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# A Brief History of Finance

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## David Hargreaves

on 5 March 2018

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#### Transcript of A Brief History of Finance

Barter
I would like bacon
I would like beef
Barter
I would like bacon
I would like fish
I would like beef
Barter works in this very simple economy
Barter stills works but it becomes very complicated
C only has one fish and so cannot make a straight swap
A can give C the beef he wants but he (A) doesn't want fish
Transaction cannot take place unless B is involved as well so all three transactions have to take place at the same time
C still does not have enough fish to enable the other two transactions to take place fully
However
Money
Money
I would like bacon
I would like fish
I would like beef
Money means that each transaction can take place in series
C buys cow from A for £10
B buys fish from C for £4
A buys 3 pigs from B for £9
At the end of the three transactions they each possess the following:
A: 3 pigs and £1
B: 1 fish and £10
C: 1 cow and £4
£10
£3
£3
£3
£4
x 10
x 6
x 5
Banks
The ultimate purpose of banks is to keep our money safe
How can you keep the money safe
Bank
x 6
x10
x 4
x 25
Bank can now look after everyone's savings
It could have 3 different deposit boxes for each of the three different savers
But it does not need this
It simply needs:
One deposit box for all the 'reserves'
A spreadsheet which keeps track of everyone's savings
Everyone else can use the same bank
x 25
So the bank becomes
One big deposit box of actual cash
A
£6
B
C
£10
£4
x 25
The spreadsheet is updated
A
£6
B
C
£10
£4
Now if A wishes to buy bacon from B for £3
-£3
+£3
=£3
=£13
And the money never actually moves
However there are lots of banks
What if person A banks at RBS and person B banks at Barclays
Transfers in both directions are added up and netted off
This is called the clearing system
Hence these banks are called the clearing banks
But
Does this mean a bus load of gold or silver is moved between banks each day
No
The Bank of England acts as banker to the bankers
Netted off cashflows
Bank of England is really just a bank
A lot of gold bullion
So how did the Bank of England find the money to bail out the banks?
It didn't - it just typed the number into a computer
So why don't we solve all the problems of the world like this
Inflation
So what is the Bank of England
Now returning to our normal bank
Can the spreadsheet have negative numbers in it
x 25
A
-£4
B
C
£20
£4
Supposing A buys another £7 of goods from B
Does A now owe B money
No
A owes the bank AND
The bank owes B
What if A cannot pay
If A cannot pay then:
B still has £20
A effectively has £0 - although bank may attempt to sieze assets
Bank still has £25 in its vault - but its net asset position is now £25 - £20 - £4 = £1
Are B and C now worried
No
The total deposits of B and C are:
£20 + £4 = £24
The total reserves of the bank are:
£25
B and C know that their money is completely safe despite the default of A
However along comes D
D wishes to borrow £80 to buy £80 worth of goods from B
The maths is simple: the spreadsheet becomes:
A
-£4
B
C
£100
£4
D
-£80
x 25
And the bank still has £25
Are B and C now worried
Yes
The total deposits of B and C are:
£100 + £4 = £104
The total reserves of the bank are:
£25
Both B and C may now want to try and get their money out before the other one does, as the bank is now exposed to the default of A and D
This is called a run on the bank
So is this allowed
YES
It's called fractional reserving
That is the bank only holds a fraction of the reserves it needs to back the outstanding deposits
So how does it work
Basel II - stipulates the amount of reserves that must be held and the quality of assets (loans) that are required
The rating agencies assess whether the bonds and synthetic bonds which the banks are holding are of sufficient quality
The auditors check that the banks are actually holding the assets they say they are holding
The banks own risk management team will run daily simulations to stress test the risks that the bank is exposed to from assets and loans defaulting
Why not just ban the negative numbers
The negative numbers allow people to spend money they have not yet earned
This is essential to enabling entrepeneurs to start businesses - as most business uses capital (money) before making money for its owner
As we can see this is risky for the bank and the various regulating parties may not allow it
Thankfully, there are other ways of businesses raising finance
Corporate Finance
They can issue bonds
They can issue shares
A Corporate Bond
This is an asset which companies sell to investors
The selling company then has to make coupon payments and a redemption payment at the end of the period of the bond
Investment banks help organise the isssue of new corporate bonds by underwriting them. They then sell the bonds onto the market. This means that the individual bank does not run the risk of the whole bond defaulting. It is particularly useful for very large companies who wish to borrow a lot of money
Coupon payments
Redemption payment
£104 after 4 years
£5 every 6 months
How much is this bond worth?
How much would you need to put in the bank now to make all the payments under the bond
If I put £120 in the bank now and the interest rate is 4% then
In one year I will have 120 x 1.04 = £124.8
In two years I will have 120 x 1.04^2 = £129.79
In six months I will have 120 x 1.04^0.5 = £122.38
Step back and look at compound interest
so what is present value
The present value of a payment of £100 in 2 years' time is:
the amount of money I have to put in the bank now so that it will be worth £100 in 2 years' time
This is simply 100 / (1.04^2) = £92.46
So what about the PV of the bond
All we have to do is add up all the present values of all the different cashflows.
So if the interest rate is 4% then the value of the bond is:
Value of bond = 5/1.04^0.5 + 5/1.04^1.0 +...+ 5/1.04^3.5 + 104/1.04^4
But: how do we know the interest rate is 4%
We don't
Once a bond has been issued we can see the price it trades at in the market.
We can then do the calculation backwards to work out the interest rate (yield) for the individual bond
Before the bond has been issued the investors have to decide how much interest the bond should pay
The more risky the company is the more interest investors will want to receive on the bond
Shares (or equities)
Companies can also raise capital by issuing shares
This means that investors get to buy a share of the ownership of the company
Shareholders can vote on many company matters
Shareholders can also make a profit by selling their shares at a higher price OR by receiving dividend payments from the company
The value of shares can be considered by the dividend discount model
The Dividend Discount Model
This assumes that
a share will pay dividends for ever
The value of the shares can be calculated by discounting the dividends at an appropriate rate of return
The rate of increase of the dividends can be known in advance
How do investors decide which to buy
Expected return
Riskiness
Equities
Government bonds
AAA corporate bonds
BB corporate bonds
Investors will use a higher discount rate to value the BB corporate bonds and the equities than the AAA corporate bonds
Who are the investors
Life insurance companies
High net worth individuals
Pensions Schemes
Typically want bond like assets to match liabilities
Typically can afford to take risk and want the more equity like assets
Historically invested more in equites for long term growth but have moved to more bond like investments over recent years
How do they decide which assets to buy
Most of the investors delegate the decision about particular assets to fund managers
Fund managers tend to specialise in particular areas like UK equity or government bonds
A pension fund may use several different fund managers managing hundreds of millions each in its portfolio
Some hedge funds (which are specialist fund managers) specialise in very narrow niches where they think markets are mispriced
Actuaries decide how much money the pension scheme needs and which broad asset classes it needs to invest in
Fund managers often rely heavily on the accounts produced by the companies they invest in. It is the job of the auditors to check that these accounts are correct
What else do banks do
What else does the bank of Enlgand do
Sets Base Rates
Sell and construct derivative instruments
Underwrite IPO's
What techniques do they use
Asset liability matching
Diversification
Alpha generation
Involves investing in assets which produce the same cashflows as your liabilities require.
That is, for a pension scheme you invest in bonds that have a coupon payment when you need to pay a lump sum to a member of the scheme
Involves investing in a wide range of assets and assets classes so that volatility is averaged out.
If this is done well then the expected performance of the overall portfolio is not reduced but the volatility is.
It is often described as the only free lunch in the city
Alpha is the extra performance you get from being able to buy assets when they are too cheap and sell them when they are too dear. If this done well it allows a fund to increase performance without increasing risk
Regulates the financial system
When clearing banks have money on deposit over night they receive interest on this money - this is called the base rate. This is decided by the Bank of England.
If the base rate increases then (in theory) mortgage rates go up and spending goes down thus reducing inflation. Also more savers will want to save in pounds so the exchange rate should go up as well
This generates multi millions in fee income
We will consider later the role of the banks in enabling business to raise capital through issuing equities and bonds
If a farmer wishes to hedge the price of wheat or milk - the investment banks will have a derivative that can do this
If a hedge fund wishes to bet that a share will be between two price point or outside of two price points the investment banks can make a derivative that can do this
In the beginning
Then at the end of the day
That is:
Aside
Yes - the maths certainly works
x 5
Bank starts with £5 of its own capital
The actual money hasn't moved
What is investment strategy about
Investment
Money
Banking
A Brief History of Finance and Investment
Full transcript