Topics in Financial Economics
Summary
The course will be summarized per week, in the same way the presentations are also
divided. After the course summary will be a summary of the group presentation and the
papers discussed there. Finally, all the answers to the weekly assignments will be included at
the bottom of this document.
,Week 6 Interest rates
This lecture will cover only information relevant to the exam, not to how the course is
organised.
Markets are the institutions in which economic resources are allocated as a result of private
decision making. Markets are governed by prices, which are a signal that economic
resources are put to their best, most optimal use.
We distinguish between two types of markets
- product market, where manufactured goods and services are traded
- factor market, where production factors like labour and capital are traded.
- the financial market is seen as a part of the factor market.
Some other key definitions before we start:
- an asset is any possession that has value in exchange
- tangible assets are those assets whose value depends on physical properties. You can
touch them, like an apple or a car.
- intangible assets are those assets whose value depends on the legal claim of some future
benefit. The form in which these are presented doesn’t impact the value.
- financial assets are non-tangible assets. The role of financial assets is to transfer funds
from surplus parties to those who need it to invest in tangible assets, all in such a way that it
is redistributing risk.
- issuers of financial assets are entities that agree to make future cash payments
- investors are the owners of financial assets
- debt instruments obligate an issuer to repay a fixed amount of money during a specified
period.
- e.g. bonds
- equity instruments obligate an issuer to repay an amount based on earnings over an
indefinite period after holders of debt instruments have been paid.
- e.g. shares
Sometimes, a security falls under both categories (both debt and equity instruments). Think
about preferred stocks and convertible bonds.
- debt and preferred stock paying fixed amounts are called fixed-income instruments
A basic economic principle that also applies here: the price of a financial asset equals the
present value of its expected cash flows
- this is even the case when cash flows aren’t certain.
Future cash flows always have some sort of risk, which we can classify in three main
categories of risk.
- purchasing power risk, also called inflation risk, which has to do with the fact that your
purchasing power can change in the future due to inflation. You might have an asset that
,costs €100 now and gives you €150 in a year, but if inflation rises harder than 50% in one
year (unlikely but still), you could have better bought goods of that €100 right now.
- credit risk, also called default risk, which has to do with the possibility that the issuer does
not hold his end of the bargain and defaults on repaying you, whether that is because he
can’t (forced default) or won’t (strategic default).
- foreign exchange rate risk, which has to do with the uncertainty of exchange rates in the
future. If you invest in American bonds today and the Dollar depreciates by a large amount,
you would have been better off not buying the bonds.
A financial market is a market where financial assets are exchanged. We also distinguish the
spot market, where financial assets are traded for immediate delivery. It is also referred to
as the cash market.
Financial markets have three main roles:
- price discovery process: because of the interaction between buyers and sellers of financial
assets, the price of the traded asset is determined
- financial markets provide a mechanism for investors to sell financial assets, like the bid-
ask spread.
- financial markets reduce transaction-, search- and information costs.
There are many different ways we can distinguish the financial market:
- by nature of claim
- debt market versus equity market (see lecture 1, bonds vs stocks
- by maturity of claim
- money market (short term, <1 year) versus capital markets (long term, >1 year)
- by seasoning of claim
- primary market (first-time offering) versus secondary market (already traded asset
being traded again)
- by delivery:
- cash or spot market (get goods immediately) versus derivative market (good
deliverance occurs in the future. Think of futures and forwards.
- by organizational structure:
- double auction markets (you can both buy and sell at the same time) versus Over
The Counter or OTC-market (tailor-made trades between two parties directly) versus
intermediated markets (one or more financial institutions stand between
counterparties in a transaction)
Example: where could we classify a new 6-month US treasury bill?
- it belongs in the debt market, as you have a claim to a fixed amount
- it belongs in the money market, as the duration is shorter than a year
- it belongs in the primary market, as it is new and not traded before
- it belongs in the derivative market, as delivery occurs in the future
- it belongs in the auction market, but you could also argue the OTC market depending on
, the size. Smaller orders are generally put up for sale, but if it is a larger order of say 10,000
treasury bills you might arrange something tailor-made.
The globalisation of the financial market was caused by three different factors
- deregulation of markets and the activities of market participants in key financial sectors: in
most countries, funds are easier transferred between countries.
- technological advantages: things like internet speed up transactions online, allow for 24/7
worldwide trading.
- increased institutionalisation of financial markets: retail investors and institutional
investors like pension funds make worldwide diversification a lot more accessible.
We can classify the global market into two groups:
- internal market, which is at the national level
- external market, which is at the foreign level and looks at things like off-shoring
A derivative is a financial instrument whose value depends on other underlying assets. It is
derived from other assets, hence the name. Holders of derivative assets often have the
obligation or the choice to buy or sell at some future time. Types of derivatives we will look
at:
- futures and forward contracts: agreements where you promise to deliver goods (or assets)
at a predetermined price in the future. One party agrees to sell and the other to buy. The
main difference between the two is that forwards are tailor-made while futures are
standardised
- option contracts: the holder of an option has the right/option to exert a buying or selling
order at maturity, but is not obligated to do so unlike a futures or forward contract.
- the price of an option is a fee to exert the option
- e.g. you have the right to buy share X in six months at a predetermined price of €50
for which you pay €1 as a fee. If the market value in six month turns out to be €60,
you exert your option. If the market value turns out to be €40, it is more attractive
to buy from the market directly and you forfeit your right to buy.
The role of derivatives is to adjust the same level of risk exposure, have faster transactions,
be a more liquid market than the cash market and be a vehicle for speculation.
Because financial institutions play such a major role in the general economy, government
regulation is deemed necessary.
- disclosure regulation: preventing issuers of securities from defrauding investors by
concealing relevant information
- financial activity regulation: promoting competitiveness and fairness in the trading of
financial securities
