Ch 8 Money Markets Finance Monday March 24 2014 6 17 PM 1 Trends for the World a Sources of funds for nonfinancial business Bank loans small in US compared to other contries b US relies more heavily on bond markets Financial markets more developed in the US i i 1 Firms can easily issue stocks bonds and people will buy them Only large well established corps have easy access to securities market Stocks bonds etc 2 Direct Finance 3 Indirect Finance a b a b c Banks Indirect much more important Financial intermediaries reduce transaction costs i ii Economies of scale Expertise Asymmetric Information Problems 4 a Adverse selection i ii Occurs before transaction Problem of distinguishing good risk from bad risk b Moral Hazard After transaction Problem of verifying borrowers are using funds as intended Example 1 If people get insurance are less careful 5 Adverse Selection a Characteristics If quality cannot be assessed buyer WTP reflects average quality Sellers of good quality leave market since they want higher price Buyers end up not buying at all if they realize only bad sellers left i ii iii i ii iii i ii iii i ii iii b Example Bond Issue Firms sell bond to finance project with cost 100 Savers will buy if expected payment is 110 Two types of firms 1 Safe firms a 125 for sure 2 Risky Firms a b 2 3 chance for 150 return 1 3 chance for 0 return c Symmetric Information Bond issuers and bond buyers all know risks They know which firms are risky or not 1 All risky firms are driven out Example Bond Issue Safe firms 1 a b c Earn 125 Pay 110 Safe firms earn profit of 15 2 Risky firm a Expected payment must be 2 3 x 110 for savers to buy bond M B lecture notes Page 1 a Expected payment must be 2 3 x 110 for savers to buy bond i Must be 165 b Firm cannot issue bond as no buyers d Asymmetric Information i ii iii Assume buyers do not know if firm is risky or not Safe firms will leave Example Bond Issue Assume 50 50 firm is risky or safe Probability of payment averaging both a 5 6 1 2 3 4 a b a b c d Savers require expected payment of 110 earnings must be 132 for firms Safe firms 132 earnings of 125 Firms will not issue bond 5 Risky firms Since 2 3 chance of earning 150 expected profit 150 132 18 If project fails firm defaults and lose nothing Savers realize only risky firms are issuing bonds Probability of repayment is now 2 3 Require 165 in payment i 6 Moral Hazard a Principal agent problem Stockholder Less info Principal 1 2 Agent 1 2 3 Manager More infor Pursue own benefits vs value to shareholders b Symmetrical information Saver knows exactly what project firm will take on Expected payment promised payment c Asymmetrical information After bond is issued firm can pursue risky or safe projects In the end savers will demand different return 7 Tools to solve Asymmetric Information Problems Private production and sale of information a b Government regulation to increase information i ii i ii i ii i i i ii Research institutes Credit rating agency Financial statement c Financial institutions Banks due diligence Expertise Econs of scale 1 2 d Collateral and net worth Default payment i e Monitoring M B lecture notes Page 2 Ch 3 Money Wednesday March 26 2014 11 38 AM Anything accepted in payment for goods or services or in the repayment of debts Used for transactions Commodity Money Something that has intrinsic value in itself d Fiat Money i i Object used as money has no intrinsic value 1 Money a b c 2 3 Wealth a b Income a Net worth at a point in time stock Flow of earnings per unit of time 4 Functions of Money a Medium of exchange i ii iii Eliminates trouble of finding double coincidence of wants Promotes specialization To be useful 1 2 3 Standardized units Widely accepted Available in small denominations b Unit of account i Unit in which prices get expressed c Store of value i ii Measuring Money 5 Allows to save purchasing power over time Return vs Liquidity a b M1 i ii M2 i ii Most liquid assets Currency checking accounts Also Savings money market mutual funds M B lecture notes Page 3 Ch 10 Wednesday April 2 2014 11 19 AM 1 Central bank a Discount loans i ii Commercial Bank 2 Assets Loaned out to commercial loans reserves Currency in vaults and deposits at central bank Most liquid assets Required ratio of 10 a b Liabilities i Assets i Deposits Reserves 1 2 3 Working with Balance Sheets Levels of items a 3 4 b T Accounts a i Asset Management Goals i ii iii Tools i b i Quantity of loans borrowing net worth Focus on items that have changed Highest returns on loans and securities Reduce Risk Adequate liquidity Find good borrowers Pay high interest Low risk of default 1 2 ii iii iv Purchase securities with high return and low risk Diversification Balance need for liquidity against increased returns from less liquid assets 5 Liability Management a Since checkable deposits no longer source of funds i More important Expansion of overnight loan markets Negotiable CDS 6 Capital Adequacy Management b c a Goals i Help prevent bank failure If Assets down 1 ii iii Amount of capital affects returns for owners Regulatory requirements i ii Assets Liabilites If A down enough buffer prevent failure 1 Basl 3 b Bank Capital c Balance Sheet i i d Return to Equity Holders Return on assets 1 Focus on firm Banks come up with risk ratings for loans and securities weigh assets by risks M B lecture notes Page 4 1 2 3 4 Focus on firm Net profit after taxes per dollar assets ROA Net Profit after taxes Assets A Return on Equity ii Focus on shareholder ROE Equity capital iii Equity Multiplier 1 2 3 1 2 Assets per dollar of equity capital EM Assets Equity capital iv v ROE ROA EM e cap A x A e cap e Costs Benefits i Benefit by making investments safe 1 High cushion against drop in assets ii Costly as higher bank capital lower return on equity Money sits as cushion not put to work 1 iii Choice depends on state of economy and levels of confidence 7 Capital Crunch Credit Crunch 2007 09 a Shortfall of bank capital led to slower credit growth i ii Huge losses bank assets in MBS Losses reduced bank capital Bank cannot raise capital in weak economy b i Tighten and reduce lending 8 Capital Adequacy Management if e cap asset ratio is too low high c Credit Rationing i ii Increase interest rates Refuse to make loans a Raise Equity capital asset by Issue new equity i ii iii 1 2 3 Reserves up Bank capital up Overall ratio up Increase RE reduce dividends 1 2 Increases capital account Overall …