the shares and sells the shares to the public market 2. IB best effort basis - The IB does not underwrite the shares rather they are simply committing to do their best effort to sell them 3. All or none offering - All the shares are sold at a designated offer price but if some are outstanding the entire order is cancelled

Bankers Acceptances

An acceptance is a promissory note issued by a non-financial firm to a bank in return for a loan. The bank resells the note in the money market at a discount and guarantees payment. · They usually tied to the sale or storage of specific goods, such as an export order for which the proceeds will be received in two or three months. · An investor purchases the acceptance at a discount from face value and then redeems it for face value at maturity.

Attributes of formal financial markets

o Liquidity - ease with which trading can be conducted o Transparency - availability of prompt and complete information about trades and prices o Reliability o Legal procedures - adequate to settle disputes and enforce contracts o Suitable investor protection and regulation o Low transaction costs

Why would someone invest in a foreign bond

1) Facilitate a currency exchange 2) Borrow at lower interest rates

Financial Capitalism

An economic system that is increasingly guided by financial institutions

Tools the Fed has to soften boom and busts

Include large scale asset purchase, currency swaps, and quantitative easing.

Contemporary Risk Management

Risk: The potential that events, expected or unexpected may have an adverse impact on financial institutions capital earnings or reputation Risk management: The employment of systems and processes to manage the trade off between risk and return in financial decision making. The best proactive is multi disciplinary in employing both quantitative and qualitative means

speculative bubbles and ponzi schemes

"Something similar happensin the case of asset bubbles. In the 1920s, a stock market frenzy drove share prices spiraling upward, without any apparent change in the productivity of underlying assets. In effect, new investors were paying off old ones, not as the result of any one person's malevolence but simply as part of an ever-widening scramble to get hold of stocks."

U.S. Financial Numbers

- 25% of world GDP - Nearly 50% of world's finance is in U.S. financial markets - Financial markets can exceed GDP because markets measure flow

Repo agreement

- A repo is a contract in which a seller usually a securities dealer or IB agrees to sell bonds in return for a cash loan, but also promises to repurchase the bonds at a specific date and price. - For the seller (IB) a repo offers a low cost way to borrow to finance the purchase of more bonds... for the buyer, a repo is a low risk alternative to keeping cash in the bank, as the securities serve as collateral Why would someone invest in a foreign bond 1) Facilitate a currency exchange 2) Borrow at lower interest rates

Stock exchanges

- A stock exchange is a private firm that facilitate the trading of shares - 68.7 market cap in markets worldwide - Market cap = (current price) x (total shares outstanding(both those held privately and publicly)) - US stock market is about 30 trillion or 44% of world total. China is 6.3 trillion - Us market capitalization is 166% of GDP - Not all a firms shares trade on exchange (the ones that are referred to a public float)

Financial instrument

- A type of financial instrument is a security, which includes stocks and bonds Every financial instrument has two parties, the issuer, or who agrees to future cash payments, and the investor, the one who receives future cash payments

delivery

- As a contract approaches its delivery date, the issue of pyshical delivery must be resolved - For the buyer of a futures contract, physical delivery means taking possession of the underlying assets. - For the seller, it means providing those assets - Only 1-2% of all contracts in futures end in physical delivery

futures mark to market

- As part of the settlement process, the futures commision merchant calculates the margin required of each investor - Each investors contracts are marked to market or revalued based on the latest settlement price - If an investors holdings have lost value, money from the investors account is transferred into the accounts of investors whose holdings have gained in value. - Each clearing members entire customer portfolio is marked to market in the same way - If the total value of all its customers contracts decline, the clearing member must pay an additional variation margin to the clearing house - Conversely money is transferred form the clearing house into the account of clearing members, futures commission merchants and individual customers whose contract has gained in value

Banks in less developed countries

- Banks play an even more important role in less-developed companies where information available to the public is not at a premium - The role of traditional banks in developing companies has been on the decline for decades. The % of the national debt that is accounted for by traditional banks has been in decline for years. This is because the the quality of publicly available information about securities is improving and thus the moral hazard and selection bias problems are reduced.

Universality of CEO pay problem

- CEO compensation problems exist even in communist countries - CEOs in communist countries enjoy the same bonus systems and perks if they do well. Thus they are just as susceptible to milk the enterprise for their own advantage as some capitalist country CEOs do - Soviets recognized the advantages of a system that rewarded CEOs who would work hard to make an enterprise successful - Overpaid and compensated CEOs are simply an element of financial capitalism. - Companies can better justify the public ire about CEO pay by awarding benefits in a way the public accepts and educating the public about the principles underlying the pay

WTI Contract

- Contract UNIT 1000k barrels, CL on NYMEX - Qouted in dollars and cents per barrel - Minimum price fluctuation: each cent per barrel is one cent per barrel which equates to 10$ for every contract - WTI has 12 monthly contracts, termination of trading 3 business day prior to 25th calendar day of the month - Contracts listed for 10 years of monthly contracts - Physical delivery in Cushing OK no earlier than first day of contract month and no later than last day of the contract month

Why trade options

- Do not pay interest or dividends 1) Hedging Allows a producer to agree to sell a product in the future at a specific price for a specific quanity Conversely, a processor may want to buy a product from a supplier at a price and quantity well in advance of when it needs them in order to protect against rising prices 2) Speculation Involves the trading with intention of profiting from changes in the price of futures or options contracts, rather then a desire to hedge specific risks. Speculation is essential to the smooth functioning of the market because by buying and selling contracts with great frequency there is great liquidity increase Without the liquidity that speculation provides , the futures and options markets would be less attractive to hedgers because it would be difficult to buy and sell contracts at favorable prices

why people set out on ponzi schemes

- Don't intend to perpetuate a Ponzi scheme - Tend to be people with high need for approval and recognition but also charismatic - Tend to have high fears of investments not paying off - More likely to fall victim to other schemes

Market Efficiency

- Efficiency of any market is about information processing - In an efficient market the price for the asset reflects material information about the asset - As new info arrives the price will change - In efficient markets, prices will change very quickly and often - Requires informed and knowledgeable participants trading frequently

Debt and fixed income

- Fixed income investments are generally capped in value - Advantage for corporations to issue fixed income: Do not lose any ownership or governance rights, interest payments are tax deductible Negative for corporations in issuing fixed income: Become restricted due to covenants

Foundations

- Foudnations have to give out 5% of fund each year - Three ways to make impact: Grants, PRI investment (loans, capital, etc.), MRI use entire foundation to make investments instead of 5% mandatory amount

Financial futures

- Futures contracts available on many different terms of US treasury securities - Useful for both hedging and forecastning of interest rates - Futures contract on exchange rates on many different currencies - Futures contracts on stock market indices including Dow J industrial avg and the S&P 500

Corporate bond terms

- Governed by contracts (trust indenture, administered by indenture trustee) - Interest calculated simple not compounded, so half the stated interest rate paid as coupon every six months in arrears - At issuance, stated interest rate and initial offering price are set - Zero coupon = bonds sold at initial discount and no interest payments - 100% of principal paid at maturity. Interest between issuance and maturity - Typically five to seven year maturities but some sovereign bonds are 100 years - Indenture contains restrictive covenants - Importance of credit ratings

Vulnerabilites of securitization

- Incentives to weak underwriting, desire to increase securitization which increases mortgage lending - Mortgage system built for home ownership, not speculation. Speculation can cause bubbles especially when home ownership is incentivizes - Rating system built for commercial bonds assumed to be independent, false. - Covariance: Ratings system assumed that each mortgage held independent risk (3% risk of one mortgage default, had no relation to another mortgage). However, the system failed to take in to account phenominom that could call all the mortgages in the security could increase in their default rate in the same direction - Mark to market accounting: Finance institutions had to report losses when defaults began to occur - Complexity and Opacity - Mortgage lenders have an incentivize securitizing many loans they give so they do not really care if they are sound. Now, however, many countries require banks to hold on to a large proportion of loans they hold

Interest rate swaps

- Not traded on an exchange - Governed by ISDA standard documentation - Exchange of interest rate obligations, usually fixed for floating 70% of all derivative contracts - Ex. Levered private investment fund A holds many fixed rate high yields bonds, but its leveraged line of credit is floating; Financial service firm B benefits from high floating rates of interests, wants to hedge low interest rate environment - A swaps 6% fixed with B for LIBOR +300 basis points

Futures and options

- One of the biggest risks in Financial markets... time - Purpose of futures and options markets is to protect against risk when prices are changing constantly - Futures and options developed to help suppliers lock in a price for future supply of a commodity

Efficient Market Hypothesis (Consequences)

- Price discovery is the setting of a price for a security, asset, commodity by market mechanisms - where supply and demand meet - In an efficient market, price discovery incorporates all public information and forecasts, thereby it become meaningful as a measurement of value - EMH states the future stock market moves are a random walk and therefor also unforecastable - current prices are meaningful, future process are unforecastable - Gambler's fallacy - once you've engaged in a sequence and one outcome occurs, it is more likely a different outcome will occur - Auto regressive properties - everytime a series of occurrence deviates from the mean, the more likely that is the series will return to the mean

weak form efficiency

- Prices reflect all historical price information about the asset - Using past returns and price does not allow us to predict future prices - Technical analysis - not a reliable method of earning an abnormally high return (abnormally high returns are returns that are justified by the risk) - Going forward changes in prices are random

Origins of banks

- Protecting wealth from theft or loss is a fundamental problem that has animated people from the very beginning of the exchange economy. - Even in todays anti-finance climate, people remain grateful for the services banks provide and still trust them

Agency securities

- Several entities sponsored by the US govt. promote secondary markets for mortgage backed securities. Collectively the securities are known as agency securities

Stock market

- Stock market goes beyond exchanges - The legal structure of a share of stock is a bundle of certain economic and governance rights in a firm - Firms raise capital by selling ownership - Preferred stock has priority over common stock in liquidation

other's wealth

- Sumptuary laws are laws forbidding the display of extravagant wealth - The theory of leisure class - people spend lavishly on themselves not because it brings them joy but it signals others they are rich - Theory of social comparison process - People are inclined to compare themselves to those around them, not to those far above or below, and feel delight when they are doing better. Cognitive dissonance makes people convince themselves they are enjoying wealth consumption because their purchases are inherently good and not positional in motive - Our brains are stimulated when one receives a reward not enjoyed by others

Stock exchanges

- Superior to OTC for several reasons 1) many investors offering great liquidity so better prices can be obtained 2) the exchange is able to obtain and publish the prices at which trades have occurred or are being offered immediately 3) the exchange has rules that that ensures parties live up to their commitments - Exchanges also set requirements for listings that exclude small firms - NSDAQ and NYSE account for about 30% of trades worldwide - A smaller number of brokerage firms now dominant much of trading - Competitive markets have forced many exchanges to close or consolidate

Tangible Assets v. Intangible assets

- Tangible assets are assets that are referred to as fixed - Intangible asset are assets for which there is a legal claim to some future benefit or benefits. Stocks, bonds, patents, copywrights, etc. - Intangible assets are financial instruments

Role of FM intermediaries

- When there are conditions that make it difficult for lenders or investors of funds to deal directly with borrowers if funds in a financial market, intermediaries are necessary - Include; depository institutions, non-deposit finance companies, regulated investment companies, investment banks, insurance companies - Role is to create more favorable transaction terms than would be possible if borrowers had to deal directly with lenders/investors - Intermediaries accomplish two things in the process

Capital Market

- Where long term financial instruments issued by corporations and governments trade (greater than 1 year) - Two types of capital markets: 1) Shares of ownership (equity), and 2) shares of indebtedness of govt. and corps. - Common stock is perpetual and prefered stock can be either perpetual or have a redemption date - Capital market debt obligation is a financial instrument whereby the borrower promises to repay the maturity value at a specified period of time beyond one year...... Can be broken down in to bank loans and debt securities

Debt pricing - conventional bonds

- Yield to maturity is the rate of return an investor earns who purchases the bond today at a given price and holds the bonds to maturity (assuming no default) - Price > 100 YTM rate < stated coupon rate - Price < 100 mean YTM rate > stated coupon rate - Current yield = annual stated coupon payment/price - Two different forces driving bond price 1. Market interest rate 2. Risk of default

Bond indexes are not all reliable because

1) Inconsistency 2) Uncertain pricing 3) Disqaulification 4) Poor diversification

Four types of bonds

1) National govt. - Called sovereigns - Considered most secure type 2) Lower level govt. - Called semi sovereign - Considered riskier because lower levels of govt. cannot print money like sovereigns - Some national govts. try and curtail semi sovereign bond markets to curtail indebtedness and ensure healthy bank business - General obligation bond: Gives bond holders a priority claim on tax revenue if the bond defaults - Revenue bond gives bond holders a claim on the revenue a project creates in case of default - Special purpose bonds - provide for repayment from a particular revenue sources such as a tax on hotel stays to service the bonds for a convention centre, but usually these are not backed by the issuer's general fund 3) Corporations - Bonds can be issued by corporations with specific assets pledged to bond holders in case of default. - However, those who have senior debt may have first claim on those assets. - Those with subordinate debt will get paid after bond holders 4) Securitization vehicles - An asset backed security is a type of bond which the required payments will be made out of the income generated by specific assets (mortgage loans or future sales)

Derivative Providers

1. A derivative is a contract whose value is based on something else 2. The asset from which a derivative takes its value is called the underlying. Each contract has a precisely defined underlying, that is a standard size and a variety of expiration dates, typically monthly or qaurterly 3. Derivative speculators vs. hedgers: Hedgers use derivatives as an insurance policy, that is locking in a specific price. Whereas speculators use derivatives as a way to make a profit. 4. Anything that is continuely traded will have an options market

American v. Euro style options

1. American style options - can be exercised at any time before their expiration date. The owner of an American style call can exercise the option whenever the price of the underlying shares exceeds the strike price 2. Euro style options - can be exercised only at or near the expiration date 3. Capped options - have a predetermined cap price which is above the strike price for a call and below that for a put. The option is automatically exercised when the underlying closes at or above (for a call) or at or below (for a put), the cap price

Summary of FM Intermediaries

1. Financial intermediaries serve the financial system by facilitating the flow of funds from entities with funds to invest to entities seeking funds 2. Financial markets provide price discovery, provide liquidity, and reduce transaction costs in the financial system 3. Financial intermediaries not only facilitate the flow of funds in the financial system, but they also transform financial claims, providing more choices for both investors and borrowers, thereby reducing risk through diversification and reducing costs 4. Regulation of financial markets takes one of four forms: disclosure regulation, financial activity regulation, regulation of financial institutions, and regulations of foreign participants 5. Financial markets can be classified as follows: Money markets versus capital markets, cash vs. derivative markets, primary v secondary markets, and market structure 6. Market price efficiency falls into three categories; weak form, semi strong form (u.s), and strong form and the form of this efficiency determines whether investors can consistently earn abnormal profits

Types of derivatives

1. Forwards: A forward contract is an agreement to set a price now for something to be delivered in the furture. Can be arranged to mature further into the future 2. Interest rate swaps: a contract between parties to exchange interest payment obligations. Largest OTC derivative market is for interest rate swaps 3. Currency swaps - involve exchanging streams of interest payments in two different currencies 4. Interest rate options: A large variety if derivatives with different types of optionality. A cap is an option contract in which the buyer pays a fee to set a max interest rate on a floating rate loan. A floor involves purchasing a minimum interest rate 5. Commodity derivatives - function much the same as exchange traded options, allowing the buyer to lock in a price in exchange for a premium payment 6. Equity derivatives: synthetic equity is a derivative designed to mimic the risks and rewards of an investment in shares or in an equity index. Synthetic equity can be used to permit an investor to take a position that it could not take by purchasing equities owing to legal restrictions on its equity holdings

Special features used in derivatives

1. Multipliers - multipliers are used to increase leverage. For ex. an interest rate swap may provide that the party agreeing to pay a floating rate will not pay LIBOR plus two % but rather the square of libor minus 5% 2. Path dependent options - essentially parlaying certain events such that all events must occur for payment to occur Problems with derivatives 1. It is difficult to apply standard accounting principals to derivatives so investors have difficulty assessing the true value or lackthereof of a company holding derivatives 2. Many participants still don't settle through clearing houses so the risk of unsettled derivatives is high

What a commodity contract has to have

1. Size (contract units) 2. Delivery dates (Delivery months) 3. Quality ( Deliverable grades)

Value of Finance Professionalism

An essential part of what finance professionals actually do is deal makings - structuring of projects, enterprises, and systems

Benefit of public markets

Can raise capital more cheaply

On avg. legal professionals salary more than financial markets professions

Financial investors make money on bonuses

Market Flow

Flow of funds creates a series of assets that allows for a money supply that is exceed market value As money flows markets increase in size. •Household is paid salary by Employer and deposits in •Local Bank which lends to •Regional Bank who gives Commercial Loan to •Corporation funding physical plant 1 underlying Financial asset (paycheck) forms the basis for 4 total assets and 3 liabilities

Basel III

Harmonizing banking international Most latest basel agreement set mandatory capital requirements and made significant use of credit ratings in order to assist in regulating banks (major guide to risk assessment and purchasing bank loans and bonds)

PIF v. Hedge FUnd Horizon

Hedge Funds - Allow periodic redemption - Often have gates which are fund level and/or investor level caps on redemption per quarter or year. - Some have "side pockets" which allow designated illiquid investments to be exempt from redemption requests - protects remaining investors after redemptions - Incentive fees are based on net asset value which include unrealized gains; subject to "high water mark" net losses have to be recovered in subsequent periods before fees can be paid again - Suitable for liquid investments - Experiencing underperformance and decreased new investment allocation; net outflow of assets under management in 2018, 2019, and 2020 Private Equity - Investors is locked up for 6-8 years Investments are difficult to value Investors don't want dillutions Time to improve the investment and properly sell

Fed Reserve Mandates

In 1977, Congress gave the Fed its dual mandate: stable prices and maximum employment. - Achieving financial stability is hard — really hard. - Human societies are prone to mass delusion and to bubbles; history has numerous examples, from the tulip bubble in Holland in the 1600s to the stock market bubble in the 1920s to the housing bubble in the 2000s. - Future generations are exceptionally good at repeating past mistakes. - Even if we focus just on the Fed's official dual mandate, financial crises can cause very high unemployment and low inflation or even deflation.

Two types of investors

Individuals Investors 1. · Insurance companies (owe 1/3 of all financial assets owned by institutions) 2. Investment companies - Mutual funds - Unit trusts - Hedge funds 3. Banks 4. Foundations 5. University endowment funds

FM Markets can be categorized as the internal market and external market

National market (Domestic) External is foreign

- Contrary to idea that percent consumption/possession is superior to future consumption/possession - World of longer life spans, low inflation, less need for investment? - Bonds like stock sell when prices get higher - Cash is difficult to hold because banks charge fees for large savings deposits

Negative interest rates?! (only sovereign bonds trade negative)

Distressed debt investing styles

Passive - Interest in undervalued securities and loans trading at distressed levels - Long/short capital structure arbitrage - Both hedge funds and private equity funds Active - Seeking 1/3 block or ½ ontrol - Knowledge of bankruptcy and negotiation - Private equity illiquid and control investments -Need understanding of the following - Industry and fundamental analysis - Historical performance and cause of distress - Capital structure - Debt covenants - Bankruptcy and legal issues - Company valuation - Trade execution - Exit strategy

Bank Acceptances

Short term loans, usually to importers and exporters, made by banks to finance specific transactions. An acceptance is created when a draft is written by a bank's customer and the bank accepts it promising to pay. The banks acceptance of the draft is a promise to pay the face amount of the draft to finance a transaction, giving this draft to the supplier in exchange for goods. Because acceptances arise from specific transactions, they are available ina wide variety of principle amounts. Typically bankers acceptances have maturities of less than 180 days. Banker's acceptances are sold at a discount from their face value and the face value is paid maturity. Default chance on a bankers acceptance is small because acceptances are backed by both the issuing bank and the purchaser of the goods.

Spreads

The difference in interest rates on different instruments.

Multiple value of a firm

The resulting multiple can be compared to other companies Assumes fair values in the market and that similar companies should have similar multiples Relatively simple - use average multiples of similar companies to apply to valuation of a new example company Issue: Multiples could all be suspect (market in a bubble) or group of comparable companies could be too small or larges, ignores private companies

Break down value into: value assets in place and value of future growth opportunities - Assets in place are creating the current cash flows for the firm: Relevant for cash flow is earnings before interest, taxes, depreciation, and amoritization, or EBITDA

Value of a firm 2

- Trades on an organized exchange - All terms, (except price) are standardized and specified - Contract is with exchange - no counterparty risk. Significant difference from previous two commodity trades. Important because pricing of futures contract is pure representation of supply and demand because no counterparty risk. Put another way, financial markets factor in counterparty default risk in to price - Vast majority (95-99%) financially settled, no physical delivery - If you go long, when that contract comes due you will go short and sell thereby offsetting the contract resulting in no physical delivery - Futures market should converge with spot market as the contract comes due - Limit on price movement and minimum price - Position limits for speculative traders - Nearby contract = next contract to be coming due

futures contract

2008 Crisis Broad cause

not due simply to the greed or dishonesty of players in the world of finance; it was ultimately due to fundamental structural shortcomings in our financial institutions

- Contracts on the future level of a particular share index have prove popular among portfolio managers and their growth has gone hand in hand with the growth of the tracker or index equity funds as they offer a nearly exact hedge for a share potfolia that is constructed to mimic the index

stock index futures

Abnormal return in FM

when investors make a return on their investment beyond that necessary for them to have assumed the risk (beating the market) Harder to do in the more efficient market

Fed Structure

- 12 Federal Reserve Districts, Minneapolis is the District Office location for District 9. - Each Federal Reserve District is responsible for issuing money - Bills tell which district ordered them - 7 Federal Reserve Board of Governors - Federal Open Markers Committee sets Fed policy (FOMC) - MORE IMPORTANT FOR MONETARY POLICY - FOMC consists of Federal Board of Governors, plus district 2 (NY) Fed president, plus four other rotating Fed presidents

Futures contracts

- A futures contract represent a deal between two investors who may not be known to eachother and are unaware of one anothers motives - A futures contract is a derivative because its price and terms are derived from an underlying asset - Allow there is a limit on the amount of a commodity there can be produced, there is no limit on the number of futures contracts that can be traded on that commodity

What is a bond

- A loan in the form of a debt security by borrower - Fixed maturity date when principal amount is due - Fixed coupon (interest rate) stated as annual rate - Interest payments are made every 6 months at half the annual rate - Ex. TSLA 5.30% 15Aug2025 (B+ S&P) Pays $265 interest every six months for every 10k. Every bond will pay $530 annaully, $265 semi-annually - Credit ratings provide risk assessment on purchasing of bank loans and bonds. Have significant impact on pricing and who can purchase them

Repo agreement

Compulsive gambling disorder

- Around .05-1.1% of people have a gambling addiction - Financial markets are very attractive to fraudsters

What if we had a more expansive options trading market

- Case Schiller US Home Price Index - Shiller created home price index option for a period of time - Could do the same for health care expense levels - Avg wage rates - GDP

Structured finance

- Collateral mortgage obligations = mortgage securities that allow investors to accept greater or smaller amounts of risk by dividing the asset pools into sections called assets or tranches - This allows securitizers to meet the needs of a prticular investors in regards to timing, tax consideration, regulatory restrictions - STRIPS - Securities that threat the interest bearing component of the security separate from the repayment of principle: Interest only strips will lose value when interest rates fall as investors pay off their loans early and pay less interest than anticipated even as the principal only strips gain in value as their owners receive principal payments sooner than expected - Stripping creates ways to attach an explicit price to an optionality that is inherent in most asset backed securities, that is the right to repay early, or in some cases extend - Shorter tranches, those likely to be repaid quickly, are least likely to be affected by payment variations and are most stable in regards to strips - Support tranche, or toxic waste, offers high returns when rates are stable and payments are made. However, if rates rise or fall significantly, borrowers may be inclined to pay more quickly or extend and thus valuation can fluctuate widely

Derivative Market

- Contrast with Cash market (spot market) = market for the immediate purchase and sale of a financial instrument. Some financial instruments are contracts that specify that the contract holder has either the obligation or the choice to buy or sell something at or by some future date. The something is referred to as an underlying asset Derivative is a contract - The underlying something can be a stock, bond, financial index, interest rate a currency or a commodity. Such contracts derive their value from the underlying and thus are derivatives. - Derivative markets include futures, forwards, options, swaps, caps, and floors. - Primary role of derivative instruments is to provide a transactionally efficient vehicle for protecting against various types of risks encountered by investors

Impact of Current Bond Yields

- Current market yield on benchmark 10 year U.S. treasury note is approximately 0.50% one year ago it was 1.70% - US rate of inflation was 1.3% so negative real yield - FOMC cut fed funds rate to zero in March 202 and announced September 16, 2020 it expects to hold rates near zero for at least three years, need inflation exceeding 2% - Negative real yields make future corporate cash flows more desirable and valuable, increasing equity market multiples - Lower U.S. treasury yields have weakening effect on U.S. dollar

Securities regulations and regulations

Guest Speaker on Professional Money Managers - Kim Voss

- Difference between hedge fund and private equity is about fees and liquidity - Hedge funds - more liquid - Private equity - closed end fund - There is merit to getting access to talented financial managers

Tools for corporate finance

- Equity = sale of stock = value growth = dilution concern - Other was to finance project: take a loan or issue debt = fixed income = return limited to principal + interest

Firms and stock market

- Firms need financing to invest in projects - Stock market is a financial intermediary investors and capital seeking firms - Why of a firm - create value for shareholders - How of value creation - invest in projects that have positive returns

Credit Rating

- Moodys, Standard and Poors, and Finch - Assess the risk assesment with purchasing bank laons and bonds - Conflict of interest concerns. Credit ratings are providing ratings for fees. However, it's in the interest of credit agencies to issue ratings of value - Dodd Frank Rule - Can't issue unsolicited ratings - Zero unsolicited reports since Dodd Frank Rules

Commodities and Futures

- Recently, large deposits in to banks and money markets accounts... Consumers wanting to stock savings? - So banks have increased amounts of deposits, where is it going? Treasury securities and agency securities (very conservative positions) - When interest rates are low, they aren't earning a very high profit and banks stocks have languished

Bonds

- Short term bond is called a note - Most widely used of all financial instruments - Needing to raise capital and low interest rates affect bond issuance occurrence - Bonds are categorized as a fixed income, but nowadays can be risky - Principle reason for bond issuance: 1) Diversify sources of funding and 2) obtain many creditors instead of just several large banks or financial institutions. 3) You can also raise more money without exhausting existing credit lines

Why debt spending and/or cutting taxes don't fix financial distress

- Starting with the GD in 1930's the idea took hold that government policymakers need to stimulate the economy from time to tome, when central bank policy has proven inadequate - This is done by cutting taxes, raising government expenditures, or both. - However, cutting taxes without spending raises the national debt. If a depression continues for years, the debt becomes a concern and the public is likely to call for a period of fiscal austerity, resulting in a premature reversal of stimulus. - Tax increases weaken the affect of fiscal stimulous. Thus if one wants to boost the economy with balanced budget expenditures, one needs a lot of expenditure. Here, there is also problems with agreement over how to spend that money. And, once programs are in place they are seldom cut.

Bankers as providers of safe liquidity return

- Tabernae argentariae - Roman money lenders who you could deposit money with and earn interest - Banks are managers of investments on behalf of clients, just like other kinds of investment managers, but with greater claims to safety - Banks pay a fixed interest rate rather than an uncertain return - Also deposits are generally liquid and can be withdrawn at any time - Available as money in the ground but unlike buried treasure pay interest

Traders as managers of a financial reward system

- The existence of traders allowed financial markets to respond instantaneously to new developments - They in essence deliver rewards to those in the market who bet correctly - Traders can be viewed as a valuation machine - they are constantly evaluating changing market environments and give nearly instant feedback in the form of price movements - When a company announces that a new special dividend will be paid to shareholders, traders bid up the stock immediately after the announcement thereby sending out a signal to the world much like the human dopamine system signals to the whole brain - However, traders influence is when good news is received not when it is realized (think future increase in dividend). No dopamine or price boost occurs when the good news takes effect quarters down the line

CLASS ON PROFESSIONAL MONEY MAANAGEMENT

- U.S. Household assets: 30 trillion - occupied houses and farms (subject to 10 trillion in mortgage loans). Corporate stocks - 19.5 trillion, pension funds - 27 trillion, mutual funds - 9.5 trillion, savings accounts - 11 trillion, checking accounts - 1.8 trillion - Some larger asset managers - California public employee retirement system: Largest public pension fund in USA, total size 389 billion, early to embrace ESG, began hedge fund investment in 1999 and announced phased exit in 2014 (maybe a theme) - Hedge fund v. private equity - Hedge fund outflows and private equity influx. Private equity have a lock meaning they can't redeem investment in the fund. Whereas hedge funds don't have a lock so they have to invest in somewhat liquid assets where private equity funds do not

Key interest rates

- U.S. treasury note and bond yields U.S. treasury notes are considered risk free Traded deep into market which helps set other rates Many different maturities to select on Used as a base for setting initial bond interest rates and as a market reference - LIBOR - London Interbank Offerred Rate Interest rate on US dollar loans among London based banks Set daily by survey of 18 banks asking at what rate they could borrow from other banks Used for setting and adjusting rates in floating rate loans Problems - the banks fixed indications so plan is no longer to set LIBOR after year end 2021 Replacement will be Secured Overnight Financing rate SOFR is set by market transaction data (over longer period of time now), LIBOR by expert judgment

Debt seems to be the key risk in bubbles

- What determines if an asset price correction will trigger a crisis or just a milder downturn? - Debt seems to be a key factor. Housing is a huge, highly leveraged market. The mortgage market is roughly a $10 trillion market. Today, people often buy homes with 20 percent as a down payment. Those loans were bundled into mortgage-backed securities, which were then bundled into collateralized debt obligations, and then banks bought them with yet more borrowed money. It was leverage on top of leverage with little equity supporting it all. - Contrast that with the stock market, where individual investors are limited to a 50 percent margin. In other words, those investors have to put at least 50 percent down on their equity investments. Most put down much more. Similarly, mutual funds tend to have much less leverage than mortgage lenders, for example. - it is safe to say that as an asset class, housing is far, far more leveraged than the stock market.

Fed policy in 2020

- What's different now? - Two rapid easing movements in March AND December 2008 - Dramatic escalation of QE - Purchasing corporate debt securities (novel and extreme measure) - August 2020 announcement places clear emphasis on employment over inflation, even if employment increases inflation. Will only act on inflation if decisively over 2% This indicates interest rates will be lower of the foreseeable future (committing itself to an environment of lower rates) - Effectiveness after big deployment of tools? Have to hope it has an effect because it has been moved just about as far as it ever has. - Proposed addition of third policy goal (made by politicians and commentators): racial justice

Behavior Finance Psychological Theories

- Who are the unintelligent participants? Are they influenced by animal spirits? Usually those who participate in the market are attracted to competition, gambling, reward, and herd behavior - Heuristics are simple strategies people use for day to day decision making. Are heuristics employed in investing and trading decisions and are they subject to identifiable erroneous congnitive biases - Prospect theory: If you look at human behavior, you can find many instances where people are more influenced by and moved incremental losses than incremental gains. People are willing to settle for reasonable levels of gain but people are willing to engage increasingly risky behavior to obtain a potential gain - Behavioral Finance 1. Overconfidence - overestimate ones own qualities 2. Cognitive dissonance - seek out evidence to support ones belief and disregard counterevidence 3. Confirmation bias- search for and interpret information in a manner which confirms preexisting beliefs 4. Anchoring - setting opinions on things which capture attention 5. Storytelling - overly influenced by stories, esp. human interest 6. Social influence - Large value on perceived behavior of other

Securitization in 2008

- Worst of the worst BB BBB tranches had a 96% default rate - A tranches had a 76% default rate - AAA tranches had 4% default rate Dodd Frank - Dodd Frank required higher levels of risk retention - Increases oversight of rating agencies - Later policy increased disclosure requirements for underlying loans

Risks of OTC Derivative markets

1. Counter-party risk: Derivatives are usually traded between businesses, must pay attention to creditworthiness of other parties or secure sufficient collateral 2. Price risk: market for OTC derivatives may be small so it can be difficult to sell 3. Counterparty deals involve higher chance of claims from one party against the other not found in exchange traded derivatives 4. Settlement risk: There is risk in OTC derivatives markets that transactions will not be settled timely.

Expiration dates

1. Date on which the option contract is set to expire by the exchange 2. Most have four, the limited number of dates increases trading volume for each contract 3. Some with heavier trading volume already have monthly 4. Triple witching days - when equity index options, equity index futures, and equity options expire all on the same day.

Factors affecting option prices

1. Intrinsic value - simply the extent to which the option is in the money. If a companies shares are trading at 100, the c105 call has an intrinsic value of 5 because immediately upon purchase the call could be exercised for a profit of 5 per share. The premium must be greater than the intrinsic value or the writer will have no incentive to sell an option. If an option is presently out of money, its instrinsic value is zero 2. Time value - The longer the time until an option expires the greater the likelihood that the purchaser will be able to exercise the option. As an options expiration approaches the time value goes to zero 3. Volatility - the more volatility the greater chance the option will hit a strike price and all options on that share will have higher premiums than options on the other share 4. Delta - change invlaue of an option that is associated with a given change in the price of the underlying asset. If a 1% change in the price underlying the currency or stock market index is associated with a 1% change in the value of the option, the option will have a delta of 1.00. The option of a put delta is the negative of the delta of a call option on the same underlying. An option with a lower delta will have a lower premium than one with a high delta because a change in the price of the underlying will have little effect on the options value 5. Gamma - rate at which an options delta changes as the price of the underlying asset changes. Gamma is calculated as the change in delta divided by the change in the price of the underlying. A positive gamma means that a small change in the price of the underlining will cause a larger change in the value of the option than delta would alone predict. A negative delta gets further away from the starting point 6. Rho is the expected change in an options price in response to a percentage point change in the risk free interest rate 7. Vega - refers to the change in an options price, expressed in currency terms, in response to a percentage point change in volatility. A high vega, all other things remaining the same would make an option more costly

Five components of FM

1. Lenders 2. Borrowers 3. Markets 4. Intermediaries 5. Regulators

Properties of bonds

1. Maturity - the date on which the bond issuer will have repaid all the principal and will redeem the bond (1-5 short, 5-12 medium, 12+ long) 2. Coupon - stated annual interest rate as a percentage of the price at issuance. Once a bond has been issued its coupon never changes 3. Current yield: Effective interest rate for a bond at its current market price (annual coupon/ current price 4. Yeild to maturity: Annual rate the bondholder will receive if the bond is held to maturity. Unlike current yield, yield to maturity includes the value of any capital gain or loss the bondholder will enjoy when the bond is redeemed 5. Duration: Number expressing how quickly the investor will receive half the tota payment due over the bond's remaining life with an adjustment for the fact payments in the distant future are worth less than payments due soon

Intermediary effects on the FM

1. Maturity intermediation 2. Risk reduction via diversification 3. Cost reduction for contracting and information processing

Why securitization took off in the u.s.

1. Regulatory climate was favorable to innovation 2. Legal system did not prevent it 3. Willingness of investors to perform complicated mathematical analysis in order to determine the value of an asset back security

Bond indexes

1. Credit Card securities - fallen sharply since recession 2. Home equity loans 3. Automotive loans 4. Student loans 5. Small business loans, property insurance

COmmon non-mortgage securities

1863 U.S. Natl. Banking Act

Created standardization of currency

commodity basics

Financial settlement - holder of either short or long positions enters into an offsetting trade, closing an open position Margin - Traders must maintain margin though a license futures merchant, typically 5% for hedgers and 10% for speculators; daily settlement against margin have post to main or may withdraw surplus

Why securitize

Fundraising alternative, as opposed to - Sell a pool of financial assets (whole loan sale results in loss of customer and borrower relationships and pricing may be difficult - Sale of equity (control and valauation consideration - Issue debt or obtain a loan Fundraising alternative, motive to securitize - Keep customer borrower relationship, if you securitize you still act as servicer for the securitization transaction - Large universe of buyers for securitization

Bankruptcy and bonds

In bankruptcy, bonds get paid out first because they are considered debts not assets

Styles of Private Equity Strategy

Leveraged buy-outs - purchasing controlling intest in private companies or taking public companies private, using governance control to improve the target company for eventual sale -Real estate - purchasing properties of performing and defaulted loans -Assets- purchasing illiquid assets such as commercial aircraft, rail cars, ocean going vessels, floating oil rigs, timber forests and power plants, improving them for sale, and looking for cyclical fluctuations in value -Distressed debts

(Covered calls): Purchase stock and write a call option at a higher strike price than you paid for the sock (cost of profit now forgone appreciation in the future)

Making a stock porfolio work

PIF Fees

PIF Management fees - Charged on capital contributions PE or assets HF - Formerly 2.0% market is now 1.0-1.8% with a typical fee of 1.5% for PE; highly variable for HF's some new HF's have 0% management fee - Used for salary and office expensives Private Equity Incentive Fees - Referred to as carried interest - Taxible as capital gains or ordinary income? Capital gains now - Distributions paid to investors as investments are realized - Paid in waterfall 100% to investors until hurdle rate return, typically 8% compounded annual return Catch up payments of 50-100% to manager until it has received 20% Fee split of 80% to investors and 20% to manager - Private equity - Return of capital first, then deal by deal (American waterfall) now more common aggregate fund as a whole (Euro waterfall) more common

- Total value of U.S residential real estate on June 30, 2020 was 32.9 trillion - U.S. residential property was subject on June 30, 2020 to mortgage debt totaling 11.3 trillion - U.S. home equity was 20.2 trillion, compared to total U.S. stock market capitalization of 37.7 trillion

Real estate market

Benefits of securitization

Securitization = Pool of cash flowing assets, like mortgage loans. Placed into a trust. Set of fixed income securities is issued by the trust. Cashflows from assets service the securities. Pass through Certificates = Principal and interest due monthly in securitized assets would pass through the lender directly to the ivnestors - Change and allocate risk profile - Increase access to capital - Market pricing of risk - Financial institution specialization

- Allocation of opportunities - me or my clients? - Pricing of illiquid positions - smooth returns hide problems - Mispriced dealing with friends

Subtle Misbehavior examples

Financial markets fwd. looking

Why covid hasn't hurt stock market for prolonged time Expectation of monetary policy change

- Access to superior managers - Access to inefficient markets requiring specialized knowledge which would be difficult to invest in otherwise - Uncorrelated returns - Vehicle for alternative investments

Why invest in PIF

Inventory or stock variables (Economic Indicator)

how much we have of something at a point in time (money supply and financial market size)

Norweigen sovereign wealth fund

- Largest pool of managed money in the world - Assets represent 207k for every Norwegien citizen - 2020 will be first withdraw in excess of cash inflows - 2019 decision to divest in oil and gas expiration companies (but not producers/ distributors) - Alaska does something like this

Foreign Markets

- In the U.S. non- U.S. corps must comply with U.S. security laws to be issued - Other sector of a countries financial market is the external market, where securities with the two features below are traded (Also referred to as the offshore market) 1) At issuance the securities are offered simultaneously to investors in a number of countries 2) The securities are issued outside the jurisdiction of any single country.

Freddie Mac

- Like Fannie Mae, Freddie Mac operates only in the secondary market and does not lend money directly. - The corp. is obliged by the govt. to devote a share of its mortgage financing to low and moderate income families.

Costs of stock exchange listing to firms

- Must be public which menas SEC reporting and scrutiny (costly to maintain standards) - Exposure to ongoing market evaluation - Possible emphasis on daily stock price over long term prospects which may produce earnings mismanagement and creative accounting

Reserve requirements of banks

- banks are required to make deposits with the federal reserve - % of transaction accts. must be held in Federal Reserve deposits - Transaction accounts are checking type accounts - 10% of accts. have to be held - since 2008 banks hold large reserves.... Fed now pays .25% interest rate on it (before they did not pay) - money multiplier of 10. Bank is able to have transaction amount of 10 times their reserve. So if it was set to 5 banks could have transaction amounts of 20 times their reserve

Exchange traded funds

- operate under exemptions or SEC exemptive orders from investment company act - traded like a public stock on an exchange - expense ratios typically 0.1 - 1% - Taxation - like corporate stock , gain on slae - No suitability requirement - - Invest on themes, less active than actively managed mutual fund but more active than passive mutual fund - Similar to short high yield bonds - Can even hedge some large exchange traded funds

types of future contract

1) Commodity futures: were once based exclusively on bulk commodities known as physicals. Recently however, the risking demand for ways to manage risk has led to trading of non-physical contracts as well. 2) Financial futures: Become popular as a result of the abandonment of fixed exchange rates in the major industrial countries. Trading volume in financial futures now exceeds trading volume in commodity futures by a wide margin

Three main methods of trading futures contracts

1) Continous auction or open-outcry trading Conducted by floor brokers on the floor of the exchange. The futures commission erchant has a clerk outside each pit who recives customers order by phone and then relays those orders to the firms floor broker with hand signals or slips of paper. The floor broker then announces the buy or sell in the put and the other brokers respon with shouts or hand signals until a price is agreed on 2) Single price auction trading An exchange official opens each session of trading in a given contract by posting a provisional price for the nearest delivery month. Members then buy or sell orders at that price. If sell orders outnumber the buy orders the price is lowered to attract more buyers and vice versa... When the sell orders is equal to the amount of buy orders the price is fixed and contracts are executed 3) Electronic trading is executed through a computer system rather than a trading floor. Electronic trading lowers transaction costs and democratizes information. Also opened the door to after hours trading

Reasons for bonds

1) Minimize financial costs - bonds are low cost and can be paid over a long period of time 2) Matching revenue and expenses - Many capital investments such as a bridge or mine, take years to complete but will produce revenue for awhile. Bonds offer a way of linking repayment of borrowings for such projects to anticipated revenue 3) Bonds allow govts. to charge future taxpayers for the infrastructure they build instead of putting the burden on current tax payers 4) Controlling risk - The obligation to repay a bond can be tied to a specific project or govt. agency. Thus this can insulate the parent corporation or govt. from responsibility is the bond payments are not made 5) Avoiding short term financial constraints - govt. and firms may turn to the bond market to avoid painful steps such as tax increases or wage reductions

other reasons for bonds

1) Minimize financial costs - bonds are low cost and can be paid over a long period of time 2) Matching revenue and expenses - Many capital investments such as a bridge or mine, take years to complete but will produce revenue for awhile. Bonds offer a way of linking repayment of borrowings for such projects to antipated revenue 3) Bonds allow govts. to charge future taxpayers for the infrastructure they build instead of putting the burden on current tax payers 4) Controlling risk - The obligation to repay a bond can be tied to a specific project or govt. agency. Thus this can insolate the parent corporation or govt. from responsibility is the bond payments are not made 5) Avoiding short term financial constraints - govt. and firms may turn to the bond market to aboid painful steps such as tax increases or wage reductions

Types of bond issuers

1) National govt. - Called sovereigns - Considered most secure type 2) Lower level govt. - Called semi sovereign - Considered riskier because lower levels of govt. cannot print money like sovereigns - Some national govts. try and curtail semi sovereign bond markets to curtail indebtedness and ensure healthy bank business - General obligation bond: Gives bond holders a priority claim on tax revenue if the bond defaults - Revneue bond gives bond holders a claim on the revenue a project creates in case of default - Special purpose bonds - provide for repayment from a particular revenue sources such as a tax on hotel stays to serice the bonds for a convention centre, but usually these are not backed by the issuer's general fund 3) Corporations - Bonds can be issued by corporations with specific assets pledged to bond holders in case of default. - However, those who have senior debt may have first claim on those assets. - Those with subordinate debt will get paid after bond holders 4) Securitizatio vehicles - An asset backed security is a type of bond which the required payments will be made out of the income generated by specific assets (mortgage loans or future sales)

Credit default swaps

1. A credit default swap is a contract in which two parties agree to exchange the risk that a borrower will default on its bonds or loans 2. The seller of the swap receives a fee or premium from the buyer. In return the seller will compensate the buyer if there is a credit event such as the borrower failing to pay obligations 3. If a credit event does occur, the seller must compensate the buyer by paying the difference between the full face value of the securities and their market value after the credit event, which is invariably less than the face value but often much more than zero 4. If no credit event occurs, the sell of protection profits from the premium it received from the buyer 5. Concerns with credit default swaps 1. Sellers of default swaps could be wiped out by financial downturns causing large losses to those that purchased the swaps represented by unfulfilled payments 2. Conflict of interest problems - a holder of many default swaps that also held substantial stake in the company could help drive a company into bankruptcy, losing value on the equity but making money on the payment from default swaps

Synthetic securities

1. A synthetic security is created by combining securities to mimic the properties of another security. The security being mimicked may not actually exist. It is often straightforward to mimic the a security with a portfolio of derivatives that reproduce the returns on their underlying. 2. Problem is they may be difficult to value and perform unpredictably 3. A credit linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay the debt if a specified event occurs.

Equity options

1. An equity option entitles the owner to buy or sell a certain number of common shares in a particular company. Note, it is not the company itself that issues the options 2. Options on indexes can also be traded. Each index option is based on the index times the multiple

What the intermediary gets for playing his role

- 1) obtain funds from lenders or investors -2) the funds that a financial intermediary acquires become, depending on the financial claim, either the debt of the financial intermediary or equity participants of the financial intermediary. - Ex. Commercial bank: XYZ can deposit to B, deposits are the banks liability. B then lends to MNO in the form of loans or buys securities. The loans and/or securities become the banks assets - Ex. Mutual fund: M accepts investments from I who in turn receives a share in M. M invests in a portfolio of financial instruments. The M funds shares represent an equity interest in the portfolio of financial instruments and the financial instruments are the assets of the mutual fund - In essence the intermediary is able to transform assets that are not desirable for a large portion of the public into other financial assets, aka their own liabilities, which are more widely preferred.

Other analysts commentary on Fed Policy

- A number of explanations for low inflation have been offered by economists and policymakers, including: (1) transitory factors (which essentially mean one-offs that don't signal an underlying trend), (2) technology development that is driving production costs lower, (3) a global supply of labor that is keeping U.S. wages down, (4) additional domestic labor supply that is not captured by the headline unemployment rate and (5) falling inflation expectations. - It is important to note that many advanced economies have been experiencing low inflation in recent years. It is not simply a U.S. experience. This is important because any explanation for low inflation ought to be able to explain what is happening around the world. - Ongoing technology development is not a new phenomenon, nor is a large group of workers, from China for example, entering the global labor market. - In addition, productivity in advanced economies has been low for some time. It is hard to reconcile low productivity growth with a burst of new technology that is keeping prices low. - So how does my story of FOMC tightening explain low advanced-economy inflation? While advanced-economy central banks are not formally coordinating policy, they do tend to move in the same direction. The Fed, European Central Bank and Bank of England all pursued very low interest rates, hitting their own effective lower bounds at roughly the same time - Another important issue some people point to is that financial conditions as measured by various indexes have strengthened as the FOMC has removed accommodation. Some suggest this indicates that the FOMC has not in fact removed accommodation during this time. I don't find this argument compelling. I believe that the apparent easier financial conditions are likely a reflection of the market's own recognition that equilibrium long-term real rates have fallen. A lower future interest rate environment could justify higher asset prices and seemingly easier financial conditions today by virtue of markets' discounting cash flows with a lower interest rate.

automatic stabilizers

- Appropriate financial systems will help lessen the impact of economic fluctuations and relieve policymakers of the burden to make politically difficult stabilization moves..... these are known as automatic stabilizers. - Other automatic stabilizers included unemployment insurance. Also a progressive income tax is a stabilizer in the way it decreases in periods of economic downtown and increases in boom times, thus acting as a natural dampener of fluctuations - In the future, automatic stabilizers will continue to evolve. One could see insurance policies against declines in home price or home equity. - Govts. could also issue shares of their GDP or similar measure of economic success. - This could be a way that countries finance their debt with more favorable terms by way of flexibility and provide even stronger internal pressure to manage their fiscal policy in a way that will allow them to repay that debt

Maturity Intermediation

- Banks hold deposits that are payable on demand, even though the loans they give using those deposits are longer in nature (typically over many years) - If not for commercial banks borrowers would have to either 1) borrow for a shorter period of time in order to match how long lenders are willing to loan funds or 2) locate lenders that are willing to invest for the length sought - Instead by issuing its own claims, a commercial bank transforms a longer term assets in to a shorter term by giving borrowers the time horizon they need to payback the loan and the lender the investment horizon they desire

First line of defense against economic calamity

- Central bankers have been the first line of defense against economic instability ever since the Bank of England evolved from a private bank in to the first central bank - The success of the central bank of England in stabilizing economies spurred the creation of the Federal Reserve. - The role of a central bank is to manage the driving force of the economy, credit. - Thus, the bank plays the role of managing assets in the good times so as to be best positioned to lend capital (effectively) when calamity comes - Central banks biggest problem is the ability to anticipate financial crisis and prepare for them. - A study by the IMF found that virtually all central banks (96%) gave a positive assessment of soundness in the domestic financial system - The suspected reason is that being politically subservient, central bankers wanted to avoid sounding any alarms until they had objective evidence of a problem.

Types of equity

- Common stock and partnership shares are examples of equity instruments - Common stock = ownership in a corp whereas a partnership share is an ownership interest in a partnership - Distribution of a companies earnings = dividends - Some financial instruments fall in to both a partnership and common stock - Preferred stock = Payment to investors is made only after obligations to the companies creditors are satisfied AND investors in a preferred stock are only entitled to receive a fixed contractual amount (like a debt obligation) (referred to as a fixed instrument) - Convertible bond/note = a debt instrument that allows the investor to convert it into shares of common stock under certain circumstances and at a specific exchange ratio

Intermediaries: Risk reduction via diversification

- Consider a mutual fund. That fund will diversify investments in a large number of companies - Diversification = the reduction of risk from investing in assets whose returns do not move in the same direction at the same time - Mutual funds helps investors who don't have the time or money to invest in many different companies - Even if individuals can accomplish diversification on their own, doing it as cost effectively is difficult

Difference between debt and equity

- Debt instrument, or debt = issuer agrees to pay the investor interest plus repay the amount borrowed. (Can be in the form of a bond, loan, or note). But Interest payments are fixed contractually - In the case of a debt instrument that is required to make payments in U.S. dollars, the amount may be a fixed dollar amount or percentage of the face value of the debt - The investor who lends the funds and expects interest and the repayment of the debt is a creditor - Key point - An investor in a debt instrument can realize no more than the contractual amount (fixed income instruments) - In contrast, to a debt obligation, an equity instrument specifies that the issuer pay the investor an amount based on earnings if any after the obligations that the issuer is required to make to the companies creditors are paid

Moral Hazrd Problem

- Definition: A hidden action which benefits one party in a fincaical transaction at the expense of the other party - Ex. Insurance - One party takes out a plan on a property and burns it down to collect on the plan and rebuild anew - Ex. Loaner - If you have a habit of putting out risky loans you will attract borrowers who have riskier businesses - How to fix (never can fully fiX) Information is value. Scarcity is opportunity In order to profit you must partially reveal information when advantageous. Ex. Give a tell on an investment after you are already in

Market Efficiency

- Efficient market = Market where all available information is rapidly impounded into an assets price - Three levels of market efficiency 1) Weak form = current asset prices reflect all past prices and price movements. All worthwhile info about historical prices is reflected in today's price... the investor cannot use the same info to predict tomorrows price 2) Semi strong form = the current asset prices reflect all publicly available information. The implication being that if investors employ all publicly available information, they cannot earn abnormal profits. Prices may not change instantaneously but rather asset prices reflect this information rapidly. The U.S is probably a semi strong form 3) Strong form = asset prices reflect all public and private and publicly available information. All investors know everything about the product. Strong form implies that investors cannot make abnormal returns from trading on inside information that has not been made public. The U.S. is not strong form as investors profit off insider information all the time.

Fed goals today

- Fed is seeking higher inflation - No one expects the policy setting revamp to boost growth right away because unemployment is still above 10% and the Corona is devastating large swaths of the economy - Stimulus tools may be less powerful today than they were a decade ago - The Fed is not powerless to avert financial panics because they can devise new emergency lending backstops - The Fed had plans to keep rates lower for longer. As a result, the spread between the Fed's overnight rate and longer term interest rates stayed historically narrow when the Fed cut rates to zero in March - Aggressive action taken in March may make it less powerful now. - Two tools the Fed will primarily use: 1) Asset purchases and 2) guidance about its policy plans (this could take the form of describing the inflation and employment conditions that would need to be satisfied before considering rate increases or a slowdown in asset purchases)

Intermediaries

- Investors who want to make a loan to a consumer or business need to have the skill to write a legally enforceable contract with provisions to protect their interests - After making the loan they have to be able to monitor the financial condition of the borrower and if necessary pursue legal action if there are violations - Information costs - time plus costs to acquire information regarding the condition of a loan - Costs associated with writing loan agreements - contracting costs (includes enforcing the terms of the loan agreement) - The staffs of both mutual fund firms and commercial banks will have professionals that can better manage these costs more effectively (economies of scale)

Financial Information

- Most important resource in financial market is information - It is expensive and difficult to obtain good information. - There is high levels of asymmetric information right now. That is there is uneven and unequal distribution of information across the parties in financial markers and in financial services (Also what creates oportunities) - Financial markets help us deal with this problem

Central Banks post 2008

- Reforms in the wake of the financial crisis have included the creation of new government agencies tasked with learning more about financial instbalities and recommending policies to deal with them. - Dodd-Frank Act of 2010 created the Financial Instability Oversight Council. But this counsel, and others like it across the world, face the difficult task of not only figuring out looming crises, but taking the politically divisive and difficult measures to counter them. - The severity of the world crisis in 2008 suggests that the efforts of the central bank were late in coming but nevertheless helped stave off real disaster. - Central banks alone are not enough to prevent save dislocations arising from economic transactions. - The other main tool for stabilization of the modern economy is fiscal policy, the tax and expenditure policy of the government

Adverse selection and FM

- Some information problems are impossible to completely solve - People who have characteristics not well suited for the demands of the market are favored by the economic situation - Lazy bank: There are good borrows and some bad borrowers. Profit would increase if you could eliminate the bad borrowers. Tough to figure out though. Lets assume it's 50/50. You could charge everyone 12.5% instead of 5% to the good and 20% to the bad. Problem is the good borrowers will go elsewhere. And the bad borrowers will seek out the 12.5 rate harder. Ways to fix this phenomenon - Due diligence - Collateral - Downpayments

Fed Changes

- The Fed has been more vocal about calls for elected officials to provide economic support with changes to spending or tax policy - The Fed's new framework codifies two important changes: 1) It effectively raises the Fed's inflation target by saying the central bank should take past misses of the 2% target in to account and seek periods of moderately higher inflation to compensate. 2) Officials wont raise interest rates simply because unemployment rates fall below a level estimate to put pressure on prices. In doing so, they have set aside the consensus the guided central bank policy following the runaway inflation of the 1970s - The new policy represents a deficiency their old one confronted in a world with more frequent or extended episodes in which interest rates can't be lowered once following to near zero. - If the central bank targets 2.5 inflation and consistently falls short, expectations of future inflation will slide lower making it harder to achieve their target. - Fed officials hope their policy will help by influencing expectations of future inflation thus avoiding a monetary black hole. - If investors believe the Fed's words are credible, markets will expect a longer period of easier policy thereby increasing the amount of effective stimulus - Inflation during the expansion phase of the business cycle has trended lower on average - Generally, there is a belief the Fed is going to be less capable of buffering the economy from recessionary shocks than it would have been 30 or 40 years ago.

Niel Kashakari - Tools of the Fed

- The primary tool the FOMC uses to set monetary policy is the Federal Funds Rate which is an overnight rate. - (Noted above individauls and businesses don't care about the overnight rate) So why would adjustments to the FFR affect the economy? If the FOMC raises the FFR it is a signal that rates will likely be higher in the future. If the FOMC lowers the FFR is sends a message that rates will likely be lower - The second tool the FOMC uses to set monetary policy is foreward guidance. FOMC gives out quarterly economic projections that indicate to the public how the economy is likely to perform in the future. - During the recession overnight rates were lowered to near zero, which gave households, businesses, and individuals confidence that interest rates would be low for longer and likely contributed to increased economic activity and recovery - The third tool the FOMC used in the aftermath of the Great Recession to affect monetary policy was quantitative easing (QE), or using the Fed's balance sheet. Once the FFR was effectively at zero, the Fed embarked on its QE programs to directly drive longer-term interest rates down by buying longer-term bonds. One of the channels through which QE affects the economy is also expectations — by further signaling the FOMC's commitment to stimulating the economy through accommodative monetary policy.

Repurchase Agreement

- There are participants in the financial system that use leverage in implementing trading strategies in the bind market, That is, the strategy involves buying bonds with borrowed funds. Rather than borrowing from a bank, a market participant can use the bonds it has acquired as collateral for a loan. Specifically the lender will loan a certain amount of funds to an entity in need of funds using the bonds as collateral. This lending agreement is referred to as a repurchase agreement because it specifies that the borrower sells the bonds to the lender in exchange for the proceeds and at some specified future date the borrower repurchases the bonds from the lender at a specified price. The specified price called a repurchase price is higher than the price at which the bonds are sold because it embodies the interest cost that the lender is charging the borer. Thus a repurchase agreement is a collateralized loan backed by a specific asst.

Primary Market

- When an issuer first issues a financial instrument it is sold in the primary market - Companies sell new issues and thus raise new capital in this market - Bringing these news issues to market typically involves an investment bank. The investment bank brings to this process is underwriting. - Another method is through an auction process. - All securities must register with the SEC

Secondary Market

- Where financial instruments are resold among other investors, therefore the issuer of the security does not receive proceeds from the sale. - We categorize secondary markets based on the way they trade - this is referred to as market structure. There are two primary market structures 1) order driven and 2) quote driven - Market structure is the mechanism by which buyers and sellers interact to determine price and quantity. On an order driven market structure, buyers and sellers submit their bids through their broker who relays these bids to a centralized location for bid matching and transaction execution - An order driven market may also be referred to as an auction market - In a a quote driven market structure, intermediaries quote the prices at which the public participants trade. Market markers then provide a bid quote to buy and offer to quote (sell) and realize revenues from the spread between these two quotes - Exchanges are central trading location where financial instruments trade. The financial instruments must be those listed by the organized exchange. - OTC market is generally where unlisted financial instruments trade. Typically found here are currency exchanges, bonds, and loans.

Certificates of Deposit

- written promises by a bank to pay a depositor. Investors can buy and sell negotiable certificates of deposit which are CD's issued by large commercial banks. Negotiable CD's have original maturities between one month and a year and have denominations of 100k or more. Investors pay face value for negotiable CD's and receive a fixed rate of interest on the CD. On the maturity date the issuer repays the principle plus interest.

Three major functions of FM

1) Price discovery - buyers and sellers determine the price of a traded asset. FM signal how the funds available from those who want to lend or invest funds are allocated among those needing funds 2) liquidity - presence of buyers and sellers ready and willing to trade. Appealing when someone is forced to sell an asset. Without liquidity an investor would be compelled to hold onto an asset until conditions arise that allow for the disposal of the asset or the issuer is contractually obligated to pay it off (for a debt instrument, when it matures. No such thing for a equity, it is perpetual) 3) reduced transaction costs - search costs = explicit (advertise intention to sell) and implicit costs (value of time locating a counterparty), both of which are reduced in FM

Why do we need financial assets

1. Allow the transference of funds from those entities that have surplus funds to invest to those who need funds to invest in tangible assets 2. They permit that the transference of funds in such a way as to redistribute the unavoidable risk associated with the tangible asset's cash flow among those seeking and those providing funds

four forms of regulation

1. Disclosure regulation - ie any publicly traded company provide financial or nonfinancial information on a timely basis that would be expected to affect the value of its security. - Justified by the fact the issuer has better access to information about the companies economic well-being than those contemplating investment in the company. - This is asymmetric information. In the U.S. the SEC does not take a role in preventing the issuance of risky assets, only punishing those who fraudulently mislead. - Another role of the SEC is to monitor trades made by those with non-public information to ensure they are not trading on that information to the disadvantage of the public. 2. Financial activity regulation - The SEC and the Commodity Futures Trading Commission share the responsibility of regulating options trading, futures, and other derivative investments. - Call option = Derivative security whose value depends on the value of the underlying stock. If the value of the stock increases, the value of the call option on the stock increases as well 3. Regulation of financial institutions - justified because of the vital roles financial institutions play in the economy 4. Regulation of foreign participants - Restrictions on foreign participants role to play in a country's market has been lessening (written in 2010) - Common elements of regulatory reform proposals include: Advanced warning system that can try and identify systemic risks, increased transparency in consumer finance, mortgage brokerage, asset backed securities, and complex securities. Increased transparency of credit rating firms. Enhanced consumer protections. Increased regulation of nonbank lenders. Some measure to address the issue of financial institutions that may be so large that their distress affects the rest of the economy

The FOMC has taken three types of actions to tighten monetary policy in the following chronological order:

1. Ending QE. - QE affects the economy by driving down longer-term interest rates and through signaling a commitment to maintaining accommodative monetary policy in the future. - When the Fed began discussing tapering QE in mid-2013, it effectively began the process of removing accommodation by significantly changing expectations of further QE. And once the taper was complete and the Fed's balance sheet was fixed at $4.5 trillion, its stimulative effects began to shrink, albeit slowly, relative to the growing U.S. economy. - In addition, the end of QE also signaled an end of the commitment of the FOMC to use extraordinary measures to support economic activity at that time 2.Hawkish Foreward guidance - For several years, the FOMC, through its SEP, put forward rate paths that were very aggressive compared with what the economy ended up needing (and even higher than what markets had been expecting at the time) - SEP set the expectation that by December 2016, the FFR would be at 2.50 percent, when, in fact, the FFR ended up at only around 0.6 percent. With the benefit of hindsight, this guidance ended up being far too hawkish and likely had a somewhat contractionary effect on economic activity by signaling significantly higher interest rates in the future. 3. Four rate hikes. - The FOMC began actually raising the FFR in December 2015 and followed up with three more hikes through June 2017, despite muted wage and inflationary pressures. The signal from this activity suggests a strong desire to raise rates, even with an absence of inflationary pressures. - We know that monetary policy operates with a lag. I believe these actions to remove various forms of accommodation are now having an effect on the economy by lowering inflation expectations. - inflation expectations declined because actual inflation was below target for a long time, and the Fed's actions to reduce accommodation led to a weakening of confidence that it was serious about bringing inflation back to target in a reasonable time frame.

Commercial Paper

A short-term debt obligation of a private-sector firm or a government-sponsored corporation. · Maturity, greater than 90 days but less than nine months. · Main advantage, that it allowed financially sound companies to meet their short-term financing needs at lower rates than could be obtained by borrowing directly from banks. · It's common for issuers to roll over their paper, using the proceeds of a new issue to repay the principal of a previous issue.....This allows issuers to barrow money for long periods of time at a short-term interest rate, which may be significantly lower than long-term rates.

Time Deposits:

Another name for certificates of deposit or CD's, are interest bearing bank deposits that cannot be withdrawn without penalty before a specific date.

Interbank Loans

Loans extended from one bank to another with which it has no affiliation. · Overnight loans are short-term unsecured loans from one bank to another. Often the borrowing bank adds the money to its reserves in order to meet regulatory requirements and to balance assets and liabilities.

commercial paper

Short-term unsecured debt issued by large corporations. - Instruments up to one year in maturity, but mostly overnight or a few days - Generally exempt from registration with SEC regulation - Commercial bank loans are not a security but you secure the loan with collateral - Commercial paper market is unsecured - Short maturity - low interest rate and unsecured - Large chunks: 1 mil denomination common - Borrowers with reputational collateral - large corporations are participants in this market - These large corporations will both issue and and purchase commercial paper. Helps cover uneven cash flows. Ie ford retooling a factory for their new models may buy commercial notes to do so and pay them back when they sale the vehicles in the next year - Rolling over cash management programs

Model Predictability

The forecasts are fine at predicting run of the mill recessions, but they are not of much value in predicting rare and sever economic crises that arose in 2007 for example. (Not surprising that the models are poorest at predicting rare events, but these are the ones that matter the most). Any analytical data analysis is also constrained by changes in politics and social forces. These inputs are not easily measured and applied.

Stable value and money market

While interest rates may fluctuate, the stable value fund shares have a fixed value.

Financial Markets

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