Tag: financial markets

Excerpt: A Framework for Financial Market Development

We call the second grand compromise the seniority-control compromise. This compromise is based on a tradeoff between seniority of claims and explicit control rights. Securities with high seniority generally assign few explicit control rights to the lender, while securities lower down the seniority ladder assign more such rights. Money market debt is in effect a very senior claim because of its short maturity — it must be paid off when due or the firm could be forced into bankruptcy. Bank loans and bonds represent claims that are effectively junior to money-market claims, but may often include clauses that establish relatively higher seniority. In particular, many bank loans and bonds require future borrowings of the firm to be subordinated to them. In compensation for a lower seniority position, banks and bondholders demand some control rights over the firm. These are passive control rights, in the sense that they are simply rules and stipulations about the use of the firm’s assets and place restrictions on the actions of the borrowers. They are enforced by acceleration clauses that require repayment of the entire outstanding debt in case of any covenant violation. And as in the case of money market debt, bonds and bank loans have significant contingent control rights that can be exercised if the firm comes close to or enters into bankruptcy. Finally, common stock holders are the last in line as “residual claimants” on the firm’s assets and cash flows, but have explicit control rights over the election of the Board of Directors and hence over the firm’s managers.

From a lender’s perspective, the seniority-control compromise works as follows: seniority reduces default risk by increasing the chances of being paid in full, and/or by increasing the amount that the lender expects to recover in the case of default. Short maturity debt (especially bank loans) is the most senior. But lenders will accept control rights over the use of the firm’s assets as a substitute for seniority. Control also reduces default risk, but through a different mechanism. Explicit control rights enable lenders to force the borrower to take actions to decrease the probability of default. Seniority and control are imperfect substitutes for lowering the risk of losing money, and lenders take this into consideration when designing financial instruments. Another way to view such tradeoffs is that high-seniority and high-control securities represent different investment strategies that lenders can choose. Investors in high-seniority secrutiies earn high returns by lending to firms that promise payments that are large relative to the probability of default. Investors in high-control securities earn high returns by managing the firm’s operations more profitably.

From Ralph Chami, Sunil Sharma, Connel Fullenkamp, A Framework for Financial Market Development (IMF Working Paper 2009), pp.22-23.

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Excerpt: Donald MacKenzie, Material Markets

It is of course the exotic nature of pit trading that makes its embodiment stand out. As pits have declined, they have been replaced by screen-based trading, and trading by telephone already has a long history. It’s particularly easy implicitly to posit a disembodied actor when studying such trading, because the bodily actions involved are mostly familiar to any office worker. Much of the time, for instance, one would be hard pushed to distinguish between the physical actions of a trader in a bank’s dealing room from those of an academic at his or her desk. […]

Bodily capacities still matter, however. Let me again use example of LIBOR, which is pertinent here because it is an apparently disembodied set of numbers. […] the inputs to the LIBOR calculation come from bank dealing rooms, but they are heavily influenced by interdealer brokers. Although brokers increasingly give their clients the capacity to trade electronically, the core of their business was (and to a significant extent still is) ‘voice broking’. A firm’s brokers in a given market (for example, the sterling interbank market) sit close together at a cluster of desks, with nearby clusters handling related markets such as in interest-rate swaps. Each broker has on his desk (it is another predominantly male niche) a ‘voicebox’ — a combination of [p.12] microphone, speaker, and switches — connected by dedicated telephone lines to each of his clients.

Interdealer brokers do not themselves trade: if a client bank wants to borrow money, the broker’s job is to find a bank that will lend (or vice versa). So the key skill is knowing who wants to do what who is prepared to do what […]

There’s also, however, a crucial bodily skill in interdealer broking, a skill those involved call ‘broker’s ear’: the capacity aurally to monitor what is being said by all the other brokers at a cluster of desks, while oneself holding a voicebox conversation with a client. […]

While interviewing brokers at their desks, I sometimes found ‘broker’s ear’ disconcerting. Someone could apparently be paying full attention to his conversation with me, when he would suddenly respond to a comment or question from five or six desks away that I simply hadn’t heard […]

[T]here’s no fully algorithmic way of generating an appropriate LIBOR output. Judgement, based on an understanding of market conditions, is involved, and the broker’s ear is one bodily foundation of that judgement.

From Donald MacKenzie, Material Markets: How Economic Agents are Constructed (Oxford University Press, 2009), pp.11-12.

Excerpt: Joseph Vogl, The Specter of Capital

[There is] flagrant disunity as to how one payment incident relates to another and which forces of reason or unreason drive financial activity, provide its dynamics, and motivate its anomalies. This problematic is further complicated by the question of what the play of economic signs actually refers to. In other words, what do movements on the share market indicate? How are price fluctuations on stock exchanges and financial markets to be read and interpreted? What do they have the power to represent?

This semiotic question in turns suggests a peculiar ambiguity in finance economics. On the one hand, “fundamental analysis” concentrates on comparing price movements on financial markets with basal economic data: with factors like productivity, returns, cost structures, forecast dividends, discount rates, current accounts, or purchasing power. [p.13] Such factors provide a well-founded reference point for semiotic events and a realistic or objective orientation point for pricing. From this more or less classical perspective, finance price and stock market quotations hover in the long term around the intrinsic value of companies or even whole national economies. Market trends and cycles would in this view be merely the more or less direct expression a mute economic reality, which will ultimately assert itself thanks to its true and real underlying value. […] A substantial frame of reference can thus be glimpsed beneath the fluctuations on currency and stock markets, with their shifting indices and quotations, and sufficient grounds for them can be found in the fundamental economic data.

On the other hand, the common practice of “technical analysis” operates with a form of observation that strictly disregards these referential dimensions. This is the mantic art practiced by banking and stock exchange personnel who, duly initiated into the mysteries of operations research and computational finance, glean prognostic clues for short-term investment decisions from the charts alone, that is, from their analysis of price movement characteristics. […] Better than all other data — the intrinsic or nominal value of shares, for example — these patterns supposedly reflect the true state of the market; they suggest the shape of things to come and confirm the expressive power of graphs to uncover hidden rhythms in the fluctuations of share market and currency transactions.

Joseph Vogl, The Specter of Capital (Stanford: Stanford University Press, 2015), pp.12-13.

Excerpt: Joseph Vogl, The Specter of Capital

[…] how, if at all, does an idea of the coherence of the economic universe manifest itself here? Economics — this dogma of our time — is in principle quite prepared to use completely [p.11] different, contradictory interpretations to explain everything that happens in contemporary financial dealings, including crashes and crises. One of the most prominent of these interpretations is essentially orthodox in nature. It originates in the market fundamentalism of the Chicago school and calls itself the “efficient markets hypothesis.” According to this doctrine, financial markets represent the purest distillation of market activity in general. Unencumbered by transaction costs, unimpeded by transport needs and the difficulties of production, operated by rational, profit-oriented, and therefore reliable economic agents, they are the ideal, frictionless setting for price formation mechanisms and perfect competition. That is why prevailing prices and price fluctuations on these markets directly and exhaustively reflect all the available information. Under optimal conditions of market competition, so long as all players possess equal access to information relevant to pricing — for example, how much how quickly they can buy — current price quotations will accurately convey the truth about economic activity in general at any given time. The assets to which these prices refer are never really under- or overvalued. Any errors and inefficiencies that may eventuate, such as major discrepancies between actual and forecast returns, are due only to various irritating impediments to free market activity and can quickly be rectified, given favorable conditions. As late as 2007, one of the founding fathers of this school of thought, Eugene Fama, considered it self-evident that there are no such things as “bubbles” in financial markets — the very idea is without foundation and makes no sense. […] There is another interpretation, which is a little less conservative but no less orthodox. Taking the most diverse financial crises as examples, it focuses on bubbles, runs, busts, and booms, speaking of “financial panic” or “euphoric escalations.” Since the seventeenth century, and particularly since the nineteenth century, terms such as these have been used to address the sheer irrationality of speculative transactions that deviate fundamentally from all standard practices in the commodity market, from the principles of economic rationality, and from the basis of the so-called real-economy. […] 15] […] Whether or not lessons can be learned about future price flows and investments from the history of stock exchange movements; whether and how price fluctuations relate to fundamental economic data and conditions in the outside world; whether a fictitious play of signs has become detached from the so-called real economy, and if so, how this came about; whether movements on financial markets occur by necessity or by chance; to what extent sequences of monetary events are motivated or unfounded; whether the financial system functions efficiently or chaotically, or both at once; whether market dynamics represent rational interaction or the purest irrationality: all these questions reveal the models and hypotheses of finance economics to be action programs that take a historical and prognostic approach to the economic universe without reaching any consensus about what holds that universe together. Together, they lead us to the terrain of a dark and confused empiricism. They point to uncertainty about what economic reality actually is, and they hold a number of disappointments in store.

Joseph Vogl, The Specter of Capital (Stanford: Stanford University Press, 2015), pp.10-15.