PDF 2004 Ch1 Why study Money, Banking, and FMs

2004

Ch1 Why study Money, Banking, and FMs

Financial markets: markets in which finds are transferred from people and firms who have an excess of available funds to people and firms who have a need of funds

The Bond Market: - A security (financial instrument) is a claim on the issuer's future income or assets - A bond is a debt security that promises to make payments periodically for a specified period of time. Principal is returned to lender at maturity - A bond market enables corporations and governments to borrow money to finance their activities and because it is where interest rates are determined - An interest rate is the cost of borrowing or the price of credit (price paid for the rental of funds) - Affect concumers' willingness to spend or save, and business investment decisions - Eg. High i: high cost of financing which decreases consumption, but more interest income is earned by save more - Eg. High i: causing a corporation to postpone building a new plant that would provide more jobs

The Stock Market: - A common stock represents a share of ownership in a corporation - A share of stock is a claim on the residual earnings and assets of the corporation - Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities - A place where people can get rich/poor very quickly - A factor in business investment decisions: the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending - Eg. A higher price fro a firm's shares means that the firm can raise a larger amount of funds which can use to buy production facilities and equipment - Stock prices are extremely volatile. Rising steasily during 1980s and expereicned the greatest rises from 1990-2000, then drops in 2002 & 2007

Banks and financail institutions are what make financial markets work

Financial intermediaries: - institutions that borrow funds from people (households and firms) who have saved and that in turn make loans to other people - Banks: accept/issue deposits and make loans - Others: insurnace companies, pension funds, mutual funds and investment companies

Financial innovation: - the development of new financial products and services - can be an important force for good by making the financail system more efficient (eg. efinance)

Financial crises: - major disruptions in financial markets that are characterized by sharp declines in asset prices and failures (or government rescues) of many financail and nonfinancial firms

Money (Money Supply): - anything that is generally accepted as payment for goods or services or in the repayment of debts - evidence suggests that variations in the stock of money plays an important role in generating business cycles - Business cycles: upward and downward movement of aggregate output produced in the economy - Recessions (unemployment) and expansions affect all of us - Monetary theory: ties changes in the money supply (ie. Stock of money) to changes in interest rates and asset prices and this aggragate economic activity and the price level - Aggregate price level is the average price of goods & services in an economy - A continual rise in the price level (inflation) affects all economic agents - Inflation rate: the rate of change of the price level - A positive association exists between inflation and the growth rate of Ms

financial systems and therefore the performance of the economy? - What should be the role of international financial institutions like the IMF?

Money and interest rate: - interest rates are the price of borrowed money - Prior to 1980, the monetary growth rate and the interest rate on LT US Treasury bonds tended to be closely linked - The relationship is less clear since 1980 but it's still an important factor in the behaviour of interest rates

Monetary Policy: - the management of the money supply and interest rates - conducted in the US by the Federal Reserve System; by RBA in Australia

Fiscal Policy: - deals with government spending and taxation - budget deficit is the excess of expenditures over revenues for a particular year - budget surplus is the excess of revenues over expenditures for a partcular year - any deficit must be financed by borrowing - the govt must finance any budget deficit by borrowing whereas a budget surplus leads to a lower govt debt burden

The Foreign Exchange Market: where funds are converted from one currency into another; determines the fx rate

The foreight exchange rate: The price of one currenct in terms of another currency

The International Financial System: - financial markets have become increasingly integrated throughout the world - impact on domiestic economies: - How a country's choice of exchange-rate policy affect its monetary policy? - How capital controls (that is, restrictions on international financial flows) impact domestic

Aggregate Output and Income:

Gross domestic product (GDP): - the market value of all goods and services produced in a country during the course of a year - Purchases of goods that have been produced in the past; of stocks or bonds; and intermediate goods are not counted - These categories are not current production

Aggregate income: - the total income of factors of production (land, labor, and capital) from producing goods and services in the economy during the course of the year - It's equal to aggregate output because the payments must eventually flow back to the owners of the F of Prod.

Real VS Nominal Magnitudes: - Nominal GDP: When the total value of final goods and services is calculated using current prices - Real GDP: GDP measured with constant prices = Volume GDP/chain volume GDP

Aggregate Price Level: a measure of average prices in the economy

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Growth rates: = ! - !!! ?100

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Ch2 An overview of the Financial System

Functions of Financial Markets: ? Performs the essential function of channeling funds from economic agents who have saved surplus funds to those that have a shortage of funds ? Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities (financial instruments) ? Securities are assets for the person who buys them ? Liabilities are assets for the individual or firm that sells them

Reasons for presence of the financial markets: ? Promotes economic efficiency by producing an efficient allocation of capital (wealth), which increases production ? Allow funds to move from people who lack productive investment opportunities to people who have such opportunities

? Directly improve the well-being of consumers by allowing them to schedule purchases better

? Provide funds to young people to buy what they need w/o forcing them to wait until they have saved up the entire purchase price

Structure of financial markets: 1 Debt and Equity Markets ? Individuals can obtain funds through the issuance of a debt instrument - Debt instrument: a contractual agreement by the borrower to pay the holder of the instrument interest and principal payments until the maturity date (eg. bond, mortgage) - Maturity is the no. of years until the instrument's expiration - Debt instrument: ST if its maturity term is less than a year; LT if it's ten years or longer

? Raise funds through the issuance of equities - Equities: claims to share in the net income and

the assets of a business - Equities often make periodic payments

(dividends) to their holders and are considered as LT securities because they have no maturity date

2 Primary and Secondary Markets

? Primary market: a FM in which new issues of a security are sold to initial buyers by the corporation or govt agency borrowing the funds

- Investment banks underwrite (facilitate the sale of) securities

? Secondary market: a FM in which securities that have been previously issued can be resold

- Brokers and dealers work here

3 Exchanges & Over-the-Counter markets ? 2 forums for a secondary market ? Exchanges: Buyers and sellers of securities

meet in one central location to conduct trades (Market with formal location) - Includes NY stock exchange

? OTC markets: Dealers decentralized and linked electronically

- Includes foreign exchange, wholesale banking markets, NASDAQ

4 Money and Capital Markets: ? Money market: only ST debt instruments are

traded ? Capital market: LT debt instruments and equity

instruments are traded

Financial market Instruments: - Debt instruments with STs to maturity

? US Treasury Bills: - Pay a set amount at maturity and have no

interest payments - Most liquid; most actively traded - Safest because of low probability of default - It can raise taxes or issue currency to pay off its

debs

? Negotiable Bank certificates of Deposit: - Sold by a bank to depositors that pays annual

interest of a given amount and at maturity pays back the original purchase price - Important source of funds for commercial banks

? Commercial Paper: - ST debt instrument issued by large banks &

well-known corporations eg. MS

? Repurchase Agreements: - ST loans for which Treasury bills serve as

collateral (an asset that lender receives if borrowers does not pay back loan)

? Federal funds: - Loans are made by banks to other banks - Federal funds rate: high= banks' credit needs

are high; low= needs are low

Capital market instruments: - Debt and equity instruments with maturities of greater than one year

? Stocks: equity claims on the net income and assets of a corporation

? Mortgages and mortgage-backed securities: - Mortgages: loans to house-holds or firms to

purchase land, housing, or other real structures; provided by financial institutions - Mortgage-backed securities: bond-like debt instruments backed by a bundle of individual mortgages

? Corporate Bonds: sends the holder an interest payment twice a year & pays off the face value when the bond matures

- the volume of new corporate bonds issued each year > volume of new stock

? US govt securities: to finance the deficits of the federal govt

? US govt agency securities: to finance such items as mortgages, farm loans, or powergenerating equipment

? State and local govt bonds (municipal bonds): to finance expenditure on school, roads, and other large programs

? Consumer and bank commercial loans: loans to consumers & businesses by banks

*In Australia: ? ST securities issued by the private sector mainly come from financial institutions

? Widely-used instruments are 90-day bank bills and negotiable certificates of deposit (CDs) for financing of bank loans, complementing the retail funding

Internationalization of FMs: ? Foreign bonds (both public and private): sold in a foreign country and denominated in that country's currency

? Eurobond: bond denominated in a currency other than that of the country in which it is sold

? Eurocurrencies: foreign currencies deposited in banks outside the home country ? Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks

? World Stock Markets

Function of Financial Intermediaries: Indirect Finance: - Financial intermediation: primary route for moving funds from leaders to borrowers

? Lower transaction costs: time and money spent in carrying out financial transactions o Economies of scale: ? in transaction costs as the size of transactions ? o Liquidity services: services that make it easier for customers to conduct transaction eg. banks provide depositors with checking accounts that enable to pay their bills easily

? Reduce the exposure of investors to risk: o Risk sharing: Asset transformation: enable financial intermediaries to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold

o Diversification: entails investing a collection of assets whose returns do not always move together; overall risk is lower than for individual assets

Deal with asymmetric information problems: - one party doesn't know enough about the other party to make accurate decisions

? Adverse selection (before the transaction): - Problem occurs when the potential borrowers

who are most likely to produce bad credit risks are the ones who most actively seek out a loan and most likely to be selected - Solution: try to avoid selecting the risky borrower by gathering information about them

? Moral hazard (after transaction): - Borrower engages in undesirable activities and

the loan is less likely will be paid back to the lender - Ensure borrower will not engage in activities that will prevent him/her to repay the loan.

o Sign a contract with restrictive covenants.

Conclusion: Financial intermediaries allow "small" savers and borrowers to benefit from the presence of financial markets Types of Financial Intermediaries: - Depository Institutions:

? Commercial Banks: raise funds by issuing checkable deposits, saving deposits, and time deposits o Use these funds to make commercial, consumer, and mortgage loans and to buy US govt securities

? Savings & loan associations and Mutual savings banks: obtain funds theough saving deposits and time and checkable deposits

? Credit Unions: acquire funds from deposits called shares and primarily make consumer loans

- Contractual Savings Institutions: ? Life insurance companies: acquire funds from the premiums that people pay to keep their policies in force & use them mainly to buy corporate bonds and mortgages and stocks

? Fire and casualty insurnace companies: receive funds thorugh premiums for their to buy more liquid assets

? Pension funds & govt retirement funds: acquire funds from employers and employees to buy corporate bonds and stocks

Investment intermediaries: ? Finance companies: raise funds by selling commercial paper and by issuing stocks and bonds ? Mutual funds: acquire funds by seeling shares to many individuals and then using the proceeds to purchase dicersifies portfolios of stocks and bonds; low transaction costs ? Money market mutual funds: sell shares to acquire funds and buy money market instruments that are both safe and very liquid ? Hedge funds: invest in many types of assets ? Investment banks: helps a corporation issue securities

Regulation of the financial system: ? To increase the information available to investors: o Reduce adverse selection and moral hazard problems o Reduce insider trading and related violations (SEC in United States; mainly ASIC in Australia)

? To ensure the soundness of financial intermediaries: o Restrictions on entry (chartering process) o Disclosure of information o Restrictions on Assets and Activities (control holding of risky assets) o Deposit insurance (avoid bank runs) o Limits on Competition (mostly in the past): - Branching (United States)--limits on interstate banking - Restrictions on (bank) interest rates (both U.S. and Australia--now abolished in both countries)

Regulation of the Financial System (Australia): ? The Council of Financial Regulators (CFR) is the coordinating body for Australia's main financial regulatory agencies.

? Comprises the Reserve Bank of Australia (RBA) (which chairs the Council), the Australian Prudential Regulation Authority (APRA); the Australian Securities and Investments Commission (ASIC); and the Australian Treasury. Meetings are chaired by the RBA Governor.

? The CFR members discuss regulatory issues and, as necessary, coordinate responses to potential threats to financial stability.

? Australian Prudential Regulation Authority: The prudential regulator of banks, insurance companies and superannuation funds, credit

unions, building societies and friendly societies in Australia.

? Australian Securities and Investments Commission: Australia's corporate, markets and financial services regulator.

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