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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance
- Sprache: Englisch
A clear new finance textbook that explains essential models and practices, and how the financial world works now
Contemporary Financial Markets and Institutions: Tools and Techniques to Manage Risk and Uncertainty is an ideal introduction to finance for professionals and students. It covers the basic finance theory required to understand the contemporary financial world and builds on it to present finance in a detailed yet comprehensible way. It explains markets and institutions, and the central bank and government policies that influence how they operate.
The book begins with an overview of basic finance theory, including investments, asset return behavior, derivatives pricing, and credit risk. It discusses topics that have dominated markets in recent decades, such as extreme events, liquidity, currency and debt crises, and radical changes in monetary policy and regulation. The concepts are presented alongside examples, strange market episodes, and data from recent experience. Contemporary Financial Markets and Institutions covers advanced credit topics like securitization in a straightforward, succinct way, without advanced mathematics, but with detailed examples using real market data. It integrates financial and macroeconomic content seamlessly. The book is suitable for use by undergraduate and graduate students, and by practitioners of all backgrounds. Abundant pedagogical resources in the book and online facilitate teaching.
This book will help students and practioners:
- Learn the basic concepts and models in finance, including investment, asset pricing, uncertainty and risk, monetary policy and the regulatory system
- Explore recent developments, from the expansion of central banks to the chaos in commercial banking to changes in financial technology, that are dominating markets worldwide
- Gain knowledge of risk types, models, and measurement methods, and the impact of regulation
- Prepare yourself for a successful career in finance, or update your existing knowledge base with this comprehensive reference guide
Ideal as a sole or supplementary textbook for beginning and advanced finance courses, as well as for practitioners in finance-related fields, this book takes a unique, market-focused approach that will serve readers well in our turbulent and puzzling times.
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Veröffentlichungsjahr: 2024
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Table of Contents
Cover
Table of Contents
Dedication
Title Page
Copyright
List of Figures
List of Tables
Preface
About the Author
Part I: Finance in the Economic System
1 Functions and Structure of the Financial System
1.1 Functions of the Financial System
1.2 Market Participants, Intermediaries, and Governments
1.3 Assets and Markets
1.4 Mechanics of Trading
Further Reading
Notes
2 Asset Returns and Risk
2.1 Asset Returns and Interest Rates
2.2 Asset Return Probability Distributions
2.3 Financial Risks
Further Reading
Notes
3 Information, Preferences, and Asset Prices
3.1 Information and the Quantification of Risk
3.2 Risk Premiums
3.3 An Era of Low Interest Rates and Slowing Growth
Further Reading
Notes
Part II: Markets, Uncertainty, and Risk
4 The Behavior of Asset Returns over Time
4.1 Standard Model of Asset Price Behavior and Reality
4.2 Return, Volatility, and Correlation Behavior
4.3 Volatility Forecasting
4.4 Tail Risk: the Prevalence of Extremes
Further Reading
Notes
5 Capital Markets: How Asset Prices Are Determined
5.1 Portfolios, Diversification, and Investor Choice
5.2 The Capital Asset Pricing Model
Further Reading
Notes
6 Derivatives Values and Risks
6.1 Futures, Forwards, and Swaps
6.2 Options
6.3 Market-Implied Asset Price Forecasts
Further Reading
Notes
7 Capital Market Efficiency
7.1 Asset Price Behavior in an Efficient Market
7.2 Apparent Violations of Market Efficiency
7.3 Efficacy of Active Management
Further Reading
Notes
8 Market Risk
8.1 Definition of Value-at-Risk
8.2 Computing Value-at-Risk for One Risk Factor
8.3 Nonlinear Market Risks
8.4 Incorporating Extreme Events Into Risk Measurement
Further Reading
Notes
9 Credit and Counterparty Risk
9.1 Default, Bankruptcy, and Resolution
9.2 Quantifying Credit Risk
9.3 Single-Obligor Credit Risk Models
Further Reading
Notes
Part III: Market Institutions and Risk Assessment
10 Interest Rate Risk
10.1 Sources of Interest Rate Risk
10.2 Interest Rate Risk Measurement
Further Reading
Notes
11 Leverage
11.1 Defining and Measuring Leverage
11.2 Attractiveness of Leverage and Reaching for Yield
11.3 Leveraged Trades
11.4 Incentive Alignment and Capital Structure
Further Reading
Notes
12 Liquidity
12.1 Funding and Market Liquidity Risk
12.2 Private Liquidity Creation: Commercial Banking
12.3 Private Liquidity Creation: Short-Term Funding
Further Reading
Notes
13 Portfolio Credit Risk
13.1 Credit Portfolios and Default Correlation
13.2 Measuring Portfolio Credit Risk
Further Reading
Notes
14 Securitization and Structured Product Risk
14.1 Introduction to Securitization
14.2 Securitization Structure
14.3 Credit Risk Measurement of Securitizations
14.4 Credit Correlation Trading
Further Reading
Notes
15 Financial Instability and Financial Crises
15.1 Defining Financial Crises
15.2 Runs and Liquidity in Financial Crises
15.3 Causes of Financial Crises
15.4 International Financial Imbalances
Further Reading
Notes
Part IV: Monetary and Regulatory Policy
16 Overview of Financial Regulation
16.1 Structure of Financial Regulation
16.2 Methods of Regulation
16.3 Purposes and Efficacy of Financial Regulation
Further Reading
Notes
17 Monetary Policy
17.1 The Emergence of Monetary Policy
17.2 The Framework of Monetary Policy
17.3 Monetary Operations in Normal Times
Further Reading
Notes
18 Regulation for Financial Stability
18.1 The Lender of Last Resort Function
18.2 The Onset of the Global Financial Crisis
18.3 Financial Stability Policy
18.4 The Problem of Public-Sector Guarantees
Further Reading
Notes
19 Regulation of Capital Funding, Liquidity, and Large Banks
19.1 Historical Background of the Capital Standards
19.2 Bank Accounting Standards and Regulation
19.3 Measuring Risk-Weighted and Adjusted Assets
19.4 Quality and Quantity of Capital
19.5 Regulation of Large Banks
Further Reading
Notes
20 Monetary Policies Since the Global Financial Crisis
20.1 The Monetary Policy Response to the Global Financial Crisis
20.2 Monetary Operations with a Large Balance Sheet
20.3 The Liquidity Paradox and the Banking Turmoil
Further Reading
Notes
Appendix
A Much of the Probability and Statistics You Need
A.1 Probability Distributions and Their Properties
A.2 Important Distributions
A.3 Stochastic Processes
A.4 Statistical Tests
A.5 Linear Regression Analysis
Further Reading
Notes
B Notation
C Abbreviations
References
Index
End User License Agreement
List of Tables
Chapter 2
Table 2.1 Return experience of the S&P 500 1971–2024
Chapter 4
Table 4.1 Estimating volatility with the EWMA model
Table 4.2 Recursive formula for EWMA volatility estimates
Table 4.3 Extreme moves in the S&P 500 1928–2023
Chapter 5
Table 5.1 Feasible and efficient portfolios
Table 5.2 Summary of optimal investor choice
Table 5.3 Systematic and nonsystematic risk: example
Chapter 6
Table 6.1 Deriving a foreign-currency interest rate curve from forwards
Chapter 7
Table 7.1 Returns to option writing strategies
Chapter 8
Table 8.1 Monte Carlo computation of Value-at-Risk
Table 8.2 Order statistics for historical simulation Value-at-Risk
Table 8.3 Comparison of Value-at-Risk techniques
Table 8.4 Parametric normal estimate of expected shortfall
Table 8.5 Historical simulation estimates of expected shortfall
Table 8.6 Computation of expected shortfall by historical simulation
Chapter 9
Table 9.1 Rating migration rates, 1920–2022
Table 9.2 Default probability analytics: example
Table 9.3 Merton model valuation of firm liabilities
Chapter 10
Table 10.1 TBA convexity calculations
Chapter 11
Table 11.1 Debt overhang example
Chapter 13
Table 13.1 Granularity and credit Value-at-Risk
Table 13.2 Violations of subadditivity
Table 13.3 Impact of a market shock
Chapter 14
Table 14.1 Contactually stipulated bond payments
Table 14.2 Securitization scenario analysis
Table 14.3 Senior bond default probability
Table 14.4 Equity tranche: probability of negative return
Table 14.5 Mezzanine bond default probability
Table 14.6 Credit Value-at-Risk of securitization tranches
Chapter 19
Table 19.1 Capital and leverage ratios of large banks
Chapter 20
Table 20.1 Effective versus target fed funds differences
List of Illustrations
Chapter 1
Figure 1.1 Who’s borrowing in the United States, 1945–2023
Figure 1.2 Who’s lending in the United States, 1945–2023
Figure 1.3 OTC derivatives markets 1998–2022
Chapter 2
Figure 2.1 Comparing arithmetic and logarithmic returns
Figure 2.2 US Treasury yield curve
Figure 2.3 Spot and forward curves in the example
Figure 2.4 Price and total return of S&P 500 1971–2024
Figure 2.5 Nominal and real return of T-bills 1971–2024
Figure 2.6 Nominal and real return of S&P 500 1971–2024
Figure 2.7 Cumulative total and excess return of S&P 500 1971–2024
Figure 2.8 Comparison of more and less volatile stocks
Figure 2.9 Impact of correlation on joint return distributions
Chapter 3
Figure 3.1 US and Turkish dollar-denominated sovereign yield curves
Figure 3.2 US credit spreads 1996–2024
Figure 3.3 European credit spreads 1999–2024
Figure 3.4 US 2- and 10-year nominal rates 1976–2024
Figure 3.5 US, German, and Japanese 10-year nominal rates 1976–2023
Figure 3.6 US inflation 1960–2023
Figure 3.7 Estimated US real interest rates 1961–2023
Figure 3.8 US GDP growth rate and its volatility 1947–2023
Figure 3.9 US labor productivity 1947–2023
Figure 3.10 World GDP per capita 1820–2018
Figure 3.11 Life expectancy 1770–2021
Figure 3.12 US debt-to-GDP ratio by sector 1946–2022
Chapter 4
Figure 4.1 Sample paths of a geometric Brownian motion
Figure 4.2 Volatility of crude oil prices 1987–2024
Figure 4.3 Correlation of stock returns and rates 1962–2024
Figure 4.4 Effect of the decay factor on the volatility forecast
Figure 4.5 GARCH(1,1) and EWMA volatility estimates
Figure 4.6 S&P 500 returns 1927–2023
Figure 4.7 10-year Treasury Note yield fluctuations 1962–2024
Figure 4.8 Exchange rate volatility
Figure 4.9 Normal and non-normal distributions...
Figure 4.10 Quantile plot of S&P 500 returns 1928–2020
Figure 4.11 Volatility asymmetry in the US stock market 1927–2023
Chapter 5
Figure 5.1 Impact of diversification on portfolio return volatility
Figure 5.2 The risk-return trade-off
Figure 5.3 Optimal portfolios
Figure 5.4 Optimal investor choice with a risk-free asset
Figure 5.5 Computing beta via linear regression
Chapter 6
Figure 6.1 S&P 500 index volatility smile
Figure 6.2 Risk-neutral distribution of the EUR-USD exchange rate...
Chapter 7
Figure 7.1 Evidence on active management outperformance
Figure 7.2 Returns to option writing strategies
Chapter 8
Figure 8.1 Distribution and quantile functions
Figure 8.2 Value-at-Risk example
Figure 8.3 Monte Carlo computation of Value-at-Risk
Figure 8.4 Computation of Value-at-Risk by historical simulation
Figure 8.5 Historical simulation Value-at-Risk scenario
Figure 8.6 Value-at-Risk responsiveness to shocks
Figure 8.7 Nonlinearity and option risk
Figure 8.8 Delta and delta-gamma approximations
Figure 8.9 Definition of expected shortfall
Figure 8.10 Relationship of expected shortfall to Value-at-Risk
Chapter 9
Figure 9.1 Schematic company or household balance sheet
Figure 9.2 US bond market default rates 1920–2022
Figure 9.3 Default time distribution with a constant hazard rate
Figure 9.4 Merton default model
Chapter 10
Figure 10.1 Yield curve scenario analysis: parallel shift
Figure 10.2 Yield curve scenario analysis: curve steepening
Figure 10.3 Duration and convexity of US 10-year note
Figure 10.4 Response of US 10-year note to shocks
Figure 10.5 MBS convexity risk
Chapter 12
Figure 12.1 Schematic balance sheet of a commercial bank
Figure 12.2 US commercial banking assets and liabilities 1991–2023
Figure 12.3 Bank charge-off and delinquency rates 1985–2022
Figure 12.4 Net interest margin of US banks 1934–2023
Figure 12.5 US stock market margin debt 1997–2023
Figure 12.6 US broker-dealer and triparty repo 1975–2023
Figure 12.7 Owners of money market fund shares 1974–2023
Figure 12.8 Money market fund assets 1974–2023
Chapter 13
Figure 13.1 Skewness of credit risk
Figure 13.2 Uncorrelated default count distribution...
Figure 13.3 Uncorrelated default count distribution and granularity
Figure 13.4 Default probability in the single factor model
Figure 13.5 Asset and market returns in the single factor model
Figure 13.6 Correlated and uncorrelated defaults
Figure 13.7 Conditional default probability distribution
Figure 13.8 Market factor and loss rate
Figure 13.9 Credit loss distribution and default correlation
Figure 13.10 Credit loss distribution and default probability
Figure 13.11 Credit Value-at-Risk and default correlation
Chapter 14
Figure 14.1 US fixed-income securities issuance 1996–2023
Figure 14.2 US asset-backed securities issuance 1985–2023
Figure 14.3 US asset-backed securities outstanding 1985–2021
Figure 14.4 US credit spreads 1997–2019
Figure 14.5 Tranche structure of a securitization
Figure 14.6 Pool and tranche returns in the example.
Figure 14.7 Cumulative distribution function of pool losses
Figure 14.8 Pool default behavior and senior bond returns
Figure 14.9 Pool default behavior and equity tranche returns
Figure 14.10 Pool default behavior and mezzanine tranche returns
Figure 14.11 Credit Value-at-Risk of bond tranches
Figure 14.12 Markit iTraxx CDS data 2011–2012
Figure 14.13 Stylized P&L of the Whale portfolio
Chapter 15
Figure 15.1 Growth rate of US bank lending 1970–2023...
Figure 15.2 AA financial commercial paper 2006–2010
Figure 15.3 LIBOR-OIS spread 2006–2024
Figure 15.4 Equity- and swaption-implied volatility 1990–2024
Figure 15.5 Implied and realized volatility 1990–2024
Figure 15.6 Public pension plan underfunding 1975–2023
Figure 15.7 Swap spreads 1999–2023
Figure 15.8 US insurance company credit allocation 2005–2022
Figure 15.9 World trade relative to GDP 1970–2021
Figure 15.10 Euro-Swiss franc exchange rate 2015–2016
Figure 15.11 International debt securities 1999–2023
Figure 15.12 US dollar lending abroad 2000–2022
Figure 15.13 EUR-USD cross-currency basis 2001–2023
Figure 15.14 Returns to the Turkish lira carry trade
Chapter 17
Figure 17.1 Market-implied and survey inflation 1991–2023
Figure 17.2 Actual and Taylor-rule fed funds rate 1970–2024
Figure 17.3 Federal Reserve balance sheet 2007–2024
Figure 17.4 Normal monetary operations
Chapter 18
Figure 18.1 Citigroup credit spreads 2007–2010
Chapter 19
Figure 19.1 Banks’ unrealized gains on investment securities 2008–2023
Chapter 20
Figure 20.1 The “dots plot”
Figure 20.2 Market and FOMC expectations 2012–2024
Figure 20.3 Target range and effective fed funds rate 2008–2018
Figure 20.4 Fed funds sold and purchased by banks 2002–2023
Figure 20.5 Monetary operations with ample reserves
Figure 20.6 Effective fed funds and funds target range in 2018
Figure 20.7 Repo market shocks 2019
Figure 20.8 M2 money supply and velocity 2006–2024
Figure 20.9 US Treasury securities outstanding 1996–2023
A
Figure A.1 Bivariate normal density
Figure A.2 Sample path of a random walk
Guide
Cover
Table of Contents
Dedication
Title Page
Copyright
List of Figures
List of Tables
Preface
About the Author
Begin Reading
A Much of the Probability and Statistics You Need
B Notation
C Abbreviations
References
Index
End User License Agreement
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for Aviva and Benjamin
Contemporary Finance
Money, Risk, and Public Policy
Allan M. Malz
Copyright © 2025 by Allan M. Malz. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permission.
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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Further, readers should be aware that websites listed in this work may have changed or disappeared between when this work was written and when it is read. Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
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Library of Congress Cataloging-in-Publication Data:
Names: Malz, Allan M., author.
Title: Contemporary finance : money, risk, and public policy / Allan M. Malz.
Description: Hoboken, New Jersey : Wiley, [2024] | Includes index.
Identifiers: LCCN 2024019680 (print) | LCCN 2024019681 (ebook) | ISBN 9781394179626 (hardback) | ISBN 9781394179640 (adobe pdf) | ISBN 9781394179633 (epub)
Subjects: LCSH: Finance.
Classification: LCC HG173 .M276 2024 (print) | LCC HG173 (ebook) | DDC 332—dc23/eng/20240516
LC record available at https://lccn.loc.gov/2024019680
LC ebook record available at https://lccn.loc.gov/2024019681
Cover Design: WileyCover Image: Courtesy of Julia Zimbalist and Allan Malz
List of Figures
Figure 1.1 Who’s borrowing in the United States, 1945–2023
Figure 1.2 Who’s lending in the United States, 1945–2023
Figure 1.3 OTC derivatives markets 1998–2022
Figure 2.1 Comparing arithmetic and logarithmic returns
Figure 2.2 US Treasury yield curve
Figure 2.3 Spot and forward curves in the example
Figure 2.4 Price and total return of S&P 500 1971–2024
Figure 2.5 Nominal and real return of T-bills 1971–2024
Figure 2.6 Nominal and real return of S&P 500 1971–2024
Figure 2.7 Cumulative total and excess return of S&P 500 1971–2024
Figure 2.8 Comparison of more and less volatile stocks
Figure 2.9 Impact of correlation on joint return distributions
Figure 3.1 US and Turkish dollar-denominated sovereign yield curves
Figure 3.2 US credit spreads 1996–2024
Figure 3.3 European credit spreads 1999–2024
Figure 3.4 US 2- and 10-year nominal rates 1976–2024
Figure 3.5 US, German, and Japanese 10-year nominal rates 1976–2023
Figure 3.6 US inflation 1960–2023
Figure 3.7 Estimated US real interest rates 1961–2023
Figure 3.8 US GDP growth rate and its volatility 1947–2023
Figure 3.9 US labor productivity 1947–2023
Figure 3.10 World GDP per capita 1820–2018
Figure 3.11 Life expectancy 1770–2021
Figure 3.12 US debt-to-GDP ratio by sector 1946–2022
Figure 4.1 Sample paths of a geometric Brownian motion
Figure 4.2 Volatility of crude oil prices 1987–2024
Figure 4.3 Correlation of stock returns and rates 1962–2024
Figure 4.4 Effect of the decay factor on the volatility forecast
Figure 4.5 GARCH(1,1) and EWMA volatility estimates
Figure 4.6 S&P 500 returns 1927–2023
Figure 4.7 10-year Treasury Note yield fluctuations 1962–2024
Figure 4.8 Exchange rate volatility
Figure 4.9 Normal and non-normal distributions
Figure 4.10 Quantile plot of S&P 500 returns 1928–2020
Figure 4.11 Volatility asymmetry in the US stock market 1927–2023
Figure 5.1 Impact of diversification on portfolio return volatility
Figure 5.2 The risk-return trade-off
Figure 5.3 Optimal portfolios
Figure 5.4 Optimal investor choice with a risk-free asset
Figure 5.5 Computing beta via linear regression
Figure 6.1 S&P 500 index volatility smile
Figure 6.2 Risk-neutral distribution of the EUR-USD exchange rate
Figure 7.1 Evidence on active management outperformance
Figure 7.2 Returns to option writing strategies
Figure 8.1 Distribution and quantile functions
Figure 8.2 Value-at-Risk example
Figure 8.3 Monte Carlo computation of Value-at-Risk
Figure 8.4 Computation of Value-at-Risk by historical simulation
Figure 8.5 Historical simulation Value-at-Risk scenario
Figure 8.6 Value-at-Risk responsiveness to shocks
Figure 8.7 Nonlinearity and option risk
Figure 8.8 Delta and delta-gamma approximations
Figure 8.9 Definition of expected shortfall
Figure 8.10 Relationship of expected shortfall to Value-at-Risk
Figure 9.1 Schematic company or household balance sheet
Figure 9.2 US bond market default rates 1920–2022
Figure 9.3 Default time distribution with a constant hazard rate
Figure 9.4 Merton default model
Figure 10.1 Yield curve scenario analysis: parallel shift
Figure 10.2 Yield curve scenario analysis: curve steepening
Figure 10.3 Duration and convexity of US 10-year note
Figure 10.4 Response of US 10-year note to shocks
Figure 10.5 MBS convexity risk
Figure 12.1 Schematic balance sheet of a commercial bank
Figure 12.2 US commercial banking assets and liabilities 1991–2023
Figure 12.3 Bank charge-off and delinquency rates 1985–2022
Figure 12.4 Net interest margin of US banks 1934–2023
Figure 12.5 US stock market margin debt 1997–2023
Figure 12.6 US broker-dealer and triparty repo 1975–2023
Figure 12.7 Owners of money market fund shares 1974–2023
Figure 12.8 Money market fund assets 1974–2023
Figure 13.1 Skewness of credit risk
Figure 13.2 Uncorrelated default count distribution
Figure 13.3 Uncorrelated default count distribution and granularity
Figure 13.4 Default probability in the single factor model
Figure 13.5 Asset and market returns in the single factor model
Figure 13.6 Correlated and uncorrelated defaults
Figure 13.7 Conditional default probability distribution
Figure 13.8 Market factor and loss rate
Figure 13.9 Credit loss distribution and default correlation
Figure 13.10 Credit loss distribution and default probability
Figure 13.11 Credit Value-at-Risk and default correlation
Figure 14.1 US fixed-income securities issuance 1996–2023
Figure 14.2 US asset-backed securities issuance 1985–2023
Figure 14.3 US asset-backed securities outstanding 1985–2021
Figure 14.4 US credit spreads 1997–2019
Figure 14.5 Tranche structure of a securitization
Figure 14.6 Pool and tranche returns in the example.
Figure 14.7 Cumulative distribution function of pool losses
Figure 14.8 Pool default behavior and senior bond returns
Figure 14.9 Pool default behavior and equity tranche returns
Figure 14.10 Pool default behavior and mezzanine tranche returns
Figure 14.11 Credit Value-at-Risk of bond tranches
Figure 14.12 Markit iTraxx CDS data 2011–2012
Figure 14.13 Stylized P&L of the Whale portfolio
Figure 15.1 Growth rate of US bank lending 1970–2023
Figure 15.2 AA financial commercial paper 2006–2010
Figure 15.3 LIBOR-OIS spread 2006–2024
Figure 15.4 Equity- and swaption-implied volatility 1990–2024
Figure 15.5 Implied and realized volatility 1990–2024
Figure 15.6 Public pension plan underfunding 1975–2023
Figure 15.7 Swap spreads 1999–2023
Figure 15.8 US insurance company credit allocation 2005–2022
Figure 15.9 World trade relative to GDP 1970–2021
Figure 15.10 Euro-Swiss franc exchange rate 2015–2016
Figure 15.11 International debt securities 1999–2023
Figure 15.12 US dollar lending abroad 2000–2022
Figure 15.13 EUR-USD cross-currency basis 2001–2023
Figure 15.14 Returns to the Turkish lira carry trade
Figure 17.1 Market-implied and survey inflation 1991–2023
Figure 17.2 Actual and Taylor-rule fed funds rate 1970–2024
Figure 17.3 Federal Reserve balance sheet 2007–2024
Figure 17.4 Normal monetary operations
Figure 18.1 Citigroup credit spreads 2007–2010
Figure 19.1 Banks’ unrealized gains on investment securities 2008–2023
Figure 20.1 The “dots plot”
Figure 20.2 Market and FOMC expectations 2012–2024
Figure 20.3 Target range and effective fed funds rate 2008–2018
Figure 20.4 Fed funds sold and purchased by banks 2002–2023
Figure 20.5 Monetary operations with ample reserves
Figure 20.6 Effective fed funds and funds target range in 2018
Figure 20.7 Repo market shocks 2019
Figure 20.8 M2 money supply and velocity 2006–2024
Figure 20.9 US Treasury securities outstanding 1996–2023
Figure A.1 Bivariate normal density
Figure A.2 Sample path of a random walk
List of Tables
Table 2.1 Return experience of the S&P 500 1971–2024
Table 4.1 Estimating volatility with the EWMA model
Table 4.2 Recursive formula for EWMA volatility estimates
Table 4.3 Extreme moves in the S&P 500 1928–2023
Table 5.1 Feasible and efficient portfolios
Table 5.2 Summary of optimal investor choice
Table 5.3 Systematic and nonsystematic risk: example
Table 6.1 Deriving a foreign-currency interest rate curve from forwards
Table 7.1 Returns to option writing strategies
Table 8.1 Monte Carlo computation of Value-at-Risk
Table 8.2 Order statistics for historical simulation Value-at-Risk
Table 8.3 Comparison of Value-at-Risk techniques
Table 8.4 Parametric normal estimate of expected shortfall
Table 8.5 Historical simulation estimates of expected shortfall
Table 8.6 Computation of expected shortfall by historical simulation
Table 9.1 Rating migration rates, 1920–2022
Table 9.2 Default probability analytics: example
Table 9.3 Merton model valuation of firm liabilities
Table 10.1 TBA convexity calculations
Table 11.1 Debt overhang example
Table 13.1 Granularity and credit Value-at-Risk
Table 13.2 Violations of subadditivity
Table 13.3 Impact of a market shock
Table 14.1 Contactually stipulated bond payments
Table 14.2 Securitization scenario analysis
Table 14.3 Senior bond default probability
Table 14.4 Equity tranche: probability of negative return
Table 14.5 Mezzanine bond default probability
Table 14.6 Credit Value-at-Risk of securitization tranches
Table 19.1 Capital and leverage ratios of large banks
Table 20.1 Effective versus target fed funds differences
Preface
Finance is a noble discipline that has been pursued in something like its present form since the early Renaissance. It has been an integral part of the world’s emergence from privation over the past few centuries.
This book aims to help students and professionals understand today’s financial world. It tries to soften the distinction in university teaching between economics and finance, which may be useful in designing curricula but sets up a misleading dichotomy. Today, after the global financial crisis, the era of low interest rates that led up to it, Covid, and the inflation and banking turmoil that followed, monetary policy has changed drastically. It was always simplistic to think about how monetary policy works without reference to the financial system, but today it would entirely miss the point.
One goal of the book is to integrate what is needed to understand the crisis world we’ve experienced and the public policy responses it led to. To understand crises and capital regulation, for example, you need to understand credit risk and securitization, and to understand those, you need some option pricing theory and the CAPM. This book avoids treating risk analysis and management as a distinct specialization, somehow separate from the rest of finance. Economics and finance study one unitary world, risk analysis is embedded in all decision making, and you need insights from all these disciplines to make sense of things.
Another goal is to make some of these models more comprehensible for a general finance and economics audience. There was an unavoidable trade-off between doing that for more topics and limiting the length of the book. For sufferers through the chapter on option pricing, for example, there are fine alternative presentations, cited at the end.
The book is US-centric, with US financial institutions spelled out in more detail than those of other advanced market economies. Because the details of regulation can be mind-numbing, some readers may breathe a sigh of relief that it’s kept largely to one country.
In economics and finance, unrealistic simplified starting points are often a good way to gain insight into the complicated workings of the real world. Examples include assuming that markets clear perfectly all the time, that asset price changes are normally distributed, or that households can achieve through their own borrowing and lending anything corporate managers leave undone in firms’ financial management. In explaining how finance works, we’ll therefore often start with a clear, simple sketch and then bring in some of the messy reality.
In many places in the book, I summarize the empirical evidence on an issue. I’ve done my best to be fair, but we come to things with a perspective, and I’m not aware of a controversy in economics or finance in which statistical evidence hasn’t been brought in support of opposing points of view. I’ve cited sources that present or survey empirical work, and the graphs display and cite a tiny fraction of the plethora of easily available data from many public and private sources. Readers are urged to look at controversies, arguments and data, and form their own view.
Most of the book is organized analytically but presents more recent developments chronologically. The contemporary reality can’t be understood except against the background of historically low interest rates over the past three decades and more and the global financial crisis. Some of the changes in financial institutions and public policies are so recent and so intertwined that the clearest way to describe them is in the context of the succession of stress events in the financial system.
I’d like to thank Flavio Bartmann, Aaron Brown, Richard Cantor, Don Chew, Rich Clarida, Kevin Dowd, Louis Geser, Fumio Hayashi, Ali Hirsa, and Bill Nelson for carefully reading part or all of the manuscript, and helping me organize the presentation and avoid numerous errors. I’ve had the fortune and privilege, at the New York Fed, the RiskMetrics Group, and a few hedge funds, to work with and learn from the smartest, funniest, and most annoying people I’ve ever encountered. (I may have annoyed a few myself.) I continue to learn from and enjoy the company of my colleagues at Columbia University. I’d also like to thank Mick Jagger, the former London School of Economics student who long ago taught me everything I know.
About the Author
Allan M. Malz has been chief risk officer at several multi-strategy hedge fund management firms. He began his career at the Federal Reserve Bank of New York as a researcher and foreign exchange trader, before heading the research effort at the RiskMetrics Group. Returning to the New York Fed from 2009 to 2014 as a vice president in the Markets Group, Malz helped implement the Term Asset-Backed Securities Lending Facility (TALF), a Fed emergency liquidity program addressing the financial crisis.
Malz is an investment consultant and adjunct professor at Columbia University. His work on predicting financial crises and risk measurement for options has been published in industry and academic journals, and he is the author of Financial Risk Management: Models, History, and Institutions (Wiley, 2011). Malz holds a Ph.D. from Columbia and a Diplom from Ludwig-Maximilians-Universität München.
Part I:Finance in the Economic System
1Functions and Structure of the Financial System
1.1 Functions of the Financial System
Finance is a human activity that deals with planning for the future. The financial sector of the economy is made up of markets in which promises of future payment are issued and assets are traded, the people and the firms making and assisting with these claims and exchanges, and the specialized facilities through which trading and other functions are carried out. It is embedded in a larger economic system shaped in part by how law and institutions, ranging from corporate organization to government regulations, have emerged historically. Finance is an important contributor to overall economic efficiency. Regions with developed and well-functioning financial systems tend to have higher economic growth.
The financial system carries out a number of functions aimed at improving the allocation of resources over time, between firms, and geographically, under conditions of constant change and profound uncertainty. It gathers resources from savers or lenders and transfers them to investors or borrowers, enabling people to defer consumption into the future and move resources to other places. Savers include households or firms with a surplus or resources; investors are households or firms using the resources to add to society’s capital stock, including machines, supply chain organization, education, and consumer durables. The financial system helps people plan for the future, identify risks, and insure against adverse outcomes.
An asset is a good that provides value over time, rather than being consumed and disappearing in a moment. Assets include financial instruments, contracts, such as equity, debt, and derivatives contracts, as well as real assets, such as real estate and commodities.
Risk is the possibility of an unwanted event, encompassing the many ways in which people or companies become poorer or worse off, ranging from adverse price changes to bankruptcy to losing a lawsuit. The financial system facilitates managing, reducing, and sharing of risk, via forms of financing, providing insurance, and pooling and diversification of assets. For example, it is sometimes possible to hedge against a risk, that is, isolate it and offset its effects.
Assets have value or payoffs in an uncertain future, so their values today are influenced by how much time will pass before the future value is realized, what people think the future payoffs and their probabilities might be, and how they feel about the risks posed by that range of possibilities. If asset prices are set in more or less efficient financial markets, they will roughly reflect people’s expectations, desires and fears about the future. The most important asset price is the, interest rate, which is the rate paid for borrowing money, expressed as a percent of the principal, par value, or notional amount of money borrowed per unit of time, generally annually.
Mechanisms to facilitate exchange of goods and services and for trading include the creation and use of money and other media of exchange, and more generally, of liquid assets. Payment systems also facilitate carrying out exchanges.
Many risks come bundled with benefits or with other risks. Forms of organization, such as the corporation and partnerships, and contracts, such as debt and equity, reduce risk and facilitate investment by pooling and sharing ownership and other claims on resources. Institutional structure is determined to a large extent by historical development.
In carrying out these functions of resource allocation, risk management, and facilitation of exchange, households and firms gather and create information. They identify opportunities for productive investment or allocation of capital. Financial innovation includes the discovery and implementation of new assets, such as securitization, derivatives, cryptocurrencies, and new techniques for disseminating information about prices and trading activity.
1.2 Market Participants, Intermediaries, and Governments
A number of terms are used to describe the variety of market participants, ultimately human beings, with all their disparate goals. Final consumers of financial services are called households, individuals, or investors. The term “agent” is used in two different senses: generally as a synonym for market participant and more specifically for one acting on behalf of another.
Firms that specialize in financial functions, such as banks, insurance companies, and investment managers, are called financial intermediaries. Their value added is nearly 8 percent of US gross domestic product (GDP).1 Many are parts of large holding companies with subsidiaries operating internationally in widely varying functions. Most intermediaries carry out multiple functions and can be classified from both an institutional perspective, by type of firms, and from a functional perspective, by product or service, e.g. lending or facilitating transactions.
Many of these functions are carried out by financial firms “using their balance sheets” to transform assets and change their characteristics, by acquiring assets with one set of characteristics, and issuing liabilities with different characteristics that become the assets of other market participants. Intermediaries can separate and redistribute those characteristics in a way that better suits market participants at lower cost.
Maturity transformation changes the term to maturity of a debt contract by borrowing short-term and lending at longer term. In credit transformation, the credit quality of a debt contract is changed (and not necessarily raised). Monitoring, using collateralization, by which the borrower puts assets under the control of the lender, and using guarantees, may raise credit quality. Risk distribution and transfer, such as securitization, may create some securities with lower credit quality. The liquidity transformation carried out by banks and money market mutual funds (MMMFs) makes debt contracts function more like money and goes hand-in-hand with maturity transformation.
“What do banks do?” is a perennial question, with no universally accepted definitions. Older forms of banking, dating back to the medieval era, are referred to as merchant banks, which connect investors to investment possibilities, and generally also take an ownership stake. Modern commercial banks lend directly to households and companies and monitor their creditworthiness. Banks may engage in proprietary trading of assets for their own accounts. Investment banks facilitate market intermediation, including securities issuance by companies, through syndication—arranging the securities’ initial sale—and underwriting—assuming at least part of the price risk. The share of market compared to bank intermediation is higher in the United States than in continental Europe. Some banks also provide custodial services for clients, including custody of their customers’ securities and cash balances, record keeping, and managing cash flows such as dividends and interest from investments.
Broker-dealers trade and invest in securities. Dealers, market makers, or liquidity providers take principal positions, using equity and borrowed funds to finance and execute securities trading. They take long or short positions and bear the market and credit risk of securities inventories, and are compensated through trading profits and interest. Brokers act as agents, facilitating trades and provide trading infrastructure without taking principal positions. They are compensated through fees, commissions, and may earn net interest by lending customer cash balances to other intermediaries at a higher rate than the broker pays.
Specialized intermediaries and mechanisms facilitate pooling investments. Investment managers and management companies manage investments on behalf of clients, whose portfolios remain in separate accounts. In the United States, investment companies are a legal form of pooled investment portfolio of securities and other assets in which investors own equity shares. Open-end mutual funds, the largest category of investment company, must calculate a net asset value (NAV) at the end of each day at which it issues or redeems shares at investors’ initiative, adding or selling assets in its portfolio to match. The volume of investment in the fund is not limited, in contrast to closed-end funds trading in markets. Money market mutual funds (MMMFs) are a specialized type of mutual fund that invest in high credit quality, short-term money market instruments. Exchange-traded funds (ETFs) were introduced in the 1990s and differ from mutual funds in that investors buy and sell shares in the market, rather than in transactions with the fund itself. Large intermediaries act as authorized participants, buying and selling the constituent assets of an ETF and redeeming or issuing shares.
Institutional investors are large pools of assets that manage investments on behalf of others. They include investment management companies, pension funds, insurance companies, family offices, foundations, and endowments. Many are advised by consultants, such as McKinsey and Callan, that play a large role in their decision making. Defined benefit pension funds or plans are a form of employer-provided retirement benefit common in many countries. They provide for payments of a specified annual amount over the life of the retiree that is related to the years of work, average salary earned, and age at retirement. Many such plans are indexed for inflation. The benefits are disbursed out of funds that are financed by a combination of employer and employee payments and are invested. In a defined contribution plan, employees have an ownership claim on a portion of the fund, and future benefits depend on the fund’s returns.
The financial system has evolved together with systems of government. In most of the world, government involvement with the financial system is carried out through the state itself and through central banks, which resemble commercial banks in some ways but are under some form of public ownership and government control. Monetary policy influences economic outcomes through interest rates, money markets, and control over the issuance of money. The legal structure within which financial intermediation is carried out is shaped by regulatory policy, the set of rules governing permitted, required, and prohibited actions and forms of organization.
Though these domains of state action are referred to as policy, suggesting a dispassionate process of evaluation and formulation, they are generally part of a larger political process. Historically, through their evolution, and institutionally, through legal and corporate arrangements, central banks in many countries, including the United States, are not purely government-owned agencies but have some private-sector participation in their governance. Some regulatory powers, such as standard setting and licensing, are delegated to private-sector entities.
1.3 Assets and Markets
1.3.1 Money and Money Markets
Money encompasses a wide range of commonly accepted assets with stability of exchange value that provide money services, including:2
Payment services: can be exchanged for other goods or assets, or in settlement of debts.
Liquidity services: relative certainty as a store of value.
Nominal unit of account: prices and values that are most often measured in money units.
Money has its origins in a past so remote that there is little definitive evidence for its earliest forms. In one view, state sanction is needed for a medium of exchange to be widely accepted, for example, because it must be used to pay taxes or because the state distributes it widely. More likely, money is emergent, evolving gradually during prehistory as market participants gravitated to particular commodities as convenient means of exchange.
Money can take the form of a physical or digital object or token, based on its intrinsic value or confidence in its wide acceptance. In the historical era, until the Middle Ages, most money was in the form of coins or specie issued by governments. For most of the past millennium, money has also been account-based, meaning a liability of a government, central banks, financial intermediaries carrying out liquidity transformation, or even a nonfinancial business, its value dependent on the trustworthiness of the claim issuer. New forms of money have emerged recently, for example MMMF shares in the 1970s and cryptocurrencies in the current century.
Banks have historically been the largest issuers of claims used as money. The owner of an account with a positive balance could instruct a bank to transfer funds to another person’s account at the same or at a different bank. A large part of the liabilities of central banks and commercial banks consist of deposits, book-entry liabilities that correspond to assets their owners can use to make payments or settle debts. Typically, commercial banks, government-owned enterprises, and a few other intermediaries that are allowed to issue deposits are authorized—and in many jurisdictions required—to hold deposits at a central bank, called reserve balances. In the United States, federal funds, or fed funds, are reserve balances at Federal Reserve (Fed) district banks that are traded or used to settle payments among banks.
Cash and close substitutes for cash, or narrow money, include currency and short-term central bank and commercial bank deposits that can be used for immediate payment. Some liquid short-term claims—broad or near-money and money substitutes—bear interest, including shorter-term government debt and bank deposits such as certificates of deposit (CDs). They are used less frequently as means of payment but may be readily sold for cash or used as collateral to borrow cash or other assets at reliably foreseeable values.
Many forms of money trade in money markets, which are among the highest-volume and the most active financial markets. They include interbank lending, commercial paper, and perhaps most importantly, repo markets.
1.3.2 Foreign Exchange
A foreign exchange rate is the price of currency issued in one jurisdiction in terms of another. Foreign exchange markets are among the largest financial markets in the world by many measures with, daily trading volume of $7.5 trillion.3
Appreciation (depreciation) of a foreign currency is a rise (fall) of its price in home or local currency units. Long positions in foreign currency and investments in foreign assets are exposed to appreciation of the home currency and depreciation of foreign currency. Short positions in foreign currency, such as future payment obligations for imported goods or repayment of borrowing in foreign currency, are exposed to depreciation of the home currency or appreciation of foreign currency.
1.3.3 Digital Currencies
Digital currencies are a relatively recent innovation in money and payments systems made possible by advances in technology and the rapidly declining cost of computers. They currently take several forms. A cryptocurrency is a means of exchange that relies on algorithms to preserve limited supply and scarcity and to maintain the ledger that documents ownership. Cryptocurrencies are different from most privately created forms of money used in the past in that they are not inside money, that is claims on a private issuer, but are added to the total stock of assets.
Stablecoins are digital assets with values pegged to that of another form of money. Some, such as Tether, are tied to the US dollar; others are tied to the value of a cryptocurrency. The values are promised by the issuer to be maintained either by issuing the stablecoin as a liability supported by asset reserves or through an algorithm asserted to maintain the pegged value.
Central bank digital currencies (CBDCs) are digital currencies issued by central banks or governments. They have not yet become widespread but are being widely considered. Benefits claimed for introducing CBDCs include reducing crimes committed using physical cash, such as tax evasion, money laundering, and dealing in contraband, and providing banking services to poor people.
The disadvantages include the potential for surveillance and government control of people’s transactions. Substitution of CBDCs for bank deposits raises monetary policy implementation concerns and competitive concerns for commercial banks. Public acceptance of CBDCs is also not assured in countries with weak currencies, for example, the 2023 attempt by the Nigerian central bank to introduce a digital currency.
1.3.4 Equity, Loans, and Bonds
Equity is an ownership stake in a firm, a residual claim that pays or is worth the remaining value of the firm’s assets after other claims have been met in full. Under the legal structure of firm organization prevailing since the 19th century, equity investors, or shareholders, enjoy limited liability, owing external claimants no more than the value of their investment.
Money can be invested or lent for shorter or longer periods of time. The lender receives a claim in return, part of a larger category of fixed-income debt instruments. Some short-term claims are used as money to carry out transactions.
Debt instruments are highly diverse. Loans are bilateral contracts between a lender, often a single bank or nonbank loan originator, and the borrower. Many equity claims and most bonds are securities, subject to a body of law and regulation. The legal design of debt securities including bonds facilitates offering them to many potential lenders at issuance. Bonds are generally issued by larger corporations and by governments. The largest bond markets are those for sovereign debt, that of central governments, such as the market for US government bonds, or Treasurys.
Some longer-term claims can be bought and sold in capital markets. Loans and bonds differ primarily in how readily they trade. Loans are usually retained by the originator; bonds are designed to be traded. Large loans may be syndicated, with several lenders extending credit under a uniform agreement. Regulatory policy distinguishes between public capital markets subjected to more stringent requirements regarding accounting and disclosure, and accessible to the general public and private markets open only to qualified—institutional or wealthy—investors.
Securities are initially sold to investors by the issuers of the claims, directly or through intermediaries, in primary markets. In the stock market, a firm enters the public markets and opens ownership of its shares to a wider range of investors through an initial public offering (IPO). Once issued, investors trade them in secondary markets. Secondary markets also exist for syndicated and some other large loans.
In the US Treasury market, the benchmark 10-year note and other bonds, bills, and notes issued by the US federal government are initially sold on regular schedules through an auction process to a small set of primary dealers. Secondary market trading is carried out by a much wider set of dealers.
Corporations and the legal treatment of their funding sources took on their modern forms as the result of a long historical evolution of law and corporate institutions. Corporations began emerging in the Middle Ages and, by the 16th century, were structured to outlast a specific project, such as an overseas trading voyage. Among the important features of the modern corporation is permanence: in contrast to simple family businesses and partnerships, a corporation can survive even if the partners pass away, and owners’ stakes can be sold to new owners.
Equity and debt claims began, as part of this evolution, to trade in secondary markets. Corporate forms of organization are capable of coordinating a much wider scope and greater complexity of operations and of distribution and pooling of risks, for example, the development of insurance. These institutional innovations then create a need for incentive alignment mechanisms, information generation, and corporate control to facilitate the vetting, selection, and monitoring of borrowers, managers, and other agents working on behalf of others.
Figures 1.1 and 1.2 illustrate recent developments in US loan and debt markets, with an outstanding value of $98.4 trillion in 2023. Federal, state, and local government are the largest category of borrowers, with over one-third of the total. Financial sector borrowing increased steadily until the global financial crisis, but its share has declined since. Until the disintermediation of the 1970s, banks and investment banks had been the predominant lenders but have been displaced by a combination of investment funds, the public sector, primarily through government-guaranteed residential mortgage loans, and, for a time, securitization.
Figure 1.1 Who’s borrowing in the United States, 1945–2023
Share in the total of each sector’s outstanding borrowing in US markets via loans and debt securities, annual, percent. Data source: Federal Reserve Board, Financial Accounts of the United States (Z.1), Table D.3.
Figure 1.2 Who’s lending in the United States, 1945–2023
Share of each sector in total lending via loans and debt securities in US markets, annual, percent. Banks and capital markets includes finance companies, brokers, and dealers. Institutional investors include insurance companies and private and public pension funds. Public sector includes assets held by the Federal Reserve and are held or guaranteed by government-sponsored enterprises (GSEs). Securitization includes nongovernment-guaranteed asset-backed securities (ABS). Data source: Federal Reserve Board, Financial Accounts of the United States (Z.1), Tables L.208 and L.214.
1.3.5 Spot and Derivative Assets
Spot markets involve an exchange of assets now and create no future obligation apart from fulfilling the terms of the exchange. A derivative is a financial instrument or contract agreed now but involving an exchange of assets in the future. A derivative’s value and the counterparties’ returns depend on the as-yet unknown future prices of another asset, called the underlying asset. Derivatives are widely used to establish a desired exposure to an underlying asset or to hedge an exposure.
One way to categorize the great variety of derivatives is by how their values are related to those of their underlying asset. The values of futures, forwards, and swaps have a linear and symmetric relation to that of the underlying price. A change in the underlying price has a proportional impact on the derivative’s value. Option values have a nonlinear and asymmetric relation to the underlying price, depending on its current level and the direction and size of changes.
There are futures, forwards, and options on a wide variety of assets, including foreign exchange, stocks and stock indexes, bonds, and commodities. Fixed-income derivatives include credit default swaps (CDS). Derivatives can be classified by how they are traded, on an organized exchange or over-the-counter (OTC) and can be classified by underlying asset, a stock or stock index, a bond or interest rate, a commodity or a currency. Futures are traded on exchanges; forwards are traded OTC between dealers or their customers.
Measuring the size of derivatives markets is problematic because the aggregate and its composition by underlying asset differ greatly depending on the metric. The notional or nominal principal amount outstanding is the par value of existing contracts, generally a far larger number than the aggregate net present value (NPV) that accounts for offsetting payments. The gross notional outstanding includes many offsetting trades between pairs of counterparties and is much larger than the net amount.
As seen in Figure 1.3, by far the largest share of the OTC derivatives markets is that of interest rate swaps. Foreign exchange derivatives also have a large share, with credit, equity, and others making up the remainder.
Derivatives may be built into other assets as an element of a more complex security or portfolio. For example, structured products can be analyzed as a set of derivatives contracts on an underlying set of assets. A callable bond is bundled with a short call option on the bond through which the issuer can repay the bond prior to maturity. A convertible bond is bundled with a long out-of-the-money call; the bond can be exchanged for equity in the issuing firm if the stock price rises.
Figure 1.3 OTC derivatives markets 1998–2022
Notional amounts outstanding, G10 countries including Switzerland, trillions of US dollars, semiannual, H1 1998 to H1 2022. Source: BIS, Semiannual OTC derivatives statistics, Table D5, www.bis.org/statistics/derstats.htm.
1.3.6 Alternative Investments
The largest categories of alternative investments, which are outside the public stock and bond markets, are private funds: hedge funds and private equity. Both are usually organized as limited partnerships, with a general partner making investment decisions. Mergers and acquisitions of firms are often financed in large part by borrowing from banks and through bond issuance. More recently, a portion of this credit has been extended by private credit funds, which extend credit to private companies often owned by private equity funds, without taking ownership. Alternative investments also include funds investing in real assets, such as real estate, commodities, and forests. US private funds, according to regulatory data, managed $20.9 trillion in gross assets and $14.0 trillion in net assets in Q2 2023.
Most alternative investments are highly illiquid and have high investment fees and other costs compared to public-market and traditional investments. Institutional investors are the largest investors in alternatives. In recent years, liquid alternatives, mutual funds and ETFs employing typical alternative investment strategies, have been marketed to households.
Hedge funds are a loosely defined group of investment companies that are open, due to regulatory constraints, only to institutional investors and wealthy households but not to the general public. US hedge funds managed $5051.6 billion of gross assets at the end of 2023, more than three times as much as in 2012.4 They are not subject to many restrictions on investment style and technique constraining other funds’ ability to trade derivatives, take short positions, and borrow. This permits hedge funds to take more risk than other funds and to engage in strategies that cannot be carried out without these tools.
Hedge funds are an old form of investment company, dating back (at least anecdotally) to the late 1940s. For tax reasons, they are often organized in an onshore-offshore structure, in which several accounts have nearly identical investments. The offshore account is organized as a corporation and domiciled in a tax haven, a country that does not tax profits. The investors are then responsible for paying taxes where they reside. The onshore account, typically organized as a limited partnership, is domiciled in a developed country.5 Its investors are entities, such as pension funds that are not obliged to pay profit taxes. Both accounts are managed in parallel by a hedge fund management company. Investors can withdraw funds but only on specified dates, and the manager may be permitted to limit withdrawals.
The hedge fund manager is compensated through a “2 and 20” structure. The management company organizes the fund and receives an annual management fee, often 2 percent of the fund’s net asset value (NAV), the value of the investor assets it manages. A general partner, the owner of the management company, makes the investment decisions and receives a performance fee, typically 20 percent of the return, if the fund has positive returns as measured by the excess over the previous maximum value or “high water mark” of an investor’s shares. In recent years, a number of hedge funds have accepted lower fees.
Most hedge funds are classified as following one of these strategies:
Equity funds take views on specific equity prices rising or falling.
Relative value seeks to exploit arbitrage opportunities in and between markets in all asset classes.
Macro strategies are based on views on central bank policy, foreign exchange rates, and other macroeconomic and political developments.
Event-driven strategies express views through stock and bond positions on events such as corporate mergers and acquisitions, defaults, and bankruptcies. They include activist funds, which attempt to directly influence corporate decisions.
The portfolios can be very concentrated or diversified, depending on the strategy. Many hedge funds are highly reliant on large broker-dealers for prime brokerage services including execution and financing of trades, safekeeping of securities, information and technology, and capital introduction to potential investors.
Private equity funds have grown rapidly since their origins in the 1970s and fall into two major categories: investing in leveraged buyouts (LBOs) and venture capital
