Notesale: Turn your study into money

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Financial Markets
Debt, Equity and Risk:
Shareholders control the firm, at least indirectly
...
Debt holders have no direct
control although they may set restrictions on what the firm can and cannot do with the money
...
It is only in the case of bankruptcy that the debt
holders receive less than they were promised
...

As a consequence of these differences these groups have conflicting goals for the company and
shareholders will be far more risk seeking than debt holders, the upside of any project is potentially
unlimited and will be enjoyed solely by the shareholders while their downside is limited as they can
only lose their initial investment
...
X is the cost of the project and A is the
amount of finance that can be provided through equity
...


The higher the proportion of the investment that is financed by debt, the more risky is the debt
...

Lenders also typically require collateral on their investments and this can act as a credit constraint as
firms will have a limited number of assets
...

Moral Hazard:
The incentives of the bank and of the firm are incompatible, as a debt holder the bank wants the
firm to undertake the safe project while the equity holder (the firm) would rather proceed with the
risky project
...
The
potential losses for both are both capped, the bank can only lose the amount they lent and the

equity holder can only lose their initial equity
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Financial Accelerator:
Suppose that outside lenders are ready to lend capital only if there is collateral and therefore the
firm can borrow no more than 60% of investment expenditure
...
Then 40% of the investment expenditure must be
financed by retained earnings and this acts as a constraint on investments
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When demand increases
firms are able to produce more and their profits increase, so they can finance more investment
...

When share prices increase, as they would when profits increase, the firm has access to more
collateral and this allows them to borrow more money in order to finance investment, on top of this
they also have additional profits to invest as well and for this reason a boost to aggregate demand
can be very beneficial to investment and lead to further increases in both
...
The
financial accelerator occurs because current demand has boosted the profits of the firm and thus it
has more collateral and can invest more
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The stock market and Tobin's Q:
Stocks represent the ownership shares of a company and give the right to receive a share of the
dividends paid out by the firm
...
If households discount future dividends with a real interest rate,
the value of the shares is:
𝑆𝑡 =

𝑑 𝑒 𝑡+1
𝑑 𝑒 𝑡+2
𝑑 𝑒 𝑡+3
𝑑 𝑒 𝑡+4
+
+
+
+⋯
1 + 𝑟 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4

As a simple example suppose that dividends are expected to be equal to 𝑑 in the next period and
that they are expected to increase at the rate 𝑔 from 𝑡 + 1 onwards
...
So we have:
𝑆=

(1 + 𝑔)𝑑 (1 + 𝑔)2 𝑑 (1 + 𝑔)3 𝑑
𝑑
+
+
+
+⋯
(1 + 𝑟)3
(1 + 𝑟)4
1 + 𝑟 (1 + 𝑟)2

𝑑
1+ 𝑔
1+ 𝑔 2
1+ 𝑔 3
=
+(
) +(
) + ⋯)
(1 +
1+ 𝑟
1+ 𝑟
1+ 𝑟
1+ 𝑟
=

𝑑
1
𝑑
=
1+ 𝑟1−1+ 𝑔
𝑟− 𝑔
1+ 𝑟

NB: Here we have used the formula for a geometric sum: 1 + 𝑏 + 𝑏 2 + 𝑏 3 + ⋯ =

1

...
If expectations about
future production and future profits increase, share prices will increase
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In theory, stock price movements should
reflect news about future dividends, but dividends are much more stable than stock prices
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High future profits imply high future dividends and when expected future profits are high, firms have
strong incentives to increase the capital stock
...
The relation between share prices and investment was formalized by
American economist James Tobin
...
His argument was that if existing capital assets are worth more than the costs of
producing new ones, there should be incentives to increase the capital stock
...

To see this, assume, for simplicity, that firms finance all their investments by issuing shares, that
they hand out all profits as dividends, and that shares of all firms are traded in the stock market
...
Then we can measure Tobin's
q as the value of the companies in the stock market relative to the existing capital stock:
𝑞=

𝑆
𝐾

Here, 𝑆 is the real value of all the firms in the economy
...
With a
𝑟
Cobb-Douglas production function, the share of gross income going to capital is α so real profits
after depreciation of capital are given by π = 𝛼𝑌 − 𝛿𝐾
...
If we assume that investment is associated with
adjustment costs, which slow down adjustment of the capital stock, we may think of investment as
being determined by the ratio between the marginal product minus depreciation and the real
interest rate:
𝐼 = 𝐼(

𝑀𝑃𝐾 − 𝛿
)
𝑟
α𝑌

With a Cobb-Douglas production function, the marginal product of capital is 𝐾 , so we see that
investment is a function of Tobin's q
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Banks
In the baseline model households lend directly to firms
...

(2) Maturity mismatch: bank loans are illiquid but households want liquid assets that can be
quickly be converted to cash without cost
...
When consumers lose confidence in the ability of the bank to provide them
with liquidity they will demand that the bank give the back their assets
...
This results in the firm being
significantly devalued and this is the process through which bank runs can collapse the financial
sector
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Managing and monitoring credit
2
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How can they do
that?
Law of large numbers: credit losses and withdrawals are fairly predictable in aggregate
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NB - When deposits are illiquid, i
...
they are made with assets that cannot be readily converted to
cash, then the likelihood of a bank run is diminished because depositors would not be able quickly
withdraw their money
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Today, banks rely
heavily on other types of borrowing
...
Often, this is short-term borrowing that is 'rolled over' every
three months or so
...
Note that this borrowing is not covered by deposit insurance
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These are institutions that perform similar roles to banks, but which are not commercial
banks and hence are not subject to the same regulation
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Before the crisis, a large industry of quasi-banks had developed
outside of the regular banking system, especially in the U
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Prominent examples of such institutions
were the American investment banks, which have now either gone bankrupt, merged with
commercial banks or themselves became commercial banks
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For their funding, they rely heavily on short-term
borrowing and typically have very low capital requirements - often as low as 4-5% of total assets
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This is the process through which CDOs are created

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