Financial Markets and Institutions

Course goals

Learning objectives
At the end of the course the student is able to:

• Explain and theoretically analyse the operation and interaction of financial markets and the way prices in these markets are determined, as well as actively apply this knowledge;
• Explain and theoretically analyse the respective roles of financial markets and banks as alternative and complementary channels of financial intermediation, including the emergence of digital forms of money (e.g. Central Bank Digital Currencies);
• Explain, analyse and use the concepts of market efficiency and rationality (in the context of financial markets);
• Explain and analyse the role of market imperfections, such as transaction costs and asymmetric information in shaping financial structure and financial innovation;
• Explain and analyse the role of institutional characteristics of financial markets,  as financial regulation and supervision (Basel I -IV), and  monetary and financial authorities, and evaluate their effect on financial stability and market participants' behaviour;
• Critically discuss and interpret academic  and policy-related papers (academic skills: academic working and reasoning, presenting).

Content

Major related elective. This course cannot be combined with the course Financial Markets and Institutions (LUISS).

This course is an advanced (level 3) elective course in the bachelor programme. It focuses on the role of financial markets and institutions in the global economy. The 2007-2008 crisis shows the crucial importance of the international financial system. The sudden drying up of liquidity and the collapse of major financial institutions paralysed the world economy. The subsequent euro crisis again stressed the vulnerability of the complex network of financial and economic linkages between countries. For a better understanding of these developments and their causes, consequences, and solutions, clear insight is required in financial theory, in the interaction between different financial markets - such as the money market, the bond market and the equity market, in the interaction between market participants like private investors, corporations, banks and other financial entities and in the role of monetary and supervisory authorities (regulation, supervision, etc.).

The first part of the course aims at providing a common broad theoretical basis of financial markets and institutions. In particular, we first concentrate on price determination in financial markets. Here, nominal and real interest rates are the key variables. While in most markets, we only observe nominal interest rates, it is the real interest rate - the nominal rate corrected for expected inflation - that in the end determines economic decisions. In the money market, an equilibrium real interest rate emerges which plays a central role in the economic process: for firms it is an important determinant of the cost of capital and investment decisions, for consumers it determines consumption and savings decisions. The interaction between the money market and the bond market determines the difference between short term and long-term interest rates (the yield curve), which has important consequences for interest rate risk management by non-financial corporations, banks and governments. Finally, the interaction between bond and stock market determines the funding strategy of corporations and allows an analysis of equity risk. An important issue in the analysis of price determination in financial markets is to what extent these markets are efficient and rational. 

Subsequently, we address the interaction (and competition) between financial markets and financial intermediaries as alternative ways to channel savings to investments. The analysis involves a detailed look at the role of transaction costs, market imperfections caused for instance by asymmetric information problems and the role of government regulation and supervision. The outcome has many consequences, for instance the question how firms fund their activities, how financial institutions perform and government supervision is organised. The global financial crisis has shown that bank behaviour is a crucial element in the stability of the financial system. Therefore, we explicitly focus on (the lack of) risk management in banking – including the development of securitized products. From the perspective of regulatory and supervisory authorities, we discuss the major international regulatory initiatives Basel I, II and III as well as the scope for improvement to prevent new banking and financial market crises.

This part of the course is concluded with a mid-term exam. 

In the second part of the course, we move to a more in-depth understanding of the way financial markets work, by discussing a set of (empirical) academic papers on specific topics, such as:

• What is the use of issuing index (inflation-protected) debt versus nominal debt?
• What determines real interest rates?
• Can speculative bubbles be predicted and, if so, prevented?
• What information is available in the term structure about future interest rates or economic growth?
• How and why does a firm's capital structure depend on (financial) market imperfections?
• Should banks (and/or financial markets) be regulated more than previously to prevent a new financial crisis, and if so, what would be appropriate instruments?   
• What are the implications of digital currencies and financial innovation for monetary policy and stability?   

Students (in teams of 3 or 4) will present and critically introduce one of the assigned academic papers. In addition to explaining the main contribution of the article, students are expected to reflect on its economic reasoning, assumptions, and policy implications. Presentations will be followed by a plenary discussion.

The course also highlights the interdisciplinary nature of financial markets. The design of the financial system has strong institutional foundations, while regulation and supervision connect finance to law and economics. Moreover, the analysis of rational and behavioural expectations links financial theory to behavioural economics.

Academic skills
This course focuses on the following academic skills:

Analytical skills

• Being able to solve problems (identifying the problem, devising a path towards the solution, follow this path, verify the outcome), independently and for complex problems.
• Being able to evaluate evidence in text and presentations independently and for complex problems.

Communication skills

• Being able to present any subject without specific instruction in a convincing manner to a broad audience.

Academic reasoning
For independent large economic and multidisciplinary problems/questions:

• Identifying links between problems.
• Analysing questions from different perspectives.
• Asking critical questions, having a curiosity-driven and critical attitude.
• Thinking conceptually, thinking in terms of theory.

Effort requirements
Presence and active participation in tutorial meetings. Whether sufficient participation is shown in the tutorial meetings is determined by the tutor. Timely (prior to tutorial) submission of Brightspace Quizzes; quiz submissions only count when they demonstrate sufficient effort has been put in. 

In case online access is required for this course and you are not in the position to buy the access code, you are advised to contact the course coordinator for an alternative solution. Please note that access codes are not reusable meaning that codes from second hand books do not work, as well as access codes from books with a different ISBN. Separate or spare codes are usually not available.