Lecture No 03 SlidesLecture No. 03 - Technology and Innovation in Finance

Fall 2013 ADVANCED FINANCIAL INSTRUMENTS AND MARKETS
LectureNo.03
TechnologyandInnovationinFinance
Hammad HassanMirza AssistantProfessor(Finance) DepartmentofBusinessAdministration UniversityofSargodha
Todays Today sDiscussion

SomeimportantconceptsfromLectureNo. No 02 MeaningofFinancialInnovation MotivationforFinancialInnovation FinancialInnovationandUSMortgageCrisis
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha
IntroductoryDiscussion
NoexchangeforDerivativein1970 Theproliferationoffinancialinstrumentsin40years isstunning CrisisarelikeCrash P li gof f I d d t E t and dS i li (R b t Pooling Independent Events Socialism (Robert Owen) FinancialInventionsareModernFinancialContracts. Financial Devices are complicated structures that we set up for a certain purpose, like airplanes or automobiles, t bil and d we learn l th through h time ti h how t make to k PropertyofDepartment ofBusiness Administration, University of them better and better 3 Sargodha
SomeExamplesfromOldTimes
Settingupacompanyanddividingitsownershipinto simpleparts. Limitedliability yhaskindofacomplicated p history yfrom 1811 ThecorporatelawofNewYorkin1811:Shareholders cannotbes ed sued. Other states in the United States were looking at New y g, y you're crazy. y What are y you doing? g York and saying, You can't sue the shareholders? They could do something irresponsible. State of Massachusetts, at around the same year, year made a completely opposite law PropertyofDepartmentofBusinessAdministration,Universityof 4
Sargodha
SomeExamplesfromOldTimes
Well,guesswhathappened? Itwasanexperimentthatmightnothavegonewell ExampleofChina Township and Village Enterprise or TVE There were 12 million TVEs in China. By the mid1990's, most of the industrial production of China was done by TVE
ClassicalFinancialInnovations
US indexed bonds in 1780 state of Massachusetts Why they disappeared: Gimlet Example from Chile Chile had a problem with, like many Latin American countries countries, especially of that time time, with inflation inflation. they had a currency called the peso which inflated enormously. It went up thousand times. Every body was saying, I wouldn't take a contract paying pesos. The peso is gradually becoming worthless
6
ClassicalFinancialInnovations
Chileswitchedtoanothercurrencycalledtheescudo in1960.Then,in1975,theyswitchedbacktothepeso Th exchange The h rate, t pesoto t escudo, d wasoneescudo d was1,000pesos.So,anewpesowasamillionold pesos p Ifyouhaveanice1,000pesonotefrom1955andyou pullitoutin1975,it'sworthnothing. In 1967, 6 in i Chile hil they h created d something hi called ll d the h Unidad de Fomento. That's Spanish for Unit of p It was a unit of account that is indexed Development. to inflation (Check todays worth http://valoruf.cl)
PropertyofDepartmentofBusinessAdministration,Universityof Sargodha 7
SomeModernInventions
Indexinganoldbutimportantinvention: RentingHouse,CalculatingGDPGrowth(Deflator)
Swaps Options Futures F Forwards d Convertibles
ShadowBanking??
FinancialInnovation
CategorizationofFinancialInnovationaccordingto EconomicCouncilofCanada
MarketbroadeningInstruments
Whichincreasetheliquidityofmarketsandtheavailabilityof fundsbyattractingnewinvestors.
kmanagement ti t t Ri Risk instruments

Whichreallocatethefinancialrisktothosewhoarelessrisk aversetothem.
Arbitraginginstrumentsandprocesses
Whichenableinvestorsandborrowerstotakeadvantageof costandreturndifferences. ff
FinancialInnovation
AccordingtoBankforInternationalSettlements
Pricerisktransferringinnovations Creditrisktransferringinstruments Liquiditygeneratinginnovations Creditgeneratinginstruments Equitygeneratinginstruments
10
MotivationforFinancial Innovation
TwoExtremeViews:
Endeavortocircumventregulationsandfindloopholesintax rules rules. Enhancingmarketallocationefficiencyforredistributionof riskamongmarketparticipants.
11
MotivationforFinancial Innovation
TheultimateCauses
Increasedvolatilityofinterestrates,inflation,exchangerates AdvancesinTechnology Sophisticatededucationaltrainingamongprofessionalmarket participants. FinancialIntermediariesCompetition
12
CaseofUSFinancialCrisis2008
The U.S. subprime mortgage crisis was a set of events and conditions that led to the late2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and f l d th lti d li f securities iti foreclosures, and the resulting decline of backed by said mortgages. Several major financial institutions collapsed in September 2008, with significant disruption in the flow of credit to businesses and consumers and the onset of a severe global recession.
CaseofUSFinancialCrisis2008

USSubprimeMortgageCrisis Mortgagebackedsecurities Collateralizeddebtobligation g CreditDefaultSwap
14
Endof fSession I
15
Session II
RoleofCentralBank RoleofMonetaryPolicyinFinancialMarkets
TradeOffsandConflictsAmongPolicies MonetaryGoalsandTargets CharacteristicsofTargets ChoosingOperatingTargets ChoosingIntermediateTargets
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RoleofCentralBank OpenMarketOperations
CBpurchasesandsalesgovernmentsecurities purchases
Increaseexcessreserves Increasenewloans Increasemoneysupply
sales
Decreaseexcessreserves Decreaseloans Decreasemoneysupply
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OpenMarketRepurchase Agreements
RepurchaseAgreement
CBbuyssecuritiesfromasellerwhoagreesto repurchasethematahigherpriceonacertaindate inthefuture.(Temporaryincreaseinexcess reser es ) reserves.)
ReverseRepurchaseAgreement
CBsellssecuritiesandagreestorepurchasethem atahigherpriceonacertaindateinthefuture. (Temporarydecreaseinexcessreserves.)
DiscountRate
Anincreaseinthediscountratediscouragesbanks fromborrowingfromtheFed Adecreaseinthediscountrateencouragesbanksto borrowfromtheFed
19
StateBankofPakistan
StatutoryObligations.
CASHRESERVE
Presentlytherequirementis5%onweeklyaveragebasissubjecttodailyminimumof 4%ofTime&DemandLiabilities
LIQUIDITYREQUIREMENT
Presentlytherequirementis15%(excluding5%statutorycashreserve)ofthetotalof itstimeanddemandliabilitiesinPakistan
MAINTENANCEOFLIQUIDITYAGANINSTCERTAINLIABILITIES
requiredtomaintaincashbalancewithStateBank,whichshallnotbelessthan1%of theirliabilities
SUBMISSIONOFANNUALAUDITEDACCOUNTSBYNBFIs
submittheirannualauditedaccountswithinaperiodof6monthsafterthecloseof theiraccountingyear.
20
FunctionsofStateBankofPakistan
ANNUALACCOUNTS
Atthe th expiration i ti of feach hcalendar l d year
SUBMISSIONOFRETURNS
The accounts and balancesheet together with the auditors report as passed in the annual General Meeting shall be furnished as returns to the State Bank within three months of the close of the period to which they relate
MINIMUMCAPITALREQUIREMENTS
As present, all banks operating in Pakistan are required to maintain capital and general reserve, the value of which is not less than 8% of their risk weighted g g assets. Additionally they are also required to maintain a minimum paid up capital of Rs.500 million.
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CoreFunctions
REGULATIONOFLIQUIDITY
Design and manage monetary and credit policy in a manner consistent with the Governments targets g for g growth and inflation and the recommendations of the Monetary and Fiscal Policies Coordination Board with respect to macroeconomic policy objectives
REGULATIONANDSUPERVISION EXCHANGERATEMANAGEMENTANDBALANCEOFPAYMENTS
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MonetaryAggregates
MonetaryBase:Currencyincirculation
Currencyandcoinsplustotalreserves
M1MoneySupply
Currencyplusdemanddeposits
M2MoneySupply
M1plusshorttermtimedeposits
M3MoneySupply
M2pluslongtermtimedeposits
TheMoneySupplyProcessinan OpenEconomy
ForeignExchangeMarketIntervention
TheCB CBs spurchaseandsaleofforeigncurrencies Purchaseofforeigncurrencies
Increasesmonetarybase d l of fthe h P R R Reduces value PKR
Saleofforeigncurrencies
Decreasesmonetarybase IncreasesvalueofthePKR
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RoleofMonetaryPolicyin FinancialMarkets
PriceStability FullEmployment EconomicGrowth StableInterestRates StableForeignExchangeRate
25
TradeOffsandConflictsAmong Policies
MonetaryPolicyTools
Increaserateofgrowthinmoneysupplybysupplying morereservestobankingsystem Decreaserateofgrowthinmoneysupplybysupplying fewerreservestobankingsystem
Conflictsbetweenmonetarypoliciesandmonetary goals
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MonetaryGoalsandTargets
MonetaryGoals OperatingTargets
monetaryandfinancialvariables
IntermediateTargets
interestratesandmonetaryaggregates
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CharacteristicsofTargets
Linkage Li k Observability Responsiveness
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ChoosingOperatingTargets
OperatingTargets
Leveloffederalfundsrate Levelofborrowedandnonborrowedbankreserves TheFedcannottargetbothinterestratesandreserves atthesametime
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ChoosingIntermediateTargets

Monetaryaggregates Exchangerates Levelofnationaloutput p Levelofactualorexpectedinflation Interestrates
30
ThankYou!

Lecture No 03 SlidesLecture No. 03 - Technology and Innovation in Finance

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Lecture No 03 SlidesLecture No. 03 - Technology and Innovation in Finance

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Fall 2013 ADVANCED FINANCIAL INSTRUMENTS AND MARKETS

Todays Today sDiscussion

SomeimportantconceptsfromLectureNo. No 02 MeaningofFinancialInnovation MotivationforFinancialInnovation FinancialInnovationandUSMortgageCrisis

kmanagement ti t t Ri Risk instruments

USSubprimeMortgageCrisis Mortgagebackedsecurities Collateralizeddebtobligation g CreditDefaultSwap

Linkage Li k Observability Responsiveness

Monetaryaggregates Exchangerates Levelofnationaloutput p Levelofactualorexpectedinflation Interestrates

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