Version 1.0 Outline Page 1 - Rutgers Universityeconweb.rutgers.edu/paczkows/market/structureandfunction.pdf · Capital Market Credit Market Money Market Only market in which long-term,

Notes

Page 1

Economics of Capital Markets

Page 1Version 1.0 Outline

Structure and Function of Capital MarketsStructure and Function of Capital MarketsMajor Topics

– Financial Markets Structure– Financial Economics– Capital Markets– Basic Securities– Introduction to Pricing– Sizing the Capital Markets– Studying Capital Markets– Function of Capital Markets



Structure and Function of Capital MarketsFinancial Markets StructureStructure and Function of Capital MarketsFinancial Markets Structure

Recall that physical capital is traded in the funds, or financial, markets and consumption is smoothed through the use of the financial markets

Notes

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Structure and Function of Capital MarketsFinancial Markets Structure (Continued)


Financial markets are the focal point for much of our economic operationsFrom an economic growth perspective, they are viewed as the main driver allowing growth





From an economic growth perspective (Continued)

– Sir J.R. Hicks

– J. Schumpeter

Notes

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From an economic growth perspective (Continued)

– There is a preponderance of empirical evidence that there is a positive first-order relationship between financial development and economic growth





Financial Markets

Capital Market Credit Market Money Market

- Claims or OwnershipTraded

- More Than One YearMaturity

- Stocks, Bonds, Futures,Options

- Standardized- Organized Exchanges

- Facilitates Borrowingand Lending

- Combination Of Short-And Long-term

- Nonstandardized- Usually Not Tradable- Financial Intermediaries

- Money and Short-termNear Monies

- Less Than One Year Maturity- Money, Fed Funds, T-Bills- Financial Intermediaries AndFED

- Allocates Funds- Sets Prices

Notes

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Financial Markets


Only market in whichlong-term, impersonalinvestments and borrowings can occur

Long-term and short-term personal investments and borrowings

Strictly short-term findstransfers



Structure and Function of Capital MarketsFinancial EconomicsStructure and Function of Capital MarketsFinancial Economics

Financial Economics studies how financial markets impact allocations via pricing of financial assets or securities– Methodology: micro-based via close substitutes– Capital markets one component: long-term

Notes

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Structure and Function of Capital MarketsCapital MarketsStructure and Function of Capital MarketsCapital Markets

Terms for holding claims set in capital markets



Structure and Function of Capital MarketsCapital Markets (Continued)


A function of capital markets and contracts is to establish and provide for the exchange of claims to assets, the income they generate and the value or price of those claims

Notes

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CapitalMarkets

Set Value DetermineTitle

- At a Point in Time- Capitalized Income Stream

- Assets- Income

Only market in whichlong-term, impersonalinvestments and borrowings can occur





Financial Markets


- Long-term- Standardized- Organized Exchanges

- Nonstandardized- Financial Intermediaries

- Short-term Monies-Financial Intermediaries andFED

Bring Borrowers and Lenders TogetherBring Borrowers and Lenders Together

Sets Value, DeterminesSets Value, DeterminesTitleTitle

No Ownership Claims to Assets No Ownership Claims to Assets DeterminedDetermined

Jump to slide 20

Notes

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Trading in terms of new issues and outstanding issues of claims– Exchange of outstanding issues represents

transfer of property rights– Exchange of new issues represents transfer of

funds from savers to borrowers



Structure and Function of Capital MarketsBasic SecuritiesStructure and Function of Capital MarketsBasic Securities

Equities or stock– Equities residual claims on “risky” and

uncertain future income stream of assets– Holders have incentive to promote - or push

company to promote - efficient use of assets to minimize costs

– Example: common stock

Notes

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Structure and Function of Capital MarketsBasic Securities (Continued)


Types of equities– Common stock

» Last to be paid on dissolution of firm

– Preferred stock» Reduces “risks” to investor compared to common

stock holder, but...– Preferred stock adds constraints on the firm

– Would expect fewer issues of preferred stock than common stock





Common stock income components– Dividend payments

» Dividends are profits distributed to owners; i.e., holders of stock

– Capital gains and losses» Stock price changes

Notes

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Debt– Claim to a prespecified portion of future

income stream of an asset» Portion: not whole income stream of asset» Prespecified: know portion before time

– Example: bonds» Value depends on value of underlying asset; i.e., its

income stream– If income stream is “risky”, bond is “risky”





Bond income components– Coupon payments:

» Fixed income stream» Based on

– Coupon rate – Fixed at time of issue

– Face value of bond (F)– What it is worth– Usually $1000 face value

– Repayment of loan: F

) (λ

F C λ=

Notes

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Structure and Function of Capital Markets Basic Securities (Continued)

Structure and Function of Capital Markets Basic Securities (Continued)

Example coupon bond– Face value: amount of bond

» Example: $1000

– Coupon rate: rate attached to bond at issuance and is amount issuer promises to pay each period

» Example: 6%

– Coupon amount: $1000*0.06 = $60





Simple equationsIncome from stocks:

Income = Dividend Stream + Gains/Losses

Income from bonds:

Income = Coupon Payments + Repayment

Notes

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The dollar income from any security is the dollar return from that security– Denote the dollar return in period t by Rt



Structure and Function of Capital Markets Introduction to PricingStructure and Function of Capital Markets Introduction to Pricing

Introduce simple pricing concepts– Begin with bonds and then do stocks– Assumptions

» No risk– Adjust for risk later

» No inflation– Adjust for inflation later– All dollar amounts are in real terms

Notes

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Structure and Function of Capital Markets Introduction to Pricing (Continued)


Bond prices set where suppliers and demanders agree– Can prove that bond price is present value of

future expected coupon amounts– Use infinite-lived bond called a perpetuity or

consol





Bond price is

where C is the constant real coupon amountand rf

B is the bond real discount factor devoid of risk– Follows from simple supply and demand

framework: agreement at the margin

P Cr

BfB=

Notes

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Key observation– Price of bond and real interest rate vary

inversely» Know one, then other is known automatically» Only need to know one of these

– Bond real discount factor is called the yield or rate of return - it is an interest rate

– Clearly

B

Bf P

Cr =





Stock price is similar– Present value of dividends plus value of stock

tomorrow if sold– Assume just one holding period so that

where D1 is the real dividend tomorrow, PS1 Is

price tomorrow and rfS is the stock real discount

factor devoid of risk

P D1 r

P1 rS

0 1

fS

S1

fS=

++

+

Notes

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Simple algebra shows that stock discount factor is

– Stock real discount factor is called the rate of return - it is an interest rate

r DP

P PPf

S 1

S0

S1

S0

S0= +−

Dividend %AppreciationYield In Value





Notice that the rates of return for stocks and bonds were presented as different amounts

– What is their relationship?» The two rates of return must be equal

– If not, then rational investor can earn a profit by buying the higher yielding security driving its price up and the rate of return down; conversely for the lower yielding security

– Process is called arbitrage

r and rfS

fB

Notes

Page 15





Law of One Rate of Return– Must have just one rate of return in the market– Therefore,

– Actual rates of return will differ at times because there are different “drivers” for each market (e.g., economy, policy, psychology)

fBf

Sf r r r ==





For stocks and bonds, basically have

r turnPf

Today=

$ Re

Notes

Page 16



Structure and Function of Capital MarketsSizing the Capital MarketsStructure and Function of Capital MarketsSizing the Capital Markets

1994

Straight Corp$367.4B

Conv$4.7B

Asset Backed$253.4B

Debt$625.5B

Preferred$15.5B

Common$51.6B

Equity$77.1B

Underwritten$702.5B

Debt$117.1B

Equity$23.9B

Private Placement$141.0B

Capital Market(Debt + Equity)

$843.5B



Structure and Function of Capital MarketsSizing the Capital Markets (Continued)


$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$ B

illion

s

1980 1982 1984 1986 1988 1990 1992 1994

Total Underwritten Private

Value of US Corp. Underwritingsand Private Placements

1994($ Billions)

Total Under-written

PrivatePlacements

$843.5 $702.5 $141.0

Notes

Page 17





$0

$50

$100

$150

$200

$ Bi

llions

1980 1982 1984 1986 1988 1990 1992 1994

Total Debt Equity

Value of US Private Placements

1994($ Billions)

Total Debt Equity$141.0 $117.1 $23.9





$0

$200

$400

$600

$800

$1,000

$1,200

$ B

illion

s

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Total Total Debt Total Equity

Total Value of US Corp. Underwritings

1994($ Billions)

Total Debt Equity$702.5 $625.5 $77.1

Notes

Page 18





$0

$200

$400

$600

$800

$1,000

$ B

illio

ns

1980 1982 1984 1986 1988 1990 1992 1994

Straight Corp. Debt Conv. Debt Asset Backed Debt Total Debt

Total Debt Underwritten

1994($ Billions)

Total St. Corp. Conv.Corp.

AssetBacked

$702.5 $367.4 $4.7 $253.4





$0

$20

$40

$60

$80

$100

$120

$140

$ B

illio

ns

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Pref. Stock Common Stock Total Equity

Total Equity Underwritten1994

($ Billions)

Total Preferred Common$77.1 $15.5 $61.6

Notes

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$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$ B

illio

ns

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Corp. Equities Corp. Bonds US Gov't Sec. Mun. Bonds

Equity and Debt Outstanding





Corp. Equities (39.51%)

Mun. Bonds (7.86%)

Corp. Bonds (15.79%)

US Gov't Sec. (36.85%)

1994 Equity and DebtOutstanding

Notes

Page 20





Households$2913B

Private Pension Funds$1047B

Public Pension Funds$520B

Mutual Funds$738B

Closed End Funds$33B

Foreign$341B

Life Ins. Cos.$159B

Other Ins. Cos.$105B

Bank Personal Trusts$156B

Brokers/Dealers$20B

Savings Inst.$10B

Commercial Banks$7B

Institutions$3136B

Holders of USEquities Outstanding

$6049B





40.0%

45.0%

50.0%

55.0%

60.0%

Per

cent

1980 1982 1984 1986 1988 1990 1992 1994

Households Institutions

Holdings of US Equities Outstanding(% of Market Value)

Households Institutions48.2% 51.8%

Notes

Page 21





0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Per

ecnt

1980 1982 1984 1986 1988 1990 1992 1994

Equities Bk. Dep/CDs Mut. Funds US Gov't Secs.

Muni. Bonds Money Mkt. Funds Corp. Bonds

Share of HouseholdLiquid Financial Assets





Equities (33.57%)US Gov't Secs. (12.49%)

Muni. Bonds (4.70%)Money Mkt. Funds (4.10%)

Corp. Bonds (2.30%)

Bk. Dep/CDs (31.67%)

Mut. Funds (11.19%)

1994 Share of HouseholdFinancial Assets

Notes

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Household ownership characteristics - 1990– Number of individual shareholders: 51,440K

» Female: 17,750K» Male: 30,220K

– Adult shareholder incidence: 1 in 4– Median household income: $43,800– Median age: 43– Median portfolio: $11,400



Structure and Function of Capital MarketsStudying Capital Markets Structure and Function of Capital MarketsStudying Capital Markets

Studying and understanding capital markets goes beyond just understanding how terms for holding capital are set– Major issue is resource allocation, but there are

other issues

Notes

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Structure and Function of Capital MarketsStudying Capital Markets (Continued)


The capital markets, especially Wall Street, exert large influence on investment decisions of firms– Firms have been accused of favoring short-term

investments just to meet investor demands– Implication: innovation and R&D stifled

negatively impacting long-term economic growth and competitiveness





Understanding capital markets, especially global capital markets, important for understanding international developments and U.S. competitiveness– Capital markets not restricted to national

borders– Investments can take place electronically– One implication: trying to regulate or control

capital markets next to impossible

Notes

Page 24





Understanding capital markets (Continued)

– Example» Japanese government tried to prevent trading of

some “modern complex financial derivatives” tied to the Nikkei in Tokyo

» Trading simply moved to Singapore» A trader for Barings Securities (Nick Leeson)

Placed A $29B bet in Singapore on the Nikkei (and lost!)

– Barings, one of the world’s oldest banks, collapsed






– Everyone effectively borrows capital on an “equal-access basis” on the world capital markets in New York, London, Tokyo

» For investing, “there are no rich or poor countries.”

Notes

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– Global capital markets and electronic trading systems enable huge sums of money to move around the world quickly

» On a normal day, world capital markets move $1.3Tbut world’s exports are only $3T in a year

» In 2 days, the world’s capital markets can move as much money as all economies can move in a year






– Problem this creates» Linkages make potential crashes potentially larger

and more far reaching than previous crashes

Notes

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Capital markets and crashes– Dramatic movements in the capital markets, in

particular, the stock market, can have big impact on the business cycle and growth

» We are all aware of the 1929 Stock Market Crash» In 1987, the stock market fell but was so short-lived

that it had minimal impact– We will discuss both briefly later in course





Capital markets and crashes (Continued)

– From 12/89 To 8/92, at least, the Nikkei fell from 38916 to 14309

» Bigger decline than American stock market decline in 1929 and 1932

» Led to recession in Japan that seems to still be continuing

Notes

Page 27



Structure and Function of Capital MarketsFunction of Capital MarketsStructure and Function of Capital MarketsFunction of Capital Markets

Previously viewed the capital markets as a way to bring borrowers and lenders of loanable funds together– Naive view of this market since all markets

bring two parties together– Capital markets do more...

Capital Markets manage riskCapital Markets manage risk



Structure and Function of Capital MarketsFunction of Capital Markets (Continued)

Structure and Function of Capital MarketsFunction of Capital Markets (Continued)

To understand the management function, we must understand…– The operations of capital markets– The concepts of risk and uncertainty

Notes

Page 28



Structure and Function of Capital MarketsReview QuestionsStructure and Function of Capital MarketsReview Questions

Describe the structure of Financial Markets and the individual submarkets.How does the capital market differ from the credit and money markets?Discuss the international linkages in the capital markets. What is the function of the financial markets?Describe some common income streams.



Structure and Function of Capital MarketsReview Questions (Continued)

Structure and Function of Capital MarketsReview Questions (Continued)

Describe the basic structure of the capital markets.Distinguish between common and preferred stock.What is debt?

Notes

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Structure and Function of Capital MarketsKey Concepts and TermsStructure and Function of Capital MarketsKey Concepts and Terms

Capital MarketsDebtFinancial EconomicsFinancial MarketsMoney MarketsNew issuesOutstanding issuesPreferred and common stock



Structure and Function of Capital MarketsSuggested ReadingsStructure and Function of Capital MarketsSuggested Readings

Friedman, B. M. 1987. “Capital, Credit and Money Markets” in The New Palgrave.Hakansson, N.H. 1987. “Financial Markets” in The NewPalgraveHicks, J.R. 1946. Value and Capital. 2nd. ed. London: Oxford Un. Press.Hirshleifer, J. 1970. Investment, Interest and Capital. Englewood Cliffs, NJ: Prentice-Hall.Ross, S.A. 1987. “Finance” in The New PalgraveTobin, J. 1987. “Financial Intermediaries” in The NewPalgrave

Notes

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Structure and Function of Capital MarketsSuggested Readings (Continued)

Structure and Function of Capital MarketsSuggested Readings (Continued)

Campbell, T.S. 1982. Financial Institutions, Markets, and Economic Activity. NY: McGraw-Hill.

Documents

Version 1.0 Outline Page 1 - Rutgers Universityeconweb.rutgers.edu/paczkows/market/structureandfunction.pdf · Capital Market Credit Market Money Market Only market in which long-term,