FIN 221

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FIN 221

• Chapter 1

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• The Role of Financial System
• The financial system consists of
• Financial Market two sides (D S ) buying and
  selling financial instruments also called
  financial claims or securities (stocks, bonds,
  future contracts, mortgage backed securities.
• Financial Institutions (financial
  intermediaries) facilitate the flow of funds
  from savers to borrowers. Such as Commercial
  banks, credit unions, life insurance companies
  and finance companies.

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• Economic Units
• Households Budget constraint (income ,
  consumption , real investment expenditures)
• Business firms Budget constraint
• Governments (local , state and federal) Budget
  constraint

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• Budget Position
• A balanced Budget Position (receipts
  expenditures)
• A surplus Position (receipts gt expenditures)
• A deficit Position (expenditures gt receipts)
• Surplus Spending Units (SSUs) Vs Deficit Spending
  Units (DSUs)
• SSUs have income for the period that exceeds
  spending, resulting in savings. Other words for
  SSU are saver, lender, or investor. Most SSUs
  are households.
• DSUs have spending for the period that exceeds
  income. Another word for DSU is borrower.
  Most DSUs are businesses or governments.

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• Components of a Financial Claim (loan)
• The principal
• The Price (Fee or the interest rate)
• Maturity of the loan
• How financial system transfer the SSUs excess
  purchasing power to the DSUs?
• The transfer can be done by SSU lending money to
  and accepting IOU from a DSU.

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• IOU (financial Claims) is a written promise to
  pay a specific amount of money (the principal)
  plus a fee (an interest rate) for the privilege
  of borrowing the money over a period of time
  (maturity of the loan).
• IOU for DSU is a liability and the interest
  payments are the penalty for consuming before
  income is earned.
• IOU for SSU is an asset and the interest earned
  is a reward for postponing consumption.

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• SSUs claim against DSU is liability to DSU and
  asset to SSU.
• Ones liability is anothers asset What is
  payable by one is receivable by another.
• Assets arising this way are financial assets
  The financial system balances-total financial
  assets equal total liabilities.
• Total financial liabilities MUST EQUAL to total
  financial assets.
• The ease with which a financial claim can be
  resold is called MARKETABILITY.

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Types of Finance

• There are TWO types of finance (financing
  intermediation)
• Direct Financing
• SSUs and DSUs exchange money and financial claims
  directly using direct claims. (Magdy family as
  SSU and Al -amal firm as DSU)
• Transaction

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Direct Financing Methods

• Private placements.
• Brokers act as matchmakers bringing SSUs
  DSUs together. Compensated for their services
  with a commission fee.
• Dealers They are market makers for
  securities. Make profits by selling from their
  inventory of securities. Their gross profit comes
  from the bid-ask spread.
• Investment Bankers Help DSUs market IOUs.
  Purchases an entire issue of stocks/ bonds at a
  guaranteed price and resells the securities to
  investors at a higher price, a process known as
  underwriting". They are compensated for their
  services through underwriting spread

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Problems of Direct Financing

• The denomination of the securities sold in direct
  credit markets are very large.
• Because of the first problem, few consumers can
  transact in these markets.
• Double coincidence of wants (desires) of both SSU
  and DSU.
• To solve (overcome) these problems, financial
  intermediaries intervene between SSU and DSU.

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Comparative Advantages
Financial intermediaries (institutions) enjoy 3
sources of comparative Advantages 1- Economies
of scale 2- Low costs 3- information
(reliable)
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Intermediaries Services
5 services 1- Denomination Divisibility
(different size of securities) intermediaries
offer a wide range of denomination from 1 to
many millions. 2- Currency Transformation
exchange financial claims denominated in various
currencies. 3- Maturity Flexibility offer
different maturities to both SSUs and DSUs.
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Intermediaries Services contin.
4- Credit Risk Diversification Spread risks
over many different types of SSUs / DSUs 5-
Liquidity Liquidity means easy to convert into
money at low costs. Many of financial commodities
produced by intermediaries are highly
liquid. Note Intermediaries engage in one or
more of the above intermediation (denomination,
currency, risk, maturity or liquidity).
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Types of Financial Intermediaries
Contractual Saving Institutions
Deposit type Institutions
Investment Funds
Others
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Types of Financial Intermediaries

• First Deposit Type Institutions
• The most commonly recognized intermediaries
  because most people use their services daily.
• Interest rate on deposits is usually insured
  (so, deposits are devoid of any risk of loss of
  principal.
• Deposits are highly liquid because they can be
  withdrawn on very short notice, usually in
  demand.

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Deposit Type Institutions
1- Commercial Banks 2- Thrift Institutions 3-
Credit Unions We can add Islamic Banks
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• 1- Commercial Banks
• According to the assets and liabilities, they
  are the largest and most diversified
  intermediaries.
• Many of them have trust department and leasing
  operations may underwrite certain classes of
  securities.
• They are the most highly regulated of all
  financial institutions.

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• 2- Thrift Institutions (called saving and loan
  associations, or saving banks)
• Savings and loans associations and mutual
  savings banks are commonly called thrift
  institutions.
• They issue checking accounts, savings accounts
  and a variety of consumer time deposits.
• They use these funds to purchase real estate
  loans (long term mortgages) (different from
  commercial banks)
• They are the largest providers of residential
  mortgages loans to consumers.
• They are also allowed to make limited number of
  consumer and business loans.

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• They specialize in maturity and denomination
  intermediation .. Why?
• Because BORROW small amounts of money short
  term with checking and saving accounts and LEND
  long term on real estate collateral.
• The FDIC insures deposits in thrifts in amounts
  up to 100,000

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• 3- Credit Unions
• Credit unions are small, nonprofit, cooperative,
  consumer organized institutions.
• They are owned by their member- customers.
• Their primary liabilities are checking accounts
  (called share drafts) and saving accounts (called
  share accounts).
• Their investment are devoted to short term
  installment consumer loans.
• They are organized by consumers having a common
  bonds.

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• The FDIC insures deposits in credit union in
  amounts up to 100,000
• To use any service of a credit union, you must
  be a member.
• Q what are the major regulatory differences
  between credit unions and other depository
  institutions?
• 1- common bond requirement
• 2- the restriction that most loans are to
  consumers.
• 3- their exemption from federal income tax
  because of their cooperative nature.

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• Second Contractual Savings Institutions
• They OBTAIN funds under long term contractual
  arrangements and INVEST the funds in capital
  market.
• Their funds are relatively steady.
• Liquidity is NOT a problem in the management of
  these institutions.

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Second Contractual Savings
Institutions
1- Life Insurance Companies 2- Casualty Insurance
Companies 3- Pension Funds
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• 1- Life Insurance Companies
• They obtain funds by selling insurance policies
  that protect against loss of income from
  premature death or retirement.
• Because their inflow and outflow of funds are
  predictable, they able to invest in higher
  yielding and long term assets.
• Regulation on their operations by state is less
  strict than in case of deposit - type
  institutions.

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• 2- Casualty Insurance Companies
• They sell protection against loss of property
  from fire, theft, accident, negligence, and other
  causes that can be predicted.
• Their major sources of funds is premium charged
  on insurance policies.
• Their insurance policies are pure risk
  protection policies.
• They provide NO liquidity to the policyholders.
• Because their outflow of funds are NOT
  predictable, they invest in short - term assets.

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• To solve the lower returns generated by
  investment in short term assets, they hold equity
  securities. AND they also hold municipal bond to
  reduce their taxes.
• 3- Pension Funds
• Obtain their funds from employers and employees
  during the employees working years.
• Provide monthly payment upon retirement.
• Their purpose is to help workers plan for their
  retirement years.
• Because their inflow is long term and outflow is
  highly predictable, they are able to invest in
  highly yielding and long term securities
  (cooperate bonds and equity obligations)

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• Third Investment Funds
• Sell shares to investors and use funds to
  purchase direct financial claims.
• They offer benefits of both denomination
  flexibility and default risk intermediation.

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Third Investment Funds
1- Mutual Funds 2- Money Market Mutual Funds
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• 1- Mutual Funds
• Sell equity shares to investors and use these
  funds to purchase stocks and bonds.
• Provide small investors access to reduced
  investment risk that results from
  diversification, economies of scale in
  transaction costs, and professional financial
  managers.
• The shares value changes as the price of the
  stocks held by the mutual fund change.

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• 2- Money Market Mutual Funds (MMMF)
• They invest in money market securities.
• Money market securities are
• A - short term securities
• B- low default risk.
• C- sell in denomination of 1 million or more
• D- most of them offer check writing privileges
• Disadvantages
• A- most of them restrict the amount of
  withdrawals
• B- the federal government doe NOT insure the
  funds.

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Fourth Other Types of Financial Institutions
1- Finance Companies 2- Federal Agencies
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• 1- Finance Companies
• They make loans to consumers and small
  businesses.
• They obtain the majority of their funds by
  selling short term IOUs, called Commercial
  Papers, to investors.
• The balance of their funds comes from the sale
  of equity capital and long term debt
  obligations.
• They are regulated by the states and are subject
  to many federal regulations.

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• There are 3 types of finance companies
• 1- Consumer finance com. Specializing in
  installment loans to HH.
• 2- Business finance com. Specializing in loans
  and leases to businesses.
• 3- Sales finance com. That finance the products
  sold by retail dealers.

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• 2- Federal Agencies
• The US government acts as a major financial
  intermediary through borrowing and lending
  activities of its agencies.
• The main purposes of federal agencies are 1-
  to reduce the cost of funds 2- to increase the
  availability of funds to targeted sectors.
• They sell debt instrument called agency
  securities in the direct credit market at or near
  government borrowing rate.
• Most of these funds are to support agriculture
  and Housing sectors.

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Types of Financial Markets

• 1- Primary Secondary Markets
• Primary sell / issue of financial claims for
  the first time
• Secondary exchange of used / issued financial
  claims.

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• 2- Organized Over the counter
• Organized physical meeting place and
  communication facilities to exchange securities
  under a specific set of rules and regulations on
  the floor or through the computer system.
• unorganized or over the counter market
• 3- Spot and Future Market
• Spot Market market for current exchange
• The future contract date the future time when
  the contract is scheduled to be settled by
  exchange of cash for contracted goods.

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• 4- Option market
• Trade option contracts that call for conditional
  future delivery of a security, a commodity, or a
  futures contract.
• Option writer and option buyer or owner make an
  option contract.
• Option contract gives the buyer / seller the
  right to either buy or sell a security depending
  upon whether the option is a call or put
  option.
• Call options give the security issuer the right
  to buy a predetermined (given) amount of a
  security at a given/ agreed price on, or possibly
  before, the expiry date of the options.
• Put options give the buyer the right to sell a
  predetermined (an agreed) amount of a security at
  the agreed price prior to the options expiry
  date.
• Convert option give the buyer the right to
  convert the security to another one.
• Options contract are traded on organized
  exchanges.

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• 5- Foreign Exchange Market
• Involves Spot, future forward and option markets
• 6- International Domestic Markets
• According to where they are located.
• Eurodollar and Eurobond markets are examples of
  major international markets.
• Eurodollars are US dollars deposited outside the
  US.
• Eurobonds are issued outside the US but
  denominated in US dollars.

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The Money Market

• Borrow, lend, invest for short term period
• Money market instruments characteristics
• 1- high liquidity
• 2- Low risk (and consequently low yield)
• 3- short maturity (often 90 days or less)
• Money market are wholesale and over the
  counter in character.
• Minimum primary market transaction is usually 1
  million.
• There is NO organized exchange brokers and
  dealers specialize in various instruments.

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• Money Market instruments include
• Treasury Bills
• IOUs auctioned weekly by the US Treasury.
• 2. Negotiable Certificates of Deposit
• Large, marketable CDs sold by a few large banks.
• 3. Commercial Paper
• Unsecured IOUs issued by large, creditworthy
  businesses.
• 4. Federal Funds
• Excess reserves of depository institutions in the
  Federal Reserve System.

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The Capital Market

• To finance Capital Goods.
• Its instruments are
• long maturities (usually 5 to 30 years)
• Less liquidity
• Higher risk in most assets (so higher yields)
• Traded in organized market and in over the
  counter markets

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• Major capital market instruments are
• Common Stock shares of ownership in an
  incorporated business and its net profit.
• Corporate Bonds long term debt securities
  issued by large corporations.
• Municipal Bonds long term debt securities
  issued by long term debt securities issued by
  state and local governments.
• Mortgages long term loans secured by real estate
  (land or buildings)

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Financial Market Efficiency

• Allocational Efficiency
• Funds find their highest and best use.
• 2. Informational Efficiency
• Prices reflect relevant information.
• 3. Operational Efficiency
• Transactions costs are minimized.

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Risks Faced By Financial Institutions

• First Credit Risk (or default risk)
• Borrower may not pay as agreed.
• Financial institutions manage to credit risk in 3
  concurrent ways
• 1- diversify their portfolios.
• 2- conduct a credit analysis of the borrower to
  measure ability and willingness to pay.
• 3- monitor the borrower over the life of the loan
  or investment to detect any critical changes in
  financial health.

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Second Interest Rate Risk Change in interest
rates causes fluctuations in a securitys price
and reinvestment income. Third Liquidity
Risk It is possibility that a financial
institution may be unable to pay required cash
outflow. Fourth Foreign Exchange
Risk Fluctuation of exchange rate causes
fluctuation in the earning or value of a
financial institution Fifth Political Risk It
is possibility that government action will harm
an institutions interests.