The interrelationship among markets is vitally important. A change in one market will also lead to changes in other markets. Understanding these links is important. This series of posts addresses the important link between the labor and product markets.
The production process generally involves (a) purchasing resources- like raw materials, labor services, tools, and machines; (b) transforming these resources into products (goods and services); and (c) selling the goods and services in a product market. Production is generally undertaken by business firms. Typically, business firms will demand resources, while households will supply them. Firms demand resources because they contribute to the production of goods and services. In turn, households supply them in order to earn income.
Just as in product markets, the demand curve in a resource market i s typically downward-sloping and the supply curve upward-sloping. An inverse relationship will exist between the amount of a resource demanded and its price because businesses will substitute away from a resource as its price rises. In contrast, there will be a direct relationship between the amount of a resource supplied and its price because a higher price will make that resource more attractive to provide. As in product markets, prices will coordinate the choices of buyers and sellers in resource markets, bringing the quantity demanded into balance with the quantity supplied.
The labor market is a large component of the broader resource market. Actually, there is not just one market for labor, but rather there are many labor markets, one for each different skill-experience-occupational category. Let’s look at the labor market for low-skilled, inexperienced workers. The supply of young, inexperienced workers has declined in recent years in many areas of the United States. This lower supply has pushed the wages of young workers upward. The higher price of this resource increases the opportunity cost of goods and services that young workers help produce. In turn, the higher cost reduces the supply (shifting S, to S,) of products like hamburgers at McDonald’s and other fast-food restaurants, pushing their price upward. When the price of a resource increases, it will lead to higher production costs, lower supply, and higher prices for the goods and services produced with the resource.
Of course, lower resource prices have the opposite effect. Lower resource prices reduce costs and expand the supply of consumer goods made with the lower-priced resources (shifting the supply curve to the right). The increase in supply will lead to a lower price in the product market. Thus, when the price of a resource- such as labor- changes, the prices of goods and sevices produced with that resource will change in the same direction.
Changes in product markets will also influence resource markets. There is a close relationship between the demand for products and the demand for the resources required for their production. An increase in demand for a consumer good- automobiles, for example- will lead to higher auto prices, which will increase the profitability of producing automobiles and give automakers an incentive to expand output. But the expansion In automobile output will require additional resources, causing an increase in the demand for. and prices of, the resources required for their production (steel, rubber, plastics, and the labor services of autoworkers, for example). The higher prices of these resources will cause other industries to conserve on their use, freeing them up for more automobile production.
Of course, the process will work in reverse if demand for a product falls. A decrease In demand will not only reduce the price of the product but will also reduce the demand for and prices of the resources used to produce it. Thus, when the demand for a product changes, the demand for (and prices Of the resources used to produce it will change in the same direction.
The link between resource and product markets
October 5th, 2010OVERVIEW OF MARKET PARTICIPANTS
September 14th, 2010With an understanding of what financial assets are and the role of financial assets and financial markets, we can now identify who the players are in the financial markets. By this we mean the entities that issue financial assets and the entities that invest in financial assets. We will focus on one particular group of market players, called financial intermediaries, because of the key economic functions that they perform in financial markets. In addition to reviewing their economic function, we will set forth the basic asset/liability problem faced by managers of financial intermediaries.
There are entities that issue financial assets, both debt instruments and equity instruments. There are investors who purchase these financial assets. This does not mean that these two groups are mutually exclusive—it is common for an entity to both issue a financial asset and at the same time invest in a different financial asset.
A simple classification of these entities is as follows: (1) central governments; (2) agencies of central governments; (3) municipal governments; (4) supranationals; (5) nonfinancial businesses; (6) financial enterprises; and (7) households. Central governments borrow funds for a wide variety of reasons. Many central governments establish agencies to raise funds to perform specific functions. Most countries have municipalities or provinces that raise funds in the capital market. A supranational institution is an organization that is formed by two or more central governments through international treaties. Businesses are classified into nonfinancial and financial businesses. These entities borrow funds in the debt market and raise funds in the equity market. Nonfinancial businesses are divided into three categories: corporations, farms, and nonfarm/noncorporate businesses. The first category includes corporations that manufacture products (e.g., cars, steel, computers) and/or provide nonfinancial services (e.g., transportation, utilities, computer programming). In the last category are businesses that produce the same products or provide the same services but are not incorporated.
Financial businesses, more popularly referred to as financial institutions, provide services related to one or more of the following:
1. Transforming financial assets acquired through the market and constituting them into a different and more preferable type of asset—which becomes their liability. This is the function performed by financial intermediaries, the most important type of financial institution.
2. Exchanging financial assets on behalf of customers. 3. Exchanging financial assets for their own account. 4. Assisting in the creation of financial assets for their customers and then
selling those financial assets to other market participants. 5. Providing investment advice to other market participants. 6. Managing the portfolios of other market participants.
Financial intermediaries include: depository institutions that acquire the bulk of their funds by offering their liabilities to the public mostly in the form of deposits; insurance companies (life and property and casualty companies); pension funds; and finance companies. The second and third services in the list above are the broker and dealer functions. The fourth service is referred to as securities underwriting. Typically, a financial institution that provides an underwriting service also provides a broker- age and/or dealer service.
Some nonfinancial businesses have subsidiaries that provide financial services. For example, many large manufacturing firms have subsidiaries that provide financing for the parent company’s customer. These financial institutions are called captive finance companies.
Operational Efficiency
September 1st, 2010In an operationally efficient market, investors can obtain transaction services as cheaply as possible, given the costs associated with furnish- ing those services. Commissions are only part of the cost of transacting as we noted above. The other part is the dealer spread. Bid-ask spreads for bonds vary by type of bond. Other components of transaction costs are discussed below.
In an investment era where one-half of one percentage point can make a difference when an asset manager is compared against a performance benchmark, an important aspect of the investment process is the cost of implementing an investment strategy. Transaction costs are more than merely brokerage commissions—they consist of commissions, fees, execution costs, and opportunity costs.
Commissions are the fees paid to brokers to trade securities. Execution costs represent the difference between the execution price of a security and the price that would have existed in the absence of the trade. Execution costs can be further decomposed into market (or price) impact and market-timing costs. Market impact cost is the result of the bid-ask spread and a price concession extracted by dealers to mitigate their risk that an investor’s demand for liquidity is information-motivated. Market-timing cost arises when an adverse price movement of the security during the time of the transaction can be attributed in part to other activity in the security and is not the result of a particular transaction. Execution costs, then, are related to both the demand for liquidity and the trading activity on the trade date.
There is a distinction between information-motivated trades and informationless trades. Information-motivated trading occurs when investors believe they possess pertinent information not currently reflected in the security’s price. This style of trading tends to increase market impact because it emphasizes the speed of execution, or because the market maker believes a desired trade is driven by information and increases the bid-ask spread to provide some protection. It can involve the sale of one security in favor of another. Informationless trades are the result of either a reallocation of wealth or implementation of an investment strategy that utilizes only existing information. An example of the former is a pension fund’s decision to invest cash in the stock market. Other examples of informationless trades include portfolio rebalances, investment of new money, or liquidations. In these circumstances, the demand for liquidity alone should not lead the market maker to demand the significant price concessions associated with new information.
The problem with measuring execution costs is that the true mea- sure—which is the difference between the price of the security in the absence of the investor’s trade and the execution price—is not observable. Furthermore, the execution prices are dependent on supply and demand conditions at the margin. Thus, the execution price may be influenced by competitive traders who demand immediate execution, or other investors with similar motives for trading. This means that the execution price realized by an investor is the consequence of the structure of the market mechanism, the demand for liquidity by the marginal investor, and the competitive forces of investors with similar motivations for trading.
The cost of not transacting represents an opportunity cost. Opportunity costs may arise when a desired trade fails to be executed. This component of costs represents the difference in performance between an investor’s desired investment and the same investor’s actual investment after adjusting for execution costs, commissions, and fees. Opportunity costs have been characterized as the hidden cost of trading, and it has been suggested that the shortfall in performance of many actively managed portfolios is the consequence of failing to execute all desired trades.14 Measurement of opportunity costs is subject to the same problems as measurement of execution costs. The true measure of opportunity cost depends on knowing what the performance of a security would have been if all desired trades had been executed at the desired time across an investment horizon. As these are the desired trades that the investor could not execute, the benchmark is inherently unobservable
Market Price Efficiency
August 24th, 2010The term “efficient” capital market has been used in several contexts to describe the operating characteristics of a capital market. There is a distinction, however, between an operationally (or internally) efficient market and a pricing (or externally) efficient capital market.
Pricing efficiency refers to a market where prices at all times fully reflect all available information that is relevant to the valuation of securities. That is, relevant information about the security is quickly impounded into the price of securities. In his seminal review article on pricing efficiency, Eugene Fama points out that in order to test whether a market is price efficient, two definitions are necessary. First, it is necessary to define what it means that prices “fully reflect” information. Second, the “relevant” set of information that is assumed to be “fully reflected” in prices must be defined. Fama, as well as others, defines “fully reflects” in terms of the expected return from holding a security. The expected return over some holding period is equal to expected cash distributions plus the expected price change, all divided by the initial price. The price formation process defined by Fama and others is that the expected return one period from now is a stochastic (i.e., random) variable that already takes into account the “relevant” information set.
In defining the “relevant” information set that prices should reflect, Fama classified the pricing efficiency of a market into three forms: weak, semistrong, and strong. The distinction between these forms lies in the relevant information that is hypothesized to be impounded in the price of the security. Weak efficiency means that the price of the security reflects the past price and trading history of the security. Semistrong efficiency means that the price of the security fully reflects all public information (which, of course, includes but is not limited to historical price and trading patterns). Strong-form efficiency exists in a market where the price of a security reflects all information, whether or not it is publicly available.
A price-efficient market has implications for the investment strategy that investors may wish to pursue. Throughout this blog, we shall refer to various active strategies employed by investors. In an active strategy, investors seek to capitalize on what they perceive to be the mispricing of a security or securities. In a market that is price efficient, active strategies will not consistently generate a return after taking into consideration transaction costs and the risks associated with a strategy that is greater than simply buying and holding securities. This has lead investors in certain markets that empirical evidence suggests are price efficient to pursue a strategy of indexing, which simply seeks to match the performance of some financial index.
Role of Brokers and Dealers in Real Markets (2)
August 14th, 2010The fact of imbalances explains the need for the dealer or market maker, who stands ready and willing to buy a financial asset for its own account (add to an inventory of the security) or sell from its own account (reduce the inventory of the security). At a given time, dealers are willing to buy a security at a price (the bid price) that is less than what they are willing to sell the same security for (the ask price).
In the 1960s, economists George Stigler and Harold Demsetz analyzed the role of dealers in securities markets. They viewed dealers as the suppliers of immediacy—the ability to trade promptly—to the market. The bid-ask spread can be viewed in turn as the price charged by dealers for supplying immediacy, together with short-run price stability (continuity or smoothness) in the presence of short-term order imbalances. There are two other roles that dealers play: they provide better price information to market participants, and in certain market structures they provide the services of an auctioneer in bringing order and fairness to a market.
The price-stabilization role relates to our earlier example of what may happen to the price of a particular transaction in the absence of any intervention when there is a temporary imbalance of order. By taking the opposite side of a trade when there are no other orders, the dealer prevents the price from materially diverging from the price at which a recent trade was consummated.
Investors are concerned with immediacy, and they also want to trade at prices that are reasonable, given prevailing conditions in the market. While dealers cannot know with certainty the true price of a security, they do have a privileged position in some market structures with respect to the flow of market orders. They also have a privileged position regarding “limit” orders, the special orders that can be executed only if the market price of the security changes in a specified way.
Finally, the dealer acts as an auctioneer in some market structures, thereby providing order and fairness in the operations of the market. For example, the market maker on organized stock exchanges in the United States performs this function by organizing trading to make sure that the exchange rules for the priority of trading are followed. The role of a market maker in a call market structure is that of an auctioneer. The market maker does not take a position in the traded security, as a dealer does in a continuous market.
One of the most important factors that determine the price dealers should charge for the services they provide (i.e., the bid-ask spread) is the order processing costs incurred by dealers, such as the costs of equipment necessary to do business and the administrative and operations staff. The lower these costs, the narrower the bid-ask spread. With the reduced cost of computing and better-trained personnel, these costs have declined over time.
Dealers also have to be compensated for bearing risk. A dealer’s position may involve carrying inventory of a security (along position) or selling a security that is not in inventory (a short position). There are three types of risks associated with maintaining a long or short position in a given security. First, there is the uncertainty about the future price of the security. A dealer who has a long position in the security is concerned that the price will decline in the future; a dealer who is in a short position is concerned that the price will rise.
The second type of risk has to do with the expected time it will take the dealer to unwind a position and its uncertainty. And this, in turn, depends primarily on the rate at which buy and sell orders for the security reaches the market (i.e., the thickness of the market). Finally, while a dealer may have access to better information about order flows than the general public, there are some trades where the dealer takes the risk of trading with someone who has better information This results in the better-informed trader obtaining a better price at the expense of the dealer. Consequently, in establishing the bid-ask spread for a trade, a dealer will assess whether the trader might have better information. Some trades that we will discuss below can be viewed as “information- less trades.” This means that the dealer knows or believes a trade is being requested to accomplish an investment objective that is not motivated by the potential future price movement of the security.
Role of Brokers and Dealers in Real Markets (1)
August 2nd, 2010Common occurrences in real markets keep them from being theoretically perfect. Because of these occurrences, brokers and dealers are necessary to the smooth functioning of a secondary market.
One way in which a real market might not meet all the exacting standards of a theoretically perfect market is that many investors may not be present at all times in the marketplace. Further, a typical investor may not be skilled in the art of the deal or completely informed about every facet of trading in the asset. Clearly, most investors in even smoothly functioning markets need professional assistance. Investors need someone to receive and keep track of their orders for buying or selling, to find other parties wishing to sell or buy, to negotiate for good prices, to serve as a focal point for trading, and to execute the orders. The broker performs all of these functions. Obviously, these functions are more important for the complicated trades, such as the small or large trades, than for simple transactions or those of typical size.
A broker is an entity that acts on behalf of an investor who wishes to execute orders. In economic and legal terms, a broker is said to be an “agent” of the investor. It is important to realize that the brokerage activity does not require the broker to buy and hold in inventory or sell from inventory the financial asset that is the subject of the trade. (Such activity is termed “taking a position” in the asset, and it is the role of the dealer.) Rather, the broker receives, transmits, and executes investors’ orders with other investors. The broker receives an explicit commission for these services, and the commission is a “transaction cost” of the capital markets.
A real market might also differ from the perfect market because of the possibly frequent event of a temporary imbalance in the number of buy and sell orders that investors may place for any security at any one time. Such unmatched or unbalanced flow causes two problems. First, the security’s price may change abruptly even if there has been no shift in either supply or demand for the security. Second, buyers may have to pay higher than market-clearing prices (or sellers accept lower ones) if they want to make their trade immediately.
For example, suppose the consensus price for ABC security is $50, which was determined in several recent trades. Also suppose that a flow of buy orders from investors who suddenly have cash arrives in the mar- ket, but there is no accompanying supply of sell orders. This temporary imbalance could be sufficient to push the price of ABC security to, say, $55. Thus, the price has changed sharply even though there has been no change in any fundamental financial aspect of the issuer. Buyers who want to buy immediately must pay $55 rather than $50, and this difference can be viewed as the price of “immediacy.” By immediacy, we mean that buyers and sellers do not want to wait for the arrival of sufficient orders on the other side of the trade, which would bring the price closer to the level of recent transactions.
Perfect Market
July 24th, 2010In order to explain the characteristics of secondary markets, we will first describe a “perfect market” for a financial asset. Then we can show how common occurrences in real markets keep them from being theoretically perfect.
In general, a perfect market results when the number of buyers and sellers is sufficiently large, and all participants are small enough relative to the market so that no individual market agent can influence the commodity’s price. Consequently, all buyers and sellers are price takers, and the market price is determined where there is equality of supply and demand. This condition is more likely to be satisfied if the commodity traded is fairly homogeneous (for example, corn or wheat).
There is more to a perfect market than market agents being price takers. It is also required that there are no transaction costs or impediments that interfere with the supply and demand of the commodity. Economists refer to these various costs and impediments as “frictions.” The costs associated with frictions generally result in buyers paying more than in the absence of frictions, and/or sellers receiving less.
In the case of financial markets, frictions would include:
Commissions charged by brokers. Bid-ask spreads charged by dealers. Order handling and clearance charges. Taxes (notably on capital gains) and government-imposed transfer fees. Costs of acquiring information about the financial asset. Trading restrictions, such as exchange-imposed restrictions on the size of a position in the financial asset that a buyer or seller may take. Restrictions on market makers. Halts to trading that may be imposed by regulators where the financial asset is traded.
Secondary Markets
July 15th, 2010The secondary market is where already-issued financial assets are traded. The key distinction between a primary market and a secondary market is that in the secondary market the issuer of the asset does not receive funds from the buyer. Rather, the existing issue changes hands in the secondary market, and funds flow from the buyer of the asset to the seller. Below we explain the various features of secondary markets. These features are common to any type of financial instrument traded.
It is in the secondary market where an issuer of securities, whether the issuer is a corporation or a governmental unit, may be provided with regular information about the value of the security. The periodic trading of the asset reveals to the issuer the consensus price that the asset commands in an open market. Thus, firms can discover what value investors attach to their stocks, and firms and noncorporate issuers can observe the prices of their bonds and the implied interest rates investors expect and demand from them. Such information helps issuers assess how well they are using the funds acquired from earlier primary market activities, and it also indicates how receptive investors would be to new offerings.
The other service a secondary market offers issuers is that it provides the opportunity for the original buyers of the asset to reverse their investment by selling it for cash. Unless investors are confident that they can shift from one financial asset to another as they may deem necessary, they would naturally be reluctant to buy any financial asset. Such reluctance would harm potential issuers in one of two ways: either issuers would be unable to sell new securities at all or they would have to pay a high rate of return, as investors would demand greater compensation for the expected illiquidity of the securities.
Investors in financial assets receive several benefits from a secondary market. Such a market obviously offers them liquidity for their assets as well as information about the assets’ fair or consensus values. Further, secondary markets bring together many interested parties and so can reduce the costs of searching for likely buyers and sellers of assets. Moreover, by accommodating many trades, secondary markets keep the cost of transactions low. By keeping the costs of both searching and transacting low, secondary markets encourage investors to purchase financial assets.
Relative Returns: Adding Alpha
July 5th, 2010Portfolio or asset managers who are on the other hand looking to maximize relative returns compared to an unhedged position will most likely adopt a strategy of active currency management whether the emphasis is on adding alpha or relative return. Either the portfolio manager or a professional currency overlay manager will “trade” the currency around a selected currency hedging benchmark for the explicit purpose of adding alpha. In most cases, this alpha is mea- sured against a 100% unhedged position, although it could theoretically be measured against the return of the currency hedging benchmark. With active currency management, the emphasis should be on flexibility, both in terms of the availability of financial instruments one can use to add alpha and also in terms of the currency hedging benchmark itself. On the first of these, an active currency manager should have access to a broad spectrum of currency instruments in order to boost their chance of adding value. Similarly, their ability to add value is significantly increased by the adoption of a 50% or symmetrical currency hedging benchmark rather than by a 100% hedged or 100% unhedged benchmark.
Budget Rates
June 29th, 2010The budget exchange rate can drive both the corporation’s hedging strategy and its pricing strategy as well, and can be set in a number of ways. It can simply be the spot exchange rate at the end of the previous fiscal period. This is often referred to as the accounting rate. Alternatively, when dealing with forecasted cash flows, the issue becomes slightly more complex. Theoretically, the budget exchange rate should be derived from the domestic sales price and the foreign subsidiary sales price. Thus, if the parent sales price for a good is USD10 and the Euro area sales price for argument’s sake is EUR15, the theoretical budget rate would be 0.67. The Euro–dollar exchange may be different from that, so the corporation needs to evaluate whether there is room to change its Euro-denominated pricing without reducing margin substantially in order to set a budget rate that is closer to the spot exchange rate. If there is a major difference between the spot exchange rate and the budget rate, the corporation may have to reassess its currency risk management policy. Once the budget rate is set, the Treasury has to secure an appropriate hedge rate and ensure minimal slippage relative to that hedge rate. Timing and the instruments used are key to achieving that. Finally, it is important to note that the budget rate comes from relative price differentials. This however is also at the heart of PPP, which states that exchange rates should adjust for relative price differentials of the same good between two countries. Thus, a corporation could use PPP as a benchmark for setting budget rates.