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Financial Economics > Package 3 > Flashcards

Package 3 Flashcards

1
Q

Deciphering the Liquidity and Credit Crunch

What about is paper?

A

The paper attempts to explain economic mechanisms that caused losses in the mortgage market to amplify into turmoil in financial markets, and describes common economic threads that explain the plethora of market declines, liquidity, dry-ups, and bailouts that occurred after the crisis broke in 2007. The main concentration on the U.S. market.

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2
Q

Deciphering the Liquidity and Credit Crunch

Which Two trends in the banking industry laid the foundation of crisis:

A
  1. „Originate and distribute“ model

2. Asset holdings were financed with short maturity instruments

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3
Q

Deciphering the Liquidity and Credit Crunch

„Originate and distribute“ model - describe

A

– NOT holding loans on bank’s balance sheet; repackaging loans and selling them to other financial investors; offloading risk => create structured products a.k.a. collateralized debt obligations – CDOs (tranches).

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4
Q

Deciphering the Liquidity and Credit Crunch

How the funding liquidity risk is related to „Originate and distribute“ model

A

• Off balance sheet strategy exposes banks to funding liquidity risk- investors might stop buying asset-backed commercial paper, preventing these vehicles rolling over the s-term debt.

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5
Q

Deciphering the Liquidity and Credit Crunch

Why most investors prefer assets with short maturities

A
  • It allows them to withdraw funds on short notice;
  • Can serve as a commitment device to discipline banks with the threat of possible withdrawals.
  • The short term assets= “asset backed”, are backed by pool mortgages or other loan as collateral. In case of default, owners of asset-backed commercial paper have the power to seize and sell the underlying collateral.
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6
Q

Deciphering the Liquidity and Credit Crunch

How CDO is created:

A
  • Form diversified portfolio of mortgages and other types of loans, corporate bonds, etc.
  • Slice these portfolios into different tranches, which are sold to different investor groups according to their appetite to risk. (Senior tranche= the safest (AAA); low interest rate, first to be paid in case of default. The most junior/ equity tranche/toxic waste= will be paid only when other tranches are paid. Mezzanine tranches are between these two extremes.
  • Buyers f these tranches can protect themselves by buying credit default swaps (CDS)- contract insuring against the default of a particular bond or tranche.
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7
Q

Deciphering the Liquidity and Credit Crunch

TWO types of liquidities:

A

Funding liquidity

Market liquidity

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8
Q

Deciphering the Liquidity and Credit Crunch

Funding liquidity

A

describes the ease with which expert investors and arbitrageurs can obtain funding from (possibly less informed) financiers. It is high- the markets are “awash with liquidity”- when it is easy to raise money.

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9
Q

Deciphering the Liquidity and Credit Crunch

Three risk forms for funding liquidity

A
  • Margin/haircut funding risk- risk that margins/haircuts will change;
  • Rollover risk- risk that it will be more costly to roll over short-term borrowing;
  • Redemption- risk that depositors will withdraw funds.
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10
Q

Deciphering the Liquidity and Credit Crunch

Market liquidity

A

market liquidity is a market’s ability to purchase or sell an asset without causing drastic change in the asset’s price.

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11
Q

Deciphering the Liquidity and Credit Crunch

Three sub-forms of market liquidity

A
  • Bid- ask spread- measures how much traders lose if they sell 1 unit of asset and then buy it back;
  • Market depth- shows how many units traders can sell or buy at current bid or ask price without moving the price;
  • Market resiliency- tells how long it will take for prices that have temporarily fallen to bounce back.
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12
Q

Deciphering the Liquidity and Credit Crunch

Benefits of structured financial products

A
  • Shift the risk to those who want to bear it;
  • Spread the risk among many market participants (lower interest & mortgage rates; certain institutional investors (e.g. pension funds) can directly hold assets that they were previously prevented from by regulation).
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13
Q

Deciphering the Liquidity and Credit Crunch

Four economic mechanisms through which the mortgage crisis amplified into a severe financial crisis

A
  1. Borrowers’ balance sheet effects cause two “liquidity spirals”
  2. Lending channel can dry up when banks become concerned about their future access to capital markets and start hoarding funds
  3. Runs on financial institutions e.g. (Lehman brothers)
  4. Network effects
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14
Q

Deciphering the Liquidity and Credit Crunch

Asset-backed commercial paper

A

a pool of assets (mortgages, loans) and in case of default, owners can sell the underlying asset (super senior tranche the safest > mezzanine > subordinate)

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15
Q

Deciphering the Liquidity and Credit Crunch

Collateralized Debt Obligation

A

pool of asset backed commercial papers (same sequence)

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16
Q

Deciphering the Liquidity and Credit Crunch

CDS (Credit Default Swap)

A

contract insuring against the default of particular bond or tranche. The buyer pays a periodic fixed fee in exchange for a contingent payment in the event of credit default

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17
Q

Deciphering the Liquidity and Credit Crunch

“Margin run”

A

faced by AIG, when counterparties requested additional collateral for its CDS positions.

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18
Q

Deciphering the Liquidity and Credit Crunch

Conclusion

A

An increase in mortgage delinquencies due to a national wide decline in housing price was triggered by a liquidity crisis. The current crisis can be characterized by a “classical banking crisis”. The particularity of this crisis is was the level of securitization which led to a strong level of interconnection. This paper outlined several amplification mechanisms that help explain the causes of the financial turmoil.

While it is individually beneficial for firms to have higher leverage, losses for a group of investors can initiate fire-sales by other investors via loss and margin spirals  which lead to reduced liquidity and uncertainty in counterparty positions Need for regulations of financial markets!!!

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19
Q

Deciphering the Liquidity and Credit Crunch

Macro-factors

A

a. Low interest rate (fear of deflation)
b. Capital inflows from abroad
c. Increased popularity of structured products

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20
Q

Deciphering the Liquidity and Credit Crunch

Micro factors

A

a. Originate-to-hold (Hold loans on banks BS) -> originate-to-distribute model (pool, tranche and resolve loans via securitization).
Security is riskier than loan.

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21
Q

Deciphering the Liquidity and Credit Crunch

Main problems

A

a. Moral hazard
b. Profit seeking (institutions – banks wanted more mortgages)
i. Lending no ninjas even (credit lending standards decreased a lot)
c. Complexity of financial system
i. Very complexed, even investment bankers sometimes don’t understand what instruments they are trading
d. Rating agencies

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22
Q

Deciphering the Liquidity and Credit Crunch

Factors leading to housing bubble

A

Low interest rates in the U.S.
Decline in lending standards
Increased popularity of structured products

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23
Q

Deciphering the Liquidity and Credit Crunch

What were the reasons of Low interest rates in the U.S.

A

– Capital inflows (Asia)

- Lax interest rates by FED

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24
Q

Deciphering the Liquidity and Credit Crunch

Loss spiral

A

Risk associated with the reduction in the value of an asset, leading to losses and higher margin/haircut

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25
Q

Deciphering the Liquidity and Credit Crunch

margin spiral.

A

Prices of assets decline -­‐> margins rise -­‐> investors sell even more to reduce leverage ratio -­‐> increase margins further
Margins increase after large price drops because:
(i) volatility increases,
(ii) asymmetric information frictions emerge (financiers become more careful about accepting as collateral)

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26
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Moore’s Law

A

growth of semiconductor industry which had profound impact on the financial system.

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27
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Murphy’s law

A

“whatever can go wrong will go wrong” and it corollary “whatever can go wrong will go wrong faster and bigger when computers are involved”

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28
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Algorithmic trading

A

the use of mathematical models, computers and telecommunication networks to automate the buying and selling of financial securities.

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29
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Authors’ idea

A

A more systematic and adaptive approach to regulating this system is needed, one that fosters the technological advances of the industry while protecting these who are not as technologically advanced.”

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30
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Good aspects of algorithmic trading

A

o Lower costs (bid ask-spread)
o Reducing human error (ex: broker doesn’t buy the needed stock)
o Increasing productivity

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31
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Bad aspects of algorithmic trading

A

o The regulatory framework doesn’t adjust so fast to technological innovation.

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32
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Facilitators of development of algorithmic trading:

A

1) Financial markets are becoming more complex
2) Developments in the financial technology/financial modeling.
3) Breakthroughs in computer technology.

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33
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Five major developments that have fueled algorithmic trading’s popularity:

A

1) Quantitative models
2) Emergence and proliferation of index funds
3) Arbitrage trading activities
4) Push for lower costs of intermediation and execution
a. One doesn’t have to go to the market to sell all his stocks/bonds/CDOs etc.
5) Proliferation of high-frequency trading (40-60% of all trading activities)

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34
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Definition for Index fund:

A

Collection of securities by some set of easily observable attributes, construct a portfolio weighted by their market capitalization.

35
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
2 critical roles of arbitrage

A

liquidity provisions and price discovery

36
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
High-Frequency trading

A

A form of automated trading that consumes extremely many trades per day/ second. It is an innovation in financial inter mediation that does not fit neatly into a standard liquidity-provision framework.

37
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
“Spoofing”

A

placing an order to buy or sell a security and then cancelling it shortly thereafter.

38
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
“Layering”

A

placing a sequence of limited orders at successively increasing or decreasing prices to give the appearance of change in demand or artificially increase or decrease the price.

39
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
5 policies can be implemented for algorithmic trading

A

1) Do nothing
2) Banning high-frequency trading
3) Change the definition and requirements of a market maker
4) Force all trades to occur at distinct time intervals
5) Tobin tax (small transaction tax on all financial transactions)

40
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
+ and - of doing nothing

A

+ Allow for intermediaries to find their own ways to optimize costs, leading to an even greater supply of immediacy and efficient trading
- Unlikely to address investor’s concerns about fair and orderly markets.

41
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
+ and - of banning high-frequency trading

A

+ More fair and orderly markets in the short-run

- Reduce market liquidity, efficiency, capital formation

42
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
+ and - to of Change the definition and requirements of a market maker

A

+ Fair and orderly market (No withdrawal when their services are needed)
- Increase the cost of intermediaries of being present, greater legal costs

43
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
+ and - of forcing all trades to occur at distinct time intervals

A

+ Higher supply of immediacy

- Investors seemed to prove having preference for continuous systems

44
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
+ and - of Tobin tax

A

+ Increase government budget

- Decrease liquidity, transactions will migrate to other countries

45
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
four types of financial regulations

A

1) System engineered
2) Safeguards-Heavy
3) Transparency-Rich
4) Platform-Neutral

46
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
System engineered

A

Financial regulations should approach automated markets as complex systems composed of multiple software, not only from human side perspective.

47
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Safeguards-Heavy

A

Regulation should encourage safeguards at multiple levels of the system to check the fairness and the order in all transactions.

48
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Transparency-Rich

A

Financial regulation should aim to make the financial operations more transparent and accessible.

49
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Platform-Neutral

A

Financial regulation should be designed to encourage innovation in technology and finance and should be neutral how computer systems in this financial system work.

50
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Examples how algorithm trading destabilized the situation, market

A

August 2007: Arbitrage Gone Wild - Record loss of hdge fund

May 6, 2010: The Perfect Financial Storm - Order imbalance; At some point of time investors saw the highest volatility (e.g. Apple stock) orders were really enhanced

March and May 2012: Pricing Initial Public Offerings in the Digital Age - i. Facebook IPO delayed by half an hour. Took more time to calculate initial price. And when it was recalculating new offers came in place and many were cancelled.; BATS Global Market, cancelled IPO, due to “computer” glitch

August 2012: Trading Errors at the Speed of Light - i. Knight Capital lost 400m USD and went bankrupt. Algorithm dint manage to pick errors and had to sell hundreds of assets in open markets. In half an hour, the whole capital was wiped out. (150 stocks decreased in their price)

September 2012: High-Frequency Manipulation - Put the orders, so that price would decrease

51
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Quantitative models

A
  • Portfolio theory
  • CAPM
  • BS option pricing
  • Optimization models
52
Q

Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents
Which three developments in the financial industry have greatly facilitated the rise of algorithmic trading.

A
  • The financial system becoming more complex over time
  • Breakthroughs in the quantitative modeling of financial market
  • Breakthroughs in computer technologies
53
Q

The economic consequences of legal origins

Legal origin

A

is highly persistent systems or style of social control on economic life.

54
Q

The economic consequences of legal origins

What about authors argue

A

Authors argue that common law stands for the strategy of social control that seeks to support private market outcomes, whereas civil law seeks to replace such outcomes with state-desired allocations.

55
Q 
The economic consequences of legal origins
Common Law (countries)
A

English colonies and English speaking countries: United States, Australia, Canada.

56
Q

The economic consequences of legal origins

Common Law

A
  • Role of judges: large (independent judges with longer tenure);
  • Jurisprudence matters (appellant judges establish precedents);
  • Judging based on cases; can make decisions that later will be taken as precedent. Law interpretations.
  • Stands for social control that seeks to support private markets outcomes;
  • Dispute resolving.
57
Q 
The economic consequences of legal origins
Civil Law (three parts)
A

French law (original Civil law), German law (accomodates greater judicial law making) and Scandinavian Law

58
Q

The economic consequences of legal origins

Civil Law

A
  • Role of judges: small (statutes and comprehensive codes based on Roman Law);
  • Seeks state desired allocations;
  • Policy implementing.
59
Q

The economic consequences of legal origins

Differences between Civil Law and Common Law in capital markets

A 
•	Civil law
 Lower capital market development
Lower # of firms per capita
Higher ownership concentration
Lower private credit to GDP
•	Common law
- Improved financial development
- Better access to finance
- Higher ownership dispersion
60
Q

The economic consequences of legal origins

LEGAL ORIGINS THEORY

A
  1. Historically England and continental Europe have different styles of social control of economic life;
  2. These laws were involuntary transplanted via colonization to the rest of the world;
  3. Although many legal and regulatory changes happened; these styles persist till now.
61
Q

The economic consequences of legal origins

Conclusion

A

Legal rules & regulations differ across countries and these differences can be measured; diff in rules & reg are accounted by legal origins; the measured difference matters for economic and social outcomes. The authors don’t know which regulation will be in the future (if they don’t converge). But they think that common law approach to social control over economic life is better (when markets work well it is better to support them). But if bad times => civil law is better.

62
Q

The economic consequences of legal origins

Differences between Civil Law and Common Law in the government

A 
COMMON LAW
  Less corruption
 Better functioning labor markets
 Smaller gray economies
CIVIL LAW
 Corruption
 Unofficial employment
 Lower labor participation rate
63
Q

The economic consequences of legal origins

Differences between Civil Law and Common Law in the Judicial system

A 
COMMON LAW
 Secure property rights
 Better contract enforcement
CIVIL LAW
 Lower security of property rights
 Weaker contract enforcement
64
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century
Why do some countries become more open than others, or open up at some times rather than at others—do the incumbents not oppose opening up?

A

Some countries have no choice. Because they are small, or because they are close to other countries, they are likely to have more trade. Therefore, these countries are likely open for reasons that are not political. If important parts of the world are open, then natural leakages across borders (the gray trade, smuggling, under-invoicing, over-invoicing, etc.) are likely to be high and make it hard for a country to remain closed. The economic importance of other countries that are open can be thought of as largely exogenous to a country’s domestic politics.

65
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

How can we argue that the link between openness and financial development should be interpreted as one causing the other rather than simply as evidence that incumbents who favor openness also favor financial development?

A

First, in examining the link between trade openness and financial development, we instrument trade openness with a measure of natural openness (largely based on a country’s distance from its trading partners). We thus focus on the exogenous component of a country’s trade. Because distance matters less for capital, we do not have a similar instrument for cross-border capital flows. But precisely because capital is more mobile, the strategic complementarities in cross-border capital flows are likely to be stronger. So we can use world-wide cross-border capital flows over time as an exogenous measure of whether countries are more open to capital flows. International capital mobility is high both in the beginning and towards the end of the twentieth century for most countries. Thus, we test in the cross-section of countries if financial development is positively correlated with the exogenous component of a country’s openness to trade (correcting for the demand for finance), both in the beginning of the century and towards the end of the century, and it is.

66
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

What do we mean by financial development?

A

The right measure would capture the ease with which any entrepreneur or company with a sound project can obtain finance, and the confidence with which investors anticipate an adequate return. Presumably, also, a developed financial sector can gauge, subdivide, and spread difficult risks, letting them rest where they can best be borne. Finally, it should do all this at low cost.

67
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century
Various measures of financial development

A

Banking sector
Equity issues
Capitalization
Number of companies listed

68
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century
Development of Banking sector

A

 We use the ratio of deposits (commercial banks plus savings banks) to GDP as a measure of the development of the banking sector.

69
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century
Development of Equity issues

A

 The proxy we use is the ratio of equity issues by domestic corporations to gross fixed capital formation (GFCF) during the year.

70
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century
Development of Capitalization

A

 A more stable measure of the importance of the equity market is the total stock market capitalization.

71
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century
Number of companies listed as a measure of development

A

 A final indicator of the importance of equity markets is the number of publicly traded domestic companies per million of population.
One indicator that is missing from our list is the volume of securities traded.
 Unfortunately, the way volume is recorded (even today) is quite controversial.

72
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

The essential ingredients of a developed financial system include the following:

A

 respect for property rights,
 an accounting and disclosure system that promotes transparency,
 a legal system that enforces arm’s length contracts cheaply, and
 a regulatory infrastructure that protects consumers, promotes competition, and controls egregious risk-taking.

73
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

The political economy of financial development

A

 A more efficient financial system facilitates entry, and thus leads to lower profits for incumbent firms and financial institutions.

74
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

two hypothesis of the test of the private interest theory of financial development

A
  1. For any given level of demand for financing, a country’s domestic financial development should be positively correlated with trade openness at a time when the world is open to cross-border capital flows.
  2. The positive correlation between a country’s trade openness and financial development should be weaker when worldwide cross-border capital flows are low.
75
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

contributions of this work

A
  • The first is to show the reversal in financial markets, a finding inconsistent with pure structural theories of financial market development.
  • Second, is fact, that trade openness is correlated with financial market development, especially when cross-border capital flows are free.
  • Third, we argue that findings are consistent with interest group politics being an important factor in financial development across countries.
  • Lastly, we suggest that a county’s institutions might slow or speed-up interest group activities. This might indicate that institutions matter, though the way they matter might primarily be in tempering interest group activities.
76
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

Motivation of research

A

If financial development facilitates economic growth, why do so many countries still have underdeveloped financial sectors?

77
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

 Major findings

A

o Financial systems were highly developed in 1913
o Countries most advanced in 1913 do not necessarily stay advanced
- Legal Origins Theory works only after WWII
o Indicators of financial development fall then rise between 1913 and 1999

78
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

Reasons why incumbents prefer financial underdevelopment instead of more direct barriers:

A

1) Direct-entry restriction (ex: licensing) is very costly (ex: competitors create a substitute for the products whose market is restricts)
2) Active enforcement of restrictions on entry is very public and politically transparent (citizens/customers are unlikely to remain ignorant)

79
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

Reason for decrease in financial development in the period after WWI

A

o Governments created barriers to imports to get themselves out of depression (many countries followed this strategy, otherwise government won’t be able to financially support/insure its citizens)=> trade and capital flows decreased.
o Or incumbents lobbied their rights.
 After 1980 trade flows increased, because with the growing volume of trade, it was too difficult for incumbents to control for potential leakage of capital → competition forced financial modernization, and State intervention ↓

80
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

Ingredients of a developed financial
system

A

• Respect to property rights
• Transparent accounting & disclosure system
• Well-developed legal system
• Infrastructure that promotes competition,
protects consumers and controls risk-taking

81
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

An interest group theory

A

• Incumbents are against developed financial system
• Developed financial systems increase number of market
players, boost competition and wipe out incumbents’
profits
• Financial system remains underdeveloped if there are
bureaucratic barriers, powerful lobby groups against
development
• Usually incumbents have big political power (lobby)
• The only way to promote financial development –
dramatic political change

82
Q

The Great Reversals: The Politics of Financial Development in the Twentieth Century

Arguments why Structure matters

A

• Common Law countries have more developed
financial markets
• In Civil Law countries interest groups have
higher influence on politic decisions

83
Q

Does Finance Benefit Society?

Conclusion

A

• Competitive and inclusive financial system can
exist only if the rule of laws is respected and
expected to be respected in the future

Financial Economics (28 decks)

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