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An Overview of the Financial System

Characteristics of a Good Financial System l Diversifies Risk

Defining Risk l In a world with no uncertainty, we could make the following statement: “Tomorrow, the temperature will be 35 degrees” l In an uncertain worlds, we can’t state anything with certainty, only with degrees of probability. “There is a 45% chance that it will be 35 degrees tomorrow”

Probability Distributions l l l More generally, uncertainty is characterized by a probability distribution Expected value (mu) refers to the most likely event. Standard Deviation (sigma) refers to the “spread” of possible events. It is equal to the expected value of squared differences from the mean.

Statistics l Expected value is equal to the sum of each possible event multiplied by its probability. Prob(35) =. 45 Prob(25) =. 55 E(Temperature) =. 45(35) +. 55(25) = 29. 5 l Variance is equal to the expected value of squared differences from the mean. Variance (Temp) =. 45(35 – 29. 5)^2 +. 55(25 -29. 5)^2 = 24. 75 Standard Dev. (Temp) = SQRT(24. 75) = 4. 97

Diversification l Suppose the chance of a cold winter is 40% (the chance of a warm winter is 60%). You own an oil company. In a cold winter, you earn \$100 in profit. In a warm winter, you lose \$50. E(Profit) =. 40(\$100) +. 60(-\$50) = \$10 Variance (Profit) =. 4(100 -10)^2 +. 6(-50 – 10)^2 = 5, 400 Standard Deviation = 73. 5

Diversification l Now, suppose you buy stock in Disney. If its warm, your stock appreciates by \$20. If its cold, Disney stock falls by \$10. You pay \$15 for the stock. E(Profit) =. 4(\$100 - \$15) +. 6(-\$50 + \$20 - \$15) = \$3 Variance (Profit) =. 4(75 - 3)^2 +. 6(-45 - 3)^2 = 3, 455 Standard Deviation = 58. 8 You’ve lowered your risk by 20% (At a cost of \$7)

Diversification & Correlation l Adding uncorrelated (Corr = 0) variables to a portfolio lowers the risk attached to that portfolio

Diversification & Correlation l Negative correlations (Corr < 0) enhance the power of diversification

Stock Market Diversification l B Solnik, “Why Not Diversify Internationally”, Financial Analysts Journal

Characteristics of a Good Financial System Diversifies Risk l Creates Liquidity l

Enron: Sinner or Saint? l l In December 2001, Enron declared bankruptcy – one of the largest corporate failures in history. While Enron did a lot of things wrong, what did it do right?

Enron: Sinner or Saint? l Enron’s core business was to become the “middleman” in energy markets – this helped manage risk and improved liquidity.

Characteristics of a Good Financial System Diversifies Risk l Creates Liquidity l Provides/Communicates Information l

Asymmetric Information l Adverse Selection l Prior to a transaction taking place, one party is missing vital information about the other party (can’t tell the good eggs from the bad eggs!) l Moral Hazard l After the transaction takes place, one party can’t observe the other’s actions (the good eggs might become bad eggs!)

An Adverse Selection Example l Suppose you are shopping for a new car. There are 10 cars on the lot. l 8 Cars are good (P = \$1000) l 2 Cars are Lemons (P = \$100) What price do you offer? (You can’t distinguish lemons from good cars) Solution: Signaling or Regulation!

A Moral Hazard Example l Suppose a company has one bondholder (\$100) and one stockholder. The company has two possible projects to invest in: l l Project A: \$100 profit with certainty Project B: 50% chance of \$0 profit, 50% chance of \$200 profit. Which project should the company invest in?

A Moral Hazard Example Project A (Safe) Project B (Risky) Bondholders: \$100 Stockholders: \$0 Bondholders: 50% chance of \$0, 50% chance of \$100 E(B) =. 5(100) +. 5(0) =\$50 With certainty Stockholders: 50% chance of \$0 50% chance of \$100 E(S) = (. 5)(100) +. 5(0) =\$50

A Moral Hazard Example As a bondholder, you can’t always observe the stockholder actions, but you would prefer the stockholder to only take on low risk projects. l How do you do this? ” l l Monitoring l Optimal Contracting

Why Do We Care? l l With a financial system, your consumption expenditures are no longer restricted to equal your income (i. e. , the financial system efficiently transfers income between households) Financial Markets Transfer Savings from households to firms for the purpose of financing investment projects S = I + (G-T) + NX

“Black Tuesday” l On Tuesday, October 29, 1929, the Dow Jones Closed at \$230 – Down 23% from its opening of \$299 with huge volume (16, 410, 030 shares)

The October 29 th drop was only the beginning of a 89. 7% collapse over the next 714 days.

The Dow make it back to its pre 1929 highs until 1954.

“Black Monday” l On Monday, October 19, 1987 The Dow fell from \$2246 to \$1738 – 22. 6% of its value

However, unlike the 1929 crash, the market quickly recovered – by September 1989, the Dow returned to its pre-1987 levels

The Players Securities Market Institutions l Contractual Savings Institutions (40%) l Investment Institutions (25%) l Government Institutions (10%) l Depository Institutions (25%) ________________ \$30 Trillion in Debt and Equities l

Securities Market Institutions l l Securities market institutions match up buyers with sellers. (provide liquidity) Securities market institutions also provide information and analysis to help buyers and sellers of assets Primary Markets Secondary Markets Investment Banking Brokers Dealers Exchanges

Contractual Savings l l Contractual Savings Institutions are by far the biggest participant in financial markets (\$12 Trillion in assets) Specialize in writing contracts to protect policyholders from financial loss associated from specific events. l Insurance Companies Property/Casualty (\$1 T) vs. Life(\$3 T) l Mutual vs. Stock l l Pension l Funds Defined Benefit vs. Defined Contribution

Investment Institutions (\$8 T) l l Investment Institutions represent the fastest growing segment of financial markets The key service provided is low cost diversification l Mutual Funds l Money Market Funds l Hedge Funds (LTCM) l Venture Capital Funds

Government Institutions (\$3 T) l Provision of Liquidity l l l Fannie Mae Freddie Mac Ginnie Mae Sallie Fae Regulation and Oversight l l l Federal Reserve SEC FDIC

Depository Institutions (\$8 T) l The distinguishing characteristic of a depository institutions is the acceptance of deposits and the creation of loans. l Commercial Banks l Savings & Loans (Thrifts) l Credit Unions l Savings Banks

Evolution of the Financial System Financial Innovation l Integration and Globalization l Regulation l Competition l