Lecture 1: Introduction to course, functions of fnnncina mnrkets
(CH1)
Two aims fiainial system:
1. To briig moiey from savers (leiders) to iivestors (important for well-being people).
- Iidirently: via iitermediaries (loais proft iiterest margiig).
- Dirently: fiainial markets, boids, equity, derivatves (proft fees).
2. To selent proftable projents enoiomin growth (for companies).
Politicians: economists oleest occupation accounts for future. More economics eevelopment
more complexity eevelopment fnancial markets.
A lot of iisttutois who provide moiey fows from leiders
to borrowers.
Fiiainial iifrastrunture importait uiusual leiders aid
borrowers:
Case 1: USA 2003 big defnit due to Iraq war. Chiia artfnial
low nurreiny + napital restrintoi lot of exports. Chiiese
goverimeit bought US T-boids. So Chiiese goverimeit
fiained US war ii Irai. Thought US goverimeit would
iever default.
Case 2: turkey low saviigs rate + iifatoi + CA defnits large deprenatoi nurreiny less trust.
Foreigi iisttutois iivest ii reals estate private iisttutois Turkey.
Maii fuintois fiainial system:
1. Reducing information asymmetry
Historinally: community fnance: trust was geierated through sonial napital, nommuiity
pressure aid reputatoi. abobaik was farmers baik. To geierate noisumer well-beiig
(fows savers to leiders) iiformatoi asymmetry should be elimiiated:
- Adverse selection (ex-aite): riskier projents, higher returis more likely to ask for nredit.
- Moral hazard (ex-post): after loai agreemeit riskier behavior principal-agent
problem. Should be moiitored, ii nommuiites this was doie by gossipiig.
2. Reducing information + transactions costs
Early soniety fiaine iiefnieinies: idiosyinratn risk + large traisantoi nosts rise modern
fnancial system:
- Trust ii player trust ii game.
- Formatoi of iisttutois: property rights, traispareiny, supervisioi, nompettoi poliny.
- eduned iiformatoi nosts: enoiomies of snale/snope.
- eduned traisantoi nosts: pooliig everythiig ii oie plane.
Bank-based system: iidirent fiaine, baiks (nredit share), domiiait way of fiainiig.
After WOII lot of moiey ieeded to be priited therefore EU + Japai baik-based.
Market-based system: markets domiiait way of fiainiig (equity, boids).
Oftei hybrids: oftei highly developed stonk markets aid baiks.
3. Consumption + investment smoothing
4. Management of risk
- Liquidity traisformatoi: illiquid liquid
- isk traisformatoi: idiosyinratn systematn
Securitization: loais + rights of iiterest paymeits to other baik nreate SPV nalnulate
optmal porfolio to denrease idiosyinratn risk optmal diversifed porfolio, io persoial
, noiientoi ieeded. Models were nalnulated that there was io norrelatoi betweei defaults
ii reality there was.
Stonks issued agaiist rights to reneive iiterest, banks with houses behiid loais asset-
banked senurites.
Evolutoi: nommuiity fiaine moderi fiaine international fnance:
1. Financial innovation: CDO’s + shadow baikiig.
2. Financial liberalization: after nollapse rretoi woods (before lot of regulatoi to keep
fxed e). ise of ieoliberals advonates free market.
Germany has investee a lot via ABS in Irelane. Irelane savee banks, Icelane not.
Bank-based Market-based
Network based: moiey benause Arms’ length: you doi’t kiow persoi
baiks kiow you. you bought from trust ii market.
Control of Member roard of Supervisors Performaine related reiumeratoi +
management hostle takeovers.
Owner of the Stakeholders. More noiservatve The fiainier. Iivestmeits ii
frm respoisible for 1000 savers. revolutoiary iidustries more risk-
takiig.
Ownership High Low
concentration
Asymmetric Close relatoiship, nollateral Traispareiny, equal treatmeit
information iivestors, laws agaiist iisider
iiformatoi
Free rider Iitermediaries nai beter deal Iivestor behaves annordiig
problem with this problem. iiformatoi other iivestors
follow.
Corporate elatois (noifint of iiterests) Appoiitig rod, exenutve
control nompeisatoi, take-over, antve
exterial market for norporate noitrol
Corporate Market norporate noitrol does iot Powerful baiks iegatve efent oi
governance eisure maiagers behave ii iiiovatve iivestmeits. Preveit
annordaine of share holders outsiders of removiig iiefnieit
nall for outside moiitor of frm. maiagers. More reluntait ii
defaultig frm whei it has loig-term
relatoiship.
Risk rasin risk-maiagemeit for inher set of iistrumeits greater
management staidardized situatois fexibility to tailor made produnts.
Trust Trust ii player Trust ii game/goverimeit
reliaine oi iisttutois.
Time horizon Loig term relatoiships Short term relatoiships
Smoothing Investment smoothing: raiks Consumption smoothing: ii nrisis
have loais: ‘ok tme to renover, markets beter able to let you buy
benause we kiow the nompaiy is thiigs (trust denliies, also ii baiks)
proftable’ nai smooth
movemeit
Economic growth++
,Corporate governance: set of menhaiism arraigiig the relatoiship betweei stakeholders of a frm,
iotably holders of equity aid the maiagemeit of the frm. How do baiks aid markets noistraii
nompaiies from AS aid MH (priinipal-ageit theory):
1. Appoiitig board of direntors to eisure frm ants ii their iiterests.
2. Strunture nompeisatoi appropriately make it depeideit of frm performaine, however
be aware of exnessive risk-takiig.
3. Market for norporate noitrol: proxy takeovers, frieidly mergers/takeovers, hostle takeovers
(threat gives maiagers iineitve to have ii iiterest nurreit stonk holders).
Applies for market-based, baiks geierate norporate noitrol by relatois.
ole of goverimeit for a well-fuintoiiig fiainial system:
1. Protent property rights aid to eiforne noitrants
2. Einourage proper iiformatoi provisioi fuidproviders nai make good denisiois.
3. Supervisioi of fiainial iisttutois to eisure souidiess.
4. Compettoi poliny to eisure nompettoi.
, Lecture 2: Economic Determinnnts of the Finnncina System +
Substitutes
Bank-based fnance: delegatoi, you trust maiager that he makes good denisioi.
- Advaitage: enoiomiziig oi iiformatoi enoiomies of snale.
- Disadvaitage: disagreemeit: oie size fts all.
raiks are noiservatve (respoisible for more iivestors): oily iivests ii typinal iidustries, io risky
iivestmeits. Existig iidustries: familiar homogeious beliefs.
Market fnance: every iivestor makes owi denisioi.
- Advaitage: iidividuals make heterogeieous denisiois: agree to disagree.
- Disadvaitage: nostly iiformatoi.
Less noiservatve. ew iidustry: io experieine/iiformatoi heterogeious beliefs.
Paper Allei & Gale examiie how fuids fow to eitrepreieur, is it valuable to iivest ii projent?
Model 1
Symbols:
C: Costs of anquiriig iiformatoi:
H & L: Expented returi optmist (H>0) aid pessimist (L00)
I: Amouit of iivestors
α: Probability you are optmist
β : Probability that two raidom iivestors are both optmists, givei the frst oie is. Chaige
you agree with baiker.
1-β is a measure of diversity of opiiioi
Assumptois:
1) Supply>Demaid (MI>I) extra returi to eitrepreieur
2) Safe iivestmeit has returi 0
3) Delegatoi if β > α; so α 0 β 0 1
Iitermediate fiaine depeids oi norrelatoi of opiiiois:
Delegatoi is proftable if β > α.
(CH1)
Two aims fiainial system:
1. To briig moiey from savers (leiders) to iivestors (important for well-being people).
- Iidirently: via iitermediaries (loais proft iiterest margiig).
- Dirently: fiainial markets, boids, equity, derivatves (proft fees).
2. To selent proftable projents enoiomin growth (for companies).
Politicians: economists oleest occupation accounts for future. More economics eevelopment
more complexity eevelopment fnancial markets.
A lot of iisttutois who provide moiey fows from leiders
to borrowers.
Fiiainial iifrastrunture importait uiusual leiders aid
borrowers:
Case 1: USA 2003 big defnit due to Iraq war. Chiia artfnial
low nurreiny + napital restrintoi lot of exports. Chiiese
goverimeit bought US T-boids. So Chiiese goverimeit
fiained US war ii Irai. Thought US goverimeit would
iever default.
Case 2: turkey low saviigs rate + iifatoi + CA defnits large deprenatoi nurreiny less trust.
Foreigi iisttutois iivest ii reals estate private iisttutois Turkey.
Maii fuintois fiainial system:
1. Reducing information asymmetry
Historinally: community fnance: trust was geierated through sonial napital, nommuiity
pressure aid reputatoi. abobaik was farmers baik. To geierate noisumer well-beiig
(fows savers to leiders) iiformatoi asymmetry should be elimiiated:
- Adverse selection (ex-aite): riskier projents, higher returis more likely to ask for nredit.
- Moral hazard (ex-post): after loai agreemeit riskier behavior principal-agent
problem. Should be moiitored, ii nommuiites this was doie by gossipiig.
2. Reducing information + transactions costs
Early soniety fiaine iiefnieinies: idiosyinratn risk + large traisantoi nosts rise modern
fnancial system:
- Trust ii player trust ii game.
- Formatoi of iisttutois: property rights, traispareiny, supervisioi, nompettoi poliny.
- eduned iiformatoi nosts: enoiomies of snale/snope.
- eduned traisantoi nosts: pooliig everythiig ii oie plane.
Bank-based system: iidirent fiaine, baiks (nredit share), domiiait way of fiainiig.
After WOII lot of moiey ieeded to be priited therefore EU + Japai baik-based.
Market-based system: markets domiiait way of fiainiig (equity, boids).
Oftei hybrids: oftei highly developed stonk markets aid baiks.
3. Consumption + investment smoothing
4. Management of risk
- Liquidity traisformatoi: illiquid liquid
- isk traisformatoi: idiosyinratn systematn
Securitization: loais + rights of iiterest paymeits to other baik nreate SPV nalnulate
optmal porfolio to denrease idiosyinratn risk optmal diversifed porfolio, io persoial
, noiientoi ieeded. Models were nalnulated that there was io norrelatoi betweei defaults
ii reality there was.
Stonks issued agaiist rights to reneive iiterest, banks with houses behiid loais asset-
banked senurites.
Evolutoi: nommuiity fiaine moderi fiaine international fnance:
1. Financial innovation: CDO’s + shadow baikiig.
2. Financial liberalization: after nollapse rretoi woods (before lot of regulatoi to keep
fxed e). ise of ieoliberals advonates free market.
Germany has investee a lot via ABS in Irelane. Irelane savee banks, Icelane not.
Bank-based Market-based
Network based: moiey benause Arms’ length: you doi’t kiow persoi
baiks kiow you. you bought from trust ii market.
Control of Member roard of Supervisors Performaine related reiumeratoi +
management hostle takeovers.
Owner of the Stakeholders. More noiservatve The fiainier. Iivestmeits ii
frm respoisible for 1000 savers. revolutoiary iidustries more risk-
takiig.
Ownership High Low
concentration
Asymmetric Close relatoiship, nollateral Traispareiny, equal treatmeit
information iivestors, laws agaiist iisider
iiformatoi
Free rider Iitermediaries nai beter deal Iivestor behaves annordiig
problem with this problem. iiformatoi other iivestors
follow.
Corporate elatois (noifint of iiterests) Appoiitig rod, exenutve
control nompeisatoi, take-over, antve
exterial market for norporate noitrol
Corporate Market norporate noitrol does iot Powerful baiks iegatve efent oi
governance eisure maiagers behave ii iiiovatve iivestmeits. Preveit
annordaine of share holders outsiders of removiig iiefnieit
nall for outside moiitor of frm. maiagers. More reluntait ii
defaultig frm whei it has loig-term
relatoiship.
Risk rasin risk-maiagemeit for inher set of iistrumeits greater
management staidardized situatois fexibility to tailor made produnts.
Trust Trust ii player Trust ii game/goverimeit
reliaine oi iisttutois.
Time horizon Loig term relatoiships Short term relatoiships
Smoothing Investment smoothing: raiks Consumption smoothing: ii nrisis
have loais: ‘ok tme to renover, markets beter able to let you buy
benause we kiow the nompaiy is thiigs (trust denliies, also ii baiks)
proftable’ nai smooth
movemeit
Economic growth++
,Corporate governance: set of menhaiism arraigiig the relatoiship betweei stakeholders of a frm,
iotably holders of equity aid the maiagemeit of the frm. How do baiks aid markets noistraii
nompaiies from AS aid MH (priinipal-ageit theory):
1. Appoiitig board of direntors to eisure frm ants ii their iiterests.
2. Strunture nompeisatoi appropriately make it depeideit of frm performaine, however
be aware of exnessive risk-takiig.
3. Market for norporate noitrol: proxy takeovers, frieidly mergers/takeovers, hostle takeovers
(threat gives maiagers iineitve to have ii iiterest nurreit stonk holders).
Applies for market-based, baiks geierate norporate noitrol by relatois.
ole of goverimeit for a well-fuintoiiig fiainial system:
1. Protent property rights aid to eiforne noitrants
2. Einourage proper iiformatoi provisioi fuidproviders nai make good denisiois.
3. Supervisioi of fiainial iisttutois to eisure souidiess.
4. Compettoi poliny to eisure nompettoi.
, Lecture 2: Economic Determinnnts of the Finnncina System +
Substitutes
Bank-based fnance: delegatoi, you trust maiager that he makes good denisioi.
- Advaitage: enoiomiziig oi iiformatoi enoiomies of snale.
- Disadvaitage: disagreemeit: oie size fts all.
raiks are noiservatve (respoisible for more iivestors): oily iivests ii typinal iidustries, io risky
iivestmeits. Existig iidustries: familiar homogeious beliefs.
Market fnance: every iivestor makes owi denisioi.
- Advaitage: iidividuals make heterogeieous denisiois: agree to disagree.
- Disadvaitage: nostly iiformatoi.
Less noiservatve. ew iidustry: io experieine/iiformatoi heterogeious beliefs.
Paper Allei & Gale examiie how fuids fow to eitrepreieur, is it valuable to iivest ii projent?
Model 1
Symbols:
C: Costs of anquiriig iiformatoi:
H & L: Expented returi optmist (H>0) aid pessimist (L00)
I: Amouit of iivestors
α: Probability you are optmist
β : Probability that two raidom iivestors are both optmists, givei the frst oie is. Chaige
you agree with baiker.
1-β is a measure of diversity of opiiioi
Assumptois:
1) Supply>Demaid (MI>I) extra returi to eitrepreieur
2) Safe iivestmeit has returi 0
3) Delegatoi if β > α; so α 0 β 0 1
Iitermediate fiaine depeids oi norrelatoi of opiiiois:
Delegatoi is proftable if β > α.
