FinancialMarketsandgrowth

UniversitéParis-DauphineInternationalOffice

2017-2018By

YeganehForouheshfarYeganeh.forouheshfar@dauphine.fr

R E S E A R C HU N I V E R S I T Y

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Introductiontothiscourse• Outlineofthecourse:

– Ch1:Introduction,keydefinitionsandsomehistory– Ch2:Financeandgrowthnexus– Ch3:Growth,inequality,povertyandfinancialdeepening– Ch4:TheStructureofthefinancialsector– Ch5:Financialrepressionand liberalization– Ch6:Thedomesticfinancialsystem

• Evaluation:50%Finalexam,50%presentation(yourattitudeintheclasscanplayarole!)

• Theslidesareavailableathttp://forouheshfar.com/course-fmg/

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Readingsuggestions• “DevelopmentFinancedebatesdogmasandnewdirections”-

StephenSpratt(2009)

• “FinancialMarketsandInstitutions”- FredericS.Mishkin &StanleyEakins(8thEdition-2015)

• Worldbank:Globalfinancialdevelopmentreport– annually

• IMF&OECD:workingpapersandreports

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Chapter1:Introduction,keydefinitionsandsomehistory

FinancialMarkets andGrowth2017-2018

ByYeganehForouheshfar

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Outlineofthechapter

• WhatarefinancialMarkets• Definingkeyterms• Classificationoffinancialmarkets• Howdofinancialmarketsdifferfromothermarkets

• Majorrolesofthefinancialsystem• Marketorgovernment:Somehistory

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WhatarefinancialMarkets?• Financialmarketsperformtheessentialfunctionofchanneling

fundsfromeconomicplayersthathavesavedsurplusfundstothosewithashortageoffunds.

• Exchangebetweenthesetwogroupsofagentsissettledinfinancialmarkets.

• Thefirstgroupiscommonlyreferredtoaslenders,thesecondgroupiscommonlyreferredtoastheborrowersoffunds.

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Featuresofaneffectivefinancialsystem

• Financialtransactionsarebasedontrust

• Stronglegalinfrastructure

• Safe,reliableandefficientpaymentsystem

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Definingkeyterms• Thereexisttwodifferentformsofexchangeinfinancial

markets.Thefirstoneisdirectfinance,inwhichlendersandborrowersmeetdirectlytoexchangesecurities.

• Thesecondtypeoffinancialtradeoccurswiththehelpoffinancialintermediariesandisknownasindirectfinance.Inthisscenarioborrowersandlendersnevermeetdirectly,butlendersprovidefundstoafinancialintermediarysuchasabankandthoseintermediariesindependentlypassthesefundsontoborrowers

Securities areclaimsontheborrower’sfutureincomeorassets.Commonexamplesarestock,bondsorforeignexchange

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Anoverviewofthefinancialsystem

Source:Mishkin &Eakins(2015) 9

Definingkeyterms (cont.)• Asset:Anypossessionthathasvalueinanexchange.

– Tangibleassets:Itsvaluedependsonparticularphysicalproperties:Ex.buildings,land,machinery,…

– Intangibleassets:Legalclaimstosomefuturebenefit(itsvaluebaresnorelationtotheform,physicalorotherwise,inwhichtheseclaimsarerecorded):Financialassets/instruments

• Issuer (ofthefinancialinstrument):Entitythathasagreedtomakefuturecashpayments.

• Investor:Ownerofthefinancialinstrument.

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ExamplesoffinancialinstrumentsContext Issuer Investor Termsoftheloan

AloanbyBNP Theindividualwhobuysacar

Commercialbank

Specifiedpaymentsovertime=repaymentoftheloan+interest

Abond issuedbytheFrenchgovernment

Frenchgovernment

Buyerofthebond

Interestpaymentseverysixmonth tillmaturitydate->amountborrowed

Abond issuedbyTotalInc.

Corporation Sameasabove!

Abond issuedbythegovernment ofAustralia

Acentralgovernment

Sameasabove!

AshareofcommonstockissuedbyL’Oréal

Corporation Receivedividends+aclaimtoaproratashareofthenetassetvalueincaseofliquidation

AshareofcommonstockissuedbyToyotaMotorCorporation

TheJapaneseCorporation

Sameasabove!

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Definingkeyterms(cont.)• Globallywecanidentify2typesofFinancialinstruments(identifiedbytypeofclaimthattheholderhasontheissuer):

1. Debtinstrument:Theissueragreestopayinterestandrepaytheamountborrowed

2. Equityinstrument:Obligatestheissuerofthefinancialinstrumenttopaytheholderanamountbasedonearnings,ifany,aftertheholdersofthedebtinstrumentshavebeenpaid.Ex:commonstock,apartnershipshareinabusiness

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Characteristicsofdebtinstruments• Debtinstrumentsinclude:loans,moneymarketinstruments,

bonds,mortgage-backedsecuritiesandasset-backedsecurities.

• Maturity:Thenumberofyearsoverwhichtheissuerhaspromisedtomeettheconditionsoftheobligation

• MoneymarketinstrumentàMaturity<1year• CapitalmarketdebtinstrumentàMaturity> 1 year

• Parvalue/principal/facevalue/maturityvalue:Theamountthattheissueragreestopaybythematuritydate.

• Couponrate/nominalrate/contractrate:Theinterestratetheissueragreestopayeachyear.Thefrequencyofinterestpaymentsvariesbythetypeofthedebtinstrument.

• Zero-coupon bonds:debtinstruments thatarenotcontractedtomakeperiodiccouponpayments

• Floating ratesecurities:coupon paymentsresetperiodicallyaccordingtosomereferencerate

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Definingkeyterms(cont.)• Financialmarkets:Wherefinancialinstrumentsareexchanged

3majoreconomicfunctions• Interactionofbuyerandsellersdeterminethepriceoftradedasset(pricediscoveryprocess)

• Amechanismforaninvestortosellafinancialinstrument(offeringliquidity)

• Reducingthetransactioncosts– Searchcost :Ex.advertising– Informationcost:tocalculatethemeritsofafinancialinstrument

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Classificationoffinancialmarkets1. Type offinancialclaim

• Debtmarkets• Equitymarkets

2. Maturity oftheclaim• Moneymarket• Capitalmarkets

3. Issuance:• Primarymarket (newlyissued)• Secondarymarket (previouslyissued)

4. Time ofthetransaction:• Cashmarket• Derivativesmarket(Thecontractholderbuysorsellsafinancial

instrumentatsomefuturetime)5. Organizational structure:

• Auctionmarket/organizedExchange• Over-the-countermarket 15

Debtvs.Equity• Debttitlesarethemostcommonlytradedsecurity.Inthese

arrangements,theissuerofthetitle(borrower)earnssomeinitialamountofmoney(suchasthepriceofabond)andtheholder(lender)subsequentlyreceivesafixedamountofpaymentsoveraspecifiedperiodoftime,knownasthematurityofadebttitle

• Debttitlescanbeissuedon:– shortterm(maturity<1yr.)– longterm(maturity>10yrs.)– intermediateterms(1yr.<maturity<10yrs.)

• Theholderofadebttitledoesnotachieveownershipoftheborrower’senterprise

• Commondebttitlesare bondsormortgages16

Debtvs.Equity(cont.)• Themostcommonequitytitleis(common)stock

• Anequityinstrumentsmakesitsbuyer(lender)anowneroftheborrower’senterprise

• Formallythisentitlestheholderofanequityinstrumenttoearnashareoftheborrower’senterprise’sincome,butonlysomefirmsactuallypay(moreorless)periodicpaymentstotheirequityholdersknownasdividends.Oftenthesetitles,thus,areheldprimarilytobesoldandresold

• Equitytitlesdonotexpireandtheirmaturityis,thus,infinite.Hencetheyareconsideredlongtermsecurities

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Debtvs.Equity(cont.)Twoformsofequitymarket:

1)Publicequitymarket(sharemarkets/stockexchanges):Wherecompanieslist theirsharesfortradingpurposes.Totalvalueofthecompany’soutstandingsharesàMarketCapitalization (Ex:acompanywith100millionshares&eachsharehasamarketvalueof10$àcap.=?) Investorsreceivedividends

2)Privateequity:Sharesarenotlistedonapublicmarket,theyaresolddirectlytotheinvestors

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Moneymarketsvs.capitalmarkets• Moneymarketsaremarketsinwhichonlyshorttermdebt

titlesaretradedEx:Banker’sacceptances,commercialpaper,governmentbills

withshortmaturities

• Capitalmarketsaremarketsinwhichlongerterm debtandequityinstrumentsaretraded:Bondmarkets:Ø EnableInc.orgov. toborrowdirectlyfrominvestorsinthecapital

markets)Ø Regularstreamofincomepaymentsthroughcoupons.(interest

payments)Ø Paymentofthedebt’sprincipal uponmaturity

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Primarymarketvs.secondarymarkets• Primarymarketsaremarketsinwhichfinancialinstruments

arenewlyissuedbyborrowersØ Theyarenotveryknowntothepublic(sellingbehindcloseddoors)Ø Animportantinstitution:investmentbanks

• SecondarymarketsaremarketsinwhichfinancialinstrumentsalreadyinexistencearetradedamonglendersØ Ex:TheNewYorkStockExchangeØ Ex:NASDAQ

Themagnitudeofthecouponissetatthetimeofissuanceà Fixedinterest

Inthesecondarymarkets,afallinthepriceofthebondresults inanincreaseintherateofinterest,oryield paid.

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Cashvs.Derivativesmarket

Derivativesmarkets:2typesofbasicinstruments:

» Futures/forwardcontract:transactionofafinancialinstrumentatapredeterminedpriceataspecifiedfuture.

»Optioncontract:Ownerofthecontracthastherightbutnottheobligationtobuy/sellafinancialinstrumentataspecificpricefromanotherparty.

• Toolsforhandlingoffinancialrisk:Derivativescanbeusedforanumberofpurposes,includinginsuringagainstpricemovements(hedging),increasingexposuretopricemovementsforspeculationorgettingaccesstootherwisehard-to-tradeassetsormarkets.

Timeofthetransaction!

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Exchangevs.over-the-countermarkets• Secondarymarketscanbeorganizedas:

Ø OrganizedExchange,inwhichbuyersandsellersofsecuritiesmeetinonecentrallocation,suchasastockexchange(Avisiblemarketplaceforsecondarymarkettransactions)

ØOver-the-counter(OTC)marketsinwhichdealersatdifferentlocationswhohaveaninventoryofsecuritiesstandreadytobuy&sellsecuritiestoanyonewhocomestothem.(Atelecommunicationnetwork)üTitlesaresoldinseverallocationsüVerycompetitivesinceOTCdealerareincomputercontactandknowthepricessetbyanother

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Nationalorinternational?

• Capitalandmoneymarkets National

• Forex andderivativesmarkets International

FXmarkets:(Foreignexchangemarket/Forex)Amarketfortradingcurrenciesinternationally

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• Internationalizationofthefinancialmarketsà importanttrend

• Americancorporationsarenowmorelikelytotapinternationalcapitalmarketstoraisefunds

• Foreignersbecomeimportantinvestors(inUS,France,…)

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InternationalBondMarket• Foreignbonds:aresoldinaforeigncountryanddenominatedinthatcountry’scurrencyEx:ifPorschesellsabondinUSdenominatedin$àforeignbond

• Foreignbondhavebeenanimportantinstrumentforcenturies:alargepercentageofUSrailroadsbuiltisthe19th centurywerefinancedbysalesofforeignbondsinBritain

• Arecentinnovationintheinternationalbondmarket:Eurobond 26

• Eurobonds:AbondissuedinacurrencyotherthanthecurrencyofthecountryormarketinwhichitisissuedEx:AbondthatisdenominatedinU.S.dollarsandissuedinJapanbyanAustraliancompany

• AvariantoftheEurobondàEurocurrencies:foreigncurrenciesdepositedinbanksoutsidethehomecountry

• ThemostimportantEurocurrenciesareEurodollars:US$depositedinforeignbanksoutsidetheUS

AbonddenominatedineurosiscalledaEurobondonlyif itissoldoutsidethecountriesthathaveadoptedtheeuro

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Commercialfinancialinstitutions• Commercialbanks:

• Investmentbanks:

• Universalbanks:

• Mortgagebanks:

• Contractualsavings:

• Assetmanagementcompanies:

• Venturecapitalists/Privateequitycompanies:

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Commercialfinancialinstitutions• Commercialbanks:Takedepositfrompublicandlendto

individualsandcorporateborrowers.ü Differencebetweentheinterestratepaidtosaversandthatchargedto

borrowers Spreadü Thesebankstransformshorttermliabilitiesintolongtermassets

• Investmentbanks:Financialservicesthataregenerallyrelatedtothebusinesses(findingandstructuringvariousformsoffinance,issuanceofcorporatebonds,arrangementofmergersandacquisitions,…)

• Universalbanks:Combinefunctionsofcommercialandinvestmentbanks

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• Mortgagebanks:Providefinanceforthepurchaseofproperty.

• Contractualsavings:Institutionssuchaspensionfundsandinsurancecompanies.

Assetmanagement:Ø In-houseØ Out-sourced

• Assetmanagementcompanies:provide“Portfoliomanagement”servicesbyaccessingpublicandprivatefinancialmarkets

• Venturecapitalists/Privateequitycompanies:ProvidecapitalforneworexpandingbusinessInthelast2decades,wehaveseenaconsiderabledestructionofthe‘functionalboundaries’betweendifferenttypesofbankandnon-bankfinancialinstitutions. 30

Quasi-commercialfinancial institutions

• Statedevelopmentbanks:Ownedbygovernments,directcredittoprioritiesofthegovernment.

• Mutualcooperativebanks:Collectivelyownedbytheirmembers.(higherinterest,lowercharges)

• Postofficesavingsbanks:Basicfinancialservices(lowincome)

• Creditunions:Ownedbytheirmembers,creditgrantedtomembersonlowincomes

• Microfinanceinstitutions:Providingthepoorwithaccesstofinancialservices,informofbank,cooperative,creditunionetc.

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Governmentalfinancialinstitutions• Centralbanks:Havethemonopolyoffiatmoney

issuance.– Provideliquidity(controlmoneysupply)– LOLR:actasalender-of-lastresorttothedomesticbankingsystem

Mainfeatures:ØNationalpaymentsandsettlementsystemØ Prudentialregulation/supervisionØ InsurancefordepositsØ Executemonetarypolicyà inflationtargetingØ Exchangeratepolicy

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TypesoffinancialIntermediaries

1. Depositoryinstitutions:Financialintermediariesthatacceptdepositsfromindividualsandinstitutionsandmakeloans.

2. Contractualsavingsinstitutions:Financialintermediariesthatacquirefundsatperiodicintervalsonacontractualbasis.

3. Investmentintermediaries

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Financial

Intermediaries

Contractual savings

Institutions

Investment Intermedari

es

Depository Institutions

Commercial Bank

Mutual Funds (Investment Funds)

Finance Companies

Pension Funds

Credit Unions

Insurance Companies

Savings and Loans Associations (S&L)

Mutual Saving Banks

Money market Mutual Funds

Specialized Banks

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Howdofinancialmarketsdifferfromothermarkets?

Timeandmanagementofrisk• Deliveryinfutureasopposedtothepresent,futureis

uncertainà Riskyà interestpayment(timevalueofamoney)

• Transfersacrosstime:smoothingconsumptionandinvestment

• Transferandmanagerisk• Creditrisk:dangerofdefault• Marketrisk:lossbysuddenchangesinassetprices• Liquidityrisk:unabletosellassetsquicklywithoutloss• Systemicrisk:contagionfromanotherbank

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Risksassociatedwithinvesting• Definitionofrisk=hazard,peril,exposuretolossorinjury• Quantifyingriskà thevarianceofanasset’sexpectedreturn

• Criticisms oftheuseofthevariance:– Thepossibilityofreturnsabovetheexpectedvalue(favorableoutcomeviewedasunfavorable)• Propositionsàmeasuresofdownsiderisk:riskofloss,valueatrisk

– Varianceisonlyonemeasureofhowthereturnsvaryaroundtheexpectedreturnà variance+Skewness

What isavariance?

Skewness:measurestheasymmetryofadistribution38

Mainrolesofthefinancialsystem(Levine,2005)

1. Producinginformationandallocatingcapital:

Ø Largecostsof:Evaluatingfirms,managersandmarketconditionsàHighinformationcostsmaykeepcapitalfromflowingtoitshighestvalueuse

Ø Improveresourceallocation

Ø Leadstoamoreefficientallocationofcapital

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Mainrolesofthefinancialsystem(cont.)

2. Monitoringfirmsandexertingcorporategovernance:

Ø Shareholdersmayexerteffectivegovernancedirectly byvotingoncrucialissues(mergers,liquidations,…)orindirectly byelectingboardsofdirections.

Ø Wellfunctioningstockmarkets:Linkingstockperformancetomanagercompensationhelpsaligntheinterestofmanagerswiththoseofowners

Ø Debtcontracts:reducetheamountoffreecashavailabletofirmsà reducesmanagerialslackAcceleratestherateofadoptionofnewtechnologies

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3.Riskamelioration:Ø Cross-sectionalriskdiversification:high-returnprojectstendtoberiskierthanlow-returnprojectsà financialmarketsmakeiteasierforpeopletodiversifyriskandshiftportfoliostowardshigherexpectedreturns.

Ø Intertemporal risksharing:Someriskscannotbediversifiedataparticularpointintime,suchasmacroeconomicshocks,theycanbediversifiedacrossgenerations.Long-livedintermediariescanfacilitateintergenerationalrisksharingbyinvestingwithalong-runperspective.

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ØLiquidityrisk:Liquidityreflectsthecostandspeedwithwhichagentscanconvertfinancialinstruments intopurchasingpoweratagreedprice.Liquidityrisk uncertaintiesassociatedwithconvertingassetsintoamediumofexchangeLinkbetweenliquidityandeconomicdevelopment:High-returnprojectsrequirealong-runcommitmentofcapital,notsavors’favorite!(Ex.Industrialrevolutionandliquidcapitalmarketsin18thcenturyinEngland)

Anotherformofliquidity:accesstocreditduringtheproductionprocess

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4.Mobilizeandpoolsavings:

Ø Theprocessofagglomeratingcapitalfromdisparateinvestorsiscostly

Ø Financialarrangementsthatmobilizesavingsfrommanydiverseindividualsandinvestinadiversifiedportfolioofriskyprojectsfacilitatereallocationofinvestmenttowardhigherreturnactivitieswithpositiveeffectsoneconomicgrowth.

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5.Easetheexchangeofgoodsandservices

Ø Financialarrangementslowertransactioncost

ØMorespecializationrequiresmoretransactions,sinceeachtransactioniscostlyà financialdevelopmentleadstomorespecialization àpositiveimpactongrowth

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Roleoffinancialmarkets:aSummary

• Althoughinapureneoclassicalframeworkthefinancialsystemisirrelevanttoeconomicgrowthinpracticeanefficientfinancialsystemcan:

• Lowerthecostofexternalborrowing• Raisethereturntosavors• Ensurethatthesavingsareallocatedtoprojectsthatpromisehighestreturns

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Financialsectorandthegovernment

• Governmentsregulate theactivitiesofthefinancialsystem

• Governmentsborrowfromthefinancialsystem:issuanceofsovereignbonds

• Governmentsmaytakemoredirectroleinthesystem:Intervenedirectlyinthefunctioningofthesystem,e.g.directingtheallocationofcreditthroughdevelopmentbanks,owningorcontrollingasectionofacommercialbank

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Shouldit?Towhatextent?

Marketorgovernment:Somehistory• BeforeKeynes:Althoughmarketscanfailthesefailuresare

justanomalouseventsà PeriodoffreecapitalmovementsOptimismaboutthenatureandroleoffreemarkets

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• Keynes(1936):imperfectionsareinherentinmarketsandthereisnonaturaltendencytowardstheproductionofoptimaloutcomesà Toensurethedesirableoutcomesofhighlevelsofgrowthandemployment,governmentsshouldnecessarilyinterveneintheeconomy.

• (WithouttheGreatDepressionKeynesviewswouldnothavetheimpactthattheydid!)

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• IrvingFisher,thegreatdepressionandBrettonWoods:

Ø Anotherstrandofthoughinthisperiod:viewingfinancialcrisisasanintegralpartofthebusinesscycle(notanomaliesorrationalresponsetodeterioratingeconomiccircumstances)

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Ø Fisher(1933)attemptedtodeterminetherootcauseoftheGreatDepressionà Acrucialfactor:levelofdebtintheeconomy§ Upswingsintheeconomyencourageincreasingdebtlevels(appearanceofgreaterinvestmentopportunities)

§ Higherinvestmentà higherdebtà growthofspeculationinassetmarket(gainsthroughrisingassetprices)à raiseininflationrate(increaseinborrowingincreasesmoneysupply)àreducesthevalueofdebtàencouragingmoreborrowing

§ Atacrucialpoint:CRISISà borrowersarenolongertomeettheirliabilities,theyliquidatetheirassets(distressselling)à deflationà debtincreasesà fearofbankinsolvencyàbankrunsà activitydeclinesàunemploymentrises 52

• IrvingFisher,thegreatdepressionandBrettonWoods(cont.):

Ø TheGreatDepression(1929-1939),shookpeople’sfaithintheabilityoffreefinancialmarketstodeliveroptimaloutcomes.

Ø BrettonWoodsinNewHampshirein1944:§ Representativesof44countries§ Aim:toconstructaninternationaleconomicsystemthatwouldreduce

theinstabilityofthefinancialsystem§ Thesereformscausedlongperiodofstability§ Currenciesholdingtotheirpeg§ Internationalmovementofcapitalwasgreatlyrestricted§ Keynesarguedthatcapitalcontrolsshouldbeobligatoryonall

countriesà IMFwouldallowsuchcontrolsbutnotinsistsuponthem

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• Structuralism:

Ø Destructionofmarketswasnotlimitedtoindustrialcountries

Ø InLatinAmericathestructuralismdevelopedwithintheEconomicCommissionforLatinAmerica(ECLAC)in1947§ Structuralist approach:“center-periphery”paradigm:UnequalnatureoftheworldeconomicsystemTheindustrialrevolutionin“center”à increasetheproductivityofthefactorsofproductionDevelopingcountries,“periphery”,havetoexportmoreandmorethesefactors(commodities)tobeabletoimportthesamequantityofcapitalgoodsà trappedincommodityproductionandexporttoservethecenter

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• Structuralism(cont.):

§ “Import-substitutionindustrialization”/ISM:Hightariffsonindustrialimports,exceptforessentialhigh-techcapitalgoods

Aim:movetheeconomyontoavirtuouscircleofindustrialization,risingproductivity,wagesandemployment.

§ Encouragecapitalinflowstofundthisdevelopment§ Criticismin60s:keyindustrializingsectorscontrolledbyforeigninvestors

§ Sweptawayin70s:authoritarianmilitaryregimesandmonetaristpolicies

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• Monetarismandreturnoffaithinmarkets:Ø Kindleberger (1978)distinguished2differentschoolsofthoughts:modernschoolsofmonetarismandKeynesianism(Currencyschool vs.Bankingschool)

ØCurrencyschool:ControlthemoneysupplyØBankingschool:Expandit

Ø Monetarists:Moneysupply(M)isexogenoustorealincome(Y),prices(P)andinterestrate(R)i.e.anincreaseinMà increaseinPbutnochangetoYFaithinabilityoffreemarketsandpriceadjustmentmechanismandlittlefaithinstate’sabilitytotakethisrole

Ø Keynesians:“quantitytheoryofmoney”:increasingMcouldincreaseY,Misendogenousandaresponsetocreditneeds

ØDominanceofeachschoolindifferentperiodsØPost-war:BankingschoolØ1970s:collapseofthefixedexchangeratesàMonetarist

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• Neo-liberalism:Ø ChicagoSchoolofEconomics:efficiencyofmarketsandfree

competitionvs.governmentinterventionsinmarketsthatdistortmarketsandpreventoptimaloutcome

Ø Noneedforgovernmenttointerveneintheeconomytoensurefullemployment,inafreemarketsituationpriceswilladjusttoensurethatallfactorsofproductionareemployed

ØMarketsautomatically adjusttofullemploymentmonetaryorfiscalpolicymerelycreateinflation

Ø ElectionofMargaretThatcher(1979)andRonaldReagan(1980)à ideologicalperspectivecametothefore

Ø Neverthelessearlypuremonetaristpoliciessuchascontrolforthemoneysupplyweresoonabandoned 58

• Neo-liberalism(cont.)Ø Relevantdomesticpolicyproposals

Ø Thederegulation ofdomestic financialmarketsØ PrivatizationØ Reduction inthepoweroftradeunionsØ SmallergovernmentØ LowertaxratesØ Opening theinternationalgoodsandcapitalmarkets

Ø In1990,thebirthadriseofthe“WashingtonConsensus”:Ø PrivatizationØ FreetradeØ Export-ledgrowthØ FinancialcapitalmobilityØ Deregulated labormarketsØMacroeconomicprudence

Ø Interventioninmarketsisusuallycounterproductive;regulationsshouldbelightandmarketsshouldbefreed

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• Financialfragility,uncertaintyandasymmetricinformation

ØKindleberger (1978)distinguishedbetween“upswings”(maniabehavior)and“downturns”(panicbehavior)intheeconomy

ØInupswingà demandforcreditincreasesà riseinbankloansà assetpricesriseà encouragemoreborrowingà thebubble expands

ØDistinguish:ØInsiders:areawareofthesituation,selloutatthetopofthemarket

ØOutsiders:attractedbythemania60

• Financialfragility,uncertaintyandasymmetricinformation(cont.)

ØBubblecancontinuetoexpandifoutsidersoutnumberinsidersà atsomepoint:Periodof“distress”whennatureofbubbleisrecognizedandinfluxofoutsidersceaseà untilsometriggersetsoffapanicandinvestorsrushtowithdrawtheirfunds(likeabankrun)

ØE.g.dotcomboomoflate1990sortheDutchTulipmaniain1637(Atthepeakoftulipmania,inMarch1637,somesingletulipbulbssoldformorethan10timestheannualincomeofaskilledcraftsman!!!!)

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(Whatarebubbles?)

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• Financialfragility,uncertaintyandasymmetricinformation(cont.)

Ø Keynes(1936):FutureisinevitablyuncertainThereisnowaytodeterminethevalueofatrueassetintoday’smarketà thetruevalueisthediscountedfutureprofitsàtheseprofitscannotbeknown

Ø Davidson(1998):Agentsanalyzepastandpresentmarketdatainformingrationalexpectationsasabasisformakingutilitymaximizingdecisionsà awaytoobjectivelyobtain“fundamentalprice”thatthemarketcanconvergeon

Ø Allnewinformationisinstantlydiscountedintothecurrentmarketpriceà nopossibilityofspeculativeprofit,boomsandcrashes! 66

• Financialfragility,uncertaintyandasymmetricinformation(cont.)

Ø Newstrandoftheoryin1980s:Asymmetricinformation(JosephStiglitz - Nobelprize):lendersandborrowersdonothaveaccesstoequalinformation(usuallyborrowersarebetterinformed!)

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• Financialfragility,uncertaintyandasymmetricinformation(cont.)

ØMishkin (1996):2problemsofasymmetricinformation:ØAdverseselection(beforethetransactionoccurs):Indebtandequitymarketslendershavenowaytodistinguishgoodborrowersfrombadonesà thepricetheyarewillingtopayrepresentsthequalityofthefirmbutlow-qualityfirmswillbeeagertoissuesecuritiesatapricethatinflatestheirvalueandhigh-qualityfirmsareunwillingtoissuesecuritiesataverageprice.

ØMoralhazard (afterthetransactionoccurs):Theborrowerhasanincentivetoengageinhigh-riskstrategies.

– Banksarelesssubjecttoasymmetricinformationproblemsthansecuritiesmarketsà relationshipwiththecustomersandknowledgeoflocalmarket

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• Returnofpsychologyandbehavioralfinance:Ø Foundationoffinancialtheory:assumptionofrational,utility-maximizingagentsà banishpsychologyfromthestudyofeconomicbehavior

Ø 1970sPioneersbehavioraleconomists:Ø AmosTversky,Ø DanielKahneman

ØActualbehaviorsystematicallyviolatesthepreceptofrationaloptimizingbehaviorà theseanomaliescouldbepredicted

Ø Supportersofmarketefficiency:deviationsfromrationalbehaviorarerandomanduncorrelated

ØNewschoolofthough“Behavioralfinance”:peopleemploypsychologicalshort-cutsintheirdecisionmaking.

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• Returnofpsychologyandbehavioralfinance(cont.)Ø Someconceptsofbehavioralfinance:Emotionsareakey

driverofaperson’sbehavior.Peoplehavebeenshowntobelossaverse,generallyappearingtodislikelosingsomethingroughlytwiceasmuchastheylikegainingit.

Ø Prospecttheory(Kahneman &Tversky):

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References• “DevelopmentFinancedebatesdogmasandnewdirections”-

StephenSpratt(2009)

• Financeandgrowth:theoryandevidence– RossLevine(2005)

• Financialmarketsandinstitutions– Mishkin&Eakins(8thedition,2015)

• Handbookoffinance(2008)Volume1- Chapter1

• Economix:HowOurEconomyWorks(andDoesn'tWork)byMichaelGoodwin

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