01.24.2001Lecture Notes Finance 3191 Finance 319 Lecture 5 & the beginning of Lecture 6 Course Website u Galina Albert.

01.24.2001 Lecture Notes Finance 319 1

Finance 319 Lecture 5 & the beginning of Lecture 6

Course Website http://www.citi.umich/u/galka/319 Galina Albert Schwartz Department of Finance University of Michigan Business School


Practical Matters: Investment History Video

On Wed, 01.31.2001

7:00pm, room - D1230

How The Really Smart Money Invests:

A Brief History of Investing


A Summary: Market Structure & Institutions

Readings: Levich, Chapters 2 & 3 Volume of foreign exchange

market: 60 times world trade, [which is

10 - 20 times world GDP]. Why? Foreign Exchange Market Structure,

p. 83 - 85 Is this market a zero-sum game?


Financial Institutions

Two types of Financial Institutions– 1. commercial banks– 2. investment banks[US: illegal to do 1 & 2 simultaneously]

Functions of Banks– Intermediation– Liquidity provision services– Risk management


A Brief on Bank Regulation

Regulatory Environment [history]– FED (Federal Reserve System) (Act of

1913)»Reserve requirements were fixed by

Federal Reserve Act»FED controls the economy through

money supply & discount loans to member banks


A Brief on Bank Regulation (cont.)

–Glass-Steagall Act (1933): »Limits the competition between banks (makes them less likely to fail)»Separates banking and securities [1 & 2, see above]»Establishes Federal Deposit Insurance Corporation (FDIC)»G-S: prohibits interest bearing checking»Limits the interest paid on time deposits


A Brief on Bank Regulation (cont.)

Regulation Q (until 1986 a ceiling interest rate on

saving deposits): (Req. Q is likely to be abolished) Regulation Z (the “truth in lending”

regulation)– Lender must disclose a total interest

cost of the credit The reasons for these regulations?


Debt Classification & Asset Liquidity

Debt classification:– Short term < 1 year– Medium term 1 year to 10 years

maturity– Long term >10 years

Liquidity of an asset: relative ease & speed to be converted into the medium of exchange


Classification of Securities

Money Market Securities:– Short-term, low risk, very liquid

Capital Market Securities (for example, mortgages)– long term, highly risky & of limited liquidity: the features are opposite to Money Market

Securities


Foreign Exchange Market Structure (Figure 3.4)

Transactions of two types: 1. through Direct Dealing or 2. through a broker

1. Direct Dealing is direct phone contact with another bank dealer– advantage – information from the way the dealer

“shades the price” Dealers are market makers (p. 81), the role

of dealers’ trades is– to acquire and lay risks &

– to discover transaction prices


Foreign Exchange Market Structure (cont.)

2. Brokers are intermediaries who reduce search costs – advantage – lower price through

shopping around, – disadvantage – commission to pay

Reuters Dealing 2000-1 up to 4 dealers’ quotes on the same screen (still far from a worldwide polling)


Contracts Spot contract – a binding commitment

for exchange of funds with normal settlement and delivery in two business days (in case of North American Currencies – in one day)

Forward contract – a binding commitment TODAY about exchange of funds at the pre-specified future date.


Types of Trading Activities:

Speculation & Arbitrage

– Speculation – when individual’s expectations differ from the market ones

– Arbitrage – almost simultaneous (or nearly) purchase of securities in one market for sale in another [in expectation of a risk free profit]


Risks in Foreign Exchange Trading, Levich, p. 91

I. Exchange rate & II. Interest rate risksIII. credit & IV. delivery risks I. Exchange rate risk addressed by

– placing the limits on the size of open currency positions

II. Interest rate risk addressed by– placing the limits on the size of open

forward positions


Risks in Foreign Exchange Trading, (cont.) I

III. Credit risk addressed by:– diversification, – placing maturity limits on each customer & – limiting their positions

IV. Delivery risk addressed by– spreading delivery time dates

[Risk associated with delivery of a contract across the time zones

(because the two transaction legs are NOT simultaneous)]


Aggregate Statistical Facts

Annual volume of foreign exchange market is about 10 - 20 times of world Gross National Product (GDP). Why???

90% of spot trades are between financial institutions (i.e. investment banks and securities firms)

2/3 are cross-border serious concerns about counterparty risks and clearing and settlement arrangements.


Bank for International Settlements (BIS)

settlement risk is– due to weak (or high cost) legal system– important in international contracts

[because international law is poorly enforceable]

BIS (1996) report:

urges banks & central banks – to cooperate [to reduce exposure to

settlement risk]


Risks in Foreign Exchange Trading, (cont.) II 1. Counterparty risk is

the risk of default on the terms or conditions of the contract

2. Clearing risk & 3. Settlement risk 1, 2 & 3 are related All buyers & sellers have the same

counterparty– a clearinghouse. This standardizes the

clearing risk [to a certain extent]


Explaining Aggregate Facts Positive Investment Banks’ Profits

Since profits are positive the game is not a zero-sum game

Why aggregate foreign exchange market is not a zero-sum game? Financial institutions: – hold the risks (instruments: forwards, swaps)– provide intermediation (spot)– provide information – provide facilities (`physical infrastructure’)


Explaining Aggregate Facts Why Trading Volume Is

That High? To provide 1 - 4 (i.e. international financial

infrastructure) one has to trade a lot, (which explains a very high volume of

foreign exchange market transactions). This high volume is an `intermediate good’,

which permits to accomplish 1 - 4. 90% of this volume are inter bank

trades, which is consistent with the `intermediate good’ explanation


Next Lecture: Purchasing Power Parity

Purchasing Power Parity = PPP To read: Levich, Ch. 4 Rogoff, Kenneth, (1996), “The

Purchasing Power Parity Puzzle,” Journal of Economic Literature, Vol. 34, No. 2. , pp. 647-668. (S)


Summary of Today

Terminology & Market Structure Is foreign exchange market a zero-

sum game? [NO] Banks have positive profits due to

infrastructure provision

01.24.2001Lecture Notes Finance 3191 Finance 319 Lecture 5 & the beginning of Lecture 6 Course Website u Galina Albert.

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