Chapter 2 overview financial system revise for st

Chapter 2 overview financial system revise for st © 2013 Pearson Education, Inc All rights reserved 2 1 Required Chapters • 1) Why study Money, Banking and FMs? • 2) An overview of the Financial System • 3) What is Money? • 4) Understanding the interest rates • 5) The behavior of interest rate • 6) Risk and Term structure of Interest rate • 8) An Economic Analysis of Financial Structure • 10) Banking Management of FIs • 17) The Foreign Exchange Market © 2013 Pearson Education, Inc All rights r.

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Required Chapters

• 1) Why study Money, Banking and FMs?

• 2) An overview of the Financial System

• 3) What is Money?

• 4) Understanding the interest rates

• 5) The behavior of interest rate

• 6) Risk and Term structure of Interest rate

• 8) An Economic Analysis of Financial Structure

• 10) Banking & Management of FIs

• 17) The Foreign Exchange Market

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Review: The evolution of money

M3 (4+3+4)

Small Den Dep.

Savings and MM Money Market Mutual Funds Shares

Review Questions

Questions:

• 1 Why is simply counting currency an

inadequate measure of money?

• 2 In prison, cigarettes are sometimes used

among inmates as a form of payment How

is it possible for cigarettes to solve the

“double coincidence of wants” problem,

even if a prisoner does not smoke?

• 3 Why did cavemen not need money?

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• 4.Identify which function of money is emphasized

• A Brooke accepts money in exchange for

performing her daily tasks at her office, since she

knows she can use that money to buy goods and

services

• B Tim wants to calculate the relative value of

oranges and apples, and therefore checks the price

per pound of each of these goods quoted in

currency units

• C Maria is currently pregnant She expects her

expenditures to increase in the future and decides

to increase the balance in her savings account

6 For each of the following assets, indicate

which of the monetary aggregates (M1 and

M2) includes them:

a Currency

b Money market mutual funds

c Small-denomination time deposits

on the effect of your action (with everything else the same) on M1 and M2

• 8 If you use an online payment system

such as PayPal to purchase goods or

services on the Internet, does this affect the

M1 money supply, M2 money supply, both,

An Overview

of the Financial Market

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Chapter Preview

We study the effects of financial markets and

institutions on the economy, and look at their

general structure and operations

2.2 Funcition of Financial Market

2.3 Structure of Financial System

2.4 Financial Instruments

Chapter Preview - Ex

A Preview of The Financial System

• Boby, who is a business major student, receives an

$8,000 scholarship loan for college at the beginning of the school year at UEL, but he needs only $3,000 of it right away After checking out deals at different banks, Bob decides to deposit the $8,000 in Techcombank near campus: $3,000 in a checking account and

$5,000 in a certificate of deposit (CD) that pays 5% interest and matures in 6 months later (CDs are debt instruments issued by banks that pay interest and are insured by the government.) Boby buys the CD because the interest rate is competitive, and the maturity date matches the time when Bob has to buy books and pay his tuition

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A Preview of The Financial System

• At the same time that Boby bought his CD, the bank

received a loan request from Tony, who owns a local

restaurant shop near campus (‘Bạn Tôi’) Tony wants to

borrow $25,000 to expand his delivery service The

interest rate on the loan is 9%, which is a competitive rate

and payable in 5 years The money for Tony’s loan comes

from Bob and other persons who recently bought CDs from

the bank After careful evaluation, the bank decides to

make the loan to Tony because of his good credit rating

and because it expects his business plan to generate

enough cash flows to repay the loan During the same

week, the bank made loans to other businesses whose

qualifications were similar to Tony’s and rejected a number

of loan requests because the applicants had low credit

scores or the proposed projects had low rates of return

2 Comment on how FIs (banks) make profits

3 Comment on the competitiveness among banks from the perspecitve of interest rate

4 Comment on the function of allocating funds

to business or investment projects

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Function of Financial Markets

• Perform the essential function of

channeling funds from economic

players that have saved surplus funds to

those that have a shortage of funds

(SSUs and DSUs)

• Directly improve the well-being of consumers by allowing them to time purchases better

Figure 1 Flows of Funds Through

the Financial System

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Basic components of the financial system : Markets and institutions.

instruments, also called financial claims

or securities.

intermediaries) facilitate flows of funds

from savers to borrowers

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Economic units with financial needs:

Households, Businesses, Governments.

and save for the future

and invest in productive assets

goods” (e.g education, defense)

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Budget positions creating financial needs

of economic units: Deficit or Surplus.

– Other words for “SSU” are , , Most SSUs are

that exceeds income

– Another word for “DSU” is Most DSUs

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Financial claims arise as SSUs lend to

DSUs.

• SSU’s claim against DSU is

(liability/asset) to (DSU/SSU) and (liability/asset) to

• One’s liability is another’s asset: What is payable by one is receivable by another • Financial claims: IOU, securities, financial instruments © 2013 Pearson Education, Inc All rights reserved 2-28 Marketability: Ease with which a financial asset may be sold to another SSU. Ability to resell financial claims makes them more liquid by giving SSUs choices: • Match maturity of claim to planned investment period; • Buy claim with longer maturity, but sell at end of period; or • Buy claim with shorter maturity, then reinvest Direct Financing: The simplest way for funds to flow. • Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities • DSU and SSU find each other and bargain • SSU transfers funds directly to DSU • DSU issues claim directly to SSU • Preferences of both must match: (i)

• (ii)

• (iii)

• (iv)

Direct Financing: The simplest way for funds to flow. • Preferences of both must match: (i)

• (ii)

• (iii)

• (iv)

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Matching criteria_SSU & DSU (1)

DSU needs $100,000 but SSU only has $50,000 available to lend

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DSU wants to borrow money to invest in the plant for at least 3

years, but SSU is willing to lend in 1 year

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DSU wants to use money to invest in a new technology, for

example self-driving motobike but SSU thinks that is a crazy idea

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what happen if SSU need to take the money back for solving family issues, for example? Can SSU sell the loan note/ loan agreement to

others easily?

Direct Financing: efficient for large transactions if

preferences match.

• DSUs and SSUs “seize the day”—

DSUs fund desired projects immediately

SSUs earn timely returns on savings

• Direct markets are “wholesale” markets

Transactions typically $1 million or more

Institutional arrangements common

Institutional arrangements common in direct finance.

• Investment bankers “underwrite” new

issues of securities

• Brokers and dealers bring buyers and

sellers of direct claims together

• Private placements are simplest

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Private placements are simplest.

• DSU sells whole security issue to one

investor or investor group

• Advantages include speed and low

• Buy entire issues of securities from DSUs

• Find SSUs to buy securities at higher price

spread”

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Brokers and dealers

• Brokers buy or sell at best possible price for

their clients

• Dealers “make markets” by carrying

inventories of securities

– buy at “bid price;” sell at “ask price”

– “Bid-ask spread” is dealer’s gross profit

$20 million (buy bonds)

$20 million debt (sell bonds)

Direct Financing through issuing bonds

Indirect Financing (“Financial Intermediation”):

• Financial intermediaries “transform”

– SSU has claim against ;

– Intermediary has claim against

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Investors, depositors (Tony) Bank Debt

Insurance company (intermed -iary)

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Direct and Indirect Financing

• What is the difference between

indirect and direct financial

markets regarding the form of the

2 Maturity of financial instruments

6 Nature of the relationship between SSUs and DSUs

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Structure of Financial Markets

Classify by the nature of the relationship between SSUs and DSUs:

1 Debt Markets

─ Short-Term (maturity < 1 year)

─ Long-Term (maturity > 10 year)

─ Intermediate term (maturity in-between)

─ Borrowing-lending relationship

2 Equity Markets

─ Pay dividends, in theory forever

─ Represents an ownership claim in the firm

─ New security issues sold to initial buyers

– Who does the issuer sell to in the Primary

Market?

2 Secondary Market

─ Securities previously issued are bought

and sold

– Examples include the NYSE and Nasdaq

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Structure of Financial Markets (cont.)

Even though firms don t get any money, from

the secondary market, it serves three

important functions:

•Provide , making it easy to buy and sell the securities of the companies

•Establish a for the securities

•Help investors to select their own and their portfolio

Functions of secondary market

Provide , making it easy to buy and sell the

securities of the companies

Establish a for the securities

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Help investors to select their own and

their portfolio

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Structure of Financial Markets

We can further classify secondary markets

• Securities: Treasury bills, CDs, Commercial paper, Federal

Funds, REPO, Bank Acceptance, etc.

• 2 Capital Markets

• Capital markets deal in longer-term

(debt/equity/both) instruments (>1 year)

• Generally used to secure long-term financing for capital

investment

• Securities: Stocks, Corporate bonds, local and state

government bonds, commerical loans,etc.

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FINANCIAL INSTRUMENTS

Money Market Instruments

Capital Market Instruments

What is a financial instrument?

• A financial instrument is any contract that

gives rise to both a financial asset in one

entity and a financial liability or equity

instrument in another entity

• A financial asset can be cash, an equity

instrument of another entity, or a

contractual right to receive cash or another

financial asset from another entity

• Financial liability is any contractual

obligation to deliver cash or another

financial asset with another entity

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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.

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• 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

Capital Market Instruments

Bonds Stocks Mortgages Consumer &

Commercial Loans

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Bonds Represent Borrowing

• Agreement by issuer to pay interest on specified dates and redeem the bond upon maturity

– Make no interest payments

– Sold at price well below face value

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• Bond with warrant

– Owns part of the corporation and receives

dividends from the issuer.

• Capital Gains

– Difference between price initially paid and amount received when stock is sold.

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– Preferred stock that can be converted into

common stock at a stated price

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Measures of Trends in Common Stock Prices

• Standard & Poor’s 500 Stock Index

– Based on prices of 500 individual stocks

• NASDAQ Composite Index

– Based on all stocks listed in NASDAQ

• Dow Jones Industrial Average

– Based on price of 30 “blue-chip” stocks

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Common vs Preffered stocks

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Common Stocks

• Residual Owners: stockholders of a firm are the

owners, who are entitled to dividend income and a

prorated share of the firm s earnings only after all

the firm s other obligations have been met.

• Stock return decomposition: Returns to stock

investments come in two forms:

– Dividend yield: Due to dividend payment

– Capital gain: Due to stock price appreciation

– The two can be taxed at different rates Capital

gains are taxed only when realized

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Advantages of Stock Ownership

• Provide opportunity for higher returns than other investments

• Over past 100 years, stocks earned annual returns that we roughly double the returns provided by corporate bonds

• Good inflation hedge since returns typically exceed the rate of inflation

• Easy to buy and sell stocks

• Price and market information is easy to find in financial media

• Unit cost per share of stock is low enough to encourage ownership

Disadvantages of Stock Ownership

• Stocks are subject to many different kinds of risk:

– Business risk

– Financial risk

– Purchasing power risk: Chance that return lags inflation

rate

– Market risk: market goes up and down

– Event risk: corporate event

• Hard to predict which stocks will go up in value due

to wide swings in profits and general stock market

performance

• Low current income compared to other

investment alternatives

Characteristics of Common Stock

• Equity Capital: evidence of ownership position in

a firm, in the form of shares of common stock This is why stocks are sometimes called equities

• Publicly Traded Issues: shares of stock that are

readily available to the general market and are bought and sold in the open market

• Public Offering: an offering to sell to the

investing public a set number of shares of a firm s stock at a specified price

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