Hello. Welcome to Session 2 of Stanford GSBGEN 544. [inaudible] I'm your lecturer Martin Chavez. Let's go over to the slide deck. In this lecture, I'm going to cover an extremely broad topic which is Capital Markets, Trading, and Risk. Let's start off with how markets are supposed to work, at least in theory, with the very beautiful, elegant, straightforward payments Capital Asset Pricing or CAPM, which you all know extremely well. Of course, William [inaudible] Sharpe, Harry Markowitz, Merton Miller received the Nobel Prize in economics for CAPM back in 1990. CAPM is also closely associated with the efficient market hypothesis. The hypothesis that asset prices reflect all available information. Many people have worked on that, and you'll see the references in our reading list. Very briefly, to review the CAPM. It says that the expected return on some asset with an index i out of all the available asset, it's just the risk-free rate plus the Beta of that asset multiplied by the excess return of the market over the risk-free rate. The Beta of the asset is just the covariance of the asset with the market divided by the variance of the market. There it is on the right-hand side of the slide. Now, unfortunately, as beautiful as it is, there is this statement from Fama, and French, which is that, ''The failure of the CAPM in empirical tests implies that most applications of the model are invalid.'' That's a strong statement. I would say that these models, these theories, and they are many in finance, give us a framework, give us guide posts. What actually happens in practice is we recognize that the model assumption don't comport 100 percent with reality. We don't necessarily throw the model out. We begin hacking, and tweaking, and adapting the model to comport with reality. That's the theory. Now, let's go into the practice of capital markets. What's the role of capital markets in the free market system? Well, first, another dichotomy. There are two very broad categories of markets. On the left, we have primary markets, and on the right, secondary markets. Primary markets, simply bring together companies that are seeking capital with investors who have capital to deploy. To make it even more straightforward, we would say, companies deliver capitals securities of the various kinds, stocks, bonds, and there are many other capital instruments, and then they receive from investors cash. Investors are just doing the reverse, they're paying cash, and they are receiving securities from the companies. Those are the primary markets and you'll often hear the term primary issuance, as the major activity within the primary market, as the process by which companies, generally through intermediaries, bring their securities and make them available to investors to purchase. Then we have the secondary markets. Secondary markets are hugely important. If you could never turn your security into cash, that would be problematic for many investors, and so the secondary markets allow owners of securities to exchange them with one another or to exchange them for cash with one another. The secondary markets often work through intermediaries. We'll talk about those intermediaries in a moment. Now let's look at the key players in the capital markets. We've got three categories, very broadly speaking. We've got investors, and asset managers. They are collectively known as the buy side because, of course, they're buying and selling. Then on the right, we have intermediaries. Another synonym for these intermediaries is the sale side. Let's look at the buy side on the left, investors with capital to deploy. There are many kinds of investors, I've listed a few of them, not a comprehensive list. Individuals, family offices, sovereigns, cooperation, pensions, endowments, foundations. Then, in the middle, we have the asset managers. Generally- They're called the institution to the institutional asset managers. They allocate pool of capital that come from the investors. There are many kinds of asset managers. Here are a few, there's venture capital and private equity and then there are the long only asset managers and the hedge funds who can be both long and short securities. We also have the principal trading firms or the PTF. They often used to be called high-frequency traders, we use that term very much these days. The principle trading firms provide liquidity in the market, they trade in and out. Often they trade in and out a very great deal. In the limit, the PTF go home, flat risk. They bought a bunch of things, they've sold it by the end of the day. Though, the PTF also have pooled the capital in which they do hold riff overnight and sometimes even for longer periods. There are many other kinds of asset managers by no means is that a comprehensive list. Intermediaries, we have broadly speaking two kinds of intermediaries. We have the investment banks and broker-dealers. Often an investment bank and a broker-dealer will travel together and belong to part of a larger group, often a bank holding company. Let's take a look at those two different categories. Investment banks underwrite or act as the client agent in the issuance of securities and of course, that is a primary market activity. They also invite in mergers and acquisitions. Another way to think about investment banks is that the client of investment banks, rather than being individual, are corporations, institutions, governments. Then another category of intermediary are the broker dealers. Broker-dealers can come in different flavors and many brokers dealers will perform both of these activities and others as well. Under broker dealers, I think there's two kinds of activities. First, there's making market. Making a market in a security means that you hold yourself out or you stand ready to trade as principle, meaning your own capital and balance sheet at risk, and you do that at the request of clients. Meaning if a client wants to sell, you're the buyer and if client wants to buy your the seller. Broker-dealers also can trade as agent on behalf of clients. They will, if the client wants to buy, go find the other side, more are all familiar with brokers in the housing market, works in a very similar way in the capital market. Now let's talk about the many different kinds of asset types in the world. Let's start with capital securities. We usually say stocks and bonds. I'm going to list them the other way around only because the bond market is bigger than the stock market. The total amount of bonds outstanding in the world all turned into dollars and that is 2017 data, was a 100 trillion dollars of which 40 trillion, 40 percent were in the US. Now lets look at US bond, that 40 trillion breaks down to treasuries and issued by the US Treasury of course, backed by the full faith and credit of the US government, net 14 trillion of bond outstanding, that's the debt of the United States, and that's 14 of the 40 trillion. The next largest category are mortgage-related bonds and corporate bonds in the US at nine trillion each. Followed by all others, which is eight trillion. Now if we look at that hundreds trillion dollars that global bond outstanding, a 180 trillion traded in that year meaning on average, each bond traded almost twice. Now let go over to the right and look at the stock market. It's 64 trillion dollars in global value outstanding. About two-thirds the size of the bond market and almost half of the total stocks in the world were in the US, worth 30 trillion. Then if we look at the stock market, the total amount traded in a year was 68 trillion dollars and that's a little bit more than one time of each stock trading on average. What actually happened, of course, is that some stock trade a very great deal and other stocks don't trade at all. Let's keep those numbers in mind, a 100 trillion global outstanding bonds, 64 trillion global outstanding stock as we go and look at other kinds of asset classes. Next considered physical commodities. A total exported amount of physical commodities, a little over $90 trillion. That's to be compared with the traded amount that we just talked about of bonds and stocks, $180 trillion bonds, $68 trillion stock. If we break down that $19 trillion of commodities traded in a year, the single largest category might surprise you, is electrical machinery and computers. The next largest category is mineral fuels of all kinds. Of course, crude oil and refined petroleum products, are a major part of that at $2.5 trillion. Just behind that mechanical got $2.3 trillion, vehicles, especially automobiles, $1.5 trillion. Then behind that at $656 billion, we have plastics. Let's go onto futures and listed options. I'll come back to our friend Hammurabi, picture of him on the right, a picture you've all seen. You may think of futures and listed options as a relatively new fangled investment asset class, not the case. They go way back to Hammurabi, roughly 1700 BC. If we look at the total outstanding amount in terms of open interest or contracts, that mark is about 60 percent futures and 40 percent options. If we look at the amount traded any year, it's roughly the same 60 percent, 40 percent breakdown between futures and options. About 33 billion futures and options contracts were traded in 2018. Now, futures and options contracts control many different kinds of underlying physical commodities. Each futures contract will have a specification that maps to a certain amount of a commodity. For instance, the West Texas Intermediate futures contract controlled a thousand barrels of crude oil, a barrel is 42 gallons, and all of the different contracts or different specifications. Then of course, the prices of all the underlying commodities will be different but just to turn this into a very rough dollar amount, we said they were 33 billion contracts traded in 2018. The open interest at the end of 2018 was about one three-fifths of that or 900 million contracts. This is not the case, but at a rough proxy. Let's imagine that all those contracts were West Texas Intermediate. At a crude oil price of $40, which is the price when I began preparing these lectures. Though with the COVID-19 crisis, the price is now down in the 20s, but at a crude oil price of $40 per barrel, with one contract that I mentioned controlling 1000 barrels. That traded notional value of 900 million contracts that turns into about $1300 trillion or 1.3 quadrillion dollars. A lot of trading, and that's $36 trillion of opened interests. The sizes, at least the notional terms are, vast. Now let's look at over-the-counter derivatives, cleared and non-cleared. Before the financial crisis, most of them were not cleared. Post-financial crisis, most of them are cleared, and we'll get into that distinction and why it matters and why it's important in a later lecture. The outstanding amount at the end of 2018 at the OTC derivatives markets with $600 trillion and you can compare that to the figures that we gave before. The outstanding notional amount of about $36 trillion in all futures and lift options. You can see that the OTC market is much, much bigger by more than an order of magnitude. Of all those OTC derivative, 80 percent of the outstanding notional amount, we're in interest rate derivative. Then if we wanted to look at the amount traded in a year, the notional amount is 85 trillion. That's to be compared with our rough figure of $36 trillion of open interests in the futures and lifted options market and $1300 trillion of traded notional value in the listed futures and options market. The numbers are quite disparate. You can see that there's very active trading of the futures contracts. A major activity of all that futures contract trading is market-makers, broker dealers, hedging the market that they're making and over-the-counter derivatives. So that partially explain why there's so much more traded volumes of futures contracts than traded volume of OTC derivatives. I'll point out that some of these OTC derivatives, can have a 10 year life of the contract and so there will be a lot of hedging, with future's going on during the life of an open OTC derivative contracts. Now lets go to loans, loans do trade, perhaps not as actively. Trading a loan can be complicated. It's really a multi-party legal negotiation to trade a loan, so lets talk about outstanding amount the loan market, generally smaller than the numbers we've been talking about $8 trillion of outstanding loans globally. Of which 7 trillion were investment grade and 1 trillion non-investment grade are leveraged loans. Fascinating market, the illiquid, sometimes called the alternatives and the alternative include private equity, venture capital, real estate hedge fund. By far, the biggest category is real estate. Unfortunately, the areas of these circles are not scaled according to the values of the particular liquid market. Because it's just so dominated by global real estate which is $228 trillion of that $228 trillion globally, about a 169 trillion is residential real estate. Then a much smaller asset class is private equity. Those certainly gets a lot of press. The African drum management globally in private equity, are $6.5 trillion. If you break that out, that 6.5 trillion buy out of the classic private equity is almost 3 trillion. Venture is about 1 trillion, growth it's 0.7 trillion. Within venture just to put that in perspective, I've given you the assets under management globally and annually there's about a 100 to a $110 billion of venture capital investments made in privately held companies in the US at an annual figure. Then hedge fund about half the size in terms of assets under management compared to private equity, $3.2 trillion. Neither figures as at the end of 2019. For now let's move on, and talk by no means comprehensively of some highlights, or maybe they're really low lights in the history of capital markets to give you some perspective. Commodity futures close to my heart, I grew up in the commodities market. My very first job on Wall Street without the strategist, strata or data scientists or the coffee, sugar, and cocoa, creating desk at Goldman Sachs. That was a relatively short and after that I moved on to the oil desk. Commodity futures as I mentioned, go way back to ancient Mesopotamia. Many things, go back to ancient Mesopotamia, we talked about ledger, money of account for instance, it goes back to leaf band. It closely associated with the sixth Babylonian king. The fame of Hammurabi and the rules for trading commodity futures were specified along with many other things in the Code of Hammurabi. Hammurabi's Code allowed the sale of goods and assets to be delivered for an agreed price today, but with delivery at a future date. It required those contracts to be in writing, and to the witnessed or notarized, and it allowed the assignment contracts. For instance, the buyer or seller of a contract could step out of the contract and someone else could step in, and the reason one could do that is that the contracts were heavily standardized even back then. The code facilitated the first derivatives in the form of forward and futures contracts. A futures contract, is just a particular forward agreement that's been heavily standardized. There was an active derivatives market and the trading was actually carried out in the temple. There's a sculpture of Hammurabi with his attorney, a guy called Frank. Another infamous episode you all would have heard of is the tulip bubble from November 1636, that's when it began. By May of next year, it was all over. It was the first recorded speculative bubble during the Dutch Golden Age. At that time, the Dutch Republic was the world leading economic and financial power. Future markets appeared in the Dutch Republic in the 17th century. The futures agreements, like Hammurabi's, were agreements to receive or deliver a specified number of a specified kind of bulbs at the end of the season, and prices were specified upfront at the time you entered into the agreement. There was no posting of margin or collateral, that was a mistake. You were just depending on the buyer and seller both to show up and carry out their part of the futures agreement as agreed. The whole thing ended in tears and a lot of wilted tulips. That's actually a figure of speech, they were tulip bulbs, most of which likely ended up rotting. The British East India Company or the EIC, another infamous story or chapter in the history of the capital market. To put that company in perspective, it accounted for 20 percent of all of Britain's export trade in 1750. On a relative basis, far greater and economic might than any private companies today. It was also not coincidentally one of the bloodiest and most aggressive capitalists organizations ever seen. The CEO, Robert Clive was as reckless, as he was charismatic. In one particularly noxious episode, the EIC loaded the entire contents of the Bengal treasury, stole it onto a 100 boats on the Ganges and sent it down the river to the EIC's Calcutta headquarters, and that happened in 1757. I mentioned the company because they pioneered the limited liability joint-stock approach, living outside shareholders to shoulder the risk. Also unusually, this company raised its own private army and it became an empire unto itself within the British Empire. It used all of its power and influence to resist regulation. But when it came close to collapse in the 1770s, received a mega bailout from the UK government. It was genuinely too-big-to-fail. Let's talk a bit about exchanges. Why do we even have exchanges? Well, here are the three functions of the exchanges and there are many others. They consolidate pools of liquidity. Another way of saying they bring lots of buyers and lots of sellers. Meaning people wanting to buy, people wanting to sell together into one place. They standardize the widgets being sold, and importantly reduce systemic risk by netting and clearing. To be very specific about how that happens, let's take an example of what happens when you've got a standardized contract trading on an exchange. In this case, I'm taking the example of a futures contract and all traders in the futures contract face the exchanges central counterparty. It is one side of every single trade. The two important features, not only are the contract themselves standardized, but one side of the contract, either the buyer or the seller, is standardized and it is the same entity, the same credit, the same legal entity. Over on the right, let's take the example of OTC bilateral derivatives contract. These contracts are mostly identical. All the terms are the same except the counterparty I'm facing is different. Let's say I'm long a 100 units of an OTC contract with counterparty A and I'm short a 100 units. All the terms are the same. The only thing is different, is that on my short side, I'm facing counterparty B, not counterparty A. This is something that people forget to their parallel and it was a major cause of the dislocation in the 2008 financial crisis. These two contracts that are more or less the same, but they're not. Because I'm facing a different counterparty. Do not net, do not affect, I'm not. Long one short the other, and the gross risk and that risk of zero, as in my future's contract example in the middle, rather they just don't nap. The only way to think about the risk, is to add up the absolute values. When you add up the absolute values, you don't get 100 minus 100 equals zero, you get 100 plus a 100 equals 200 units of gross risk. Collapsing the gross risk through netting is a major and hugely important function of the exchanges. I should note there on the lower left that up to say reduce systemic risk, not systematic risk. Now let's talk about exchanges, but in this case I'm only talking about stock exchanges and I'm only talking about stock exchanges in the US. This is the latest state of play in the US, though it's constantly changing. This is the first time, because we created this for the class, that I've seen all the exchanges represented in this consolidated way. Of the 13 exchanges, 12 of the 13 are owned by three groups. That there are three families that exchanges and then there's the 13th exchange, the IEX gets off on it's own. On the left, we have the exchanges that are part of the NYSE or New York Stock Exchange family. That of course, NYSE was acquired by ICE or the Intercontinental Exchange. They are really all owned and operated by ICE. That's NYSE, NYSE Chicago, NYSE National, NYSE Arca, NYSE market, are all part of the ICE family. Going over to the right, we have the Nasdaq family of three exchanges: Nasdaq, Nasdaq BX, and Nasdaq PSX. Again going further to the right, we have the Cboe global markets or Cboe family of exchanges. Cboe originally stood for Chicago Board Options Exchange, now it's just Cboe, and that family is also the result of M and A. There are the two BATS exchanges, BZX and BZY different rule set, and the two Direct EDGE exchanges: EDGA and EDGX also different rules. Then over on the right we have the IEX, that's an independent exchange, it's the subject of a wonderful book by Michael Lewis, Flash Boys, I encourage all of you to read it. There to mitigate the side effects of latency arbitrage and the high frequency trading, IEX inserted a 38 miles coil of optical fiber in front of its trade engine. Now, the speed of light is one foot per nanosecond and a vacuum that's a little bit slower than that in optical fiber, and that results in about 350 microsecond delay on all the trades. You can read about it in the Flash Boy. I was just the US stock exchanges. What are some of the takeaways? Well, there are numerous tools with liquidity across the many financial products from you can say, well, that's a good thing to have all those pooled illiquidity with all of those choices about the rule set. You can say generally, that reduces the cost of capital ultimately. Let's look at it in another way. We mentioned there are three groups, 13 exchanges, but all together there are 57 stock trading then used in the US, and that's if you include the various alternative trading system. There you could say the fragmentation gives market makers the potential to arbitrage price across exchanges, we'll talk more about that. There is, for sure, among those 57 different dangers a dangerous proliferation of incompatible rule books, and that itself introduces operational and systemic risk. One could certainly posed the question, are lifting these anti-competitive, almost everybody lists with Nasdaq and NYSE, IEX did started listing business but gave up on that. You could also ask, are the rate for commission and especially for market data competitive or anti-competitive among all of these exchanges. I'll stop there and we'll begin the next chapter on trading.
