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CHAPTER 01 WHY ARE FINANCIALCHAPTER 01 WHY ARE FINANCIAL
s angp ng sa
Spring 2013Master
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Preview
Suppose you invented the iRobot and you plan toproduce it.
http://resources.irobot.com/index.php/video/US/11305111
Walter inherited lots of funds
With financial markets,
you, Walter and the economy would all be better off.
General Structure and Operation of the Financial SystemGeneral Structure and Operation of the Financial System
is a good start!is a good start!
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verv ew
Direct Finance/Indirect Finance
Overview of the Financial System
Why are Financial Intermediaries (FIs) Special?They reduce
Transact on costs R s Asymmetr c In ormat on
How Asymmetric Information Influences the
Facts about Financial Structure/Tools to Solve the
Problem
Why Does the Financial System Receive SpecialRegulatory Attention?
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Direct Finance vs. Indirect Finance
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Function of Financial Markets
Channeling of funds (Fig 2.1) Also called securities markets
Why is this channeling of funds so
mpor an Because savers (lenders) entrepreneurs(borrowers)
ANDWithout financial markets, they may never get
to ether
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Structure of Financial Markets
It helps to define financial markets along a
mutually exclusive). For starters,
ur : r v . u y r Seasoning: Primary Market vs. Secondary
Secondary Markets: Exchanges vs. Over-the-
Original Maturity: Money Markets vs. Capital
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Nature
Short-Term (maturity < 1 year)
Debt Markets
Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
In U.S., total value was $52.4 trillion at the end of 2009
Equity Markets
Pay dividends, in theory forever
Represents an ownership claim in the firm
In U.S., total value was $20.5 trillion at the end of 2009 Disadvantage: residual claim
Advantage: share the extra profit of the firm
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Seasoning: A new issue or not
New security issues sold to initial buyers
Primary Market
offering
Previously-issued securities are resold (traded)
Secondary Market
o e: ssu ng rms ge any money rom e secon arymarket
Involves both brokers and dealers (do you know the
difference?) Classification of the secondary market
Functions of the secondary market
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Secondary Markets Classification
Exchanges
(e.g., New York Stock Exchange(NYSE), TaiwanStock Exchange (TWSE) )
Over-the-Counter (OTC) Markets
Dealers at different locations buy and sell.
(e.g., the market for Treasury securities,Foreign Exchange Markets).
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The Secondar MarketTwo Crucial Functions
Provide Liquidity
making it easy to buy and sell the securities ofthe companies
Establish a Price
for the securities in the Seasoned-Equity
Offerings (SEOs) note: n t a u c er ng
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Original Maturity
Money Market
Short-Term (maturity < 1 year)
Capital Market
Long-Term (maturity > 1 year)
Best known capital market securities Bonds & Stocks
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Without FIs: Direct Investment
E uit & Debt
CorporationsHouseholds
(net borrowers)(net savers)
as
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FIs Specialness
Without FIs: Low level of fund flows.
Information costs Economies of scale reduce costs for FIs to screen and
monitor borrowers
Substantial price risk
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With FIs
FI
Households Corporations(Brokers)
Cash E uit & DebtFI
(Asset
Transformers)epos s nsurance
Policies
as
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Functions of FIs
Brokerage
Direct Finance Asset Transformer
Direct Finance
Indirect Finance
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Functions of FIs- Brokerage
Brokers
Acting as an agent for investors e.g. Merrill Lynch, Charles Schwab
Reduce costs through economies of scale
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Functions of FIs- Asset Transformer
Purchase primary securities by selling
financial claims to households These secondary securities (financial claims
sold to households) often more marketable
Transformation of financial risk
Examples:
Banks: deposits Insurance Companies: insurance policies
Mutual Funds: mutual fund shares
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Other Special Services
Maturity Intermediation
Banks: deposits vs. loans Denomination intermediation
Mutual funds vs. investments in bonds stocks
Payment Services, ,
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Direct Finance vs. Indirect Finance
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Indirect Finance is FAR MORE
IMPORTANTthan Direct Finance
.
WHY?
Transaction Costs
Ris aring Asset Trans ormation
As mmetric Information
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Sources of External Funds
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Transaction Costs
The loan contract
. ., ,
High costs freeze out individual lenders
Can anyone come to the rescue?
s can. y
Economies of scale: the reduction in transaction costs.
So the lender decides to obtain a deposit account ona y, s prov e qu y serv ces o cus omers.
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Risk Sharing (Asset Transformation)
Risk sharing
A benefit from low transaction costs
FIs help reduce the risk exposure of investors (e.g.,de ositors
Also called a sse t t r a n s f o r m a t i o n , In a sense, risky assets are turned into safer
.
Examples of risk sharing
Banks (deposits)
Insurance Companies (insurance policies)
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Asymmetric Information
Definition
The borrower has better in o about the investmentprojects (potential returns & risks) than the lenderdoes.
It creates two problems
Adverse selection
Moral hazard (conflict of interest)
to reduce information roblems
FIs have expertise
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Adverse Selection
e ore ransac on occurs
adverse outcome are ones most likely toseek a loan
Loan decisions to Conservative Aunt (Aunt C) vs. Get-rich- uick Aunt Aunt G
Similar problems occur with insurancew ere un ea y peop e wan e r nownmedical problems covered
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Moral Hazard
er ransac on occurs
The risk hazard that borrower hasincentives to engage in undesirable (immoral)activities making it more likely that wont pay
.
Again, with insurance, people may engage inr s y ac v es on y a er e ng nsure
Also called conflict of interest e.g., the borrower has incentive to act in his/her
own interest rather than the lenders interest
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FIs Help Reduce Asymmetric Information
FIs have expertise to produce information
from good ones (reduce loss from adverseselection)
Expertise in monitoring the borrowers (reduceloss from moral hazard
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3. How Asymmetric Information Influences
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Facts about Financial Structure
throughout the Worldv ence rom gure a e .
1. Stocks are not the most important source of external
financing2. Marketable securities are not the primary source of finance
3. Indirect finance is more important than direct finance
.
5. The financial system is heavily regulated
6. Only large, well-established firms have access to securities
markets7. Collateral is prevalent in debt contracts
8. Debt contracts have numerous restrictive covenants
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Sources of External Funds for Businesses
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Asymmetric Information: Adverse
Selection and Moral Hazard We will now use these ideas of adverse
selection and moral hazard to explain howthey influence financial structure.
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The Lemons Problem: How Adverse Selection
Influences Financial Structure (1/2)
Lemons Problem in Used Cars
1. If we can't distin uish between oodandbad (lemons) used cars, we are willing payonly an average of good and bad car values
2. Result: Good cars wont be sold, and theused car market will function inefficiently.
What helps us avoid this problem with
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The Lemons Problem: How Adverse Selection
Influences Financial Structure (2/2)
Lemons Problem in Securities Markets
1. If we can't distin uish between ood and badsecurities, willing pay only average of goodand bad securities value
2. Result: Good securities undervalued andfirms won't issue them; bad securitiesovervalued so too many issued
3. Investors won't bu bad securities somarket won't function well
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Tools to Help Solve Adverse Selection
(Lemons) Problems
Free-rider problem interferes with this solution
Private Production and Sale of Information
Increase the information available to investors
Government Regulation to Increase Information
.,
-
Financial Intermediation
buy stocks/bonds from the open market
Large firms (well-known corporations) are more likely to
use direct instead of indirect financin . WHY?
Collateral and Net Worth
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How Moral Hazard Affects the Choice
Between Debt and Equity Contracts (1/3)
Moral Hazard in Equity Contracts:
the Principal-Agent Problem1. Result of separation of ownership by
stockholders (principals) from control by
managers (agents)2. Mana ers act in own rather than
stockholders' interest
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How Moral Hazard Affects the Choice
Between Debt and Equity Contracts (2/3)
Suppose you become a silent partner in an ice
n examp e: qu y
,($9,000). The other owner, Steve, provides theremaining $1,000 and will act as the manager. If
eve wor s ar , e s ore w ma e ,
after expenses, and you are entitled to $45,000of it.
However, Steve doesnt really value the $5,000(his part), so he goes to the beach, relaxes, and
even s ends some of the rofit on art for hisoffice.
How do you, as a 90% owner, give Steve the
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How Moral Hazard Affects the Choice
Between Debt and Equity Contracts (3/3)
-(Equity)
Government Regulation to Increase Information
Financial Intermediation (e.g, venture capital)
e t ontracts
Explains why debt (rather than equity) is the mostimportant source of financing for business
However, e t s st su ect to mora azar . Infact, debt may create an incentive to take on veryrisky projects.
amount (interest), so the borrower can keep any cashflow above this amount.
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How Moral Hazard Influences Financial
Structure in Debt Markets (1/2)
An example: Debt
(requiring a 10% interest rate) he needs to setup his business. With your money, Steve may
cream (which is riskier) instead.
.
Success: you get 10%, but Steve get a lot more
Failure: you loss $9,000, but Steve losesnothing or $1,000 at most.
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How Moral Hazard Influences Financial
Structure in Debt Markets (2/2)
Net Worth
Tools to Help Solve Moral Hazard in Debt Contracts
Monitoring and Enforcement of Restrictive Covenants.Examples are covenants that
discoura e undesirable behavior
encourage desirable behavior keep collateral valuable
Financial Intermediationbanks and otherintermediaries have special advantages in monitoring
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A i I f i P bl d
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Asymmetric Information Problems and
Tools to Solve Them
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4. Why Does the Financial System Receive Special
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Regulation of the Financial System
Main reasons for regulation
Investor rotection Information Disclosure: Increase information
available to investors
Ensure the soundness of financialintermediaries
Information Disclosure
Restrictions on Entry
Deposit Insurance
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Reference Ant ony Saun ers an Marcia Mi on Conett, 2008, Financia
Institutions Management, 6th edition, Chapter 1.
Erederic S. Mishkin and Stanle G. Eakins 2012 FinancialMarkets and Institutions, 6th edition, Chapters 2 & 7
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