2 Financial Markets and Transformation Functions

Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
2 Financial Markets and Transformation Functions
Financing and Transformation Functions
financial deficit
units
(mainly
companies)
Institutions:
issuing of financial assets
capital investment
Exchanges
OTC Markets
Bank Markets
Insurance Markets
financial intermediaries
financial institutions
financial intermediation
transformation functions
of financial markets
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financial excess
units (mainly private
households)
lot size and spatial
transformation
period and liquidity
transformation
risk transformation

Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
a) Lot Size and Spatial Transformation
Spatial transformation:
- Solvency at different places (monetary transactions, loans)
- Capital transfers between regions financial balancing
Effects of the failure of a banking system?
Lot size transformation:
- Matching investments of a different size
- Pooling small deposits
- Splitting large deposits
37

Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
b) Period and Liquidity Transformation
- Financing long-term investments with short-term funds (positive period
transformation) and vice versa (negative period transformation)
- Option to withdraw financial resources out of long-term projects prior to
maturity
Enabled by:
Secondary markets
Price and liquidity risks
Possibility of hedging with particular financial products
Intermediation
Counter party risk for the investor
Limited default risk of the financial intermediary by setting financing
rules
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Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Financial Rules to Limit the Risks that Arise from Period and Liquidity Trans-
formation
Golden Banking Rule/Golden Rule of Finance:
Total maturity matching
Golden Rule of Balance Sheet
Basis: “Schichtenbilanz”
assets liabilities
A1: Assets with a capital commitment of over
4 years
A2: Assets with a capital commitment of 3
months to 4 years
A3: Assets with a capital commitment up to 3
months
A1 ≤ F1 and A1+A2 ≤ F1+F2
“Bodensatzregel” (Principles II and III of BAKred)
Rule 1: A1 ≤ F1 + 0,6 F2 + 0,1 F3
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F1: Financial resources invested longer than 4
years
F2: : Financial resources invested 3 months to
4 years
F3: : Financial resources invested less than 3
months
Rule 2: A2 ≤ (F1 + 0,6 F2 + 0,1 F3 - A1) + 0,4 F2 + 0,2 F3

c) Risk Transformation
Via secondary markets:
Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Portfolio diversification: (stock) exchange or funds
Limiting risk by using financial derivates
Via financial intermediaries:
Portfolio diversification and available net equity of a bank or insurance
company
Banks as “delegated monitor“ and “delegated contractor“
Implementation by banks: Risk management
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Model Calculation
Arrow-Debreu-Model:
Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
- 4 states with identical probability
- 2 financial assets (A1 and A2)
- Utility functions U or V
- Amount of investment: 100
state: s1 s2 s3 s4
A1 x11 = 130 x12 = 130 x13 = 90 x14 = 90
A2 x21 = 160 x22 = 60 x21 = 160 x22 = 60
U
x
U(Al) 11,40 11,40 9,49 9,49
U(A2) 12,65 7,75 12,65 7,75
E(U(A1)) = 10,44 E(U(A2)) = 10,20
V
x
x 5
x 100
otherwise
V(A1) 11,40 11,40 4,49 4,49
V(A2) 12,65 2,75 12,65 2,75
E(V(A1)) = 7,94 E(V(A2)) = 7,70
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Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Risk Transformation by Diversification:
state: s1 s2 s3 s4
A1 x11 = 130 x12 = 130 x13 = 90 x14 = 90
A2 x21 = 160 x22 = 60 x21 = 160 x22 = 60
Portfolio formation: Purchase α = 50% of A1 and (1 – α) = 50% of A2
½ A1 + ½ A2 xd1 = 145 xd2 = 95 xd3 = 125 xd4 = 75
U(α = 50%) 12.04 9.75 11.18 8.66
V(α = 50%) 12.04 4.75 11.18 3.66
E(U(α = 50%)) = 10,40 E(V(α = 50%)) = 7,90
(“naive” diversification, without success in this case)
Portfolio formation:
Purchase α = 86.52% of A1 and (1 - α) = 13.48% of A2
xd1 = 134,04 xd2 = 120.56 xd3 = 99.44 xd4 = 85.96
U(α = 86,52%) 11.58 10.98 9,97 9.27
V(α = 86,52%) 11.58 10.98 4.97 4.27
E(U(α = 86.52%)) = 10.45 E(V(α = 86.52%)) = 7.95
(optimal diversification for utility function U)
Instruments:
Diversification via portfolio formation
Buying shares in a fund
Buying bank or insurance shares
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Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Risk Transformation by Risk Splitting:
state: s1 s2 s3 s4
A1 x11 = 130 x12 = 130 x13 = 90 x14 = 90
A2 x21 = 160 x22 = 60 x21 = 160 x22 = 60
“No-loss“ contract (e.g. on A1):
xsl1 = 120 xsl2 = 120 xsl3 = 100 xsl4 = 100
U(SL) = V(SL) 10,95 10,95 10 10
Risk free asset:
E(U(x)) = E(V(x)) = 10,47
xrl1 = 110 xsl2 = 110 xsl3 = 110 xsl4 = 110
U(RF) = V(RF) 10,49 10,49 10,49 10,49
E(U(x)) = E(V(x)) = 10,49
Hedging or financial engineering by:
Contracting with a bank
A particular fund construction
Buying financial assets on the capital market
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Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Financial Engineering on the Capital Market:
E.g.: Combination of shares in A1 and a (long) put option
Wealth of the investor
in T
State: s1 s2 s3 s4
A1 (α of 100) α130 α130 α90 α90
Put option with
strike P on α A1
0 0 α(P – 90) α(P – 90)
Desired cash flow xsl1 = 120 xsl2 = 120 xsl3 = 100 Xsl4 = 100
130
120
90
Costs:
Desired
Minimum Wealth
in T
(e.g. 100)
12
13
100
100 13
12
P90100 P 108,
3
(risk free interest rate i = 10% and risk neutral valuation of the option)
Buying shares of the asset A1:
Buying a put option 1
on share α of the asset : 2
Total costs :
Portfolio
A1
1 1 12
108, 3 90
108, 3 90
92,
31
Put Option
7,
69
100
100
44
1
i
92,
31
Value of the Asset in T
2 13
1
1,
1
7,
69