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Chapter 6: The asset management industry and banking, Closed-ended: Fixed…
Chapter 6: The asset management industry and banking
Pooled investment funds
Pooled investment vehicles aggregate funds from multiple investors to form one large portfolio
Mutual Funds
Pool money to invest in diversified portfolios (e.g., stocks, bonds).
Managed by professionals; accessible to a broad range of investors. (individuals and institutions)
Features:
Minimum investment: Relatively low.
Compensation: Fund managers earn 0.1–2% of assets under management. (AUM)
Structure:
Open-ended: Issue (buy)/redeem (sell) shares anytime.
Hedge Funds
Private investment pools for wealthy/institutional investors.
Largely unregulated, allowing complex strategies (e.g., leverage, short-selling), so more risky strategies hence higher rewards
Fee structure: 2% of assets + 20% of profits.
Strategies:
Macro funds: Focus investment opportunities in response to expected global macroeconomic trends.
Directional funds: Exploit pricing inefficiencies and discrepancies
Event-driven funds: Focus on corporate events. (mergers, bankruptcies)
Relative value funds: Market-neutral strategies.
Can make returns when markets are rising and falling
Exchange-Traded Funds (ETFs)
Similar to mutual funds but traded on stock exchanges (will hold many securities) e.g stocks, commodities
Differences from mutual funds:
Prices change throughout the day.
More cost-effective and intraday liquid.
Insurance Companies, Pension Funds (retirement benefits)
Key Characteristics:
Diversification
Funds invest in a wide range of assets (e.g., stocks, bonds, real estate) to spread risk.
Professional Management
Fund managers make investment decisions on behalf of the investors.
Economies of Scale
Pooling resources reduces transaction costs and allows access to investments that may require large minimum investments.
Accessibility
Enables small investors to participate in markets that would otherwise be difficult or costly to enter.
Banks
Implications of Financial Intermediation
Liquidity risk:
Depositors may withdraw funds faster than the bank can convert assets to cash.
mismatch
between liquid liabilities (deposits) and
illiquid
assets (loans).
Bank run:
Triggered by depositor
loss of confidence
in the bank's solvency. This can lead to a bank's collapse if it cannot meet withdrawal demands.
Regulation aims to mitigate systemic risk through
Liquidity requirements:
Banks must hold sufficient liquid assets (e.g., cash, government bonds) to meet withdrawal demands.
Capital (equity) requirements:
Banks must maintain a minimum level of equity capital to absorb losses and protect depositors.
Deposit insurance:
Governments or regulators provide insurance to depositors, reducing the incentive for bank runs.
Act as intermediaries between savers (depositors) and borrowers (individuals, businesses, or governments). They facilitate the flow of funds in the economy by accepting deposits and providing loans. Payment services, risk management, information processing, asset transformation.
Money Market Funds (MMFs) Alternative to banks:
Offer liquidity and higher interest rates.
Key disadvantage: Lack of deposit insurance, making them vulnerable to runs.
Invest in short-term, high-quality debt instruments and aim to provide liquidity and stability.
Key Functions of Banks:
Payment Services
Banks enable transactions through services like checking accounts, debit cards, and electronic transfers.
Risk Management
They help manage financial risks through products like insurance, hedging, and derivatives.
Information Processing and Monitoring
Banks assess the creditworthiness of borrowers and monitor loans to ensure repayment.
Asset Transformation
Banks transform short-term, liquid deposits into long-term, illiquid loans. This involves:
Maturity Transformation
Converting
short-term liabilities
(deposits)
into long-term assets
(loans).
Liquidity Transformation
Providing
liquidity to depositors
while
investing in less liquid
assets.
Risk Transformation
Managing the
risk of default
by
diversifying loans
across
various borrowers
.
Financial Assets vs. Real Assets
Real Assets:
Generate productive cash flow.
Rental properties (rental income), intellectual property (sales revenue), or machinery used for production.
Financial Assets:
Represent ownership or claims on real assets but do not directly generate cash flow.
Bonds (loan-backed claims) or stocks (ownership claims)
Sectors Utilizing Financial Markets
HHDs
Invest in financial instruments to achieve financial goals like retirement savings, home purchases, and insurance.
Instruments: Mutual funds, bonds, and equity investments.
Businesses
Issue debt (bonds) or equity to finance operations or expansion.
Use derivatives to manage risks such as interest rate or foreign exchange fluctuations.
Government
Raise funds for public projects by issuing government bonds.
Regulate markets to prevent fraud, maintain economic stability, and achieve policy objectives (e.g., controlling inflation through interest rate interventions).
OMO?
Money Market Instruments
Short-Term and High-Liquidity
Instruments typically mature within a year and are traded in large denominations.
the trade in short-term loans between banks and other financial institutions
Key Instruments:
Treasury Bills (T-Bills):
Short-term government debt instruments (28, 91, or 182 days maturity).
Low-risk, widely used for short-term financing.
Certificates of Deposit (CDs):
Fixed-term bank deposits with higher denominations ($100,000 or more).
Insured by government schemes in most cases.
Commercial Papers:
Unsecured, short-term corporate debt backed by bank credit lines.
Denominated in multiples of $100,000.
Repurchase Agreements (Repos):
Short-term loans secured by government securities, often overnight transactions.
Reverse repos allow the buyer to sell the securities back to the original seller at an agreed price.
Bond Market Instruments
Long-Term Debt Securities:
Bonds typically have maturities over a year.
Issued by governments or corporations to raise capital.
Types of Bonds:
Government Bonds:
Issued by governments (e.g., Treasury Bonds in the US, Gilts in the UK).
Perceived as low-risk or risk-free.
Zero-Coupon Bonds:
Do not pay periodic interest.
Sold below par value and redeemed at face value upon maturity.
Index-Linked Bonds:
Adjust repayments for inflation, providing real returns.
Consol Bonds:
Perpetual bonds with no maturity date, paying fixed interest indefinitely.
Equity Markets
Ownership Claims:
Equity gives shareholders ownership in a corporation, with residual claims on its cash flows after debts are paid.
IPO vs. SPO:
IPO: When a private company goes public by listing on a stock exchange for the first time.
SPO: When additional shares are issued by a company already listed on the stock exchange.
Equity Classes:
Common Stocks: Voting rights and residual claims.
Preferred Stocks: Seniority in dividends over common stocks but usually no voting rights.
Derivatives Markets
Risk Management Tools:
Instruments whose value depends on underlying assets like bonds or stocks.
Types of Derivatives:
Futures and Forwards: Obligations to buy/sell an asset at a predetermined price in the future.
Options: Rights (but not obligations) to buy/sell an asset at a specified price.
Swaps: Agreements to exchange cash flows (e.g., fixed vs. floating interest rates).
Managed Funds and Exchange-Traded Funds (ETFs)
Managed Funds:
Investors delegate decision-making to professional fund managers.
Active Funds: Fund managers actively pick investments to outperform benchmarks.
Passive Funds: Aim to replicate market indices like S&P 500.
Exchange-Traded Funds (ETFs):
Track indices but trade like individual stocks, making them cost-effective and accessible for small investors.
Trading Methods
Exchange Trading:
Buyers and sellers are directly matched through platforms like NYSE.
OTC Trading:
Transactions occur between dealers and investors, with dealers taking on inventory risks.
Key Differences:
Exchanges offer transparency and centralized trading.
OTC markets may offer greater flexibility but involve less regulation.
Regulation of Financial Markets
Importance:
Ensure fairness and transparency in market operations.
Protect retail investors from exploitation by professional or institutional investors.
Prevent fraudulent practices like insider trading or misinformation.
Methods:
Self-regulation by market organizers (e.g., stock exchanges).
Government oversight through regulatory bodies.
Closed-ended: Fixed number of shares, tradable on stock exchanges.