an overview of the financial system. characteristics of a good financial system diversifies risk...
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Characteristics of a Good Financial SystemCharacteristics of a Good Financial System
Diversifies RiskDiversifies Risk
Defining RiskDefining Risk
In a world with no uncertainty, we could In a world with no uncertainty, we could make the following statement:make the following statement:
““Tomorrow, the temperature will be 35 Tomorrow, the temperature will be 35 degrees”degrees”
In an uncertain worlds, we can’t state In an uncertain worlds, we can’t state anything with certainty, only with degrees anything with certainty, only with degrees of probability.of probability.
““There is a 45% chance that it will be 35 There is a 45% chance that it will be 35 degrees tomorrow”degrees tomorrow”
Probability DistributionsProbability Distributions More generally, uncertainty is More generally, uncertainty is
characterized by a probability characterized by a probability distributiondistribution
Expected value (mu) refers to Expected value (mu) refers to the most likely event. the most likely event.
Standard Deviation (sigma) Standard Deviation (sigma) refers to the “spread” of refers to the “spread” of possible events. It is equal to possible events. It is equal to the expected value of squared the expected value of squared differences from the mean.differences from the mean.
StatisticsStatistics
Expected value is equal to the sum of each possible Expected value is equal to the sum of each possible event multiplied by its probability.event multiplied by its probability.
Prob(35) = .45 Prob(25) = .55Prob(35) = .45 Prob(25) = .55
E(Temperature) = .45(35) + .55(25) = 29.5E(Temperature) = .45(35) + .55(25) = 29.5
Variance is equal to the expected value of squared Variance is equal to the expected value of squared differences from the mean.differences from the mean.
Variance (Temp) = .45(35 – 29.5)^2 + .55(25-29.5)^2Variance (Temp) = .45(35 – 29.5)^2 + .55(25-29.5)^2
= 24.75= 24.75
Standard Dev. (Temp) = SQRT(24.75) = 4.97Standard Dev. (Temp) = SQRT(24.75) = 4.97
DiversificationDiversification
Suppose the chance of a cold winter is 40% (the chance Suppose the chance of a cold winter is 40% (the chance of a warm winter is 60%). You own an oil company. In a of a warm winter is 60%). You own an oil company. In a cold winter, you earn $100 in profit. In a warm winter, cold winter, you earn $100 in profit. In a warm winter, you lose $50.you lose $50.
E(Profit) = .40($100) + .60(-$50) = $10E(Profit) = .40($100) + .60(-$50) = $10
Variance (Profit) = .4(100-10)^2 + .6(-50 –10)^2 = 5,400Variance (Profit) = .4(100-10)^2 + .6(-50 –10)^2 = 5,400
Standard Deviation = 73.5Standard Deviation = 73.5
DiversificationDiversification Now, suppose you buy stock in Disney. If its warm, your Now, suppose you buy stock in Disney. If its warm, your
stock appreciates by $20. If its cold, Disney stock falls by stock appreciates by $20. If its cold, Disney stock falls by $10. You pay $15 for the stock.$10. You pay $15 for the stock.
E(Profit) = .4($100 - $10 - $15) + .6(-$50 + $20 - $15) = $3E(Profit) = .4($100 - $10 - $15) + .6(-$50 + $20 - $15) = $3Variance (Profit) = .4(75 - 3)^2 + .6(-45 - 3)^2 = 3,455Variance (Profit) = .4(75 - 3)^2 + .6(-45 - 3)^2 = 3,455Standard Deviation = 58.8Standard Deviation = 58.8
You’ve lowered your risk by 20%You’ve lowered your risk by 20%(At a cost of $7)(At a cost of $7)
Diversification & CorrelationDiversification & Correlation
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# of variables
Adding uncorrelated (Corr = 0) variables to a Adding uncorrelated (Corr = 0) variables to a portfolio lowers the risk attached to that portfolioportfolio lowers the risk attached to that portfolio
Diversification & CorrelationDiversification & Correlation
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Correlation (three variables)
Std. Dev.
Negative correlations (Corr < 0) enhance the Negative correlations (Corr < 0) enhance the power of diversificationpower of diversification
Stock Market DiversificationStock Market Diversification
0102030405060708090
100
Portfolio Variance
1 3 5 10 20 30 40 50
Number of Stocks
US Stocks
International
B Solnik, “Why Not Diversify Internationally”, B Solnik, “Why Not Diversify Internationally”, Financial Analysts Journal
Characteristics of a Good Financial SystemCharacteristics of a Good Financial System
Diversifies RiskDiversifies RiskCreates LiquidityCreates Liquidity
Enron: Sinner or Saint?Enron: Sinner or Saint?
In Dec. December In Dec. December 2001, Enron declared 2001, Enron declared bankruptcy – one of bankruptcy – one of the largest corporate the largest corporate failures in history. failures in history.
While Enron did a lot While Enron did a lot of things wrong, what of things wrong, what did it do right?did it do right?
Enron: Sinner or Saint?Enron: Sinner or Saint?
Enron’s core business Enron’s core business was to become the was to become the “middleman” in “middleman” in energy markets – this energy markets – this helped manage risk helped manage risk and improved and improved liquidity.liquidity.
Characteristics of a Good Financial SystemCharacteristics of a Good Financial System
Diversifies RiskDiversifies RiskCreates LiquidityCreates LiquidityProvides/Communicates InformationProvides/Communicates Information
Asymmetric InformationAsymmetric Information
Adverse SelectionAdverse SelectionPrior to a transaction taking place, one party Prior to a transaction taking place, one party
is missing vital information about the other is missing vital information about the other party (can’t tell the good eggs from the bad party (can’t tell the good eggs from the bad eggs!)eggs!)
Moral HazardMoral HazardAfter the transaction takes place, one party After the transaction takes place, one party
can’t observe the other’s actions (the good can’t observe the other’s actions (the good eggs might become bad eggs!)eggs might become bad eggs!)
An Adverse Selection ExampleAn Adverse Selection Example
Suppose you are shopping for a new car. There are 10 Suppose you are shopping for a new car. There are 10 cars on the lot.cars on the lot. 8 Cars are good (P = $1000)8 Cars are good (P = $1000) 2 Cars are Lemons (P = $100)2 Cars are Lemons (P = $100)
What price do you offer? (You can’t distinguish lemons What price do you offer? (You can’t distinguish lemons from good cars)from good cars)
Solution: Signaling or Regulation!Solution: Signaling or Regulation!
A Moral Hazard ExampleA Moral Hazard Example
Suppose a company has one bondholder ($100) Suppose a company has one bondholder ($100) and one stockholder. The company has two and one stockholder. The company has two possible projects to invest in: possible projects to invest in:
Project A: $100 profit with certaintyProject A: $100 profit with certainty Project B: 50% chance of $0 profit, 50% chance of Project B: 50% chance of $0 profit, 50% chance of
$200 profit.$200 profit.
Which project should the company invest in?Which project should the company invest in?
A Moral Hazard ExampleA Moral Hazard Example
Project A (Safe)Project A (Safe)Bondholders: $100Bondholders: $100
Stockholders: $0Stockholders: $0
With certaintyWith certainty
Project B (Risky)Project B (Risky)Bondholders: Bondholders: 50% chance of $0, 50% 50% chance of $0, 50%
chance of $100chance of $100E(B) = .5(100) + .5(0) =$50E(B) = .5(100) + .5(0) =$50
Stockholders: Stockholders: 50% chance of $050% chance of $0 50% chance of $10050% chance of $100
E(S) = (.5)(100) + .5(0) =$50E(S) = (.5)(100) + .5(0) =$50
A Moral Hazard ExampleA Moral Hazard Example
As a bondholder, you can’t always As a bondholder, you can’t always observe the stockholder actions, but you observe the stockholder actions, but you would prefer the stockholder to only take would prefer the stockholder to only take on low risk projects. on low risk projects.
How do you do this?”How do you do this?”MonitoringMonitoringOptimal ContractingOptimal Contracting
Why Do We Care?Why Do We Care?
With a financial system, your consumption With a financial system, your consumption expenditures are no longer restricted to equal expenditures are no longer restricted to equal your income (i.e., the financial system efficiently your income (i.e., the financial system efficiently transfers income between households)transfers income between households)
Financial Markets Transfer Savings from Financial Markets Transfer Savings from households to firms for the purpose of financing households to firms for the purpose of financing investment projectsinvestment projects
S = I + (G-T) + NXS = I + (G-T) + NX
““Black Tuesday”Black Tuesday”
On Tuesday, On Tuesday, October 29,1929, October 29,1929, the Dow Jones the Dow Jones Closed at $230 – Closed at $230 – Down 23% from its Down 23% from its opening of $299 opening of $299 with huge volume with huge volume (16,410,030 shares)(16,410,030 shares)
The October 29The October 29thth drop was only the beginning of a 89.7% drop was only the beginning of a 89.7% collapse over the next 714 days.collapse over the next 714 days.
The Dow make it back to its pre 1929 highs until 1954.The Dow make it back to its pre 1929 highs until 1954.
““Black Monday”Black Monday”
On Monday, On Monday, October 19,1987 October 19,1987 The Dow fell from The Dow fell from $2246 to $1738 – $2246 to $1738 – 22.6% of its value 22.6% of its value
However, unlike the 1929 crash, the market quickly However, unlike the 1929 crash, the market quickly recovered – by September 1989, the Dow returned to its recovered – by September 1989, the Dow returned to its
pre-1987 levelspre-1987 levels
The PlayersThe Players
Securities Market Institutions Securities Market Institutions Contractual Savings Institutions (40%)Contractual Savings Institutions (40%) Investment Institutions (25%)Investment Institutions (25%)Government Institutions (10%)Government Institutions (10%)Depository Institutions (25%)Depository Institutions (25%)
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$30 Trillion in Debt and Equities$30 Trillion in Debt and Equities
Securities Market InstitutionsSecurities Market Institutions
Securities market institutions match up buyers with Securities market institutions match up buyers with sellers. (provide liquidity)sellers. (provide liquidity)
Securities market institutions also provide information Securities market institutions also provide information and analysis to help buyers and sellers of assetsand analysis to help buyers and sellers of assets
Primary Markets Primary Markets Secondary MarketsSecondary Markets
Investment Banking BrokersInvestment Banking Brokers
DealersDealers
ExchangesExchanges
Contractual SavingsContractual Savings
Contractual Savings Institutions are by far the Contractual Savings Institutions are by far the biggest participant in financial markets ($12 biggest participant in financial markets ($12 Trillion in assets)Trillion in assets)
Specialize in writing contracts to protect Specialize in writing contracts to protect policyholders from financial loss associated from policyholders from financial loss associated from specific events.specific events.
Insurance CompaniesInsurance Companies Property/Casualty ($1T) vs. Life($3T)Property/Casualty ($1T) vs. Life($3T) Mutual vs. StockMutual vs. Stock
Pension FundsPension Funds Defined Benefit vs. Defined ContributionDefined Benefit vs. Defined Contribution
Investment Institutions ($8T)Investment Institutions ($8T)
Investment Institutions represent the fastest growing Investment Institutions represent the fastest growing segment of financial markets segment of financial markets
The key service provided is low cost diversificationThe key service provided is low cost diversification Mutual FundsMutual Funds Money Market FundsMoney Market Funds Hedge Funds (LTCM)Hedge Funds (LTCM) Venture Capital FundsVenture Capital Funds
Government Institutions ($3T)Government Institutions ($3T)
Provision of Liquidity Provision of Liquidity Fannie MaeFannie Mae Freddie MacFreddie Mac Ginnie MaeGinnie Mae Sallie FaeSallie Fae
Regulation and OversightRegulation and Oversight Federal ReserveFederal Reserve SECSEC FDICFDIC
Depository Institutions ($8T)Depository Institutions ($8T)
The distinguishing characteristic of a The distinguishing characteristic of a depository institutions is the acceptance of depository institutions is the acceptance of deposits and the creation of loans.deposits and the creation of loans.
Commercial BanksCommercial BanksSavings & Loans (Thrifts)Savings & Loans (Thrifts)Credit UnionsCredit UnionsSavings BanksSavings Banks