Notesale: Turn your study into money

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Financial Markets
Monday, October 5, 2015

4:19 PM

Introduction

• Finance: one of the pilars of our society
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Banking
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Se
Financial crisis
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World perspective
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• People think that finance is he way to make money
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To have purpose
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World built on Finance
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• Finance is abot making things happened, getting capital, etc
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1899
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If you don't give it all away it is nonsense
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• There's a theory of capitalism, natural selection of some people to are able to d
• Behavioral finance, psichology, sociology applied in finance
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• Emerging markets
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Bubbles are events were peo
then it breaks
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Probability

• It's major advance in human understanding
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In a mathemathical way
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• Return: Return over an investment
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You can

ecurities
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doing things
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How we
le, that's finance
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Like

ues to build a business
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at's the moral obligation
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ople get excited about something,

e result of millions of millions things
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• They think that the world is very complex and the outcomes that we see are the
Complexity of the world
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• Financial forecast is similar to wheather forecast
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They can never be less than -100%
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• Expected value, Mean, Average
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• If you have a minus 100% return your gross return would be zero
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( Formulas also in a PDF in iTunes U
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companies are not related, the covariance tends to be zero
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If the
tendecy to move together at all
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• Variance of Sum: Sum of the variances plus two covariances
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• VaR: Value at Risk
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They tried to cumpute, for example:
million in one year
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• Law of Large Numbers: The variance of the average of an random variables th
Tossing a coin
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Related to insurance
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Xn) = var(x1) + var(x2)
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(If they are all indelendent, all the covariance a
• CoVaR is an alternative to VaR
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A lot of co
dollars they just split it to have double of shares
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Apple did
• Return = market return + idiosyncratic return
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45 at PDF
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Apple has a lot of idiosyncratic risk
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Sort of an engineering
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Finite variance
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• Financial theories have a lot of limitations
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• The fundamental essence of finance is that ther will come a day that everything
expectations
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n never loss more than what you

r
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If the two

e correlation is zero, there is no

"5% probability that we'll lose 10
ence
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pt depends on independence
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ompanies when the price reaches 60
d it in 2005
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Volatile dangerous

nce

w up
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Averages are normally

you know defies all the

• Probability is never 0
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That's the problem with them
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Invention

• 1970: There were no options exchanges
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No swips
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• Dramatic transformation
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It's hard to talk
• Financial markets ae based on mathemathical models and a core part of intuitio
risks are independent of each other, then we can pull of them
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Modern finance is about risk management
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Risk is all about limiting an equality
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Progres
• Framing theme: context and associations that we have with some things
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So we have to frame things in a way that's con
engineering
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• Gimlet: Simple tool that everyone used to have a hundred years ago
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The very simple idea of shares was a grat invention
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Limited liability: is a corporation that guarantees tha
liable for the company
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David Moss 1811
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Anybody can start a
protection
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They tried to blame shar
NY became the center of corporations
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It'
lot of people
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• Township and Village Enterprise or TVE
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It was like a company
would go to the major of the town and share profits with the town
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12 million of TVE's
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Involve the whol
• Inflation indexation
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It is uncertain, inflation risk
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After the revolutionary war ended they era
1997
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6
indexed
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Had a problem with inflation
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In 1967 they created the Unidad de Fomento
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By 1977 a UF was 150 new pesos
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If y
were protected
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Something is b
per year the inflation in the US
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on
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If
dence to improve our lives
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Financial
ssive income tax
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Finance

purpose
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Inventions come and go
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And shareholder
reholders for ecerything
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You
vention of the inception of China
le community
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Inflation meassured by
rency units
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It all should be

960 the escudo
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3%
UF
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• Chile
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So Chile switched to another currency in 19
changed back to the peso
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Gene
inflation
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Now an IF is worth 21,469 pesos
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Almost nothing is indexed in inflation in the US
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Mexico has UDI, it's the mexican version of the U
• Swap
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It's a contrac
cash flows
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Euros and dollars example
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ISD
efficiently
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The buyer promises to pay the seller until there is a bankr
insurance
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To buy insurance against default or fail
like consultants
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• United East Indian Company: 1602
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Amsterdam stock exchange (ol
brokers to sell stocks in "street name": when you buy shares, the broker puts in
but the company doesn't know because your shares for them are in name of the
times started too
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Causes interest, the VO
of the short interests
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Just informa
with a law
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" It was a breakthro
Portfolio Management and Risk

• Two main concepts: Leverage
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• Equity Premium Puzzle: companies shares do extremely well, that's a puzzle
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Markowitz 1952 graduate of Chicago published an article abo
investment
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"If I can get the statisctis I can see the optim
about it before Markovitz
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It all started with Henry Markowitz
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960 the escudo
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3%
UF
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They were more

cial Institutions

ldest one) still trading
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Short interest
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Formalized in New York in 1811
ough inovation
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The extra return
out risk
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Nobody thought

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Graphic in iTunes U presentation
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Ta
• Mutual Fund theorem
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All we need is o
Under the assumptions of Markowitz
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The theorem imp
the tangency portfolio
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Was invented by Sharp & Litner
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Risk is covariance, como
is a correction
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Insurance

• It is about making our lives work
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Live insurance,
casualty insurance
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• Risk pooling
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Funerial bills
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• Probability
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• Moral hazard, better explained with an example
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In the contract exclude risks related to moral hazard
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Select the people you are going to insure
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Founded in 1919 in Shanghai by Cornelius Vander Starr
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He ran the company until 2005
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The company became exposed to real sta
everywhere
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If AIG failed, a lot of markets would
in such a way that shareholders went real bad
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The business p
such as Goldman Sacks
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• Insurance guarantee funds in almost every state
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AIG was
AIG
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one mutual fund to serve investors
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People
ovements
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You must

nce contracts some causes of death
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urance company in the world
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The biggest bail out
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It arranged the bail out
partners pf AIG didn't lose a penny,

s way too big
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If AIG failed, a lot of markets would
in such a way that shareholders went real bad
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The business p
such as Goldman Sacks
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Insurance guarantee funds in almost every state
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AIG was
AIG
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Dodd-Frank Act creats a Federal Insurance Office approved in 2010
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Designing insurance is a matter of invention
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Health
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Creating new insurance exchanges that would offer insur
general project
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That solved the selection bias
We don't insure well against changes in probability
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It is the excess return of the portfolio return
Play tricks with sharp ratio
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• Efficient markets theoriests
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Reuters created the financial information services in L
• The efficient markets hypothesis
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The analysis of stock looking for patterns
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H
• Random walk
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Karl Pearson in 1905
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• It is a half truth
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Maybe get something qith a 13% interest rate now instead in the
happier now
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• Eugen Von Böhm Bawerk
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The int
between the supply and demand in savings
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Pay no interest
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• Compounding annual and continuous compounding
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d go wrong
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They had to rescue

gulated at the state level
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n divided into the standard deviation
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London with pidgeons
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y has to noose
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Discount Bond
•
•
•
•
•
•
•

Discount today
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You pay less than the amount
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You saw all these on Fina
Present value
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Conventional bond every six months
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Sir John Hicks in Value at Capital (1939)
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Corporate Stocks

• The Ducth East Indian Company, first company with shares
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Public equity's are
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○ Corporation: corpus latin "body"
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• One share one vote
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• In the US you have to choose a State to establish a corporation
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Certain things have to be decided there, including choo
CEO its the chairmn of the board too, in Europe not
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6 to 10 people board of directors
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• For profit and non profit corporations
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It is not obliga
never pay dividends
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Because the compan
paid it out
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If a broker hears that in some days s
consuel someone to buy right now shares to get the dividend is considered une
dividend you have to continue, otherwise you start gaining attention
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The risk in reases with
• There is a complaint that big corporations stop emitting shares after they got bi
trading the existent ones
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• Dilution, what happens when a company issues more shares
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• Bothe are neither good or bad, it has to do with circumstances,
• Common stock and prefered
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periods for ever
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Predictions
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Annual
osing a CEO
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you enter to a board you have a

nd one doesn't
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atory
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Once you start paying a

h debts
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So the stock market just keeps

ew shares are never emitted
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Dilution, what happens when a company issues more shares
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Bothe are neither good or bad, it has to do with circumstances,
Common stock and prefered
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○ Prefered stock, has a set dividend
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Are safer than common shares
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Xerox, founded on 1906
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Carlson founder
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Every public comppany has to present a report e

Behavioral Finance and the Role of Psyc

• People act stupidly
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He was a professor Moral sentim
(1776)
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We want praise
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And 1% of females
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Competition is about manipilating
• Prospect theory: invented by Kahneman and Twarsky
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• You can manipulate people using different terms
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Avoid doing something that you
• Gambling behavior: 2% of males are compulssive gamblers
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There's a human tendecy to overestimate your own abilities
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People tend to make to not aknowledg
wrong
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Another factor that people err
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Another ones stay because of cogn
• Anchoring: to anchor to something that you had recently experienced or affect
• Social contagion: people are interdependent
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ZEITGEIST: The spin of the time
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• We are volving toward better financial institutions
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Missbehavior, Crises, Regulation and Self-

ar is stablished
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They tipically don't have a

s dry in greek
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chology

ments
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The Wealth Of Nations

g people
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It says that there's
Function
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the stock market
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ted by
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nscience
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Hube financial

-regulation

• Successful people have an internal compass for these things
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○ Macroprundetial: protects the system
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• Five levels of regulation:
1
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(Oldest) Inside and outside directors of a company
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Trade groups between the firms
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Local government
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National
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International
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• Within the firm
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is part of the board of directors of Yale
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Gap betw
§ Executive compensation: sort of obvious
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○ Duty of care as a board member, have a moral responsibility with your ob
the company
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Duty of loyalty
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○ Example: New York Stock Exchange, founded in 1792
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Buttonwood agreement
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○ 1976, Mayday, monopolies
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BigBang in UK in 1985
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○ Laws called Blue Sky Laws regarding finance
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• National regulation
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They regulate anything that ha
○ SEC protects small investors
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IPO defined by
companies to stay private
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S
them
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Hedge funds are not allowed
assets and 20% of profits annually
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ween stockholders and employees
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ligation
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e first american crisis
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Dishonest

as to do with exchanges
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SEC allows many

SEC has minimal regulation on
mum
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2 and 20 rule
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Public and private securities
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§ Hedge fund is an investment company for wealthy individuals only
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3CIS Hedge fund that must have 99 accredited investors maxim
to have a networth of 5 million dollars
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○ Market surveillance
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○ FASB Financial Accounting Standards Board
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GAAP
Principles
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To prote
○ FIDC Ensures your bank account
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○ 2010 Dodd Frank Act
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It creates the FIOC, deals with systemis risks
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Idea of that you have to have
○ European Union
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European Bank
regulations
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Etcetera
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○ It is a problem
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○ Bank For International Settlements in 1930
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○ Basel Comittee
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Created in 1974
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Basel 2 (2
○ G6
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France, Germany, Italy, US, Japan, UK
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Coord
○ In 2008 the G20
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Heads of state
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Banks

• Spread income
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They used to do that
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• Origins
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Ancient Sumeria
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Traditional provate banks
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Saving banks: ord
• Adverse selection: not lending money to everyone
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• Moral hazard
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Roosevelt 1933 FDIC
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• Bank regulations
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○ Ban regulations
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1988
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○ Next Basel will be in 2019
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y the SEC
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3C7S 500 investors that have
d to advertise
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2% of

AP Generally Accepted Accounting

ect small investors
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ve an agency for each problem
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57

2004)
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dinate financial regulations
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Banks

est bank (1472), in Sienna
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○
○
○
○
○
○
○
○
○
○

Basel comitee
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Widely adopted
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Basel III (2010) G20 countries
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Risk weighting assets
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50% mortgages
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20% in bonds
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Common equity must
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5% of your Risk Weighting Assets
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§ Salinas
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There wasn't effective regulation
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§ Prices of the future
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Forward Markets:
§ Specialized Markets
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Forwards
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Futures and Forwards
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(1673)
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Forwards precede futures market
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If future prices are increasing, it's called contangle
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○ Daily settlement
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• At the futures market, contracts are standardized
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Future markets get rid of co
○ Key idea: margin
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• Interesting thing: Oil futures peaks have a correlation with economic crisis
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S&P 500 Index Futures
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Option Markets
Option: Call and Put
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○ You usually wouldn't want to exercise a call option early
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There are two kinds:
○ American: can be exercised any time until the european date
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• They give you a choice
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Why do we have them?

ounter-party risks
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Storage in stocks is a

• They give you a choice
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Why do we have them?
• Theoretical purposes: we need prices
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Incentive
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Derivatives Market
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The option creates a break
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Option Pricing
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○ Once you cave the call price, you can infer the put price
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S = stock price (today)
u = 1 + fraction up
d = 1 + fraction down
C = price of the call
Cu = price if the stock goes up
Cd = price if the stick goes down
E = Exercise price
H = hedge ratio = shares / options
Write one call to buy H shares
If the stock goes up, my portfolio is worth uHS - Cu
If it's down, then is worth dHS - Cd

Implied volatility
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• It differences from commercial banking because they don't open accounts
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• Most investing banks are not just that
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• Most investing banks are not just that
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○ Seasoned offers
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○ Bought deal
○ Best efforts offer
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It is built around trust
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First crisis (1933)

• US Congress passed the Glass-Steagall Act that split commercial banks from inv
FDIC
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• In 1999, Glam-Leach repealed the previous Act
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trading and h
Shadow banking
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They were financing a lot of proprietary investments by issuing repos
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They could've been saved via bail out, but the government h
Meryl Lynch
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It also created the

hedge funds for investment banking
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mmercial bank
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They were financing a lot of proprietary investments by issuing repos
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They could've been saved via bail out, but the government h
Meryl Lynch
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The crisis of 07 and 08 was substantially a run of repos
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• Investment managers manage risk
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• Prudent person rule: Investment managers must behave as prudent people
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Regulations
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• Financial advisors are regulated by governments
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First one: Massachussets Investment Fund in the 20s
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Pensions
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They went bankrupt
They made heavy investments
had already saved Bern Sterns and

s commercial banks
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They are designed for individuals
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The first big industrial fund was established by Carnegie Steel in 1901
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General Motors in 1950
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General
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• Paul Allen, biggest yacht, 400 ft
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Allen Family Foundation
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○ The broker acts on behalf of others, as an agent to earn a commission
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• Stock markets are both dealers and brokers markets
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○ NASDAQ is a dealer market
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Q
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kup
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○ NASDAQ is a dealer market
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Q
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" Q & P
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• Stop order, also specifies quantity and price
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• Algorithmic trading
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By the SEC
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They ended up merging with Archipelago in
• According to the US, brokers must choose the best price for their customers
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Shares gut down 10% and rebounded the same day
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• Trading as a dealer:
○ Post a bid and an ask
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The spread should be wide enough
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§ You never know if you'll get ruined the next day
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ce
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de: Archipelago & Islands
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Finding Your Purpose in a World of Financ
• A lot of stuff has turned out badly in the financial industry
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○ Cosmopolitans: understand finance
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Do not understand fina
• Expansions of finance in the future:
○ Home equity
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○ Continuous workout mortgage
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ance

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