Introduction to Finance

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Introduction to Finance
Phillip LeBel, Ph.D. Professor of
EconomicsSchool of Business Montclair State
UniversityUpper Montclair, New Jersey
07043Lebelp_at_mail.montclair.edu
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The Significance of Financial Institutions

• Finance is an essential tool in the creation of
  capital goods
• Financial institutions serve as intermediaries
  between savers and investors for the efficient
  allocation of resources
• Financial institutions include government
  agencies, banks, private equity markets, as well
  as individual savings organizations
• Interactions between savers and investors are
  governed by the pricing of credit, and which is
  reflected in given rates of interest
• While central banks are major players in the
  determination of interest rates, other actors
  play important roles as well, notably, the World
  Bank, the IMF, and other financial institutions.

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The Determination of Interest Rates

• Interest rates are set by a combination of market
  and public intervention decisions
• Central banks typically set interest rates equal
  to the opportunity cost of capital, namely, what
  it costs the central bank to obtain a given level
  of credit
• Interest rates can be distorted in the presence
  of market imperfections, with the result that
  capital flows are inefficient, thus reducing an
  economys potential rate of growth.

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Market Forces in Interest Rate Determination

• When central banks intervene in capital markets
  they can do so by a variety of means
• One is through open market operations, by which
  the buying of government securities increases
  their price and lowers the underlying rate of
  interest - however, for this to work efficiently
  depends on the orderly functioning of a
  securities market
• A second instrument is through the setting of
  required reserve ratios across the banking
  systems. Higher reserve ratios mean fewer
  lendable reserves, in which case banks ration
  credit through higher interest rates.

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• In addition, central banks can also use selective
  credit controls to favor some sectors over
  others. Such was the case with the conversion of
  the U.S. economy from producing civilian to
  military goods during the Second World War, and
  in the now abandoned use of Regulation Q to favor
  housing construction in the U.S.
• Apart from the question of an orderly functioning
  of a securities market, one additional problem is
  if government treasury operations require the
  issuance of new debt to cover obligations while
  the central bank may be pursuing a contractionary
  monetary policy - there will be no effect on the
  supply of money as long as the private sector
  purchases all new government debt, whereas if the
  central bank does so, there will be an
  expansionary effect on the supply of money, thus
  undercutting a contractionary central bank
  monetary policy.
• Private equity markets are an important
  complement to debt institutions. Transparency in
  the structure and operation of equity markets is
  an essential condition for their role in the
  efficient allocation of resources

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The Mix of Financial Institutions

• While a securities market is an important type of
  financial institution, other institutions enable
  capital flows to be priced according to different
  levels of risk.
• Risk reflects financial, economic, political, and
  environmental factors that influence the level
  and efficiency of capital flows.
• In addition, to government securities markets,
  other institutions include private equity
  markets, along with a mix of financial risk
  management products such as derivatives.

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Financial Risk Management Products

• The Black-Scholes Option Pricing Model
• Value at Risk Models
• Earnings at Risk Models
• Economic Value Added Models
• Expected Default Frequency Models

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Fundamental Principles in Finance

• Financial institutions are essential to the
  efficient allocation of resources
• Distortions in capital markets exist from a
  combination of factors the absence of financial
  intermediation, the inefficiency of capital
  markets, and mis-placed government intervention
  designed to accomplish other ends
• Financial risk management products can improve
  the functioning of capital markets but they can
  not eliminate risk. Diversification is an
  essential step in risk management, but works
  better in the presence of derivative contracts
  than in their absence.