Financial Economics

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Chapter 4
BuffDaniel Presents Money and Banking

• Financial Economics

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• 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.

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• Services
• Risk sharing - diversification
• Liquidity ease at which a financial instrument
  can be turned into cash
• Information

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• Financial Markets systems where money flows
  from savers to borrowers
• Function
• Transfer funds from savers to borrowers
• Direct finance Savers lend to the borrowers
• Indirect finance through a financial
  intermediary
• Financial Intermediary facilitates the flow of
  funds

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• Debt instruments Bonds a loan to borrower
• Bonds are debt instruments that may be issued by
  domestic or foreign governments and corporations
• Maturity date expiration date
• short term less than a year
• intermediate 1 to 10 years
• long 10
• Perpetuities have no maturity dates, pay
  interest forever
• Coupons fixed interest paid on Bonds
• Zero coupons sold below stated value
• Can be tax exempt municipal bonds
• Bonds are rated by Standards Poors and Moodys
  Investors Service

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• 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 rate
• Adjustable rate interest rate changes with the
  market about every six months
• The 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.

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• 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 stocks 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.

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• 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.

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• The SP 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 Types
• Preferred stock get fixed dividends and are
  paid first
• Common stock get what is left if any
• Beta measures the variability of a stocks 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 stocks 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 stocks price changes by 2 percent and the
  stock is riskier than the market. A beta less
  than 1 means that the price of the stocks price
  varies less than the overall market.
• Types
• Rising bull
• Falling bear

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Primary Market

• Primary initial offering (IPO) Primary markets
  are those in which newly issued claims are sold
  to initial buyers by the borrower
• The 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 public
• Morgan Stanley, Merrill Lynch, Smith Barney
• Act as brokers and dealers

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Secondary Market

• Secondary any additional trading of the
  financial instrument
• Risk-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 Exchange
• Brokers agents of investors
• Dealers link buyers and sellers
• Bid ask spread
• Bid price dealers will buy (low) 50
• Ask or Offer Price dealers will sell (high) 52

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• Markets
• Auction Markets (Exchanges) buyers and sellers
  confront directly
• NYSE, Chicago commodity market, NASDAQ
• Dealer Markets (Over the Counter) Dealers carry
  an inventory (like a store) in hopes of making a
  profit
• Use computerized trading
• Over the Counter (OTC) and NASDAQ
• Brokered Market dealers and brokers search for
  buyers and sellers and earn a commission
• Municipal Bonds  

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• Time Markets deal with maturity
• Money Market short term instruments (less than
  1 year)
• Less risky
• More liquid
• Lower information costs
• Capital Market long term instruments (1 years)
• Claims
• Cash market immediate transaction and
  settlement
• Derivative market- settlement is made later
• Financial futures commodities and metals
• Options the right to buy or sell and asset in
  the future

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Financial Instruments

• Money Markets
• U.S. Treasury Bills short term Govt issues (3
  to 12 months)
• No default raise taxes or print currency
• Used in Open Market Operations
• Third largest
• Sell at discount
• Certificates of deposits short term bank issue
• second largest
• 100,000
• First issued by Citibank in 1971
• Commercial paper short term corporate issues
• largest
• Bankers Acceptances international trade issue
• Repurchase 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 price
• Federal Funds overnight loans between banks
• Federal Funds Rate
• Eurodollars US dollars in foreign banks
• Not Euros

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• Capital Markets
• Stocks ownership of a corporation
• Price f(interest rates, company earnings)
• Influenced by monetary policy which determines
  interest rates, GDP and inflation
• Largest
• The principal of inflation-indexed bonds is
  adjusted for inflation every six months. Although
  the interest rate doesnt 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 land
• Second largest
• Corporate bonds loans to corporations
• Third largest
• US Government securities savings bonds
• Types
• Treasury Notes 1 to 10 years
• Treasury Bonds 10 years
• Most liquid
• US 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 loans
• State and Local (municipal) Government Bonds to
  finance schools and bridges etc.

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Financial Institutions

• Financial Intermediaries
• Financial Intermediaries in the Financial System
• Institutions 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  d1RSU Chapter 3
  and 13

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• Functions
• Reduce transactions costs make trading easier
• Provide risk sharing, liquidity and information
• Volume of activity allows economies of scale
• Portfolio Diversification dont put all of your
  eggs in one basket

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• 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.

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• 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 lenders 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 credit
• Moral hazard refers to a lenders verifying that
  borrowers are using their funds as intended. Loan
  is said to be for one purpose but actually used
  for another

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• 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 industry
• Thrift institutions
• Savings and loans mortgages
• Mutual savings banks mortgages
• Credit unions consumer loans
• Commercial banks (largest) all types of loans
• 8,000
• Declining percent of financial share

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• 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
  policyholders 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 companies
• insure policyholders against events other than
  death.

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• Life Insurance companies corporate bonds and
  mortgages
• Whole Life builds cash value, constant premium
• Term 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 bonds
• Private funds growing the fastest
• Pension funds invest contributions of workers and
  firms to provide for pension benefit payments
  during workers retirements.

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• Investment intermediaries also growing
• Investment institutions, which raise funds to
  invest in loans and securities, include mutual
  funds and finance companies.

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• 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.
• .

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• 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
  funds liabilities, all divided by the
  outstanding number of shares
• While 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 manager
• Families different funds managed under the same
  umbrella) Fidelity, Vanguard Group
• Specialized funds growth, bond, index

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• 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 loans
• Money market mutual funds Money market
  instruments
• Short term money market instruments
• Money market mutual funds invest in securities
  with an original maturity of one year or less
• The greatest growth in mutual funds has been in
  money market mutual funds, which hold
  high-quality, short-term assets

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• Securities market institutions
• Investment banks underwrite newly distributed
  stocks and bonds
• Morgan Stanley, Merrill Lynch, Smith Barney
• Profit on a spread determined by risk
• Brokers 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.

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• 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 firms 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.

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• 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.

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• Venture Capitalists finance risky startups
• Nonpublic
• Government Financial Institutions
• Federal 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

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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

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• Goals
• Provide information
• Maintain financial stability
• Control the money supply
• Encourage particular activities

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• Major agencies
• SEC organized exchanges and financial markets
• Established by the Securities Acts of 1933 and
  1934
• Primary Markets
• Regulates
• Public Disclosure
• Insider Trading
• NASD National Association of Securities Dealers
• FDIC Commercial banks, Savings and loans and
  Mutual savings banks
• 100,000 per account
• Federal Reserve System (FED) all depository
  institutions
• Functions
• Increase investor information
• Ensure soundness of the intermediaries
• Examines banks
• Restricts entry
• Disclosure reporting requirements
• Restricts assets and activities
• Deposit insurance

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• 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.