FINANCIAL SYSTEMS MIDTERM

What is a financial system?

combination of assets, markets, intermediaries, regulators in order to move money from savers to investors

What are the main components of a financial system?

1. assets

2. markets

3. intermediaries

4. regulators

What is the main problem the financial system helps solve? How does it solve it? What are the main dimensions of this problem?

1. investors versus projects

   1. money needs to flow, furthers economy 

   2. need architecture to carry out process

   3. contracts to secure transfers of money

Define them and define their main functions: financial assets

1. “contracts” give obligation to buyer and security to seller

2. shares, bonds, derivatives, etc

3. characteristics

   1. return: expected: dividends, coupons, price appreciation

   2. risk: return, even on the principal of the investment

   3. liquidity: how easy it is to convert it into cash

      1. T-bills/large stocks very liquid

      2. corporate bonds can be not very liquid

      3. usually more liquid is less risky

Define them and define their main functions: financial markets

1. physical or electronic place where financial assets can be bought and sold

2. primary markets

3. secondary markets

4. money markets

5. capital markets

6. order driven markets

7. price driven markets

Define them and define their main functions: financial intermediaries

1. find money and give opportunities to projects

2. pure intermediary

   1. broker, dealer: pass asset from one party to the other

3. transformer

   1. banks: transform deposits into loans, bank is party taking risk

Define them and define their main functions: regulators

1. institutions public or state that make sure everything works correctly (supervising)

2. central banks- ECB, FED, BoE, SEC

3. market regulators

1. primary markets

1. f.asset is issued/sold for the first time

   1. initial public offering (IPO)

   2. auction of T-bills (treasury)

1. secondary markets

1. “second hand” market

1. money markets

1. very short term financial instruments

   1. bills, deposits, commercial paper

1. capital markets

1. medium/long term financing

1. order driven markets

1. brokers, shares of allicanz

2. limit order book

3. most competitive price on buy side as highest price sits on top

   1. sell side is opposite of buy side (Q x P → P x Q)

   2. sell price must be higher than buy price

      1. if not you will sell immediately

   3. difference = spread

      1. sell price - buy price/ average

1. price driven markets

1. dealers, NASDAQ → D for dealer

2. buy seller price 

What is a financial market?

physical or electronic location where financial instruments are exchanged

• non electronic/non continuous markets

• open for a short period of time

• equality of information among investors

• non continuous/electronic markets

• stock market

• only open a few times a day

• stick together information

• continuous/non electronic markets

• trading floor open all day

• parallel electronic market

• continuous/electronic markets

• include every share, bond, derivatives

• work with LOB

Why are most (equity) exchanges electronic?

1. price efficiency

2. equality of access

3. volume

What is the business of an exchange?

• transaction

• settlement/compensation

• register

What are the two primary order types and what is the LOB?

1. price driven

   1. markets with market makers

2. order driven

   1. markets allow placement of orders by investors

What are the two key types of trading costs?

1. explicit costs

   1. based on country, taxes, commission

   2. all costs added to volume of operation

      1. competition btw brokers

      2. max 2.5% rates freely set otherwise

      3. commission charge shared bw market/broker

2. implicit costs

   1. depend on liquidity

   2. depth

      1. def’n: number of shares available on each side

      2. greater depth = greater liquidity

   3. bid ask spread

      1. diff btw best buy and sell price

      2. greater = less liquidity

What are the different types of markets?

• characteristics of instruments traded

  • money markets

    • very short term financial instruments, a year or less

    • high liquidity, low risk

      • bills, deposits, commercial paper

  • capital markets

    • medium/long term financing 

    • higher risk

    • stock market

• Phase of trading

  • primary markets

    • f.asset is issued/sold for the first time

      • initial public offering (IPO)

      • auction of T-bills (treasury)

  • secondary markets

    • “second hand” market

    • trade those already created

HFT/AT: cost and benefits

• high frequency trading

• costs

  • front running

    • quick access to buy/sell before others

  • quote stuffing

    • market manipulation by pretending to buy

  • quote spoofing

    • enters fake order to distort best bid

• benefits

  • place orders continuously

  • reduced risk

  • reduce spreads →  reduce transaction costs = increase liquidity

Why do we have financial regulation and regulators? PRIMARY REASONS

1. macroeconomic

   1. maintain stability of financial system, banking regulation

2. microeconomic

   1. protect users of financial services

Why do we have financial regulation and regulators? SECONDARY REASONS

• efficient functioning of financial markets

• supervision of market intermediaries: brokers, dealers

• of issuers of financial instruments by issuing public info on a regulation

• protection of investors (small)

• creation of competitive markets (ECN)

  • alternative trading systems (ATS)

• ESMA- european securities and markets authority

• ensures the integrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection

• roles:

  • Improve co-ordination among securities regulators: developing effective operational network mechanisms to enhance day to day consistent supervision and enforcement of the Single Market for financial services

  • Act as an advisory group to assist the EU Commission

  • Work to ensure more consistent and timely day-to-day implementation of community legislation in the Member States (MiFID

Who are they and what do they do? For insurance?

• general director of insurance and pensions under secretary of state for economy

• control and supervise

  • requirement compliance for expansion of private insurance, reinsurance business

• control and monitor

  • mergers/acquisitions, transfers, company break ups, insurer operations

• prudential

  • supervision/inspection of insurance co activities

• protect

  • insured, beneficiaries, affected third parties, pension plan stakeholders

Who are they and what do they do? For banks?

• European Central Bank- Supranational regulation

• FED

• regulate

  • setting rules

• supervise

  • check compliance of rules

  • done by single supervision body (SSB)

  • stress testing

• resolve

  • taking control of a bank in trouble

  • single resolution board (SRB)

• deposit guarantee fund (DGF)

  • 100,000 E per account  → at national level

  • $250,000 in US per FDIC

Who are they and what do they do? For financial systems?

• market regulation

• US: security + exchange commission (SEC)

• Europe: european securities markets authority (ESMA)

  • Spain : spanish market regulator (CNMV)

  • markets in financial instrument directive (MIFID)

What is the main regulatory framework in Europe? 

• supranational regulation (EU level)

• supranational regulation (EU level)

1. General political institutions

   1. European parliament: Regulations, Directives, Decisions

   2. Council of the EU: Directives, Regulations, Decisions.

   3. European Commission: Regulations, Directives, Decisions

2. Monetary Policy:

   1. Eurosystem and European Central Bank: Regulations and Decisions

3. The ESCB and the Eurosystem

   1. (ESCB), established under the Maastricht Treaty (TEU), is made up of the European Central Bank and the National Central Banks of all the EU member states, regardless of whether or not they have adopted the euro.

   2. The Eurosystem, on the other hand, comprises the European Central Bank and the National Central Banks of the member states that have actually adopted the euro. 30 Therefore, so long as there are member states that have not adopted this currency, it will be necessary to maintain the distinction between Eurosystem and ESCB.

national regulation

1. General political institutions

   1. Cortes Generales (General Courts): Laws, Royal Decree-laws.

   2. Government: Royal Decrees

   3. Ministry of Economy: Rules, law and Resolutions

2. Specialist supervisors

   1. Bank of Spain: regulation, implementing Monetary Policy, supervision of some markets and operators.

   2. Comisión Nacional Mercado Valores: regulation, supervision of some markets and operators

   3. Dirección General de Seguros y Pensiones (General Directorate of Insurance and Pensions) supervision of some markets and operators.

How does equity trading work in the EU?

in the EU involves buying and selling company shares on stock exchanges facilitated by brokers and subject to EU regulations.

1. Investors, who can be individuals or funds, gain partial ownership by purchasing shares.

2. trading occurs on a secondary market, where shares are continuously bought and sold after an initial public offering (IPO) in the primary market.

3. While national infrastructure still dominates, the EU aims for greater integration and harmonized rules to improve cross-border trading and investor protection. 

What institution sets Monetary Policy in the EU?

• European Central Bank (ECB)

  • main aim is maintaining price stability

    • interest rates, inflation, etc

What Monetary Policy strategy does the ECB follow and why? Provide details

• 2021 strategy approved: symmetric 2% inflation target over medium term

  • negative/positive deviations are equally bad

• independent of governments

• “ aim to fix, control and improve financial stability and therefore interest rates, inflation, etc. with the ultimate aim of promoting economic growth.”

• two cornerstones of policy

  • economic analysis

    • short/medium-term determinants of price performance

    • financial state of economy

  • monetary analysis

    • long-term link between money and prices

    • evaluation of loan and liquidity situation

What are the benefits of price stability?

1. efficient allocation of resources/increase productivity of economy

   1. improved decision criteria = calculating price variations

2. reduces inflation premium

   1. what investors demand in addition to profitability

How is Monetary Policy implemented? Instruments and mechanism

• open market operations

  • inflation rate control, market liquidity, direct monetary policy

  • four categories

    • main refinancing operations

      • national central banks inject liquidity on regular weekly basis temporarily 

      • key source of financing for loans

    • longer-term refinancing operations

      • national central banks inject liquidity on monthly basis

      • provide longer options to counterparties

    • fine tuning operations

      • hoc basis manage market liquidity and soften unexpected fluctuations on interest rates

      • national central banks also carry these out

    • structural operations

      • ECB decides to adjust position of eurosystem in comparison to financial sector

      • implemented by government bonds/bills

• permanent facilities

  • provide/absorb liquidity and overnight market interest rates in decentralized manner

  • national central banks request two types:

    • loan facility

      • obtain overnight liquidity with assets as security

      • interest rate is higher

    • deposit facility

      • place overnight deposits

      • interest rate is lower

• holding minimal reserves

  • proportion of banks liabilities that must be held by financial bodies in reserves/deposits with central bank

    • monthly average used to calculate

    • reserves earn interest at rate of eurosystem refinancing operations

What is QE? Why was it implemented?

• quantitative easing

  • buying financial assets from commercial banks/private entities to inject x amount of money into economy

  • increase money supply instead of lowering interest rates

• non standard monetary policy measures

  • LTROs

    • 2011 ECB gave two options for providing liquidity in euros w/ 3-year maturity

  • TLTROs

    • eurosystem operations provide financing to credit institutions up to 4 years

    • more restrictive than LTROs

  • APP

    • aim to maintain growth in euro area while achieving less than 2% inflation rates

• onset of crisis needed to carry out financing operations beyond three months

TARGET2 as it relates to monetary policy

• Trans-european Automated Real-time Gross-settlement Express Transfer System

• ESCB system for large euro payments

  • centralized based on interconnection of each countries payment system

  • payments settled individually with immediate value

  • payee needs balance in bank already

credibility as it relates to monetary policy

• key to price stability, built/consumed over time

• reasons for NCB needing credibility

  • influences entities expectations and inflation outlook

  • makes intervention more effective

  • independence/coherence of other econ policies → build reputation with initiatives 

What is the public fixed debt market?

• also called secondary public debt marke

• where public fixed income securities are traded

  • include coupon/periodic payment

  • may not be continuous

  • depend on variable

How is this market designed?

public fixed income debt

all securities with a predefined return issued by government

• doesn’t mean return in fixed

• issued exclusively by government

Who manages the public fixed debt market in Spain?

• Treasury of Spain

  • finances needs of state and issuing securities

  • key aims

    • stable continuous financing

    • reduce cost of financing

    • maintain level of market liquidity

    • offer investors attractive financial instruments

• also bank of spain organizes secondary market but doesnt directly finance treasury

What are the main fixed income securities?

• bonds

• notes

• convertible bonds

• coupon

• amount bond pays periodically

• expressed as % on nominal value of bond

internal rate of return (IRR)- What is the IRR and its relationship with the price of a bond?

discount rate that makes market price today same as current value of all cash flows bond will pay in future

short-term: bills

• issued through auction at discount

  • no coupon

  • price always lower than nominca100576785al value

    • difference reflects interest of security/return

    • ex. (1000-950)/950 =5.26%

• nominal value is 1000 euro

• term is usually short

  • 1-12 months

• medium term: notes

• maturity at time of issuance of more than 12 months, less than 5 years

• may pay coupons annually or semi-annually 

• par value is 1000 euro/ $100

• long term: bonds

• issued for term of more than 5 years through auction

• nominal amount 1000 euro ($100)

• coupons paid annually or semi-annually

• 10, 15, 30, 50 years

convertible bonds

are generally hybrid bonds between debt and equity where an interest is paid to the investor and, in addition, there is the option to convert these bonds into shares of the company or bank that issued them.

How are fixed income markets organized?

• primary market

• secondary market

primary fixed income markets

• gov of spain issues debt w/ different maturities via treasury

  • competitive tender as issue procedure

    • competitive bids (volume/price)

      • need price the same or higher than marginal price

      • credit institutions attend tender or redistribute debt or sell to third parties

      • single issue offered

    • non-competitive bids (volume)

      • filled at weighted average price

  • sets volume, marginal price, weighed average price

secondary fixed income markets

• carried out using four systems

1. intermediaries/blind brokers (1st tier)

   1. accessed by market makers who trade in public debt

   2. electronic, dont know counterparty

   3. buy/sell prices w/ small spread = guaranteed liquidity for market

   4. SENAF/MTS

2. bilateral trading system (2nd tier)

   1. direct or via broker

   2. trading between account holders

   3. intermediary matches operation, informs parties of counterparty

   4. communicate in terms of operation to TARGET2 for settlement/compensation

3. electronic public debt exchange/multilateral trading

   1. continuous electronic trading

   2. real time reporting

   3. min size is 1000 euro

   4. blind market

   5. cash and forward operations carried out

4. portfolio/fund managers

   1. used by investment funds and pensions both resident/non-resident

What are the main risks for bonds?

• interest rate/price risks

  • Price risk: the possibility that when the investor wants to sell the instrument, its selling price is lower than the buying price

• reinvestment risk

  • it may be that on that date the return offered by the instruments is lower than the one obtained initially with this maturity

• lack of liquidity risk

  • a possible penalisation in the price obtained on disposing of the investment, if it should be necessary to make a quick sale. 

• credit risk/insolvency

  • the issuer of a security cannot meet their payments obligations for either coupons or repayment of principal, or that payments are delayed

pricing in public debt market

• price is discounted current value of future coupons and principal

• coupon is not return

  • return not guaranteed besides to maturity

• bills quoted in interest rates

• notes/bonds quoted price w/out accrued interest

What is the relationship between bond risks, the yield curve, duration, and bond ratings?

• Bond risk is influenced by bond ratings and duration, with lower ratings and higher duration indicating greater risk

• The yield curve, representing the relationship between yield and maturity, shows how investors perceive these risks, often demanding higher yields for longer maturities (a steeper curve) to compensate for interest rate and credit risk.

• Ratings agencies assess credit risk, while duration quantifies a bond's sensitivity to interest rate changes, and both factors determine the yield an investor expectations

types of operations

1. ordinary operations

2. repo operations

ordinary operations

• cash operations; buyer receives full rights to security

• transfer of security, coupons, value of securities on maturity 

  • include those settled 5 days subsequent on transaction/later

repo operations

• investors perform one of purchase and one of sale

• one in cash, other is forward

• settling day of operation

• buyer has full availability of securities regardless of date of return

  • freedom to sell assets before expiration of purchase/sale agreement

• implied repo rate

  • rate of return earned by simultaneously selling a bond futures (contract), then buy actual bond of equal amount in cash w/ borrowed money

  • bond held until delivered into futures and loan is repaid

1. kingdom of spain = issuer

2. 1000 euro = nominal par value

3. 3.00% = coupon

4. october 2028 = maturity

Who trades in the Interbank Market and what are the primary function of this market?

1. credit institutions trade short-term very liquid instruments

2. functions

   1. obtain price of money via loans that financial institutions carry out with each other

      1. uses TARGET2

   2. To allow financial bodies to manage their treasury surplus efficiently, with the possibility of lending among themselves for a profit.

   3. To allow them to cover possible shortfalls in their compliance with liquidity ratios

      1. given that they can borrow very short-term funds and issue short-term securities.

   4. To allow them to obtain financing for active operations (in other words, financial leveraging).

   5. indicator of the monetary and financial climate of a country

      1. that they are the first markets to receive the signals given by the monetary authorities to the financial system as a whole.

What are the five different segments of the market?

1. secure segment(repo)

2. unsecured segment (lending/depos)

3. issuance of short-term securities (STS)

4. foreign exchange swaps (FX)

5. overnight index swaps (OIS)

1. secure segment (repos/reverse repos)

1. largest segment (56%) since 2008

2. lower regulatory costs and counterparty risks than unsecured

3. ordinary repos

   1. sales of instruments with agreement to buy back (purchase + sale)

   2. loans secured by gov bonds → some collateral

   3. party transfers public debt security to another for less than 1 year

   4. repurchase price agreed on interest rate

   5. binding operations

   6. buyer holds legal title to collateral

      1. entitled to coupons, dividends, income etc

   7. seller retains risk

      1. compensated by reduction in repurchase price required to buy back (manufactured payments)

4. ECB/NCB only intervene in repo

unsecured segment (lending/depos)

1. banks adjust their euro liquidity needs with other banks for maturities ranging from one day to one year

   1. most transactions are one day maturities

2. interest rates used as reference rate for ESTR and Euribor

3. 2008 crisis

   1. drastic reduction in trading volume → now mainly domestic base

1. foreign exchange (FX) swaps

1. is a contract in which two parties make a commitment to exchange a series of amounts of money on dates in the future

   1. any future exchange of goods or services (including money) referenced to any observable variable

   2. derivative instrument 

2. two types:

   1. Fixed/variable rate swaps can be defined as the commitment where one party pays/receives a fixed rate on a pre-defined notional amount N1 and receives/pays a variable rate on pre-defined notional amount N2. Normally N1 = N2 = N. 

   2. The Notional amount is the amount the interest rate is applied to. 

overnight index swaps (OIS)

1. applies an overnight rate index such as the €STR or the LIBOR rates. 

   1. The interest of the overnight rate portion of the swap is compounded and paid at reset dates (1 day or 1 week or…), with the fixed leg being accounted for in the swap's value to each party. 

   2. The floating leg's present value (PV) is determined by either compounding of the overnight rate or by taking the geometric average of the rate over a given period.

What is a REPO?

• repo market most important*

  • sell a T-bond to another bank with promise to buy it back later

  • short term, very liquid operations among banks

What is a FRA?

• forward rate agreement: contact that involves an agreement on a future loan at a previously agreed interest rate on a pre-determined quantity and for a pre-defined time period.

• does not involve actual loans being produced but rather, as with some derivatives, the parties settle the difference

• defined in FRA:

  • three dates: deal date, settlement date and termination date

  • the notional amount

  • interest rate agreed

• two types:

  • variable: the maturity is set by the parties

  • fixed: the maturity is standardised. Standardising maturity and volume facilitates subsequent trading

depo markets

1. almost absent since 2008 crisis

2. advantage is you don't need collateral 

3. disadvantage is higher interest rate > repo market

4. euribor rates

   1. offer rate for loans/deposits btw major banks in euro zone

   2. everyday banks produce average interest rates and send to ECB

   3. average for 1 week, 1 month, 3 months… 12 months 

   4. usages of euribor

      1. variable mortgages at floating rates

         1. 12mon + 0.50% 

         2. 2025 = 2.20% + 0.50% = 2.70%

      2. corporate ending short term

         1. typical euribor 3 months

      3. FRAS settlements 

what is the SOFR?

• secured overnight financing rate

• a benchmark interest rate for U.S. dollar-denominated loans and derivatives that measures the cost of borrowing cash overnight, backed by U.S. Treasury securities.

• It serves as a reliable, transaction-based alternative to the former LIBOR rate.

What is the €STR?

• euro short term rate

  • risk free index created after 2008 crisis important to transmission of monetary policy

  • reflect the cost to banks of taking funds in the wholesale market in very short-term (overnight) deposit operations

    • as well as wholesale euro unsecured overnight borrowing costs of euro area banks

  • calculated/published by ECB

    • €STR is a volume weighted trimmed mean rounded to the third decimal

how does €STR compare with LIBOR before and after its reform?

• It is an alternative to the London Interbank Offered Rate (LIBOR)

  • which was an interbank lending rate that was phased out due to manipulation concerns.

• The primary difference is that the €STR is a transaction-based, near risk-free rate (RFR),

• while LIBOR was a survey-based rate that was not anchored in actual transactions interbank offered rate

Commission formular

Quantity x (Ask/bid) x commission decimal

• commission decimal: BP → expressed as % → divide by 100 again

net return % formula

Profit / Purchase

• purchase = (Q x buy)

• always express as %

explicit cost formula

Commission buy + Commission Sell ( in BP)

implicit cost formula

• find midpoint of buys/sells separately

• compare each midpoint w/ ask/bid prices

• take differences and add them

• multiply by number of shares

steps to find profit

1. find sale and purchase (Q x sell/buy)

2. sale - purchase

3. multiply each separate sale/purchase by BP commission decimal (commission)

4. add commissions together (explicit costs)

5. subtract: (sale - purchase) - (explicit costs)

repo rate annualized formula

[( Pbuy / Psell ) -1] 360/x days

clean price

dirty price - accrued interest

accrued interest

coupon x (number of months past last coupon/12)

rates vs yields when solving FRAs

• if rates > yield, then seller returns money to FRA (buyer)

• if rates < yield, then FRA(buyer) returns to seller

when solving bond prices: increase in rate = decrease in price

1. r = coupon, P = nominal

2. r > coupon, P < nominal

3. r < coupon, P > nominal

r

yield

PV

C/(1+r)¹  + C/(1+r)²… + (C+N)/(1+r)ⁿ 

dirty price

1.  P bond = NPV(Fj) = F1/(1+r) + F2/(1+r)² + F3+N/(1+r)³

dutch auctions

everybody at marginal price in this zone