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Key Questions ASB4403 2013-14

Topic 1 International Financial Markets: An Overview
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Why do we need financial markets? What instruments are traded? Who are the participants? What are hedging, speculation and arbitrage transactions? The origins of the current financial crisis?

The role of financial markets

Efficient mechanisms for raising finance

Why do we need financial markets?

Managing and sharing risks Efficient allocation of resources. Channelling surplus funds to productive uses. Separate company ownership and management (equity) Market function: Liquidity, Price discovery, Network, Regulation / Surveillance
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Terminology
- Capital market: - long-term instruments (equities/bonds) - whereby companies/governments raise funds. - Money market: - short-term debt (maturity of less than one year). - Mainly wholesale (i.e. large scale transactions) where firms and financial institutions manage their short-term liquidity needs.

What instruments are traded?

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Terminology
Primary market: - the new issues of a security (either debt or equity) are sold to initial buyers. Secondary market: - where the securities that have previously been issued are traded. - Exchange trading versus Over-the-counter - Electronic trading, telephone, face-to-face
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Instruments / Securities
Equity stocks Money markets bills, commercial paper Fixed Income bonds Foreign exchange Derivatives forwards, futures, options, swaps Risk transfer instruments: Asset backed securities Credit derivatives
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Participants

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Who are the participants?

Depositary institutions Investment banks Mutual funds (unit trusts) Pension funds Hedge funds Insurance companies Individual investors Governments, Regulators, Rating Agencies
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Hedging Types of transactions

Hedging, speculation and arbitrage
Purchase of a financial instrument in order to insure against possible reduction in wealth caused by adverse price fluctuations. Price certainty not profit is achieved.
Use of forward contracts. Use of other derivatives. 1,2 = -1 e.g. a position in futures (see later Topics). Insure the portfolio e.g. with options (later Topics).

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Speculation
Purchase (sale) of an asset for later resale (purchase) in expectation that price change will yield profit. Speculators take risky open positions to exploit profit opportunities. May be based on fundamentals equivalent to risky arbitrage. Examples? Speculators and risky arbitrage keep prices at efficient levels i.e. reflecting information
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Arbitrage
An arbitrage opportunity takes advantage of price differentials in different markets. Can be spatial (i.e. between different markets at the same time) or temporal (i.e. over time). With spatial arbitrage, a profit is guaranteed if price differentials occur. It is an investment strategy that guarantees a positive pay-off (no risk of negative pay-off).

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Arbitrage
Its importance lies in:
Ensuring rational pricing (risky arbitrage) Equalising prices of identical assets (risk-free arbitrage)

Reading List
Cuthbertson and Nitzsche (2008) chapters 1-5 Bodie et al (2008) chapters 1-4 Elton et al (2007) chapters 1-3
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Arbitrage opportunities will normally be shortlived because the actions of arbitrage demand will cause prices to move to appropriate levels.
Important in many of our later topics

Reading List
In order to perform well on the module assessment, you need to read from the textbooks and other sources on a regular basis. You should consult the reading list both prior to, and after, each lecture topic.

Homework
On Blackboard, you should access Worksheet 1
See Lectures tab on the left hand side, then Worksheets folder

Based on your reading for Topic 1, you should be able to answer Questions 1-7 on Worksheet 1 The answers will be provided on Blackboard next week
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Sources of the crisis What are the origins of the current financial crisis?
The next 5 slides give you some background information to help you start on the assessed essay
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Prior to 2007, the low interest rate environment led to a search for high yield Integration of housing finance into capital markets Increasingly irresponsible lending sub-prime mortgages Inappropriate incentive structures e.g. in investment funds and rating agencies Inadequate regulation? Or regulation failing to keep up with innovation?
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Things start to go wrong

In late 2006, the default rate on sub-prime mortgages started to increase (falling US house prices) Substantial losses by Bear Stearns hedge funds which had invested in structured securities based on sub-prime mortgages Increased interbank interest rates (LIBOR) Lack of liquidity
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What is a credit crunch?

It occurs when lending institutions try to reduce their exposure to risk. Hoarding of liquidity. Tighter lending criteria are applied; consumers and firms face difficulties in obtaining credit Higher interest rates when lending does occur Financial markets are affected by the implications of this scenario Negative impact on consumption, investment and economic growth
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Events of September 2008

US Investment banking in crisis. Lehman Brothers bankruptcy protection; Merrill Lynch taken over by Bank of America; Bear Stearns taken over by JPMorgan in March 2008 US government injects $85bn into AIG In the UK, LloydsTSB buys HBOS; short selling ban US Treasury $700 bn plan
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A sovereign debt crisis evolves

UK and US public debt is enormous public spending will be constrained for many years Partly a result of bailing out the banking sector Irelands problems are more directly related to bank bailouts In 2009, true situation of Greece indebtedness became known. Since then, various actions to avoid a disorderly default and spillover effects Worries about Italy, Spain, and Portugal for different reasons
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