finance
mautauajalo
ClassNotes1.docClass Notes
I. INTRODUCTION AND OVERVIEW OF THE FINANCIAL SYSTEM
1. Why study financial markets, instruments, and institutions?
This course is about the study of financial markets, institutions, and instruments. Let us briefly see why it is important to study financial markets, instruments, and institutions.
· Financial markets are markets in which funds are transferred from people who have an excess of available funds to people who have a shortage.
· Financial markets are important in channeling funds from people who do not have a productive use for them to those who do, resulting in greater efficiency.
· Activities in financial markets have direct effects on individuals' wealth, the behavior of businesses, and the efficiency of our economy.
· Financial instruments (also called securities), such as bonds and stocks, are claims on the issuer's future income or assets (any financial claim or piece of property that is subject to ownership). They are important to economic activity because they enable individuals, corporations and governments to borrow to finance their activities.
· Three financial markets deserve special attention: the debt markets (bond market), where interest rates are determined; the equity markets (stock market), which has a major effect on people's wealth and on firm's investment decisions; and the foreign exchange market, because fluctuations in the foreign exchange rate have major consequences for the American economy (will not be covered in this course). Another important financial market is the derivatives market.
· Financial institutions are what make financial markets work. Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities. They thus also have important effects on the performance of the aggregate economy as a whole.
· The most important financial institution in the financial system is the central bank, the government agency responsible for the conduct of monetary policy, which in the Unites States is the Federal Reserve System (the Fed). Monetary policy involves the management of interest rates and the quantity of money, also referred to as the money supply (defined as anything that is generally accepted in payment for goods and services or in the repayment of debt).
· Because monetary policy affects the interest rates, inflation, and business cycles, all of which have an important impact on financial assets and institutions, we need to understand how monetary policy is conducted by central banks in the United States and abroad.
· Banks and other financial institutions channel funds from people who might not put them to productive use to people who can do so and thus play a crucial role in improving the efficiency of the economy.
· Understanding how financial institutions are managed is important because there will be many times in your life, as an individual, an employee, or the owner of a business, when you will interact with them.
2 Roles and Functions of the Financial System
a. What is a financial system?
Financial system refers to the collection of markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other securities are traded, interest rates are determined, and financial services are produced and delivered around the world.
The financial system is one of the most important inventions of modern society. Its primary task is to move scarce loanable funds from those who save to those who borrow to buy goods and services and to make investments in new plant and equipment and facilities so that the global economy can grow and increase the standard of living enjoyed by its citizens. Without the global financial system and the loanable funds it supplies, each of us would lead a much less enjoyable existence.
The financial system determines both the cost of credit and how much credit will be available to pay for the thousands of different goods and services we purchase daily. Equally important, what happens in this system has a powerful impact on the health of the global economy. When credit becomes more costly and less available, total spending for goods and services falls. As a result, unemployment rises and the economy's growth slows down as businesses cut back their production and lay off workers. In truth, the global financial system is an integral part of the global economic system.
b. The Global economy and the financial system
i. Flows within the global economic system
To better understand the role played by the financial system in our daily lives, we begin by examining its position within the global economy.
The basic function of the economic system is to allocate scarce resources (land, labor, management skills, and capital) to produce goods and services needed by society.
Any economic system must combine inputs (resources) to produce output (goods and services). The global economy generates a flow of production in return for a flow of payments.
(See The global economic system.)
We may depict the flow of payments and production within the global economic system as a circular flow between producing units (businesses and governments) and consuming units (principally households/individuals).
(See Circular Flow of Income, Payments, and Production in the Global Economic System.)
The Circular flow of production and income is interdependent and never ending.
ii. The roles of markets in the global economic system
The use of markets--In most economies around the world, markets are used to carry out complex task of allocating scarce resources and producing goods and services.
What is a market?--A market is an institution set up by society to allocate resources that are scarced relative to the demand for them. Markets are the channel through which buyers and sellers meet to exchange goods, services, and productive resources (factors of production).
The marketplace determines what goods and services will be produced and in what quantities. This is accomplished through changes in the prices of goods and services offered in the market. Markets also distribute income.
Types of markets--There are essentially three types of markets at work within the global economic system: Factor markets; product markets; financial markets.
(1) Factor markets are where factors of production are exchanged. Consuming units sell their labor and other resources to those producing units offering the highest prices. The factor markets allocate factors and distribute income (wages, rental payments, and so on) to the owners of productive resources.
(2) Product markets are where goods and services are exchanged. Consuming units use most of their income from factor markets to purchase goods and services in the product markets.
(3) Financial markets are an institutional mechanism created by society to channel savings and other financial services to those individuals and individuals willing to pay for them.
(See Three Types of Markets in the global economic system.)
iii. Channel for savings and investments: The financial markets and the financial system
Not all factor income is consumed. A substantial proportion of after-tax income received by households (more than $300 billion in 2008) is earmarked for personal saving. In addition, business firms save billions of dollars each year to build up their reserves for future contingencies and for long-term investments. For example, $300 billion of $600 billion in after-tax profit was set aside for possible future needs as business savings (or retained earnings).
It is here that the financial market performs a vital role within the global economic system. The financial markets channel savings to those individuals and institutions needing more funds for spending than are provided by their current incomes. The financial markets are the heart of the global financial system, attracting and allocating savings and settling interest rates and the prices of financial assets (stocks, bonds, etc…)
Nature of savings--The definition of savings differs depending on what type of unit in the economy is doing the saving. We distinguish four (4) types of savings:
(1) Personal saving (from household sector)--what is left from current income after consumption expenditures and tax payments are made.
(2) Business saving (from business sector) include current earnings retained inside firms after payments of taxes, stockholder dividends, and other cash expenses. Also called retained earnings.
(3) Government saving arises when there is a surplus of current revenues over current expenditures in a government's budget.
(4) Foreign saving arises when imports exceed exports.
Total saving = personal saving + business saving + government saving + foreign saving
Nature of investment--Most of the funds set aside as savings flow through the global financial markets to support investment by business firms, governments, and households.
Investment is defined as purchases/expenditures on capital goods or on inventories of goods or raw material that are used to produce other goods and services, causing future production and income to rise. We distinguish three types (3) of investment:
(1) Investment in plant and equipment (fixed non residential investment)--purchases/expenditures by business firms on capital goods (fixed assets, such as equipment and buildings).
(2) Investment in inventories--expenditures by business firms on inventories (consisting of raw materials and goods offered for sale).
(3) Investment in housing (fixed residential investment)--households invest when they buy new home or purchase furniture, automobiles, and other durable assets. Only purchases of new homes enter into the category of housing investment.
Note: Government spending to build and maintain public facilities (such as buildings, monuments, and highways) is another form of investment.
Modern economies require enormous amount of investment to produce the goods and services demanded by consumers. Investment increases the productivity of labor and leads to a higher standard of living. Investment is the key to growth.
Investment often requires huge amounts of funds, far beyond the resources available to a single firm, individual, and/or government. By selling financial claims (such as stocks and bonds) in the financial markets, large amounts of funds can be raised quickly from the pool of savings accumulated by households, businesses, governments, and the foreign sector. The business firm, individual, or government then hopes to repay its loans from the financial marketplace by drawing on future income.
Indeed, the financial markets operating within the financial system make possible the exchange of current income for future income and the transformation of savings into investment so that production, employment, and income can grow.
Those who supply funds to the financial markets receive only promises in return for the loan of their money. These promises are packaged in the form of attractive financial claims and financial services, such as stocks, bonds, deposits, and insurance policies.
Financial claims promise the supplier of funds a future flow of income in the form of dividends, interest, or other returns. But there is no guarantee that the expected income will ever materialize. However, suppliers of funds to the financial system expect not only to recover their original funds but also to earn additional income as a reward for waiting and assuming risk.
(See The Global Financial system).
The role of the financial markets in channeling savings into investment is absolutely essential to the health and vitality of the economy.
c. Functions performed by the global financial system and the financial markets
The global financial system has seven basic functions:
(1) Saving function--The global system of financial markets and institutions provides a conduit for the public's savings. It provides a potentially profitable, low-risk outlet for the public's savings, which flow through the financial markets into investment, so that more goods and services can be produced, increasing the world's standard of living.
(2) Wealth function--Providing a means to store purchasing power/wealth in financial assets until needed for future consumption.
Wealth is defined as accumulated assets held by an economic unit as a result of saving.
t
W
=å
i
it
A
(1)W=wealth
A=value of assets
Net wealth:
t
W
ˆ
=å
i
it
A
-å
j
jt
L
(2)L=liabilities or debt
Both wealth and net wealth are built up over time by a combination of savings plus income earned on previously accumulated wealth. In symbols,
t
W
D
=1
*
-
+
t
t
t
W
r
S
(3)
t
W
D
=change in wealthWealth is held in the form of stocks, bonds, deposits, and other financial assets (financial wealth). Wealth holdings represent stored purchasing power that will result in future periods to finance purchases of goods and services and to increase society's standard of living. Income emerges from the wealth function of the global financial system. That is, income (Y) is created by the rate of return (r) that current wealth holdings (W) generate for their owners. Or,
t
Y
=t
t
r
W
*
(4)In turn, that wealth-created income leads to both increased consumption spending (C) and to new saving (S):
t
Y
=t
C
+t
S
(5)resulting in a higher standard of living for those who hold wealth in income-generating forms. Equation (3) reminds us that any new savings that emerge from expansion of existing wealth may result in even greater holdings of wealth in the future.
(3) Liquidity function--Providing a means of raising funds by converting financial assets (stocks, bonds, deposits) into cash balances. For wealth stored in financial instruments, the global financial marketplace provides a means of converting those instruments into cash with little risk of loss. Thus, the world's financial markets provide liquidity (immediately spendable cash) for savers who hold financial instruments but are in need f money.
(4) Credit function--Providing a supply of credit to support both consumption and investment spending in the global economy.
Credit is defined as a loan of funds in return for a promise of future payment.
Consumers need credit to purchase homes, buy groceries, etc… Businesses draw on their lines of credit to stock their shelves, construct new buildings, meet payrolls….Governments borrow to construct buildings and cover daily cash expenses.
The volume of credit extended by the money and capital markets is huge and growing. In 1998, the net credit funds raised in the U.S. financial markets amounted to well over $2 trillion.
(5) Payments function--Providing a mechanism for making payments to purchase goods and services from around the world. Certain financial assets serve as a medium of exchange in making payments. Checking accounts, credit cards issued by banks, electronic means of payments are in widespread use and growing rapidly.
(6) Risk function--Providing a means to protect businesses, consumers, and governments against risks to people, property, and income by producing and selling risk-protection services. The financial markets around the world offer businesses, consumers, and governments protection against life, health, property, and income risks. This is accomplished, first of all, by the sale of insurance policies.
(7) Policy function--Providing a channel for government policy to achieve society's goals of full-employment, low inflation, and sustainable economic growth. The financial markets have been the principal channel through which government has carried out its policies of attempting to stabilize the economy and avoid inflation. By manipulating interest rates and the availability of credit, governments can affect the borrowing and spending plans of the public, which, in turn, influence the growth of jobs, production, and prices.
The most important function of the financial system of money and capital markets is to facilitate the transformation of savings into real (non-financial) investment so economies can grow and create new jobs and living standard can increase.
d. Types of financial markets within the global financial system
Charged with many different functions, the global financial system fulfills its various roles mainly through markets where financial claims and financial services are traded. These markets may be viewed as channels through which moves a vast flow of loanable funds that is continually being drawn upon by demanders of funds and continually being replenished by suppliers of funds.
i. Money and capital markets
One of the most important divisions in the financial system is between the money market and the capital market.
The money market--designed for the making of short-term loans. It is the institution through which individuals and individuals and institutions with temporary surpluses of funds meet the needs of borrowers who have temporary funds shortages.
By convention, a security or loan maturing within one year or less is considered to be a money market instrument. The money market is a financial market in which only short-term debt instruments (maturity of less than one year) are traded.
One of the principal functions of the money market is to finance the working capital needs of corporations and provide governments with short-term funds in lieu of tax collections. The money market also supplies funds for speculative buying of securities and commodities.
Principal money market instruments : U.S. Treasury bills, bank and thrift large certificates of deposits ($100,000+), small time and savings deposits at banks and thrifts, securities issued by federal and federally sponsored agencies, federal funds, repurchase agreements, Eurodollar deposits, commercial paper, bankers' acceptances.
The capital market--designed to finance long-term investments by businesses, governments, and households. The capital market is the institution that provides a channel for borrowing and lending of long-term funds (over one year). The capital market is a financial market in which long-term debt (original maturity of one year or greater) and equity instruments are traded. Financial instruments in the capital market have original maturities of more than one year and range in size from small loans to multimillion dollar credits.
The trading of funds in the capital market makes possible the construction of factories, highways, schools and homes.
Principal capital market instruments : Mortgages, common stocks, U.S. Treasury bonds and notes, corporate and foreign bonds, state and local government bonds and notes, consumer loans (non-residential)
Short-term securities have smaller fluctuations in prices than long-term securities, making them safer investments. As a result, corporations and banks actively use this market to earn interest on surplus funds that they expect to have only temporarily.
Capital market securities, such as stocks and long-term bonds, are often held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future.
ii. Debt and equity markets
A distinction between markets in the global financial system focuses on debt markets versus equity markets. A firm can obtain funds in a financial market in two ways: issue a debt instrument (bonds, mortgage) or issue equities (common stock).
Debt markets--where debt instruments are traded. A debt instrument is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when the final payment is made. The maturity of a debt instrument is the time (term) to that instrument's expiration date. Short-term (T< one year); intermediate term (one year<T<ten years); long-term (T>10 years).
Equity markets--where equity instruments are traded. Equity instruments are claims to share in the net income and assets of a business.
iii. Open and negotiated markets
Another distinction between markets in the global financial system that is often useful focuses on open markets versus negotiated markets.
Open markets--Institutional mechanisms created by society to make loans and trade securities in which any individual and institution can participate. For example, some corporate bonds are sold in the open market to the highest bidder and are bought and sold any number of times before mature and are paid off. In the market for corporate stocks, there are the major stock exchanges, which represent the open market.
Negotiated markets--Institutional mechanisms set up by society to make loans and trade securities in which the terms of trade are set by direct bargaining between a lender and a borrower. In the negotiated market for corporate bonds, securities generally are sold to one or a few buyers under private contract. Also, an individual who goes to the local bank to secure a loan for a new car enters the negotiated market for auto loans.
iv. Primary and secondary markets
The global financial markets may also be divided into primary markets and secondary markets.
Primary markets--are for the trading of new securities never issued before. A primary market is a financial market in which new issues of a security (stocks, bonds, etc…) are sold to initial buyers by the corporation or government agency borrowing the funds.
Its primary function is raising financial capital to support new investments in buildings, equipment, and inventories. You engage in a primary market transaction when you purchase shares of stock just issued by a company or borrow money through a new mortgage to purchase a home.
Secondary markets--deal in securities previously issued. A secondary market is a financial market in which securities that have been previously issued (and are thus secondhand) can be resold.
Its chief function is to provide liquidity to security investors--that is, to provide an avenue for converting financial instruments into ready cash. If you sell shares of stock or bonds you have been holding for some time to a friend or call a broker to place an order for shares currently being traded on the American, London, or Tokyo stock exchanges, you are participating in a secondary transaction.
The volume of trading in the secondary market is larger than trading in the primary market. However, the secondary market does not support new investment.
v. Exchanges and over-the counter markets
Markets can be organized in two ways: exchanges markets and over-the counter markets.
Exchanges markets--where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. The New York and American stock exchanges for stocks and Chicago Board of Trade for commodities (wheat, corn, silver, and other raw materials) are examples of organized exchanges.
Over-the-counter markets (OTC)--where dealers at different locations have an inventory of securities and stand ready to buy and sell securities "over-the-counter" to anyone who comes to them and is willing to accept their prices. Because over-the-counter dealers are in computer contact and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange.
vi. Spots, futures, forwards, and option markets
We may also distinguish between spot markets, futures or forward markets, and option markets (all known as derivative markets).
Spot markets--A spot market is one in which securities or financial services are traded for immediate delivery (usually within one or two business days). For example, if you pick up the telephone and instruct your broker to purchase Telecom Corporation shares at today's price, you expect to acquire to acquire ownership of Telecom shares in a matter of minutes.
Futures or forward markets--A futures or forward market is designed to trade contracts calling for the future delivery of financial instruments. For example you may call your broker and ask to purchase a contract from another investor calling for delivery to you of $1 million in government bonds six months from today. The purpose of such a contract would be to reduce risk by agreeing on a price today rather than waiting six months, when government bond prices might have risen. They offer opportunities to reduce risk.
Options markets--Options markets also offer investors in the money and capital markets an opportunity to reduce risk. These markets make possible the trading of options on selected stocks and bonds, which are agreements (contracts) that give an investor (holder of option) the right, but not the obligation, to either buy designated securities from (call option) or sell designated securities to (put option) the writer of the option at a guaranteed price at any time during the life of the contract (American option).
vii. Swap markets
Swap markets also offer investors in the money and capital markets an opportunity to reduce risk. A swap is a financial contract that obligates one party to exchange (swap) a set of payments it owns for a set of payments owned by another party. There are two basic kinds of swaps: (1) currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency; (2) interest-rate swaps involve the exchange of a set of interest payments for another set of interest payments, all denominated in the same currency.
viii. The foreign exchange markets
The market in which exchange rates are determined. The exchange rate is the price of one currency in terms of another.
e. Factors Tying All Financial Markets Together
Each corner of the global financial system represents a market segment with its own special characteristics. Each segment is insulated from the others to some degree by investor preferences and by rules and regulations. Yet when interest rates and security prices change in one corner of the financial system, all of the financial markets likely will be affected eventually. This implies that, even though the global financial system is split-up into many different markets, there must be forces at work to tie all financial markets together.
i. Credit, The Common Commodity
One unifying factor is the fact that the basic commodity being traded in most financial markets is credit . Borrowers can switch from one market to another, seeking the most favorable credit terms wherever they can be found. The shifting of borrowers between markets helps to weld the parts of the global financial system together and to bring credit costs in different markets into balance with one another.
ii. Speculation and Arbitrage
Another unifying element is profit seeking by demanders and suppliers of funds. Speculators in securities are continually on the lookout for opportunities to profit from their forecasts of future market developments. The speculator in the financial marketplace gambles that security prices or interest rates will move in a direction that will result in quick gains due to his or her ability to outguess the market's collective
judgment. Many speculators are risk seekers, willing to gamble their funds even when probability of success is low. Speculators perform an important function in the financial markets by leveling out the prices of securities, buying those they believe are underpriced and selling securities thought to be overpiced.
Still another unifying force in the financial markets comes from investors who watch for profitable opportunities to arbitrage funds-transferring funds from one market to another whenever the prices of securities in different markets appear to be out of line with yield between the two each other. Arbitrageurs help to maintain consistent prices between markets. aiding other security buyers in finding the best prices with minimal effort.
iii. Perfect and Efficient Markets
There is some research evidence today suggesting that all financial markets are closely tied to one another due to their near perfection and efficiency.
What is a perfect market? It is one in which the cost of carrying out transactions is zero or nearly so and all market participants are price takers (rather than being able to dictate prices to the market). In such a market, there are no significant government restrictions on trading and the movement of funds; rather, competition among buyers and sellers sets the terms of trade. No financial market today is completely perfect, but several seem to come close to being so..
Some financial markets may also have another very desirable characteristic: The prices of financial instruments may accurately reflect their inherent value and fully reflect all available information. Moreover, a new information supplied to the market may quickly be impounded in a new set of prices. A market in which prices fully reflect the latest available information is an efficient market. In an efficient market, no information that might affect security prices or interest rates is wasted. Thus, no buyer or seller can expect to reap excess profits from collecting information that is readily available in the marketplace and then trading on the basis of that information. Numerous studies of the financial markets spanning decades suggest that they approach fairly financial closely the ideal of a perfect and an efficient marketplace.
iv. Financial Markets in the Real World: Imperfection and Asymmetry
Unfortunately, as nearly perfect and efficient as many financial markets are, there is still a great deal that is imperfect in our financial system. Not all financial service markets are fully competitive, and collusion to fix prices and interest rates does occur.
We now realize that not all the information needed by purchasers of financial services is readily or cheaply available all over the world. Increasingly, we are coming to an awareness of the importance of asymmetric information in our global financial system-that is, different participants in the financial markets often operate with different sets of information, some possessing special or inside information that others do not possess. The result is that some market players may be able to earn excess profits by taking advantage of the special information they possess.
3. Financial assets, money, and financial transactions in the global financial system
a. The Creation of Financial Assets
What is a financial asset? It is a claim against the income or wealth of a business firm, household, or unit of government, represented usually by a certificate, receipt, computer record file, or other legal document, and usually created by or related to the lending of money. Familiar examples include stocks, bonds, insurance policies, futures contracts, and deposits held in a bank or credit union.
b. Characteristics of Financial Assets
Different Kinds of Financial Assets:
(1) Money--A financial asset that serves as a medium of exchange and standard of value for purchases of goods and services.
(2) Equities--Shares of common or preferred stock, with each share representing a certificate of ownership in a business corporation.
(3) Debt securities--Financial claims against the assets of a business firm, individual, or a unit of government, represented by bonds or other contracts evidencing a loan of money.
(4) Derivatives--Financial instruments, such as swaps, futures, and options, whose value depends upon an underlying financial instrument such as stock or bond.
The Creation Process for Financial Assets
Financial assets arise in the process of borrowing and lending money, or are related to such processes, e.g., derivatives. Any time funds are borrowed (or stock is issued) a financial asset is created which represents a claim against the future earnings or wealth of the borrowing unit. Since borrowing always gives rise to both a financial asset and a liability of equal amount, it follows that the volume of financial assets created and outstanding must also equal the volume of liabilities created or outstanding.
Assets represent accumulated uses of funds made by an economic unit; liabilities and net worth represent the accumulated sources of funds that an economic unit has drawn upon to acquire the assets it now holds. A balance sheet must always balance.
Total assets = Total liabilities + Net worth.
Internal Financing versus External Financing
Internal financing = Use of saving by an economic unit, rather than debt, to support the acquisition of real or financial assets.
External financing = Use of debt or equities to support the acquisition of real or financial assets.
c. Financial Assets and the Global Financial System
Equality of Financial Assets and Liabilities
Volume of financial assets created for lenders = volume of liabilities issued by borrowers
Example: A bank's loan of $4000 = a borrower's IOU of $4000
Other Basic Identities in the Financial System: Borrowing and Lending, Saving and Investment
Total uses of funds = Total sources of funds
Total assets = Total liabilities + Net worth
Real assets + financial assets = Total liabilities + Net worth
For the economy and the financial system as a whole,
Total financial assets = Total liabilities
Total real assets = Net worth (accumulated savings)
Role of the Financial System in Channeling Savings into Investment Spending to Accelerate Economic Growth
The financial system provides the essential channel necessary for the creation and exchange of financial assets between savers and borrowers so that real assets can be acquired. Without that channel for savings, the total volume of investment in the economy surely would be reduced. All investment by individual economic units would have to depend on the ability of those same units to save (i.e., engage in internal financing). Many promising investment opportunities would have to be forgone or postponed due to insufficient savings. Society's scarce resources would be allocated less efficiently than is possible with a system of financial markets. Growth in society's income, employment, and standard of living would be seriously impaired without a vibrant financial system at work.
d. Lending and Borrowing in the Financial System
Different Economic Units Active in the Financial System:
(1) Deficit -Budget units (net borrowers of funds)
(2) Surplus -Budget units (net lenders of funds)
(3) Balanced Budget units.
The financial system must conform to the following identity:
Current income receipts - Expenditures out of current income =
Change in holdings of financial assets - Change in debt and equity outstanding
R - E =
FA
D
-D
D
Deficit-budget unit (net borrower of funds) E > R; and so
D
D
>FA
D
Surplus-budget unit (net lender of funds) R > E; and so
FA
D
>D
D
Balanced-budget unit R = E; and, therefore
D
D
=FA
D
(neither net lender nor net borrower)
Major Contribution of the Financial System--Makes possible continual shifting of units and sectors between net borrowers and net Lenders of funds
e. Money as a Financial Asset
i. What is money?
The most important financial asset in the economy is money---0ne of the oldest and most useful inventions in the history of the world. Money is anything that is readily accepted to buy goods and services and to payoff debts. Metallic coins served as money for many centuries until paper notes (currency) first appeared in China during the Tang Dynasty over a thousand years ago (618-907 A.D.) and in Sweden in 1661. The Federal Government of the United States did not issue paper money until 1861 in the form of notes known as "green- backs" because of the green ink showing on the back of each note. Many other assets besides currency and coin have served as money in earlier periods, including beads, seashells, salt, cigarettes, and even playing cards.
All financial assets are valued in terms of money, and flows of funds between lenders and borrowers occur through the medium of money. Money itself is a true financial asset, because all forms of money in use today are claims against some institution, public or private. For example, one of the largest components of the money supply today is the checking account, which is the debt of a bank. Another important component of the money supply is currency and coin-the pocket money held by the public. The bulk of currency in use today in the United States, for example, consists of Federal Reserve notes, representing debt obligations of the 12 Federal Reserve banks. In fact, if the Federal Reserve ever closed its doors (a highly unlikely event!), Federal Reserve notes held by the public would be a first claim against the assets of the Federal Reserve banks.
Other forms of money gaining in popularity include credit and debit cards to allow instant borrowing or the withdrawal of funds from a bank deposit; stored-value ("smart") cards that are encoded via computer with a fixed amount of money available for spending; and digital cash available through the Internet computer network from a variety of financial service providers. Some concepts of what money is today include savings accounts at banks, credit unions, and money market funds-all forms of debt, giving rise to financial assets.
ii. Functions of Money
Money performs four important functions:
1. Medium of Exchange--An attribute of money that permits it to be used as a means of payments
2. Standard of Value--unit of account: An attribute of money that permits it to be used as a measure of the value of goods, services, and financial assets
3. Store of Value--A way to transport purchasing power from one period to the next
4. Standard of deferred payment--An attribute of money that permits it to be used as a means of valuing future receipts in loan contracts
iii. Money, barter, and the double coincidence of wants
Barter = The direct exchange of one good for another without the use of money
Barter requires the "double coincidence" of wants"--Two individuals coincidentally would have to be willing and able to make a trade.
Money eliminates this requirement.
iv. Alternative Definitions of Money (M1, M2, M3, and L)
Money performs several important functions in the financial system, serving as a medium of exchange, a store of value (purchasing power), a standard for valuing goods and services (unit of account), and a source of liquidity (spending power). These different functions of money in the financial system have given rise to a variety of different definitions of the actual money supply available to the public, with each definition reflecting a different role or function that money performs for those who hold it. For example, in the United States the principal definitions of money in use today are:
MI = The sum of all U.S. currency and coin held by the public (outside the cash in the vaults of the U.S. Treasury, the Federal Reserve banks, and depository institutions), travelers checks issued by nonbank financial institutions, and checking accounts (demand deposits), NOW accounts, and Automatic Transfer Services at all commercial (banks, credit unions, and thrift institutions (except for interbank, U.S. government, and foreign bank deposits and Federal Reserve float).
M2 = The sum of MI plus small savings and time deposits (under $100,000 each in amount), balances held in general-purpose and broker-dealer money market fund accounts, short-term repurchase agreements (bearing overnight maturities and continuing contracts that can be canceled with 24-hours notice) issued by depository institutions, and overnight foreign U.S. dollar deposits (Eurodollar) issued to U.S. residents by foreign branches of U.S. banks worldwide.
M3 = The sum ofM2 plus large time deposits (each over $100,000 in amount) and longer-term repurchase agreements issued by all depository institutions, longer-term foreign U.S. dollar deposits (Eurodollars) held by U.S. residents at foreign branches of U .S. banks worldwide and at all banking offices in the United Kingdom and Canada, and balances in institution-only money " market funds.
L = The sum of the components ofM3 plus the nonbank public's holdings of U.S. savings bonds, short-term U.S. Treasury securities, commercial paper, and bankers' acceptances net of money market fund holdings of these assets.
Note that M1, the narrowest definition of the supply of money or money stock, focuses mainly upon immediately spendable money (such as pocket change and checking accounts) and, therefore, views money primarily as a medium of exchange.
In contrast, M2 and M3 reflect mainly money's store of value role as captured by savings accounts, money market fund shares, and short-term borrowing in the money market by depository institutions.
The L (liquidity) definition of the money stock reflects both the store of value idea and the near-money assets held by the public that can be quickly converted (liquidated) into spendable cash, such as U.S. savings bonds and other shorter-term negotiable securities. No single definition of money is necessarily "right" or "wrong." Each reflects a different dimension of money's function as an important financial asset in the economy.
f. The Evolution of Financial Transactions
i. Evolution of Global Financial System Toward More Complex Financial Transactions
ii. Direct finance, Semi-direct finance, Indirect finance, Financial intermediation
When individual savers allocate some of their savings to business by purchasing a corporate bond, they effectively make a direct loan to the business. They assist in the direct finance of the capital investment that the business desires.
Direct finance = Any financial transaction in which a borrower and a lender of funds communicate directly and mutually agree on the terms of a loan, without the aid of a third party.
Limitations: There must be a coincidence of wants between surplus-and-deficit budget units in terms of the amount and form of a loan; high information costs simply to find each other.
But the process of financing is not always direct. Early in the history of most financial systems, a new form of financial transaction called semidirect finance appears. Semi-direct finance refers to any transaction (especially borrowing and lending of money) that is assisted by a security broker or dealer. Semi-direct is an improvement over direct finance in a number of ways. It lowers the search (information) costs for participants in the financial markets.
Limitations: The ultimate lender still winds up holding the borrower's securities, and therefore, the lender must be willing to accept the risk and maturity characteristics of the borrower's IOU. There still must be a fundamental coincidence of wants and needs between surplus-and-deficit budgeted units for semi-direct transactions to take place.
The limitations of both direct and semi-direct finance stimulated the development of indirect finance carried out with the help of financial intermediaries. Indirect finance is also known as financial intermediation, in which financial institutions are carried on through a financial intermediary.
Consider what happens if a saver purchases a long-term time deposit issued by a banking firm. The bank, in turn, may use these funds, together with those of the other holders, to buy corporate bonds issued by the same business. In this instance, the saver has indirectly financed business capital investment. The bank has intermediated the financing of the investment. This process of indirect finance, which is the most common way in which funds are channeled from saving to investment, is financial intermediation. Institutions that serve as middlemen in this process are financial intermediaries. The intermediaries exist solely to take funds of savers and redistribute those funds to the ultimate borrowers.
iii. Advantages of intermediation
Asymmetric Information
Adverse selection
Moral hazard
Transaction costs and (financial) economies of scale
Asymmetric information
Why should savers wish to channel their funds through some other institution instead of lending them directly? Most economists agree that one key reason is the presence of asymmetric information in financial markets.
Asymmetric information = Possession of information by one party in a financial transaction but not by the other party.
For example, a borrower who takes out a loan usually has better information about the potential returns and risks associated with the investment projects for which the funds are earmarked than the lender does. Lack of information (Asymmetric information ) creates problems in the financial system on two fronts:
Before the transaction is entered (adverse selection) and after (moral hazard).
(1) Adverse selection
Adverse selection is the problem created by asymmetric information before the transaction occurs. It is defined as the likelihood that those who desire to issue financial instruments have in mind using the funds they receive for unworthy, high risk projects. The tendency for those who desire funds for unworthy projects to be the most likely to want to borrow or to issue debt instruments. The existence of such poor quality instruments can make people less willing to lend or to hold debt instruments issued by those seeking to finance high-quality projects.
Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome-the bad-credit risks-are the ones who most actively seek out a loan and are thus most likely to be selected.
Because adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though they are some good-credit risks in the marketplace.
(2) Moral hazard
Moral hazard is the problem created by asymmetric information after the transaction occurs. It is defined as the possibility that a borrower might engage in more risky behavior after a loan has been made. That is, after the financial market transaction has been made, the borrower might increase the riskiness of the instrument the lender holds, thereby acting "immorally" from the perspective of the lender.
Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender's point of view because they make it less likely that the loan will be repaid.
Because moral hazard lowers the probability that the loan will be repaid, lenders may decide they would rather not make the loan.
Transaction cost and economies of scale
Another reason why financial intermediaries exist is because of economies of scale = the reduction that can be achieved in the average cost of managing funds by pooling savings together and spreading the management costs across many savers.
Transaction costs, the time and money spent in carrying out financial transactions, are a major problem for people who have excess of funds to lend. Financial intermediaries can substantially reduce transaction costs because they have developed the expertise in lowering them and because their sizes allow them to take advantage of the economies of scale, the reduction in transaction costs per dollar of transactions as the size (scale) of transaction increases. For example, a bank knows how to hire a good lawyer to produce a loan contract, and this contract can be used over and over again in its loan transactions, thus reducing the legal cost per transaction.
Because financial intermediaries are able to reduce transaction costs substantially, they make it possible for you to provide funds indirectly to people with productive investment opportunities.
In addition, a financial intermediary's low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions. For example, banks provide depositors with checking accounts that enable them to pay their bills easily.
The problems created by adverse selection and moral hazard are important impediment to well-functioning financial markets. Again, financial intermediaries can alleviate these problems. With financial intermediaries in the economy, small savers can provide their funds to the financial markets by lending these funds to a trustworthy intermediary (say Fleet), which in turn lends the funds out either by making loans or by buying securities such as stocks or bonds.
Successful financial intermediaries have higher earnings on their investments because they are better equipped than individuals to screen out good from bad credit risks, thereby reducing losses due to adverse selection.
In addition, financial intermediaries have earnings because they develop expertise in monitoring the parties they lend to, thus reducing the losses due to moral hazard. The result is that financial intermediaries an afford to pay lender-savers interest or provide substantial services and still earn a profit.
The success of financial intermediaries is evidenced by the fact that most Americans invest their savings with them and also obtain their loans from them. Financial intermediaries play a key role in improving efficiency because they help financial markets channel funds from lender-savers to people with productive investment opportunities. Without a well-functioning set of financial intermediaries, it is very hard for an economy to reach its potential.
iv. Major financial institutions active in the money and capital markets
(See Exhibits)
v. Disintermediation
Disintennediation is the withdrawal of funds from financial intermediaries by savers and the placement of those funds into financial assets through direct and semi-direct financial transactions. It generally occurs during periods of high and rapidly rising interest rates when financial intermediaries often cannot compete effectively with yields on securities sold in the open market.
Deregulation of deposit interest rates has reduced the severity of the problem because no matter how high interest rates rise depository institutions can compete. Recently many forms of disintermediation .have appeared in the form of loan sales by intermediaries which reduce their total assets and raise more capital and in the guise of corporations and other large borrowers avoiding borrowing from financial intermediaries in favor of selling securities directly in the open market, thus substituting direct and semi-direct finance for indirect finance (financial intermediation).
4. Sources of information for financial decision-making
a. Types of financial decisions by lenders, borrowers, investors and government and the need of information
Every day in the money and capital markets, individuals and institutions must make important financial decisions. For those who plan to borrow, for example, key decisions must be made concerning the timing of a request for credit and exactly where the necessary funds should be raised. Lenders of funds must make decisions on when and where to invest' their limited resources, considering such factors as the risk and expected return on loans, and securities available in the financial marketplace. Government policymakers also are intimately involved in the financial decision-making process. It is the responsibility of government to ensure that the financial markets function smoothly in channeling savings into investment and in creating a volume of credit sufficient to support business and commerce.
Sound financial decisions require adequate and accurate financial information . Borrowers, lenders, and those who make financial policy require data on the prices and yields attached to individual loans and securities today and the prices and yields likely to prevail in the future. A borrower, for example, may decide to postpone taking out a loan if it appears that the cost of credit will be significantly lower six months from now than it is to- day. Those who wish to attempt a forecast of future interest rates and security prices need information concerning the expected supply of new securities brought to market and the expected demand for those securities. Because economic conditions exert a profound impact on the money and capital markets, the financial decision-maker must also be aware of economic data series that reflect trends in employment, prices, and related types of information.
What are the principal sources of financial information? Where do financial decision makers go to find the data they need? We may divide the sources of information relied on by financial decision makers into five broad groups: (1) debt security prices and yields, (2) stock prices and dividend yields, (3) information on security issuers, (4) general economic and financial conditions, and (5) social accounting data. In this section, we will discuss the most important sources of each of these different kinds of information;
b. Efficient markets and asymmetric information
Before we examine the principal sources of information available to financial market participants, however, we need to be aware of a great debate going on in the fields of finance today concerning the availability and cost of information. One view, referred to as the efficient markets hypothesis (EMH), contends that information relevant to the pricing of loans, securities, and other financial assets is readily available to all borrowers and lenders at negligible costs.
The other view, called asymmetry or the concept of asymmetric information, argues that the financial marketplace contains pockets of inefficiency in the availability and use of information.
(1) The Efficient Markets Hypothesis (EMH)
The efficient markets hypothesis (hereafter EMH) suggests that all information that has a bearing on the value of stocks, bonds, and other financial assets will be used to value (price) those assets. The EMH contends that information relevant to the pricing (valuation) of loans, securities, and other financial assets is readily available to all borrowers and lenders at negligible cost. An efficient market simply does not waste information. Under the terms of the EMH, the money and capital markets will not consistently ignore information that can earn profits, so there won't be any profitable trades that are not made (at least not for very long).
Because all of the information available has been used to establish the value of financial instruments, no single user of that same information can earn "excess returns" by trading on information available to all interested investors. Rather, in an efficient marketplace, each financial asset will generate an "ordinary" or "normal" rate of return commensurate with its level of risk. And the returns on all securities and portfolios should lie along the security market line (SML).
CAPM and the Security Market Line
Under the terms of the widely accepted capital asset pricing model (CAPM), the expected return on a financial asset will be:
)
(
i
R
E
=f
r
+i
b
EMBED Equation.3)
)
(
(
f
M
r
R
E
-
)
(
i
R
E
= expected return on ith asset
)
(
M
R
E
= expected return on market's entire collection of financial asset (the whole market portfolio or M)
f
r
= risk-free interest rate (often approximated by the return on government bonds)
i
b
= a measure of an individual asset's or portfolio of asset's risk exposure compared to the risk exposure of the whole market portfolio.
i
b
= Cov(i
R
,M
R
)/Var(M
R
)
i
b
=r
(i
R
,M
R
).j
R
s
.M
R
s
/2
M
R
s
r
= correlation
s
=standard deviation
2
s
=variance
i
b
EMBED Equation.3)
)
(
(
f
M
r
R
E
-
measures the risk premium-the reward for risk-taking- that will be demanded by investors in the money and capital markets before they are willing to buy and hold a risky asset or portfolio of risky assets (such as corporate bonds or stocks) instead of holding a risk-free asset (such as a government bond). The risk premium is the product of the financial marketplace's reward for each unit of risk accepted by an investor. The line or curve for the CAPM model is called the security market line (SML).Beta (
b
) is an index of risk of an individual asset or portfolio of assets relative to the risk of the whole market's portfolio of assets.Under the terms of the EMH, the returns on all securities and portfolios should lie along the SML. If the EMH is correct, any temporary deviation of actual returns from expected returns lying along the SML (i.e., excess positive or excess negative returns) should be quickly eliminated as investors react to temporarily underpricing (when an asset's actual retun rises above its expected return along the SML) or temporary overpricing of assets (when an asset's actual return falls below its expected return on the SML) and make changes in their asset portfolios.
The essential contribution that the EMH makes to our understanding of the money and capital markets is to suggest that current prices of all financial assets represent the optimal use of available information.
Different form of the EMH . In recent years, the EMH has been split into three different versions based on what each assumes to be true about the availability and cost of information
· Weak form of the EMH, argues that the current prices of financial assets contain all information that buyers and sellers have been able to obtain on the past trading of those assets: their price history and past volume of trading. Moreover, this past price and trading information is publicly available and of negligible cost to obtain. No one buyer or seller of stocks, bonds, or other financial assets can earn excess profits beyond those that are normal for the amount of risk taken on from trading on this historical price and volume information. If this were not true, investors would have figured out long ago how to profit from such historical data and asset prices would have been adjusted accordingly, eliminating further opportunities for exceptional returns.
· Semistrong form of the EMH, contends that the current prices of stocks, bonds, and other financial assets already reflect all publicly available information affecting the value of these financial instruments, including information about past prices and volume, the financial condition and credit rating of each issuer, any published forecasts, the condition of the economy, and all other relevant information. All buyers and sellers are rational and use all publicly available information to help them value financial assets. No one buyer or seller will, therefore, find opportunities for exceptional profits by trading on any publicly available information.
· Strong form of the EMH; which argues that the current prices of financial assets capture all the information-both public and private-that is relevant to the value of those financial instruments. This includes the information possessed by "insiders," such as the officers, directors, and principal owners of a corporation issuing stocks and bonds or even accountants, attorneys, or journalists who work with the company and have access to its privileged information.
(2) The Concept of Asymmetric Information
What if all relevant information about the true value of financial assets is not readily available or costless to obtain? What would happen if some important information pertinent to decision making were distributed asymmetrically so that deep pockets of special knowledge existed in the financial marketplace?
The asymmetric view says that there are pockets of special information-a "lumpiness" in the supply of relevant information about financial assets. These pockets may include corporate insiders, journalists, security dealers, and financial analysts who possess unique analytical skills in spotting profitable trades. These possessors of special knowledge need not be operating illegally. Indeed, they may come by their unique talents in assessing value and risk through rigorous schooling and on-the-job training or by virtue of the special location they occupy within the financial system. Every year hundreds of corporations flock to college campuses to hire graduates whom they believe have the potential to become expert judges of the quality of financial assets.
Information asymmetries exist when there are pockets of information available to particular investors. These investors can earn excess profits by using this information, which is costly for others to obtain.
When information asymmetries exist, both the quality and quantity of information may vary.
Problems Information Asymmetries Can Create:
Lemon and plums
The "lemons problem" exists when buyers and sellers have different information sets. For example, the used car seller has more information than the buyer; and the bank borrower has more information than the loan officer. High quality participants may be driven from the market because prices rise to compensate the party with less information.
The Problem of Adverse Selection
Adverse selection resolves around differences in the risk presented by different groups of customers who want to enter into contracts with financial institutions. In this case, information asymmetry exists before the parties to a contract reach an agreement. When an asymmetrical distribution of information is already present, it can drastically alter the nature of contracts that a business firm is willing to write in order to serve its customers.
Adverse selection exists when more costly market participants choose one financial-service firm for the services they need, while less costly market participants choose another whose prices are more in line with their expectations. Securities regulations are one mechanism for addressing information asymmetries.
The concept of moral hazard
Moral hazard is the problem created by asymmetric information after the transaction occurs. It concerns the risk that one party to a transaction will engage in behavior that is undesirable from the other party's point of view. It also occurs when one party to an agreement or relationship uses their position of power or special knowledge to pursue their own self-interest and receives special benefits or rewards at the expense of the other party to the agreement or relationship.
Asymmetry, Efficiency, and Real-World Markets
No market in the real world in which we live is either completely efficient or completely asymmetric.
Possible Remedies for Informational Asymmetries
(One way to deal with market asymmetries is to pass laws and regulations designed to improve the flow of information between buyers and sellers and to protect the public against lying and deception in trading and valuing financial assets. For example, in 1933 the United States passed the Securities Act, requiring companies selling securities across state lines to submit a prospectus to a federal agency, the Securities and Exchange Commission (SEC), giving detailed economic and financial information on the firm's condition and prospects.
b. Major sources of financial information
If you need to gather information for a possible stock or bond purchase, where would you look? What information is available on the financial conditions of major U.S. companies?
Information exists on the history of each firm, its recent acquisitions/mergers, recent financial statements, stock prices, dividend yields, and ratings of corporations. Security price information can be gathered from numerous sources, including the Wall Street Journal, Value Line, and S&P Stock Reports. The Moody's Manuals (industrial, banking and finance, utility, transportation, and government) provide individual-firm financial data and histories. These sources can be supplemented with data from SEC 10-K Reports.
Information on debt prices and yields:
Wall Street Journal, Daily Bond Buyer, Commercial and Financial Chronicle, Federal Reserve Bulletin, Survey of Current Business.
Information on stock prices and dividend yields
Wall Street Journal, Value Line, 3-Trend Security, Charts and Cycli-Graphs, S&P's Stock Reports, S&P's Daily Stock Price Record, S&P's Stock Series.
Information on security issuers
Moody's Industrial Manual, Bank and Manual, Public Utility Manual, Transportation Manual and Municipal and Government Manual, Moody's Bond Report, Troy's Almanach, Robert Morris & Associates Annual Statement Studies, Standard and Poor's Industrial Surveys, Analysts Handbook.
Information on general and financial conditions
Federal Reserve Bulletin, U.S. Financial Data, Monetary trends, National Economic Trends, Survey of Current Business, Wall Street Journal.
d. Social accounting
Social accounting is a system of record keeping that reports transactions between the principal sectors of the economy (households, business firms, financial intermediaries, government agencies).
National Income Accounts (NIA)
NIA, a system of social accounts compiled and issued quarterly by the U.S. Department of Commerce, presents data on the nation's production, income flows, investment spending, consumption, and total savings.
NIA provides extensive information on the level and growth of the nation's economic activity, but little data on financial transactions or about what goes on in the money and capital markets.
The Flow of Funds Account (FFA)
FFA, a system of social accounts prepared quarterly by the Board of Governors of the Federal Reserve System, provide data on financial transactions between economic sectors. FFA traces the flow of savings into purchases of financial assets, shows how different sectors relate to, and interact with each other; and highlights the interconnections between the financial sector and the rest of the economy.
How the Flow of Funds Accounts Are Constructed
Construction of the Flow of Funds Account takes place in four basic steps:
(1) Sectoring the economy: divide economy into broad sectors (12 major sectors). Construct balance sheets for each sector
The data needed to construct sector balance sheets in the FFA come from a wide variety of public and private sources. For example, information on lending, borrowing and acquisitions of securities by non-financial businesses is derived from such sources as the Securities and Exchange Commission (SEC) and the U.S. Department of Commerce. Various trade groups provide financial data on their respective industries, and the Securities Industry Association provides selected information on gross offerings of securities.
(2) Prepare sources and uses of funds statements
The sources and uses of funds statement shows changes in net worth and changes in holdings of financial assets, real assets, and liabilities from each sector. These are arranged as follows:
Sources and Uses of Funds Statement
Use of funds Sources of funds
Change in financial assets Change in liabilities
Change in real assets Change in net worth
= Change in total assets = Change in liabilities and net worth
= Total uses of funds = Total sources of funds
Balancing out a Sources and Uses of Funds Statements
Net Investment in + Net Acquisitions of =Net Increase in + Change in
Plant and Equipment Financial Assets Liabilities Current surplus Account
Real Investment + Financial Investment = Current Borrowing + Current Saving
(Change in net worth)
Net Real Investment + Net Financial Investment = Net Borrowing + Net Current Saving
Total uses of funds = Total sources of funds
(3) Construct a Flow of Funds Matrix for the economy as a whole
The flow of funds matrix reminds us that, for all sectors of the economy combined into one, the amount of savings must equal the total amount of real investment in the economy, and the amount of borrowing in total must equal total financial investment.
Limitations and Uses of the Flow of Funds Accounts
The FFA contains several important limitations. They are based upon many estimates due to information and reporting gaps, do not reflect financial transactions between units occupying the same sector (intra sector transactions), rest upon market values of financial assets and liabilities which tends to distort the actual amount of savings flows in the economy, and typically contain large statistical discrepancies.
Because of these and other limitations in the FFA, we must be cautious in reading, interpreting, and using the figures generated when these accounts are constructed each quarter of the year.
PAGE
1
