CHAPTER 1: INTRODUCTION

Foundation of Financial Markets and Institutions

Frank J. Fabozzi

Franco Modigliani

Frank J. Jones

Micheal G. Ferri

CHAPTER 1

INTRODUCTION

FINANCIAL ASSETS

An asset is any possession that has value in an exchange.  It can be tangible or intangible, the latter being a financial asset.  Specifically, a financial asset is a claim to a future benefit.  For example, in the case of an automobile loan the borrower issues a note to the lender, who now holds a claim to future cash flows. 

Debt versus Equity Instruments

A debt instrument is a contractual claim, paying fixed dollar amounts. An equity instrument (or residual claim) obligates the issuer to pay the holder an amount based on earnings after holders of debt instruments are paid. Some securities combine both debt and equity features, such as preferred stock or convertible debt.

Price of a Financial Asset and Risk

The price (or value) of any financial asset is equal to the present value of expected cash flows.  The return on an asset is the amount paid to the investor relative to the price paid by him.  Related to return is the degree of risk, namely the certainty of expected cash flows.  The degree of risk ranges from very low -- as in the case of payments on U.S. Treasury securities -- to very high in the cases of some equities and low-rated bonds.  Uncertainty or risk takes several forms: (1) purchasing power risk (or inflation risk); (2) credit or default risk; (3) foreign exchange risk.

Financial Assets versus Tangible Assets

Both types of assets are expected to generate cash flows to their owners.  They are also linked in the sense that tangible assets are financed by the issuance of some type of financial claim, e.g. mortgages finance commercial buildings.  The use of the offices generates income that helps pay off the loan.

Role of Financial Assets

The principal economic functions of financial assets are: (1) to transfer funds from persons who have surplus funds to those who need funds to invest in tangible assets (e.g. mortgage funds lending to homebuyers); (2) transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds (seekers of funds ask others to share the risks in their undertakings).

FINANCIAL MARKETS

Financial markets where financial assets are exchanged.  Delivery of the actual asset may occur immediately (spot or cash market) or in the future (future or forward market).

Role of Financial Markets

Financial markets provide the following functions.

1.  Price discovery process.  Price is determined by supply and demand, the interaction of buyers and sellers.  The returns provide signals for funds allocations among investments;

2.  Liquidity.  Well-developed markets provide an opportunity to convert a financial asset into cash at close to real value of the asset;

3.  Reduced transactions costs. In the price discovery process, searching for counter parties and information costs (assessing merits of an investment or the likelihood of expected cash flows) are costly. An informationally efficient market exists when prices reflect all information known by market participants.

Classification of Financial Markets

There are various ways to classify financial markets.

Maturity of claim. Money market for financial instruments a year or less to maturity.  Capital market for securities longer than a year.

Seasoning of claim. Primary market is for new or first issue market.  Secondary market involves sales of previously marketed claims.

Time of delivery. While prices are set immediately, the actual delivery of the financial asset may be now (spot or cash market) or later (futures or forward market).

Organizational structure. Auction market involving brokers acting for clients in organized exchanges, over-the-counter markets (OTC) wherein trades are made through dealers who buy for and sell from their own inventory.  In intermediated markets, financial institutions sell their own securities issues to customers and invest the proceeds.

Market Participants

Participants run the full range, from households, non-financial business firms, financial institutions, and public regulators.

GLOBALIZATION OF FINANCIAL MARKETS

The existence of foreign financial markets permits raising and investing funds outside of the domestic market.  There is a trend toward integration of financial markets throughout much of the world.  The factors that have led to integration are:

1.  Deregulation or liberalization of markets to encourage competition;

2.  Technological advances permit more information flows and rapid execution of orders;

3.  Increased participation of financial institutions in global markets relative to individuals.  Such firms are more willing and able to transfer funds to diversify their portfolios and to take advantage of possible mis-pricing in markets.

Classification of Global Financial Markets

Financial markets can be classified as either internal or external.

Internal:  securities issued in the domestic or foreign markets.  Foreigners can issue securities in other country markets, subject to national regulations, e.g., Japanese firms can issue dollar-denominated securities in the United States, but they must follow U.S. regulations, which apply to nationals and foreigners alike.

External:  securities issued outside jurisdiction of any country, e.g., offshore or Eurodollar offerings can be dollar-denominated.  They thereby fall outside of foreign rules, which are designed to deal with domestic financial concerns. The external market is sometimes called the offshore market or Euromarket.

Motivation for Foreign and Eurodollar Markets

Some funds needs cannot be met in small country markets, e.g. giant firm Philips cannot raise all the funds it needs if it is restricted to the Dutch capital market.  Also, many underdeveloped nations simply do not have a sizeable capital market to meet their funds needs.

Lower funding costs when imperfections exist among capital markets, e.g. Eurodollar loans are often less expensive since institutions holding such funds are not hampered by regulations as would be the case in the U.S. market.

DERIVATIVE MARKETS

A derivative instrument is a financial asset whose value derives from the value of some other asset, index, or interest rate. A futures transaction is a contract that exchanges an asset or commodity at a fixed price in the future. In an option, owner has right but not the obligation to buy (call option) or sell (put option) an asset at a specified price. In a swap, parties exchange one form of cashflow for another, typically a fixed cashflow for a variable one.

Role of Derivative Instruments

Derivatives have several uses: (1) hedging interest rate risk and foreign exchange risk; (2)  lower transactions costs than on cash market; (3) faster transactions than on the cash market; (4) greater liquidity than on the cash market.

ROLE OF THE GOVERNMENT IN FINANCIAL MARKETS

Justification for Regulation

The government plays a significant role in the financial markets. It regulates the financial markets. One justification for regulation is market failure, when the market’s pricing mechanism is incapable of maintaining all the requirements of a competitive, efficient market. Regulation has several purposes: (1) to prevent issuers of securities from defrauding investors; (2) to promote competition and fairness in trading; (3) to promote the stability of financial institutions; (4) to restrict the activities of foreign concerns in domestic markets and institutions; (5) to control the level of economic activity.

Disclosure regulation is the form of regulation that requires issuers of securities to make public a large amount of financial information to investors. This addresses the problem of asymmetric information and the problem of agency.

Financial activity regulation consists of rules on trading financial assets.

Regulation of financial institutions is that form of governmental monitoring that restricts these institutions’ activities in the vital areas of lending, borrowing and funding.

Regulation of foreign participants is that form of governmental activity that limits the roles foreign forms can have in domestic markets and their ownership or control of financial institutions. Authorities use banking and monetary regulation to try to control changes in a country’s money supply.

Regulation in the United States

Regulation in the United States is largely due to the stock market crash of 1929 and the Great Depression of the 1930s.

ANSWERS TO QUESTIONS FOR CHAPTER 1

(Questions are in bold print followed by answers.)

1. What is the difference between a financial asset and a tangible asset?

A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital equipment and machines.  A financial asset, which is an intangible asset, represents a legal claim to some future benefits or cash flows.  The value of a financial asset is not related to the physical form in which the claim is recorded.

2. What is the difference between the claim of a debtholder of General Motors and an equityholder of General Motors?

The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal.  The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder.

The equity holder has a residual claim to assets and income.  He can receive funds only after other claimants are satisfied.  Income is in terms of dividends, the amount and timing of which are not certain.

3. What is the basic principle in determining the price of a financial asset?

The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows.

4. Why is it difficult to determine the cash flow of a financial asset?

The estimation and determination of cash flows is difficult because of several reasons.  These include accounting measures, possibility of default of the issuer, and embedded options in the security.  Interest payments can also change over time.  There is uncertainty as to the amount and the timing of these payments.

5. Why are the characteristics of an issuer important in determining the price of a financial asset?

The characteristics of the issuer are important because these determine the riskiness or uncertainty of the expected cash flows.  These characteristics, which determine the issuer’s creditworthiness or default risk, have an impact on the required rate of return for that particular financial asset.

6. What are the two principal roles of financial assets?

The first role of financial assets is to transfer funds from surplus spending units (i.e. persons or institutions with funds to invest) to deficit spending units (i.e. persons or firms needing funds to invest in tangible assets).

The second role is to redistribute risk among persons or institutions seeking and providing funds.  Funds providers share the risks of expected cash flows generated by tangible assets.

7.  In September 1990, a study by the U.S. Congress, Office of Technology Assessment, entitled “Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,” included this statement:

Securities markets have five basic functions in a capitalistic economy:

a.      They make it possible for corporations and governmental units to raise capital.

b.      They help to allocate capital toward productive uses.

c.       They provide an opportunity for people to increase their savings by investing in them.

d.      They reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers.

e.       They generate employment and income.

For each of the functions cited above, explain how financial markets (or securities markets, in the parlance of this Congressional study) perform each function.

The five economic functions of a financial market are: (1) transferring funds from those who have surplus funds to invest to those who need funds to invest in tangible assets, (2) transferring funds in such a way that redistributes the unavoidable risk associated with the cash flow generated by tangible assets, (3) determining the price of financial assets (price discovery), (4) providing a mechanism for an investor to sell a financial asset (to provide liquidity), and (5) reducing the cost of transactions.

The five economic functions stated in the Congressional Study can be classified according to the above five functions:

1.      “they make it possible for corporations and governmental units to raise capital” --functions 1 and 2;

2.      “they help to allocate capital toward productive uses” -- function 3;

3.      “they provide an opportunity for people to increase their savings by investing in them” -- functions 1 and 5;

4.      “they reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers” --function 3;

5.      “they generate employment and income” -- follows from functions 1 and 2 allowing those who need funds to use these funds to create employment and income opportunities.

8. Explain the difference between each of the following:

a.      money market and capital market

b.      primary market and secondary market

c.       domestic market and foreign market

d.      national market and Euromarket

a.       The money market is a financial market of short-term instruments having a maturity of one year or less.  The capital markets contain debt and equity instruments with more than one year to maturity;

b.      The primary market deals with newly issued financial claims, whereas the secondary market deals with the trading of season issues (ones previously issued in the primary market);

c.       The domestic market is the national market wherein domestic firms issue securities and where such issued securities are traded.  Foreign markets are where securities of firms not domiciled in the country are issued and traded;

d.      In a national market securities are traded in only one country and are subject to the rules of that country.  In the Euromarket, securities are issued outside of the jurisdiction of any single country.  For example, Eurodollars are dollar-denominated financial instruments issued outside the United States.

9. Indicate whether each of the following instruments trades in the money market or the capital market:

a.      General Motors Acceptance Corporation issues a financial instrument with four months to maturity.

b.      The U.S. Treasury issues a security with 10 years to maturity.

c.       Microsoft Corporation issues common stock.

d.      The State of Alaska issues a financial instrument with eight months to maturity.

a.       GMAC issue trades in the money market.

b.      U.S. security trades in the capital market.

c.       Microsoft stock trades in the capital market.

d.      State of Alaska security trades in the money market.

10. A U.S. investor who purchases the bonds issued by the government of France made the following comment: “Assuming that the French government does not default, I know what the cash flow of the bond will be.” Explain why you agree or disagree with this statement.

One would tend to disagree with this statement.  Even though there is no default risk with French bonds issued by the government, some other risks include price risk and foreign exchange risk.

11. A U.S. investor who purchases the bonds issued by the U.S. government made the following statement: “By buying this debt instrument I am not exposed to default risk or purchasing power risk.” Explain why you agree or disagree with this statement.

This is not true.  There is no default (credit) risk of U.S. government securities.  However, it is not free of purchasing power or inflation risk.  There is also price risk, which is related to maturity of any bond.

12. In January 1992, Atlantic Richfield Corporation, a U.S.-based corporation, issued $250 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

The corporate bonds issued by Atlantic Corporation are in the domestic market, but the investors can also be from foreign markets.

13. In January 1992, the Korea Development Bank issued $500 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

This issue can be classified as a domestic issue.

14.       14. Give three reasons for the trend toward greater integration of financial markets throughout the world.

There are several reasons.  These include:

a.       Deregulation and/or liberalization of financial markets to permit greater participants from other countries;

b.      Technological innovations to provide globally-available information and to speed transactions;

c.       Institutionalization -- financial institutions are better able to diversify portfolio and exploit mis-pricings than are individuals.

15. What is meant by the “institutionalization” of capital markets?

The term “institutionalization” refers to the dominance of large institutional investors such as pension funds, investment companies, banks, insurance companies, etc. in the money and capital markets.

16.a. What are the two basic types of derivative instruments?

b. “Derivative markets are nothing more than legalized gambling casinos and serve no economic function.” Comment on this statement.

a.       The two basic types of derivative instruments are futures and options contracts.  They are called derivatives because their values are derived from the values of their underlying stocks or bonds.

b.      The statement implies that derivative instruments can be used only for speculative purposes.  Actually, derivatives serve an important economic function by permitting hedging, which involves shifting risks on those individuals and institutions (speculators) that are willing to bear them.

17. What is the economic rationale for the widespread use of disclosure regulation?

The economic rationale is that disclosure mitigates the potential for fraud by the issuer. Typically, there information asymmetry between the issuer (management) and the investors, and disclosure regulation mitigates the harm to investors that could result from this informational disadvantage. As a result, there is confidence in the market and the pricing mechanism of the market.

18. What is meant by market failure?

Market failure occurs when the market cannot produce its goods or services efficiently. In the context of financial market failure, it occurs when the pricing mechanism fails and thus the supply and demand equilibrium is disrupted. This results in failure to price securities efficiently and reduced liquidity.

19. What is the major long-term regulatory reform that the U.S. Department of the Treasury has proposed?

The long-term proposal is to replace the prevailing complex array of regulators with a regulatory system based on functions. Specifically, there would be three regulators: (1) market stability regulator, (2) prudential regulator, (3) business conduct regulator.

20. Why does increased volatility in financial markets with respect to the price of financial assets, interest rates, and exchange rates foster financial innovation?

Increased volatility of the prices of financial assets has fostered innovation as investors and institutions seek ways to mitigate financial risk. Among other things, these innovations include the advancement of the modern derivatives markets.