overview of the Financial System Chapter 2 monerary.pptx

Monetary economics Chapter 2: An overview of the Financial System

1. Chapter 2: Overview Of The Financial System Chapter objectives Assessing major functions of financial markets as well as how these markets are regulated. Structure of financial markets Financial intermediaries and their functions, Transaction costs, Asymmetric information, Moral hazard Interest rates and their measurements

2. Overview Of The Financial System…… Financial system is a system that allows the exchange of funds between lenders, financial intermediary and borrowers. Financial markets perform the essential economic function of channeling funds from people who have saved surplus funds by spending less than their income to people who have a shortage of funds because they wish to spend more than their income. This function is shown schematically below Those who have saved and are lending funds, the lender-savers, are at the left, and those who must borrow funds to finance their spending, the spending, borrower-spends, at the right.

3. Overview Of The Financial System…..

4. Overview Of The Financial System……. In a given economy the principal lenders – savers are households. But business enterprises and the government as well as foreigners and their government, sometimes also find themselves with excess funds and so lend them out. The most important borrower – spenders are businesses and the government but household and foreigners also borrow to finance their purchases especially of consumer durables.

5. Overview Of The Financial System….. Direct finance refers to funds that flow directly from the lender/saver to the borrowers/investors in financial market. Securities are assets for the person who buys them but liabilities (debts) for the individuals or firms who sell (issue) them. Examples of direct finance include when a person take a loan from his friend, or a corporation issues new shares of stock or bonds.

6. Overview Of The Financial System….. Indirect finance refers to funds that flow from the lender/saver to a financial intermediary who then channels the funds to the borrower/investor. It is the process of obtaining or investing funds through third-party institutions like banks and mutual funds. Financial intermediaries (indirect finance) are the major source of funds for corporations. Why channeling of funds from savers to spenders so important to the economy?

7. Overview Of The Financial System….. Suppose that you have saved Birr 1000 this year, but no borrowing or lending is possible because there are no financial markets. If you do not have an investment opportunity that will permit you to earn income with your savings, you will just hold on to the Birr 1000 and will earn no interest. However, another person- a carpenter has a productive use for your 1000 Birr: He can use it to purchase a new tool that will shorten the time it takes him to build a house

8.  2.1.1. STRUCTURE OF FINANCIAL MARKETS Now that we understand the basic function of financial markets, let's look at the structure. The following descriptions of several categorizations of financial markets illustrate essential features of these markets.

9.  A. Debt and Equity Markets A firm or an individual can obtain funds in a financial market, in two ways. The most common method is to issue a debt instrument, such as a bond or a mortgage. Contractual agreement by the borrower to pay the holder of instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made.

10.  A. Debt Vs Equity Markets….. The second method of raising funds is by issuing equities, such as common stock, which are claims to share in the net income (income after expenses - taxes) and the assets of a business. Equities usually make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date.

11.  A. Debt Vs Equity Markets….. The main disadvantage of owning a corporation's equities is that an equity holder is a residual claimant. Corporation must pay all its debt holders before it pays its equity holders. The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset value. Debt holders do not share in this benefit because their dollar payments are fixed.

12. B. Primary Vs Secondary Markets The A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds. A secondary market is a financial market in which securities that have been previously issued can be resold. An important financial institution that assists in the initial sale of securities in the primary market is the investment bank.

13. B. Primary Vs Secondary Markets…… Broker is an agent or an investment advisor associated with a firm who matches buyers with sellers of securities. The broker does not own the securities but acts as an agent for the buyer and seller and charges a commission for these services. A dealer is a securities firm links buyers and sellers by buying and selling securities for its own account at stated prices and at its own risk.

14. A. Primary Vs Secondary Markets…… S econdary markets has two important functions First they make the financial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the primary market. Second, they determine the price of the security that the issuing firm sells in the primary market.

15. C. Exchanges and Over-the-Counter (OTC) Markets Secondary markets can be organized in two ways. Exchange is a marketplace where buyers and sellers of securities (or their agents or brokers) meet in one central location to buy and sell stocks of publicly traded companies. Examples of exchanges include New York Stock Exchange, London Stock Exchange

16. C. Exchanges and Over-the-Counter (OTC) Markets….. Over-the-counter (OTC) market is a market in which dealers at different locations trade via computer and telephone networks. Dealers who have an inventory of securities are ready to buy and sell securities “over-the-counter” for their own account to anyone who comes to them and willing to accept their prices.

17. D . Money and Capital Markets The money market is a financial market in which only short-term instruments (maturity of less one year) are traded. The capital market is the market in which longer-term debt (maturity of one year or greater) and equity Instruments are traded. Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid

18.   2.1.2. Function of Financial Intermediaries In indirect finance channel financial intermediary does this by borrowing funds from the lender-savers and then uses these funds to make loans to borrower-spenders. For example, a bank might acquire funds by issuing a liability to the public in the form of savings deposits. It will then use the funds to acquire an asset by making a loan to a business firm or investor who needs fund.

19.   2.1.2. Function of Financial Intermediaries…. Financial intermediaries are a far more important source of financing for corporations than securities markets are. Why are financial intermediaries and indirect finance so important in financial markets? To answer this question, we need to understand the role of transaction costs and asymmetric information in financial markets

20.   Transaction costs Transaction costs, the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend. We will reconsider the example we has earlier in this chapter: the Carpenter needs Birr 1000 for his new tool, and you know that it is an excellent investment opportunity. You have the cash and would like to lend him the money, but to protect your investment

21.   Transaction costs… You have to hire a lawyer to write up the loan contract that specifies how much interest he will pay you, when he will make these interest payments, and when he will repay you the 1000. Suppose, obtaining the contract costs 200. When you consider the transaction cost for making the loan, you realize that you can't earn enough from the deal (you spend 200 to make perhaps 100) and reluctantly tell the carpenter that he will have to look elsewhere.

22.   Transaction costs… Financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them Their large size allows them to take advantage of economies of scale , the reduction in transaction costs per dollar of transactions as the size (scale) of transactions increases. For example, a bank knows how to find a good lawyer to produce a loan contract, and this contract can be used

23.   Asymmetric Information Asymmetric Information: An additional reason is that in financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. For example, a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment projects for which the funds are earmarked than the lender does.

24.   Asymmetric Information Lack of information creates problems in the financial system on two fronts: before the transaction is made ( adverse selection ) and after the transaction ( moral hazard ).

25.   Asymmetric Information Adverse selection is the problem created by asymmetric information before the transaction occurs. 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

26.   Asymmetric Information….. Lenders may decide not to make any loans even though there are good borrowers (credit worthy borrowers) in the marketplace. The bad borrowers are usually those who will invest their money in a very profitable but risk investment area. If their investment happens to be a success they will enjoy huge profit and will pay back their loan with the predetermined return (interest) and if they do not success and got bankrupt they know that they will not pay anything

27. Moral hazard Moral hazard is the problem created by asymmetric information after the transaction occurs. 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 paid back. Normally when a loan contract is made the borrower will promise to repay the amount with some extra return.

28. Moral hazard…… Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan. undesirable investment.

29.  2.2 Financial Market Instruments A financial instrument is a written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under specified conditions. A financial instrument is a financial asset for the person who buys or holds one, and it is a financial liability for the company or institution that issues it. To discuss financial market instruments we focus on the instruments traded in the money market and the capital market.

30. Capital Market Instruments Capital market instruments are debt and equity instruments with maturities of greater than a year Stock: Stocks are equity claims -represented by shares- on the net income and assets of a corporation . Mortgages :Mortgages are loans to individuals or firms to purchase houses, land, or other real structure The structure or land serves as collateral for the loans.

31. Capital Market Instruments…… 3. Corporate Bonds: Intermediate and long-term debt issued by corporations with strong credit ratings to raise capital. They pay the holder an interest payment in regular intervals and pays off the face value when bond matures Corporate bonds often offer somewhat higher yields than Treasury bonds.

32. Capital Market Instruments…… 4. Convertible Bonds: They are bonds that allow the holder to convert them into a specified number of shares of stock at any time up to the maturity date. This feature makes them more desirable to prospective purchasers than bond without it and allows the corporation to reduce its interest payments.

33. Money Market Instruments All of the money market instruments are, by definition, short-term debt instruments, with maturities less than one year. Because of their short terms to maturity, the debt instruments traded in the money market undergo the least price fluctuations and so is the least risky investment. The main types of money market instruments include

34. Money Market Instruments Treasury Bill : Short-term debt issued by government to help finance its current and past deficits. Pay a fixed amount at maturity. Pay no interest but they are sold at a price lower than their face value. The most liquid instruments in the money market, and they are the most actively traded. Example A Treasury bill that pays off $1000 at maturity 6 months from now sells for $950 today. The $50 difference between the purchase price and the amount paid at maturity is the interest on the loan.

35. Money Market Instruments….. Negotiable Bank Certificates of Deposit (CDs) A certificate of deposit (CD) is a debt instrument that is issued by a commercial bank against money deposited with it for a specific period of time, usually at a specific rate of interest, with a penalty for early withdrawal. Make regular interest payments until maturity. At maturity, return the original purchase price (the principal). Negotiable CDs means CDs that are traded in the secondary markets .

36. Money Market Instruments….. Commercial Paper: Commercial Papers are unsecured short-term debt instruments (obligations) issued by large banks and well-known corporations with high credit ratings, such as Microsoft and General Motors. The investment in commercial Papers is usually relatively low risk. The holding period is usually very short, and corporation agrees to pay the money back even earlier ("on demand"), if asked. They can be either discounted or interest-bearing, They usually have a limited or nonexistent secondary market. They are available in a wide range of denominations.

37. 2.3. Types of Financial Intermediaries They fall into three categories: depository institutions (banks), contractual savings insti1utions, and investment intermediaries. 2.3.1 Depository institutions: Depository institutions are financial intermediaries that accept deposits from individuals and institutions and make loans. These intuitions include commercial banks and the so-called thrift institutions (thrift): savings and loan associations, mutual savings banks, and credit unions.

38. 2.3.1 Depository institutions… a) Commercial Banks: Are known to be the most dominant depository institutions. Serve surplus units by offering a wide variety of deposit account Transfer deposited funds to deficit units through providing direct loans or purchasing debt securities; Their deposit and lending services are utilized by households, business firms and government agencies. Thus, serve both the private and the public sectors

39. 2.3.1 Depository institutions… B) Saving Institutions (thrift institutions) Like commercial banks they rely on federal fund market to lend their excess funds or to borrow funds on short-term basis; Includes saving and loan associations (S&LAs) and saving banks Like commercial banks, these offer deposit accounts to surplus units and then channel these deposits to deficit units; Unlike commercial banks (that concentrates on commercial loans only), the S&LAs concentrate on residential mortgage loans; Saving banks have more diversified uses of funds.

40. 2.3.1 Depository institutions… C) Credit Unions Differs from the above two institutions in that they are non-profit, and restrictiveness of their credit to only union members; They are small-sized depository institutes

41. 2.3.2 Contractual Savings Institutions Contractual Savings Institutions, such as insurance companies and pension funds , are financial intermediaries that acquire funds at periodic intervals on a contractual basis. Because they can predict with reasonable accuracy how much they will have to pay out in benefit in the coming years, they do not have to worry as much as depository institutions about losing funds.

42. 2.3.2 Contractual Savings Institutions As a result, the liquidity of assets is not as important a consideration for them as it is for depository institutions, and they tend to invest their funds primarily in long term securities such as corporate bonds, stocks, and mortgages. Insurance Companies : Provide individuals and firms with insurance policies that reduce the financial burden associated with death, illness, and damage to property.

43. 2.3.2 Contractual Savings Institutions…. Insurance Companies They charge premium in exchange for the insurance they provide They also invest the funds (collected in the form of premium) until the funds are required to cover insurance claims. They commonly invest the funds in stock or bonds

44. 2.3.2 Contractual Savings Institutions…. Pension Funds : Private pension funds provide retirement income in the form of annuities to employees who are covered by a pension plan. Funds are acquired by contributions from employers or from employees, who either have a contribution automatically deducted from their paychecks or contribute voluntarily. The largest asset holdings of pension funds are corporate bonds and stocks.

45. 2.3.3 Investment Intermediaries This category of financial intermediaries includes Finance companies , mutual funds and money market mutual funds . Finance Companies: Finance companies raise funds by selling commercial paper (a short-term debt instrument) and by issuing stocks and bonds. They lend these funds to consumers, who make purchases of such items as furniture, automobiles, and home improvements, and to small businesses.

46. 2.3.3 Investment Intermediaries……. Finance Companies: Some finance companies are organized by a parent corporation to help sell its product. For example, Ford Motor Credit Company makes loans to consumers who purchase Ford automobiles.

47. 2.3.3 Investment Intermediaries……. Mutual Funds: These financial intermediaries acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds. Mutual funds allow shareholders to pool their resources so that they can take advantage of lower transaction costs when buying large blocks of stocks or bonds. In addition, mutual funds allow shareholders to hold more diversified portfolios than they otherwise would.

48. 2.3.3 Investment Intermediaries……. Money Market Mutual Funds: These relatively new financial institutions have the characteristics of a mutual fund but also function to some extent as a depository institution because they offer deposit-type accounts. Like most mutual funds, they sell shares to acquire funds that are then used to buy money market instruments that are both safe and very liquid. The interest on these assets is then paid out to the shareholders.

49. 2.3.3 Investment Intermediaries……. Money Market Mutual Funds: A key feature of these funds is that shareholders can write checks against the value of their shareholdings. In effect, shares in a money market mutual fund function like checking account deposits that pay interest.

50. 2.4 Interest rates and their measurement An interest rate is the "rental" price of money. The interest rate is the price paid for the use of money for a period of time. One type of interest rate is the yield on a bond. In a money economy, credit markets will arise because Different households have different personalities-they have different preferences for present versus future consumption Businesses can make investments in plant, equipment and/ or inventory that are profitable enough to enable them to pay back interest

51. Determination of the market rate of interest.. The supply of credit: At higher interest rates more households and businesses will become net lenders. As the rate of interest increases, more households observe a market rate of interest that exceeds their personal trade-off between present and future consumption. The Demand for credit : The community's demand-for-credit curve will negatively sloped; it falls from left to right . As the rate of interest falls , more people prefer to become net borrower .

52. The distinction between real and nominal interest rates What we have up to now been calling the interest rate makes no allowance for inflation, and it is more precisely referred to as the nominal interest rate. which is to distinguish it from the real interest rate, the interest rate that is adjusted for expected changes in the price level so that it more accurately reflects the true cost of borrowings. The real interest rate is more accurately defined by the Fisher equation, named for Irving Fisher, one of the great monetary economists of the twentieth century.

53. The distinction between real and nominal interest rates….. The Fisher equation states that the nominal interest rate i equals the real interest rate i r plus the expected rate of inflation Π e . That is Rearranging terms, we find that the real interest rate equals the nominal interest rate minus the expected inflation rate:

54. The distinction between real and nominal interest rates….. To see why this definition makes sense, let us first consider a situation in which you have made a one-year simple loan with a 5 percent interest rate ( i = 5 percent) and you expect the price level to rise by 3 percent over the course of the year ( П e = 3 percent). As a result of making the loan, at the end of the year you will have 2 percent more in real terms, that is, in terms of real goods and services you can buy

55. The distinction between real and nominal interest rates….. In this case, the interest rate you have earned in terms of real goods and services is 2 percent; that is, i r = 5% - 3% = 2% as indicated by the Fisher definition.