CHAPTER 2 Basics of Finance FINANCIAL SYSTEM 1. Financial Assets 2. Financial Markets 3. Financial Institutions Med Jaouad-Principles of Finance, PIIMT 2011

Financial System An institutional framework existing in a country to enable financial transactions Three main parts Financial assets (loans, deposits, bonds, equities, etc.) Financial institutions (banks, mutual funds, insurance companies, etc.) Financial markets (money market, capital market, forex market, etc.) Regulation is another aspect of the financial system

Basic definition of Financial Assets An asset is a legal contract between two counterparties. An asset has a defined maturity. Any asset is described as a “defined cash flow” expected at a “defined maturity”. Thus, every asset can be described as a series of (expected cash flow, cash flow-maturity) pairs. Cash flows can be either fixed or random, positive or negative. Cash flow-maturity: at what point in time is the cash flow expected.

Financial Asset: Definition It is a financial claim on an asset that is usually documented by some type of legal representation. Examples include bonds and stocks vs physical and tangible assets such as real estate or gold.  It is non-physical asset. Examples of financial assets include bank accounts and shares in a publicly-traded company. Financial assets are distinguished from physical assets like real estate and personal property. They represent a claim to the payment of a sum of money sometime in the future and/or periodic payment in the form of interest or dividend.

Financial Assets as sets of (cash flow, maturity) pairs Based on the asset-maturity, and features of it’s cash flow, financial assets fall into the following broad categories: Assets with fixed (deterministic) cash flows and fixed maturities: loans, bonds Assets with fixed cash flows and uncertain maturities: insurance products Assets with uncertain cash flows and fixed maturities: derivatives (options, swaps, …) Assets with uncertain cash flows and uncertain maturities: equity

Types of financial risk Financial assets are state–contingent claims: at time t = 0, there is always a probability of a non-positive payoff at time t = 1. Each asset has an expected payoff. Uncertainty about the expected payoff is the risk of a financial asset. In finance, this risk is captured as fluctuations in the observed value of the asset at every point in time, and is broken down into the following components: Systemic market risk Liquidity risk Credit risk Legal and institutional risk

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 Promote economic efficiency by producing an efficient allocation of capital, which increases production Directly improve the well-being of consumers by allowing them to time purchases better

Financial Market: Direct finance and Indirect finance Direct finance – funds are directly transferred from lenders to borrowers Indirect finance – financial intermediaries receive funds from savers and lend them to borrowers Securities are assets for the holder and liabilities for the issuer

Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency

Structure of Financial Markets Debt and Equity Markets Debt instruments – contractual obligation to pay the holder fixed payments at specified dates (e.g., mortgages, bonds, car loans, student loans) Short-term debt instruments have a maturity of less than one year Intermediate-term debt instruments have a maturity between 1 and 10 years Long-term debt instruments have a maturity of ten or more years Equity – sale of ownership share (owners are residual claimants). Owners of stock may receive dividends

Structure of Financial Markets Primary and Secondary Markets Primary market = financial market in which newly issued securities are sold. Secondary market = financial market in which previously owned securities are sold. Investment Banks underwrite securities in primary markets Brokers and dealers work in secondary markets Broker – match buyers and sellers Dealers – buy and sell securities

Financial Markets Stocks and Bonds securities Firms Sara Ali money Primary Market Secondary Market

Structure of Financial Markets Roles of Secondary Markets Increase liquidity of financial assets Determine security prices that help determine the price of securities in primary markets Exchanges and Over-the-Counter (OTC) Markets Exchange – buyers and sellers meet in one central location (e.g., NYSE or CSE) Over-the-counter market – transactions take place in multiple locations through dealers

Structure of Financial Markets Money and Capital Markets Money markets deal in short-term debt instruments Capital markets deal in intermediate and longer-term debt and equity instruments

Financial Market Instruments Money Market Instruments Treasury bonds/bills: 1-, 3-, 6-month maturities, discounted; no default risk Negotiable bank certificates of deposit (NCD): transferable in the secondary markets, large denominations Commercial paper (CP): issued by large banks or well-known corporations, direct finance; largest instrument Banker’s Acceptances: can be resold in the secondary markets, use abroad in international trade Repurchase Agreements (repos): treasury bills are used to serve as collateral, <2 weeks Central Bank/Fed funds: overnight loan b/w banks of their deposits at Fed/Central Bank

Financial Market Instruments Capital Market Instruments Stocks: largest instruments, hold by individuals , pensions, mutual funds, and insurance companies Mortgages. Corporate bonds: convertible or non-convertible Government securities (bonds, bills): issued by the Treasury, most liquid security State and local government bonds: also called municipal bonds, interest-exemption Consumer and bank commercial loans

The Firm and the Financial Markets Firm issues securities (A) Invests in assets (B) Retained cash flows (F) Cash flow from firm (C) Dividends and debt payments (E) Short-term debt Long-term debt Equity shares Current assets Fixed assets Taxes (D) The cash flows from the firm must exceed the cash flows from the financial markets. Ultimately, the firm must be a cash generating activity. Government

Internationalization of Financial Markets Foreign Bonds—sold in a foreign country and denominated in that country’s currency Foreign bonds may be used to avoid exchange-rate risk Eurobond—bond denominated in a currency other than that of the country in which it is sold Eurocurrencies—foreign currencies deposited in banks outside the home country Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks World Stock Markets Casablanca, London, Tokyo and other foreign stock exchanges have grown in importance

Investment Environment

Financial Institution: Definition It is an organization that acts as a channel between savers and borrowers of funds (suppliers and consumers of capital). It could be Private (shareholder-owned) or Public (government-owned) Two main types of financial institutions are: Depository banks and credit unions which pay interest on deposits from the interest earned on the loans, and Non-depository insurance companies and mutual funds (unit trusts) which collect funds by selling their policies or shares (units) to the public and provide returns in the form of periodic benefits and profit payouts.

Function of Financial Intermediaries: Indirect Finance Lower transaction costs Economies of scale Liquidity services Reduce Risk Risk Sharing (Asset Transformation) Diversification Asymmetric Information Adverse Selection (before the transaction)—more likely to select risky borrower Moral Hazard (after the transaction)—less likely borrower will repay loan

Function of Financial Intermediaries: Indirect Finance Adverse Selection: Individuals who are willing to accept a financial (or other) contract are of lower “quality” than a typical individual in the population 1. Before transaction occurs 2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected Moral Hazard: The existence of a contract causes one party to alter their behavior in a manner detrimental to the other party 1. After transaction occurs 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

Types of financial intermediaries Depository institutions Commercial banks Savings and Loan Associations Mutual savings banks Credit unions Contractual savings institutions Life insurance companies Fire and casualty insurance companies Pension funds and government retirement funds Investment intermediaries Finance companies Mutual funds Money market mutual funds Investment banks

Regulation of the Financial System Two Main Reasons for Regulation To increase the information available to investors: Reduce adverse selection and moral hazard problems Force corporations to disclose information to reduce insider trading To ensure the soundness of financial intermediaries: Restrictions on entry Disclosure Laws Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates

Quiz 2 1.Define: Financial Asset, Financial Market and Financial Institution 2. Discuss how these three elements are related 3. Characterize these financial assets : Bonds, Insurance Products, Derivatives and Equity, according to their expected cash flow and asset-maturity