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Institutions and Markets
Economics 71a
Spring 2005
Gitman/Joehnk Chapter 2
Lecture notes 3
Goals
Financial institutionsFinancial marketsFinancial transactions
Institutions (the players)
1. Commercial banks
2. Mutual funds
3. Pension funds
4. Securities firms
5. Insurance companies
6. Others
1. Commercial Banks
Consumers Deposits/savings Lending/transactions
Consumer loans Home mortgages Checking accounts Credit cards Debit cards Foreign exchange Brokerage (recent)
1. Commercial Banks
Firms Cash management Lines of credit
Loan of varying magnitude Similar to credit card
Bank loans (term loans)
1. Commercial Banks
Intermediary roles Between lenders and borrowers Repackaging financial products
Regulatory environment Key aspect of monetary policy Federal Deposit Insurance Corporation
(FDIC) Federal Reserve System
2. Mutual Funds
Function Consumer investments -> Firms
Types Stock (invest in stock market portfolios) Money market (short term lending to firms) Bond Real Estate
2. Mutual Funds
Allow consumers to better diversifyGather and process investment
informationMajor industry in Boston
3. Pension Funds
Manage/invest employee savings/pension plans
Similar in spirit to mutual fundsHired by employer
4. Securities Firms
Investment banks/brokerage firms Issue stock and bonds
(IPO: Initial public offering)Facilitate trades in securitiesBanks versus Investment Banks
The repeal of Glass-Steagall (1999)
5. Insurance Companies
Insure individual and corporate risksReceive payments (insurance premia)Payout for losses New issues
Trading insurance policies Derivatives High tech risk management
6. Other Institutions
Savings and loans Savings -> home mortgages
Credit unions Information and software services
Bloomberg Quicken Microsoft
Goals
Financial institutionsFinancial marketsFinancial transactions
Markets
Primary markets New issues (IPO’s, corporate and public
debt)Secondary markets
Trading old stuff In many cases most activity in secondary
Money and Capital Markets
Money markets Short term securities (1 year or less)
Capital markets Longer term
Money Market Securities
Treasury bills U.S. government debt Short term (less than 1 year)
Commercial paper Short term corporate borrowing
Discount pricing Buy for $10, get paid $11 in future No interest payments
Capital Market Securities
Bonds (longer term borrowing) U.S. Treasury Municipal (tax free) Corporate More later
Capital Market Securities
Stocks Common stock Preferred stock International More later
Primary Market
Initial public offering (IPO) Initial sale of stock or bondLate 1990’s boom
IPO Timing
Private firm Negotiations between shareholders and other
initial investors (Venture Capital) Find investment bank to handle IPO
Prospectus filed with Securities and Exchange Commission
Red Herring : Version of prospectus for initial investors
Quiet period: filing to 1 month after IPO Restrictions on public information releases
Investment Banks
Originating investment bank Underwriting syndicate
Insures shares will be purchased Selling group How do people get paid?
Underwriters pay IPO firm ($15/share) Sell to selling group ($16/share) Sell to investors ($17/share) Scandals and IPO prices
Trading and Secondary Markets
Stock marketsBond marketsDerivativesForeign Exchange
U.S. Stock Markets
New York Stock Exchange (NYSE)National Association of Securities
Dealers Automated Quotation (Nasdaq) American Stock Exchange (AMEX)
Continuous Trading
Market types Specialist Electronic dealer Open outcry Over the counter
NASDAQ Upstairs (negotiated) ECN (electronic crossing network)
ECN’s: Electronic Crossing Networks
Internet based trade networks Customers can meet directly (no broker) Used mostly by professional money
managers Advantage: fewer intermediaries Disadvantage: less liquidity
(Fewer people to trade with)
Fastest growing markets
Other Markets
Futures/OptionsForeign Exchange
Spot versus forwardBond
International Markets
Many major international stock markets London Tokyo China many more
US accounts for only 36% of the companies listed on stock markets around the world
Why Should U.S Investors Care?
DiversificationPerformance Industries
How Can U.S. Investors Invest Globally?
Multinational firms Microsoft Ford
Mutual funds Direct purchases
US securities/foreign firms (Yankee Bonds) American deposit receipts (ADR’s) WEBS (World Equity Benchmarks)
International Risks
Macroeconomic risksPolitical risksExchange rate risks
Trading Hours
Most U.S. stock markets 9:30-4:00
Extended hours on electronic trading networks
“After hours trading” International markets (local times) Foreign exchange markets (24 hours) Hours increasing : toward a 24 hour market
Market Regulation
Securities laws protect investors Federal and state laws
Securities and exchange commission (SEC): established in 1934
Important laws Securities act of 1933 (IPO rules) Insider trading and fraud act of 1988 Sarbanes-Oxley act of 2002
Tighter controls on accounting information
Goals
Financial institutionsFinancial marketsFinancial transactions
Long Purchase
Straight purchase of a securitySpeculate that price will increase
Buy at 100 Sell at 110 10% return
Margin Purchase
“Buying on margin”Borrow money to buy stockBuy at 75% margin
75% of money in investment is yours 25% is borrowed from broker or bank
Purchase $100 of stock at 75% margin You put in $75, and you borrow $25
Basic Margin Formula
€
Margin =Total value −Borrowed funds
Total value
Margins and Magnification
Example stock: Price = $100 Up: Price = $150 Down: Price = $75
If you purchased with your own money $100 total investment Up: + $50 Down: - $25
Margins and Magnification
Buy on 50% margin (zero interest charges)
$100 own, and $100 borrowed (needs to be paid back)
Purchase $200/$100 shares = 2 shares $100 total investment Up: 2*150 - 100 - 100 = $100 (50) Down: 2*75 - 100 - 100 = $-50 (-25)
Margin Buying
Borrowing money to buy stocks Magnifies gains and losses Can lose more than you put in
Buy $200 of stock $100 your own $100 borrowed
Stock goes to zero Lose $100 of own investment, and Owe $100 of borrowed money too
Maintenance Margins
Margin required for investor to maintain If margin falls below this level investors
must add more of their own money“Margin call”Common margin call
Prices fall Margin rises Investor needs to come up with more funds
Margin Requirements
Common stock: 50%Bonds: 50%Options: 20% stock valueFutures: 2-10% of the contract value
Short Sales
Holding negative stock Sell stock you don’t have (borrow) Buy it back later Pay dividends yourself in between
Key issue Make money on a price fall Lose money on a rise
Betting against a stock
The Mechanics of a Short
Tell broker you want to sell 100 shares of IBM short (price = $50)
Broker “borrows” shares of 100 shares of IBM owned by another client
Sells it to someone for 50*100=5000, and pays this to you
You must keep this amount on account with broker
When dividends are to be paid, you pay broker, and broker pays the other client
The Mechanics of a Short
IBM goes down to $40 per share You “buy” your 100 shares to take you back to zero,
pay broker 40*100=4000. Broker buys at market, and puts the shares back in
the other person’s account You make 5000-4000 = 1000 (less dividends) Make money when price falls Lose money when price rises
The Mechanics of a Short
IBM goes up to $60 per share You “buy” your 100 shares to take you back to zero,
pay broker 60*100=6000. Broker buys at market, and puts the shares back in
the other person’s account You lose 5000-6000 = -1000 (less dividends)
Margins and Shorts
Broker requires additional funds to cover possible losses
Fraction of additional sale amount Example
Sell $5000 worth of stock at 60% margin Need to keep 0.6*5000 = 3000 on account with the
broker Maintain fraction of value of the stock in this account When the price goes up, need to increase this “Margin call”
Oddities About Shorts
Can lose unbounded amounts of money Normally only lose what you put in With short price can go up forever, and your losses keep
increasing
Also, broker can get in trouble if you default Other customer could lose original shares Often insured for this
Short Interest
Fraction of shares sold shortMeasure of market pessimism in a
stockCommon market indicatorMeasures market pessimism
Squeeze Play
Assume Microsoft has a large number of short sellers
Price starts to rise Short sellers losing money Get nervous Buy stock to close out their short positions Prices rise more, more buying .. (etc. etc)
Goals
Financial institutionsFinancial marketsFinancial transactions