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Lecture 1 Financial Systems, Markets, Institutions, Instruments and Crisis.

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Presentation on theme: "Lecture 1 Financial Systems, Markets, Institutions, Instruments and Crisis."— Presentation transcript:

1 Lecture 1 Financial Systems, Markets, Institutions, Instruments and Crisis.

2 Introduction The international financial system exists to facilitate the design, sale, and exchange of a broad set of contracts with a very specific set of characteristics. We obtain financial resources through this system: Directly from markets, and Indirectly through institutions.

3 Introduction Indirect Finance: An institution stands between lender and borrower. We get a loan from a bank or finance company to buy a car. Direct Finance: Borrowers sell securities directly to lenders in the financial markets. Direct finance provides financing for governments and corporations. Asset: Something of value that you own. Liability: Something you owe. 3-3

4 The Balance Sheet The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time Assets are listed in order of decreasing liquidity  Ease of conversion to cash without significant loss of value Balance Sheet Identity  Assets = Liabilities + Stockholders’ Equity 4

5 5

6 U.S. Corporation Balance Sheet – Table 2.1 6

7 Income Statement The income statement is more like a video of the firm’s operations for a specified period of time You generally report revenues first and then deduct any expenses for the period Matching principle – GAAP says to recognize revenue when it is fully earned and match expenses required to generate revenue to the period of recognition 7

8 U.S. Corporation Income Statement - Table 2.2 8

9 9 Financial Management Decisions Capital budgeting What long-term investments or projects should the business take on? Capital structure How should we pay for our assets? Should we use debt or equity? Working capital management How do we manage the day-to-day finances of the firm?

10 10 Forms of Business Organization Three major forms in the United States Sole proprietorship Partnership General Limited Corporation S-Corp Limited liability company

11 11 Goal Of Financial Management What should be the goal of a corporation? Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s stock? Does this mean we should do anything and everything to maximize owner wealth? Sarbanes-Oxley Act

12 12 The Agency Problem Agency relationship Principal hires an agent to represent its interests Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent Management goals and agency costs

13 Financial system survey in three steps: 1. Financial instruments or securities Stocks, bonds, loans and insurance. What is their role in our economy? 2. Financial Markets New York Stock Exchange, Nasdaq. Where investors trade financial instruments. 3. Financial institutions What they are and what they do. 3-13

14 Financial Instruments Financial Instruments: The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions. The enforceability of the obligation is important. Financial instruments obligate one party (person, company, or government) to transfer something to another party. Financial instruments specify payment will be made at some future date. Financial instruments specify certain conditions under which a payment will be made. 3-14

15 Uses of Financial Instruments Three functions: Financial instruments act as a means of payment (like money). Employees take stock options as payment for working. Financial instruments act as stores of value (like money). Financial instruments generate increases in wealth that are larger than from holding money. Financial instruments can be used to transfer purchasing power into the future. Financial instruments allow for the transfer of risk (unlike money). Futures and insurance contracts allows one person to transfer risk to another. 3-15

16 Financial Markets Financial markets are places where financial instruments are bought and sold. These markets are the economy’s central nervous system. These markets enable both firms and individuals to find financing for their activities. These markets promote economic efficiency: They ensure resources are available to those who put them to their best use. They keep transactions costs low. 3-16

17 The Role of Financial Markets 1. Liquidity: Ensure owners can buy and sell financial instruments cheaply. Keeps transactions costs low. 2. Information: Pool and communication information about issuers of financial instruments. 3. Risk sharing: Provide individuals a place to buy and sell risk. 3-17

18 Primary versus Secondary Markets A primary market is one in which a borrower obtains funds from a lender by selling newly issued securities. Occurs out of the public views. An investment bank determines the price, purchases the securities, and resells to clients. This is called underwriting and is usually very profitable. 3-18

19 Primary versus Secondary Markets Secondary financial markets are those where people can buy and sell existing securities. Buying a share of IBM stock is not purchased from the company, but from another investor in a secondary market. These are the prices we hear about in the news. 3-19

20 Money Any generally accepted means of payment for delivery of goods or the settlement of debt Legal money notes and coins Customary money IOU money based on private debt of the individual e.g. bank deposit. ©McGraw-Hill Companies, 2010

21 Money and its functions Medium of exchange money provides a medium for the exchange of goods and services which is more efficient than barter Unit of account a unit in which prices are quoted and accounts are kept Store of value money can be used to make purchases in the future Standard of deferred payment a unit of account over time: this enables borrowing and lending ©McGraw-Hill Companies, 2010

22 Modern banking A financial intermediary an institution that specialises in bringing lenders and borrowers together e.g. a commercial bank, which has a government licence to make loans and issue deposits including deposits against which cheques can be written Clearing system a set of arrangements in which debts between banks are settled ©McGraw-Hill Companies, 2010

23 A beginner’s guide to the financial markets Financial asset a piece of paper entitling the owner to a specified stream of interest payments over a specified period Cash notes and coins, paying no interest the most liquid of all assets Bills Short-term financial assets paying no interest directly but with a known date of repurchase by the original borrower at a known price. highly liquid ©McGraw-Hill Companies, 2010

24 A beginner’s guide to the financial markets (2) Bonds longer term financial assets – less liquid because there is more uncertainty about the future income stream Perpetuities an extreme form of bond, never repurchased by the original issuer, who pays interest forever e.g. Consols Gilt-edged securities government bonds in the UK Company shares (equities) entitlements to receive corporate dividends not very liquid ©McGraw-Hill Companies, 2010

25 Credit creation by banks Commercial banks need to hold only a proportion of assets as cash reserves. This enables them to create credit by lending. Example: Assume banks use a reserve ratio of 10 per cent. Suppose, initially, the non-bank private sector has wealth of £1000 held in cash: ©McGraw-Hill Companies, 2010

26 Financial crises A financial panic is a self-fulfilling prophecy. Believing a bank will be unable to pay, people rush to get their money out. But this makes the bank go bankrupt. In a solvency crisis, an institution’s assets have become less than its liabilities. In a liquidity crisis, an institution is temporarily unable to meet immediate requests for payment. ©McGraw-Hill Companies, 2010

27 The subprime crisis A subprime mortgage is a housing loan to a low-income high-risk person. Most of these mortgages were at variable interest rates: although initially low and ‘affordable’, they could subsequently be raised US house prices peaked in As they then fell, lenders became worried and began to raise mortgage interest rates, driving many of the poor to default. Suddenly, these subprime mortgages were worth a lot less than had been thought. ©McGraw-Hill Companies, 2010

28 Securitisation Securitisation transformed this into a global problem. Financiers had bundled lots of individual subprime mortgages into large bundles and sold them on to new buyers in London, Frankfurt and Mumbai. The market was convinced that although one poor subprime household might default, they would not all do so together. However buyers of securitized mortgages had miscalculated. ©McGraw-Hill Companies, 2010

29 The Credit Crisis It was quite likely that circumstances could arise in which all subprime borrowers got into trouble at the same time. And so they did. As US house prices fell sharply, banks found their assets worth much less than they had thought. As the solvency of banks came into question, people became reluctant to lend to banks, and banks themselves became reluctant to lend to anyone else ©McGraw-Hill Companies, 2010

30 Top World’s Biggest Financial Crises Ever Panic of 1819, a U.S. recession with bank failures; culmination of U.S.'s first boom-to-bust economic cycle Panic of 1825, a pervasive British recession in which many banks failed, nearly including the Bank of EnglandBank of England Panic of 1837, a U.S. recession with bank failures, followed by a 5-year depression Panic of 1847, United Kingdom Panic of 1857, a U.S. recession with bank failures Panic of 1866, Europe Panic of 1873, a U.S. recession with bank failures, followed by a 4-year depression Panic of 1884, United States and Europe Panic of 1890, mainly affecting the United Kingdom and Argentina Panic of 1893, a U.S. recession with bank failures Black Monday (stock crashes 22% 1987) Credit Crisis of Banker's Panic 3-30

31 Top World’s Biggest Financial Crises Ever German Hyperinflation, OPEC Oil Price Shock (1973) Wall Street Crash The Great Depression 1998 Russian Crises 1997 Asian Crises Japan’s "Lost Decade," Financial crises of 2008 Subprime mortgage crisis in the U.S. starting in United Kingdom bank rescue package 2009 United Kingdom bank rescue package 2008–2009 Belgian financial crisis 2008–2012 Icelandic financial crisis 2008–2009 Russian financial crisis 2008–2009 Ukrainian financial crisis 2008–2012 Spanish financial crisis 2008–2011 Irish banking crisis European Sovereign Debt Crisis, 2009 onward 3-31

32 Black Monday In the finance world, The Black Monday refers to the time of October 19, During that day, there was a widespread stock market crash all around the world. The beginning of this crash originated in Honk Kong and eventually spread to Europe. Ultimately, the United States was affected as well. The Dow Jones dropped by 22.1%, and it took almost 2 years to reach even the previous high of

33 1907 Banker's Panic The Panic of 1907 saw the Dow drop almost 50% from the high of the previous year. It was triggered by the usual suspects: over-expansion and poor speculation. The stock market crashed in March, and a second crash in October led to a run on banks and every trust in New York, notably causing the massive National Bank of North America to fail. 3-33

34 Credit Crisis 1770 This crisis originated in London and spread to other parts of Europe, such as Netherlands. Ironically, it had been preceded by a period of great prosperity for Britain. The mid 1760s and 1770s saw a credit boom which spurred greater manufacturing and industrial activity. The period of 1770 to 1772 was politically very stable for Britain and its colony, America. However, there was a deeper systemic problem that prevailed under the surface of this prosperity. Speculative practices thrived to generate more credit, and this led to a false feeling of optimism in the market. On June 8, 1772, the fleeing of one of the partners of the Banking House “Neal, James, Fordyce and Down” due to failure to repay debts led to panic. 3-34

35 Japan’s "Lost Decade," The collapse of the Japanese asset bubble in 1991 led to a prolonged period of low growth, which has since been extended to incorporate the decade since the year The original lost decade was caused by an unsustainable level of speculation, large amounts of credit and low interest rates (sound familiar?). When the government stepped in to control this, credit became much harder to obtain, and capital investment dropped significantly. 3-35

36 Dot-Com Bubble This speculative bubble related to internet based companies saw massive rises in equity stock values of industrialized nations from This bubble began because of easy credit availability in These start- up companies wanted to establish a high market share by establishing more coverage. This meant that many of the services were freely provided, and large operational losses were actually occurring. They wanted to establish a brand and then charge profitable rates. The phrase “Get large or get lost” operated in the minds of company founders. 3-36

37 European Sovereign Debt Crisis, 2009 onward This is the most recent of the crises on our list, and no one is yet certain about when, or how, it is going to end. Markets have grown increasingly concerned about the ability of nations, particularly Greece, Ireland, Spain, Portugal, and Italy, to pay their debts, and the exposure of international banks to these potentially toxic debts has played a large part in the enormous market falls of recent days — some of the worst on record. 3-37

38 Financial crises of 2008 This crises was considered the worst one since the Great Depression itself. This easy availability of credit propelled greater demand for housing and a bubble started. However, once this ended, there was a big crash in housing prices. Mortgage values now exceeded the values of houses bought. A great level of lending to less credit worthy borrowers had also prevailed, called sub-prime lending. The existence of financial instruments like Collateralized Mortgage obligations (CMOs) allowed the effect to spread to the entire financial market. Financial innovations led to far greater risk taking appetite. However, the eventual collapse of trust in the market froze lending activity. 3-38


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