Unit 1: The financial system
1. The actors
The economy consists out of haves and havenots:
• Haves: possess capital and can lend it out (lenders)
o Example: households (ultimate beneficial owner (UBOs)), financial industry
• Havenots: have more needs than money and will have to raise capital (borrowers)
o Examples: corporations, government, etc.
Financing from have to have not’s is mediated by financial markets (= direct finance)
1.1. The main actor: households
Net wealth = assets – liabilities
Example: when a household owns a house of 100, but has a remaining mortgage debt of 80, its net wealth is 20.
-> gives an overview of assets and liabilities of a single household
1.1.1. Kind of assets
Asset: a possession that has value in an exchange transaction
1. Tangible/real assets: derive value from their physical character and the utility they generate (car, house, etc.)
2. Intangible assets: derive value from a legal claim to some future benefit (patent, trademarkt, etc.)
3. Financial assets: intangible assets that represent a claim to future cash (stocks, bonds, etc.)
1
,1.1.2. Asset classes
Traditional: Alternative:
1. Common stock (gewone aandelen) 1. Real estate
2. Bonds = govies and corporates (obligaties) 2. Commodities
3. Private equity
4. Hedge funds
5. Venture capital
6. Currencies (forex)
1.1.3.Liabilities
• Mortgage loans: protection mechanism to make sure you repay
• Consumer loans: loans for consumer goods (cars, televisions, etc.)
• Tax debt: amount of tax debt owed to a government by an individual, corporation, or other entity
1.2. Growth drivers in net wealth
Wealth is not created by doing nothing, wealth comes from taking risks, and:
• Value changes in assets and liabilities (for example: you bought a house and its value increases)
• Net-income from labour, capital or transfers (i.e. pensions, social security based income)
• Inheritances, gifts
1.2.1. Wealth creation
Poor family: nothing on balance sheet
Middle class: own house but mortgage loan -> low net wealth and low diversification = forced to save = ‘poor’
Rich: built something up (real estate to rent, stocks, bonds, etc.) -> wealth is working for them = take risks!
2
,1.2.2. Wealth inequality
Wealth is not uniformly distributed -> unlike popular belief, wealth inequality persists in developed countries as
well as in emerging markets, however, emerging markets struggle the most:
-> Belgium has low inequality!
1.3. Final thought
Do you fully realize that households are the ultimate:
• Owners of all assets in the economy?
• Bearers of risk within the financial system?
-> If you really want to become rich, you have to have the guts to become an entrepreneur
2. How do balance sheets of other actors look like?
2.1. Corporates
Market value: price of an asset on
the marketplace, based on the
prices buyers are willing to pay and
what sellers are willing to accept
3
,2.1.1. Leverage
Leverage: instrument to make your returns on your own equity/money higher by for example loaning money from
the bank at 2% and buy shares at 5% with that in hopes you make profit
Companies can be funded with:
1. Shareholder funds (equity) consisting out of original equity, rights issues and retained profit
2. Debt
-> when companies use debt to finance their operations, they use leverage
-> Most companies use leverage to raise the ROE above the ROA:
• ROE: return on equity (=profit/equity) = profit relative to shareholders’ equity
o What shareholders find very interesting: “how much do I earn on money that I invested?”
o How well company rewards its owners
• ROA: return on assets (=profit/assets) = profit relative to total assets
o Shows company’s true operational efficiency
Way to measure leverage: the Leverage Multiplier
• As an assets/equity ratio: the Leverage Multiplier (LM)
• Used in the famous Dupont scheme
• Relates the ROE to the ROA through formula: ROE = ROA (return on assets) x LM (leverage multiplier)
Way to measure leverage: the Gearing Ratio
• Gearing ratio: ratio between long-term debt and equity
• Net-gearing ratio: often defined as ratio of financial debt and equity
• Net financial debt: long-term debt + short-term debt – cash – short-term financial assets
2.2. Financial sector: bank
A bank can do much more than a company
because of their business model:
• Take money from anyone
• Give it to someone else
Example: Dutch bank had 3% equity and
financed itself with 97% debt
4
,Typical banks have very low percentages of equity and high percentages of debt
• Trading book: short-term positions bank holds for market-making or trading. Bank keeps inventory of
shares or other instruments so it can buy/sell quickly for clients or hedge risks.
• Banking book: loans the bank grants (long-term holding)
• Bond portfolio: banks invest deposits into bonds to earn higher returns. Alternative to granting loans,
often with higher interest income.
2.3. Financial sector: mutual fund
Mutual fund: third party acts as a portfolio manager and
gathers funds -> “I will do the investments for you”
Example: you give someone €1,000 and they give you a
certificate of your funds. The person is going to invest
your money into all kinds of financial products for you.
2.4. Financial sector: insurance company
Insurance companies have two big branches:
(1) Casualty insurance (example: car accident)
(2) Investment for the long-term (example: you
give money to the insurance company and they
invest it for you)
Technical provisions: estimate of contractual obligations that the insurance company has (example: life insurance)
3. The financial system
5
,Importance:
• Economic growth is linked to financial development
• Role of financial system: facilitate production, employment and consumption
• Resources are funneled through systems so resources flow to most efficient uses
3.1. Types of finance
(1) (Semi-)direct finance through financial markets (money/capital market):
• Borrowers sell securities directly to lenders in primary market
• After issuance, securities can be traded in secondary market
-> Direct finance provides financing for governments and corporations
(2) Indirect finance through financial intermediaries:
• Institution or other third party stand between lender and borrower
• Money passing through the balance sheets of financial institutions and transformed into loans
Example: you get a loan from a bank or finance company to buy a car
Shadow banking: non-bank financial intermediaries (NBFIs) that legally provide services similar to traditional
commercial banks but outside normal banking regulations
6
,4. Role of the government
Role for the government is needed because if financial market fails, the economy fails
4.1. In financial markets
Financial markets play a prominent role in the economy -> calls for regulation if market failure arises
• Disclosure regulation in order to prevent issuers from defrauding (actual or potential) investors by
concealing relevant information
• Market conduct regulation a.k.a. financial activity regulation in order to prevent insider trading, in order to
impose trading rules, etc.
• Financial institution regulation in order to prevent the default of financial intermediaries and in order to
safeguard the payment system
• Restrictions on foreign participants in order to control e.g. the money supply
4.2. Other potential roles of government
1. Act as financial intermediary (e.g. credit support through loan sand guarantees)
2. Influence the markets through monetary policy (= government sensu lato since this task is performed
independently by the central bank)
3. Provide bail outs: to preserve financial stability, governments bailed out these banks by injecting equity
and/or guaranteeing the debt of the big banks
-> The last potential role has been actively used in the past but is under discussion due to controversy
• No bail out policies
• Systemically Important Financial Institutions (SIFIs): bank, insurance company, or other financial
institution whose failure might trigger a financial crisis
Banks will not always be bailed out, but government has to make sure that the bank is not interconnected with
another bank to avoid domino effect
7
,Unit 2: Fixed income markets
1. Introduction
1.1. Financing sources
(1) Equity instruments
(2) Debt instruments:
• Loans (directly from the bank)
• Debt securities (borrow from individuals)
-> Loans and debt securities are known as “fixed income instruments”, but differences! (examples: transfering loans
versus securities to other parties is very different, a loan has a legal ground via contract, etc.)
1.2. Financial history
Financial instruments go back a long time, and debt instruments are oldest instruments in world: IOU goes back to
time of hunters-gatherers!
-> Codex of Hammurabi (1780 BC) provided loan concepts (including interest charges) and insurance/risk sharing
contracts
2. Interest rates
In world with positive interest rates, you will have to pay back more than the amount you borrowed
2.1. Definition
Interest rate: the price of money
• Price (for borrower) to ‘rent’ money
• Reward for the lender to postpone consumption (as they lend the money they would use for consumption)
!! There is a vast difference between percentage and percentage points! A difference between 3% and 4% is not
1%, but 100 basis points! (Use to remove confusion around increases/decreases)
2.2. Interest rate or interest rates?
Interest rate charged depends on risks taken by lender, and risk depends (at least) on the:
• Credit worthiness of borrower
• Maturity of debt (1 year versus 100 years)
-> We cannot speak about the interest rate; there will be a different interest rate per maturity and per borrower
8
,2.3. Term structure of interest rates
Term structure of interest rates: a graph that shows the ‘interest rate’ (or spot rate) that would be charged to
certain counterparty for maturities ranging from 1-30 years
• Graph on particular day, keeping all loan characteristics constant (except maturity of loan)
• People often talk about yield curve but this term is less precise
Yield curve of AAA-rated bonds and all
bonds (upper line)
Worse rated bonds usually have higher rates
because there is real repayment risk
Flat: you pay/earn the same interest rate over the years
Ascending: what we would typically expect – higher rate for longer
maturity
Descending: typically bad news for the economy
Humped: shaped in between
-> Short-term rates move more than long term rates, which are
rather stable, as the government influences economy through
short-term rates
9
, 2.4. Decomposition of an interest rate
Demand and supply for loanable funds determine a short-term risk free interest rate -> rewards delay in
consumption
The lender faces risks for which a compensation (premium) is required:
(1) Longer maturity delays consumption more than shorter maturity = lender will ask for a maturity premium
• Gives rise to a term structure of real riskless interest rates
(2) Because future repayments may not have same purchasing power due to inflation, lenders add
expected‑inflation premium to each real rate
• Expected inflation can vary by maturity = term structure of nominal risk‑free rates
(3) Lenders charge credit spread to cover credit losses in case of default, often including liquidity premium
• Spreads differ by maturity and borrower quality = term structure of nominal rates for risky assets
Other factors include special contractual provisions, collateral arrangements, differential tax treatment, etc.
2.4.1. Fisher’s equation
Fisher’s equation: relationship between nominal and real interest rates
-> Used to determine real interest rate (given observed nonimal interest rates and estimate of expected inflation)
(1+rnominal) = (1+rreal)(1+πe) OR rnominal ≈ rreal + πe
πe: expected inflation, r: interest rate
3. Time value of money
Timeline: linear representation of timing of potential cash flows
• Inflows are positive cash flows
• Outflows are negative cash flows
Example: assume that you are lending 10K today and that the loan will be repaid in two annual 6K payments
3.1. Single cash flow compounding (simple interest rate)
Compounding : what is the future value of my investment?
VT = V0 x (1 + r x T)
V0: present value, VT: future value at time T
Remark: both time and interest rate are measured in years
10
1. The actors
The economy consists out of haves and havenots:
• Haves: possess capital and can lend it out (lenders)
o Example: households (ultimate beneficial owner (UBOs)), financial industry
• Havenots: have more needs than money and will have to raise capital (borrowers)
o Examples: corporations, government, etc.
Financing from have to have not’s is mediated by financial markets (= direct finance)
1.1. The main actor: households
Net wealth = assets – liabilities
Example: when a household owns a house of 100, but has a remaining mortgage debt of 80, its net wealth is 20.
-> gives an overview of assets and liabilities of a single household
1.1.1. Kind of assets
Asset: a possession that has value in an exchange transaction
1. Tangible/real assets: derive value from their physical character and the utility they generate (car, house, etc.)
2. Intangible assets: derive value from a legal claim to some future benefit (patent, trademarkt, etc.)
3. Financial assets: intangible assets that represent a claim to future cash (stocks, bonds, etc.)
1
,1.1.2. Asset classes
Traditional: Alternative:
1. Common stock (gewone aandelen) 1. Real estate
2. Bonds = govies and corporates (obligaties) 2. Commodities
3. Private equity
4. Hedge funds
5. Venture capital
6. Currencies (forex)
1.1.3.Liabilities
• Mortgage loans: protection mechanism to make sure you repay
• Consumer loans: loans for consumer goods (cars, televisions, etc.)
• Tax debt: amount of tax debt owed to a government by an individual, corporation, or other entity
1.2. Growth drivers in net wealth
Wealth is not created by doing nothing, wealth comes from taking risks, and:
• Value changes in assets and liabilities (for example: you bought a house and its value increases)
• Net-income from labour, capital or transfers (i.e. pensions, social security based income)
• Inheritances, gifts
1.2.1. Wealth creation
Poor family: nothing on balance sheet
Middle class: own house but mortgage loan -> low net wealth and low diversification = forced to save = ‘poor’
Rich: built something up (real estate to rent, stocks, bonds, etc.) -> wealth is working for them = take risks!
2
,1.2.2. Wealth inequality
Wealth is not uniformly distributed -> unlike popular belief, wealth inequality persists in developed countries as
well as in emerging markets, however, emerging markets struggle the most:
-> Belgium has low inequality!
1.3. Final thought
Do you fully realize that households are the ultimate:
• Owners of all assets in the economy?
• Bearers of risk within the financial system?
-> If you really want to become rich, you have to have the guts to become an entrepreneur
2. How do balance sheets of other actors look like?
2.1. Corporates
Market value: price of an asset on
the marketplace, based on the
prices buyers are willing to pay and
what sellers are willing to accept
3
,2.1.1. Leverage
Leverage: instrument to make your returns on your own equity/money higher by for example loaning money from
the bank at 2% and buy shares at 5% with that in hopes you make profit
Companies can be funded with:
1. Shareholder funds (equity) consisting out of original equity, rights issues and retained profit
2. Debt
-> when companies use debt to finance their operations, they use leverage
-> Most companies use leverage to raise the ROE above the ROA:
• ROE: return on equity (=profit/equity) = profit relative to shareholders’ equity
o What shareholders find very interesting: “how much do I earn on money that I invested?”
o How well company rewards its owners
• ROA: return on assets (=profit/assets) = profit relative to total assets
o Shows company’s true operational efficiency
Way to measure leverage: the Leverage Multiplier
• As an assets/equity ratio: the Leverage Multiplier (LM)
• Used in the famous Dupont scheme
• Relates the ROE to the ROA through formula: ROE = ROA (return on assets) x LM (leverage multiplier)
Way to measure leverage: the Gearing Ratio
• Gearing ratio: ratio between long-term debt and equity
• Net-gearing ratio: often defined as ratio of financial debt and equity
• Net financial debt: long-term debt + short-term debt – cash – short-term financial assets
2.2. Financial sector: bank
A bank can do much more than a company
because of their business model:
• Take money from anyone
• Give it to someone else
Example: Dutch bank had 3% equity and
financed itself with 97% debt
4
,Typical banks have very low percentages of equity and high percentages of debt
• Trading book: short-term positions bank holds for market-making or trading. Bank keeps inventory of
shares or other instruments so it can buy/sell quickly for clients or hedge risks.
• Banking book: loans the bank grants (long-term holding)
• Bond portfolio: banks invest deposits into bonds to earn higher returns. Alternative to granting loans,
often with higher interest income.
2.3. Financial sector: mutual fund
Mutual fund: third party acts as a portfolio manager and
gathers funds -> “I will do the investments for you”
Example: you give someone €1,000 and they give you a
certificate of your funds. The person is going to invest
your money into all kinds of financial products for you.
2.4. Financial sector: insurance company
Insurance companies have two big branches:
(1) Casualty insurance (example: car accident)
(2) Investment for the long-term (example: you
give money to the insurance company and they
invest it for you)
Technical provisions: estimate of contractual obligations that the insurance company has (example: life insurance)
3. The financial system
5
,Importance:
• Economic growth is linked to financial development
• Role of financial system: facilitate production, employment and consumption
• Resources are funneled through systems so resources flow to most efficient uses
3.1. Types of finance
(1) (Semi-)direct finance through financial markets (money/capital market):
• Borrowers sell securities directly to lenders in primary market
• After issuance, securities can be traded in secondary market
-> Direct finance provides financing for governments and corporations
(2) Indirect finance through financial intermediaries:
• Institution or other third party stand between lender and borrower
• Money passing through the balance sheets of financial institutions and transformed into loans
Example: you get a loan from a bank or finance company to buy a car
Shadow banking: non-bank financial intermediaries (NBFIs) that legally provide services similar to traditional
commercial banks but outside normal banking regulations
6
,4. Role of the government
Role for the government is needed because if financial market fails, the economy fails
4.1. In financial markets
Financial markets play a prominent role in the economy -> calls for regulation if market failure arises
• Disclosure regulation in order to prevent issuers from defrauding (actual or potential) investors by
concealing relevant information
• Market conduct regulation a.k.a. financial activity regulation in order to prevent insider trading, in order to
impose trading rules, etc.
• Financial institution regulation in order to prevent the default of financial intermediaries and in order to
safeguard the payment system
• Restrictions on foreign participants in order to control e.g. the money supply
4.2. Other potential roles of government
1. Act as financial intermediary (e.g. credit support through loan sand guarantees)
2. Influence the markets through monetary policy (= government sensu lato since this task is performed
independently by the central bank)
3. Provide bail outs: to preserve financial stability, governments bailed out these banks by injecting equity
and/or guaranteeing the debt of the big banks
-> The last potential role has been actively used in the past but is under discussion due to controversy
• No bail out policies
• Systemically Important Financial Institutions (SIFIs): bank, insurance company, or other financial
institution whose failure might trigger a financial crisis
Banks will not always be bailed out, but government has to make sure that the bank is not interconnected with
another bank to avoid domino effect
7
,Unit 2: Fixed income markets
1. Introduction
1.1. Financing sources
(1) Equity instruments
(2) Debt instruments:
• Loans (directly from the bank)
• Debt securities (borrow from individuals)
-> Loans and debt securities are known as “fixed income instruments”, but differences! (examples: transfering loans
versus securities to other parties is very different, a loan has a legal ground via contract, etc.)
1.2. Financial history
Financial instruments go back a long time, and debt instruments are oldest instruments in world: IOU goes back to
time of hunters-gatherers!
-> Codex of Hammurabi (1780 BC) provided loan concepts (including interest charges) and insurance/risk sharing
contracts
2. Interest rates
In world with positive interest rates, you will have to pay back more than the amount you borrowed
2.1. Definition
Interest rate: the price of money
• Price (for borrower) to ‘rent’ money
• Reward for the lender to postpone consumption (as they lend the money they would use for consumption)
!! There is a vast difference between percentage and percentage points! A difference between 3% and 4% is not
1%, but 100 basis points! (Use to remove confusion around increases/decreases)
2.2. Interest rate or interest rates?
Interest rate charged depends on risks taken by lender, and risk depends (at least) on the:
• Credit worthiness of borrower
• Maturity of debt (1 year versus 100 years)
-> We cannot speak about the interest rate; there will be a different interest rate per maturity and per borrower
8
,2.3. Term structure of interest rates
Term structure of interest rates: a graph that shows the ‘interest rate’ (or spot rate) that would be charged to
certain counterparty for maturities ranging from 1-30 years
• Graph on particular day, keeping all loan characteristics constant (except maturity of loan)
• People often talk about yield curve but this term is less precise
Yield curve of AAA-rated bonds and all
bonds (upper line)
Worse rated bonds usually have higher rates
because there is real repayment risk
Flat: you pay/earn the same interest rate over the years
Ascending: what we would typically expect – higher rate for longer
maturity
Descending: typically bad news for the economy
Humped: shaped in between
-> Short-term rates move more than long term rates, which are
rather stable, as the government influences economy through
short-term rates
9
, 2.4. Decomposition of an interest rate
Demand and supply for loanable funds determine a short-term risk free interest rate -> rewards delay in
consumption
The lender faces risks for which a compensation (premium) is required:
(1) Longer maturity delays consumption more than shorter maturity = lender will ask for a maturity premium
• Gives rise to a term structure of real riskless interest rates
(2) Because future repayments may not have same purchasing power due to inflation, lenders add
expected‑inflation premium to each real rate
• Expected inflation can vary by maturity = term structure of nominal risk‑free rates
(3) Lenders charge credit spread to cover credit losses in case of default, often including liquidity premium
• Spreads differ by maturity and borrower quality = term structure of nominal rates for risky assets
Other factors include special contractual provisions, collateral arrangements, differential tax treatment, etc.
2.4.1. Fisher’s equation
Fisher’s equation: relationship between nominal and real interest rates
-> Used to determine real interest rate (given observed nonimal interest rates and estimate of expected inflation)
(1+rnominal) = (1+rreal)(1+πe) OR rnominal ≈ rreal + πe
πe: expected inflation, r: interest rate
3. Time value of money
Timeline: linear representation of timing of potential cash flows
• Inflows are positive cash flows
• Outflows are negative cash flows
Example: assume that you are lending 10K today and that the loan will be repaid in two annual 6K payments
3.1. Single cash flow compounding (simple interest rate)
Compounding : what is the future value of my investment?
VT = V0 x (1 + r x T)
V0: present value, VT: future value at time T
Remark: both time and interest rate are measured in years
10
