Presentation on theme: "BuffDaniel Presents Money and Banking Chapter 4 Financial Economics."— Presentation transcript:
1 BuffDaniel PresentsMoney and BankingChapter 4Financial Economics
2 What is the Purpose of a financial system? The financial system provides channels to transfer funds from individuals and groups who have saved money to individuals and groups who want to borrow money.Savers are suppliers of funds, providing funds to borrowers in return for promises of repayment of even more funds in the future.Borrowers are demanders of funds for consumer durables, houses, or business plant and equipment, promising to repay borrowed funds based on their expectation of having higher incomes in the future.The promises of repayment that borrowers give to savers are liabilities to the borrowers and assets to the savers.Financial markets issue claims on individual borrowers directly to savers.Financial institutions or intermediaries act as go-betweens by holding a portfolio assets and issuing claims based on that portfolio to savers.
3 Services Risk sharing - diversification Liquidity – ease at which a financial instrument can be turned into cashInformation
4 Financial Markets – systems where money flows from savers to borrowers FunctionTransfer funds from savers to borrowersDirect finance – Savers lend to the borrowersIndirect finance – through a financial intermediaryFinancial Intermediary – facilitates the flow of funds
5 Debt instruments – Bonds – a loan to borrower Bonds are debt instruments that may be issued by domestic or foreign governments and corporationsMaturity date – expiration dateshort term – less than a yearintermediate – 1 to 10 yearslong – 10+Perpetuities – have no maturity dates, pay interest foreverCoupons – fixed interest paid on BondsZero coupons – sold below stated valueCan be tax exempt – municipal bondsBonds are rated by Standards & Poor’s and Moody’s Investors Service
6 Mortgages – loans for property (real estate) Mortgages are long-term debt instruments used to purchase residential, commercial, and farm properties. The underlying property serves as collateral.Fixed rate – fixed interest rateAdjustable rate – interest rate changes with the market about every six monthsThe principal and interest payments may be insured by the Federal Housing Administration (FHA) or Veterans Administration (VA), which are agencies of the federal government.Conventional loans have no federal insurance and are made by financial institutions and mortgage brokers. Lenders may require borrowers with conventional loans to obtain private mortgage insurance.
7 Equities – Stocks (Ownership): Stocks represent equity in a corporation Firms issue stock to raise funds for long-term investment spending.An initial public offering (IPO) is a public offering of newly issued stocks by a corporation that has not previously sold stocks to the public. A seasoned stock offering is an offering of newly issued stocks by a firm that has publicly held stocks outstanding.Program trading by institutional investors allows for the pre-programming of computers to buy or sell baskets of stocks.Buying stocks on the margin refers to putting up only a fraction of the stock’s selling price and borrowing the rest. Currently, the margin requirement set by the Fed is 50 percent.Stocks may be traded in organized markets such as the New York Stock Exchange (NYSE), the American Stock Exchange, or other regional stock exchanges. Organized exchanges operate auction-type markets where a specialist trades large blocks of shares.
8 The NYSE is by far the largest organized exchange The NYSE is by far the largest organized exchange. Each stock is traded at a specific post, which may trade up to several dozen stocks.The NYSE also enforces circuit breakers to temporarily halt market trading if stock prices change by a specified amount.The over-the-counter market is an informal network of market makers who trade stocks via telephone or computer linkages.Stocks of over 30,000 companies are traded over the counter.The National Association of Securities Dealers (NASD), a privately owned organization, regulates the over-the-counter market under the supervision of the SEC.Large companies may also be National Association of Securities Automated Quotation System (NASDAQ) members. Stocks of NASDAQ members are traded on an advanced computer system that provides price quotes for the members of NASDAQ.Stock market indexes measure movements in overall stock prices of the stocks included in the index.The Dow Jones Industrial Average (the Dow) is an index of stocks of 30 of the largest companies in the country.
9 The S&P 500 is a weighted average of stocks of 500 broad-based companies and is considered to be a more meaningful index than the Dow.Dividend TypesPreferred stock – get fixed dividends and are paid firstCommon stock – get what is left if anyBeta measures the variability of a stock’s return relative to the entire market. A beta of 1 means that if there is a 1 percent price change in the overall market, this stock’s price also changes by 1 percent. A beta of 2 means that if there is a 1 percent price change in the overall market, this stock’s price changes by 2 percent and the stock is riskier than the market. A beta less than 1 means that the price of the stock’s price varies less than the overall market.TypesRising – bullFalling – bear
10 Primary MarketPrimary – initial offering (IPO): Primary markets are those in which newly issued claims are sold to initial buyers by the borrowerThe most commonly used claim is debt, which requires the borrower to repay the principal plus interest.The length of the period of time before a debt instrument expires is its maturity.Short-term debt instruments have a maturity of less than one year.Intermediate term debt instruments have a maturity between one year and 10 years.Long-term debt instruments have a maturity of 10 years or more.Debt instruments offer the advantage to the borrower that they need not pay more than the amount promised, while lenders incur the risk of receiving back less than the amount promised if borrowers default.Equity allows for variable payments from the borrower to the lender.Common stock is a good example of an equity.Equity owners generally receive periodic payments from the firm, known as dividends.Done by an Investment bank (underwriter) who then sells it to the publicMorgan Stanley, Merrill Lynch, Smith BarneyAct as brokers and dealers
11 Secondary MarketSecondary – any additional trading of the financial instrumentRisk-sharing, liquidity, and information services are provided in secondary markets.Smoothly functioning secondary markets make it easier for investors to reduce their exposure to risk by holding a diversified portfolio of stocks, bonds, and other assets.Secondary markets promote liquidity by making it easier for investors to sell financial instruments for cash.Secondary markets convey information to both savers and borrowers by determining the prices of financial assets.New York Stock ExchangeBrokers – agents of investorsDealers – link buyers and sellersBid ask spreadBid – price dealers will buy (low) $50Ask or Offer – Price dealers will sell (high) $52
12 MarketsAuction Markets (Exchanges) – buyers and sellers confront directlyNYSE, Chicago commodity market, NASDAQDealer Markets (Over the Counter) – Dealers carry an inventory (like a store) in hopes of making a profitUse computerized tradingOver the Counter (OTC) and NASDAQBrokered Market – dealers and brokers search for buyers and sellers and earn a commissionMunicipal Bonds
13 Time Markets – deal with maturity Money Market – short term instruments (less than 1 year)Less riskyMore liquidLower information costsCapital Market – long term instruments (1+ years)ClaimsCash market – immediate transaction and settlementDerivative market- settlement is made laterFinancial futures – commodities and metalsOptions – the right to buy or sell and asset in the future
14 Financial Instruments Money MarketsU.S. Treasury Bills – short term Govt issues (3 to 12 months)No default – raise taxes or print currencyUsed in Open Market OperationsThird largestSell at discountCertificates of deposits – short term bank issuesecond largest$100,000First issued by Citibank in 1971Commercial paper – short term corporate issueslargestBanker’s Acceptances – international trade issueRepurchase agreement – guaranteed issue of less than two weeks by large corporations and governments with short term extra money (usually hours)seller agrees to buy it back at a higher priceFederal Funds – overnight loans between banksFederal Funds RateEurodollars – US dollars in foreign banksNot Euros
15 International Markets Capital MarketsStocks – ownership of a corporationPrice = f(interest rates, company earnings)Influenced by monetary policy which determines interest rates, GDP and inflationLargestThe principal of inflation-indexed bonds is adjusted for inflation every six months. Although the interest rate doesn’t change, the coupon payment is based on the inflation-adjusted amount and the investor receives the inflation-adjusted principal at maturity.Mortgages – loans to purchase homes or landSecond largestCorporate bonds – loans to corporationsThird largestUS Government securities – savings bondsTypesTreasury Notes – 1 to 10 yearsTreasury Bonds – 10+ yearsMost liquidUS Government Agency Securities – issued by agencies to finance loans for housing, farm loans etc.Government agency securities are securities issued by government-sponsored enterprises and by the Federal Financing Bank.Government-sponsored enterprises such as Fannie Mae, Freddie Mac, and Ginnie Mae, are privately owned but have been chartered by Congress to reduce the cost of borrowing in such sectors as housing, farming, and student loansState and Local (municipal) Government Bonds – to finance schools and bridges etc.Revenue – has specific goalGeneral Obligation bondsConsumer and Commercial bank loans – to households and businessesInternational MarketsForeign Bonds – from other countriesEurobond – recent type and most popularWorld Stock markets
16 Financial Institutions Financial IntermediariesFinancial Intermediaries in the Financial SystemInstitutions that raise funds from savers and invest in the debt or equity claims of borrowers are engaged in financial intermediation.Financial intermediaries match savers and borrowers by pooling the funds of many savers to lend to many individual borrowers.Financial intermediaries provide risk-sharing, liquidity, and information services.Banks provide risk-sharing to individual depositors by having a large quantity of deposits and access to numerous borrowers and investments.Bank deposits and other intermediary claims are liquid.Because banks collect and process information on behalf of many depositors their costs for information gathering are lower than would be those of individual depositors [d1]RSU Chapter 3 and 13
17 Functions Reduce transactions costs – make trading easier Provide risk sharing, liquidity and informationVolume of activity allows economies of scalePortfolio Diversification – don’t put all of your eggs in one basket
18 Obstacles to Matching Savers and Borrowers Transactions costs are the costs of buying and selling a financial instrument.Brokerage commissions, minimum investment requirements, and lawyers’ fees are all examples of transactions costs.Financial intermediaries reduce transactions costs by exploiting economies of scale.
19 Information costs are the costs that savers incur to determine the credit-worthiness of borrowers and to monitor how borrowers use the acquired funds.Asymmetric information describes the situation in which one party in a transaction has better information than the other. One party knows more than the other (insurance).Adverse selection refers to a lender’s problem of distinguishing the good-risk applicants from the bad-risk applicants before making an investment. The people who need money are generally those with bad creditMoral hazard refers to a lender’s verifying that borrowers are using their funds as intended. Loan is said to be for one purpose but actually used for another
20 Depository Institutions Commercial banks are financial intermediaries that accept deposits and make loans, offering risk-sharing, liquidity, and information services to savers and borrowers.Borrowers with small or medium-sized credit needs do not rely on stock or bond markets because these markets have high transactions and information costs.In the United States, savings institutions (such as savings and loan institutions) originated as building and loan societies.Savings institutions historically suffered from a maturity mismatch, which led to a crisis in the U.S. deposit insurance system during the 1980s and early 1990s.Credit unions take deposits from and make loans to individuals who work at the same firm or in the same industryThrift institutionsSavings and loans – mortgagesMutual savings banks – mortgagesCredit unions – consumer loansCommercial banks (largest) – all types of loans8,000Declining percent of financial share
21 Contractual Savings Institutions allow individuals to pay money to transfer risk of financial hardship to someone else and to save in a disciplined manner for retirement.Insurance companies are financial intermediaries that specialize in writing contracts to protect their policyholders from the risk of financial loss associated with particular events.Insurance companies are able to engage in risk pooling because the “law of large numbers” states that the average occurrences of death, illness, or injury for large groups of people can generally be predicted.Insurance companies face problems of adverse selection and moral hazard, which they attempt to alleviate through screening potential policyholders and through the use of risk-based premiums, deductibles, coinsurance, and restrictive covenants.Life insurance companies provide insurance to protect against financial hardship for the policyholder’s survivors.With “whole life insurance” policyholders can save for the future, withdrawing the total “cash value” at retirement or turning that value into an “annuity.”With “term life insurance” premiums rise with age and the policy pays off only at the death of the policyholder.Property and casualty insurance companiesinsure policyholders against events other than death.
22 Life Insurance companies – corporate bonds and mortgages Whole Life – builds cash value, constant premiumTerm Life – no cash value, premium rises as you get older (very low in the beginning)Fire and casualty insurance companies – Government bonds (all types)Pension funds (largest) and government retirement funds – corporate stocks and bondsPrivate funds growing the fastestPension funds invest contributions of workers and firms to provide for pension benefit payments during workers’ retirements.
23 Investment intermediaries – also growing Investment institutions, which raise funds to invest in loans and securities, include mutual funds and finance companies.
24 Mutual funds are financial intermediaries that convert small individual claims into diversified portfolios of stocks, bonds, mortgages, and money market instruments.Mutual funds are investment companies that pool the funds of many investors and purchase securities that allow for much greater diversification than an investor could achieve on his/her own. Mutual funds pool the funds of many investors to invest in several hundred or even thousands of stocks or bonds offering greater safety and more diversification than investing in one or a few stocks.Mutual funds now offer indexed mutual funds that hold the same basket of stocks as represented in a stock index. Returns to an indexed fund should mirror returns to the index.Exchange Traded Funds (ETFs) are securities created by a securities firm that deposits a large basket of stocks into a fund. The basket of stocks in the fund mirrors the holdings of stocks in an index. Shares in an EFT are then issued against the basket of stocks, sold to individual investors, and traded like shares of stock on an exchange. The return on ETFs mirror the return of the index..
25 In closed-end mutual funds, the mutual fund company issues a fixed number of nonredeemable shares, which investors may then trade in over-the-counter markets. Closed-end investment companies sell a limited number of shares that may be traded openly. The price is determined by supply and demand and can differ from the net asset value.Open-end mutual funds issue redeemable shares at a price tied to the underlying value of the assets. An open-end fund continually sells new shares or buys outstanding shares from the public at the net asset value. The net asset value per share is the difference between the market value of the shares of stock that the fund owns and the fund’s liabilities, all divided by the outstanding number of sharesWhile most mutual funds are called no-load funds and earn income only from management fees, some mutual funds are load funds and charge commissions for purchases and sales.Pooled funds that are invested by a managerFamilies –different funds managed under the same umbrella) – Fidelity, Vanguard GroupSpecialized funds – growth, bond, index
26 Finance companies are intermediaries that raise large amounts of money through the sale of commercial paper and securities in order to make small loans to households and businesses.Finance companies – consumer and business loansMoney market mutual funds – Money market instrumentsShort term money market instrumentsMoney market mutual funds invest in securities with an original maturity of one year or lessThe greatest growth in mutual funds has been in money market mutual funds, which hold high-quality, short-term assets
27 Securities market institutions Investment banks underwrite newly distributed stocks and bondsMorgan Stanley, Merrill Lynch, Smith BarneyProfit on a “spread” determined by riskBrokers and Dealers: Brokerage firms (brokers and dealers) facilitate the trading of securities in secondary markets. Dealers take positions in securities to insure the smooth functioning of secondary markets.Market orders direct the broker or dealer to purchase securities at the present market price.Limit orders instruct the broker or dealer either to purchase the securities at the market price up to a certain maximum if possible or to sell the securities at the market price if it is above a certain minimum.
28 Securities market institutions reduce the costs of matching savers and borrowers and provide risk-sharing, liquidity, and information services.Investment banks assist business in raising new capital in primary markets and advise on the best way to do so.One way in which investment bankers earn income is by underwriting a firm’s new stock or bond issue.Rather than guaranteeing the price of an issue, as is done with underwriting, an investment bank might sell the issue under other conditions, such as on an “all-or-none” basis.Large issues are sold by groups of underwriting investment banks called syndicates.
29 The ability to buy and sell issues at low cost after their original issue increases their liquidity. Brokers and dealers facilitate the exchange of securities in financial markets by locating buyers when sellers want to convert securities to cash.Brokers earn commissions by matching ultimate buyers and sellers in a particular market.Dealers trade between ultimate buyers and sellers.The SEC regulates dealers and brokers and restricts trading based on insider information.Securities may be traded through exchanges or in over-the-counter markets.An exchange is a physical location at which securities are traded.In over-the-counter (OTC) markets broker-dealers match buyers and sellers over the telephone and by computer.While the market for U.S. Treasury bonds is the most liquid market in the world, the market for most corporate bonds is relatively illiquid.
30 Venture Capitalists – finance risky startups NonpublicGovernment Financial InstitutionsFederal credit agencies are government financial institutions that make loans in the interest of public policy.The U.S. government lends to farmers through the Farm Credit System, to the housing market through the Federal National Mortgage Association, the Federal Home Loan Mortgage Company, and the Government National Mortgage Association, and to students through the Student Loan Market Association.The U.S. government also guarantees loans made by private financial institutions
31 Financial Regulation Facts Governments around the world regulate financial markets and institutions in order to promote the provision of information, the maintenance of financial stability, and other policy objectives.The federal government in the United States has intervened in financial markets to require issuers of financial instruments to disclose information about their financial condition.Most regulation of the financial system is aimed at ensuring financial stability in the sense of maintaining the ability of the financial system to provide risk-sharing, liquidity, and information services in the face of economic disturbance.Other policy objectives advanced by financial regulation include controlling the money supply and encouraging particular activities.Regulation affects the ability of financial markets to provide risk-sharing, liquidity, and information services
32 Goals Provide information Maintain financial stability Control the money supplyEncourage particular activities
33 Major agencies SEC – organized exchanges and financial markets Established by the Securities Acts of 1933 and 1934Primary MarketsRegulatesPublic DisclosureInsider TradingNASD – National Association of Securities DealersFDIC – Commercial banks, Savings and loans and Mutual savings banks$100,000 per accountFederal Reserve System (FED) – all depository institutionsFunctionsIncrease investor informationEnsure soundness of the intermediariesExamines banksRestricts entryDisclosure – reporting requirementsRestricts assets and activitiesDeposit insuranceLimits competitionRestricts interest rates – Regulation QReserve requirementsControl Monetary Policy
34 Competition and Change in the Financial System Financial markets and financial intermediaries compete for funds and market share in the financial system by offering risk-sharing, liquidity, and information services to savers and borrowers.Financial innovation results from changes in the costs of providing risk-sharing, liquidity, and information services or from changes in demand for these services.The increasing ease of communicating information has allowed for greater financial integration between U.S. financial markets.In recent decades there has been global integration of financial markets.The easy flow of capital across national boundaries helps countries with productive opportunities to grow.Increasing financial integration around the world reduces the cost of allocating savers’ funds to the highest-valued uses.During the 1930s, laws and regulations built barriers that protected from competition the services offered by each type of financial institution.In the current environment, the provision of financial services is being organized more by function than by the identity of the provider.The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 removed many of the regulatory lines among financial institutions.