1 Chapter 2: The Financial System Copyright © Prentice Hall Inc Author: Nick Bagley, bdellaSoft, Inc. Objective Understanding the workings of the financial system Determining rates of return

2 Chapter 2 Contents 1. What is a Financial System 2. The Flow of Funds 3. The Functional Perspective 4. Financial Innovation & the “Invisible Hand” 5. Financial Markets 6. Financial Market Rates 7. Financial Intermediaries 8. Financial Infrastructure and Regulation 9. Governmental & Quasi- Governmental Organizations

3 The Flow of Funds Diagram Markets Intermediaries Surplus UnitsDeficit Units

4 Fund Flows via Market Markets Intermediaries Surplus UnitsDeficit Units

5 Fund Flows via Market  Example: A household buys shares of stock from a firm that issues them

6 Fund Flows via Intermediary Markets Intermediaries Surplus UnitsDeficit Units

7 Fund Flows via Intermediary  Example: You deposit your savings in an account at a bank, and the bank uses the funds to make a loan to a business firm  Your deposit: save and liquid  The loan: has default risk and may be illiquid

8 Fund Flows via Intermediary and Market Markets Intermediaries Surplus UnitsDeficit Units

9 Fund Flows via Intermediary and Market  Example: A couple may invest its savings in an insurance company account (intermediary), which then invests its funds in stocks and bonds (markets).

10 Funds Flow via Markets and Intermediaries Markets Intermediaries Surplus UnitsDeficit Units

11 Funds Flow via Markets and Intermediaries  Example: A finance company that makes loans to households might, for instance, raise those funds by issuing stocks and bonds in the markets for those securities.

12 Funds Flow: Disintermediation Markets Intermediaries Surplus UnitsDeficit Units Markets Intermediaries Surplus UnitsDeficit Units

13 Six Key Financial Functions: Transferring Resources Across Time & Space Managing Risk Clearing and Settling Payments Pooling Resources and Subdividing Shares Providing Information Dealing with Incentive Problems

14 Transferring Resources across Time and Space  Student loans, borrowing to buy a house, saving for retirement are all actions that shift resources from one point in time to another.  When German citizens invest in shares issued by firms located in Russia, recourses are shifting from one place to another.

15 Managing Risk  Example: Insurance companies are financial intermediaries that specialize in the activity of risk transfer. They collect premiums from costumers who want to reduce their risks and transfer it to investors who are willing to pay the claims and bear the risk for some reward.

16 Clearing and Settling Payments Gold ---- paper currency ---- checks ---- credit cards ---- electronic- funds-transfer

17 Pooling Resources and Subdividing Shares  Example: U.S. T bills cost at minimum $10,000. In 1970s, U.S. T-bills mutual funds were developed. Investors’ money is pooled, and the price of a share is frequently posted, if the price is now $11 and you invest $1,000, your account has $1,000/11 or shares credit.

18 Providing Information  Example: A firm earns $10 million in profits, whether to reinvest it in the business, pay it out in cash dividends to shareholders, or use it to buy back its own shares. Its own and other firm’s share prices, market interest rates will help.

19 Incentive Problems  Moral Hazard  Adverse Selection  Principal-Agent Problem

20 Moral Hazard  When having insurance against some risk causes the insured party to greater risk or to take less care.  Example: If a warehouse owner buys fire insurance, his incentive to spend money to prevent a fire is reduced.

21 Adverse Selection  Those who purchase insurance against risk are more likely than the general population to be at risk.  Example: A firm selling life annuities cannot assume that the people who buy them will have the same expected length of life as the general population.

22 Principal-Agent Problem  Agents may not make the same decisions that the principals would have made if the principals knew what the agents know and were making the decisions themselves.

23 Some Solutions by Financial System  Collateralization of loans: giving the lender the right to seize specific business assets in the event of default  Equity-Kicker in loan: Any provision of the loan contract that allows the lender to share in the benefits accruing to shareholders. Ex: a percentage sharing in profits.

24 Financial Innovation and the invisible Hand Now, you can pay for almost anything you buy almost everywhere with credit card. You need not worry about your money being lost or stolen. World travel has become less costly and more convenient as a result of credit cards.

25 Financial Innovation and the invisible Hand The first firm to offer credit cards was Diners Club, then American Express and Carte Blanche, nowadays commercial banks, two biggest: VISA and MasterCard. The revenues are from fees paid by retailers on credit card purchases and from interest paid on loans to credit card costumers.

26 Financial Assets  Debt: Bonds  Equity: Stocks  Derivatives: Options, Forward Contracts

27 Debt  Corporate bonds, government bonds, residential and commercial mortgages, consumer loans.  Fixed-income instruments

28 Debt  Money Market: Short-term Debt  Capital Market: Long-term Debt  Money market instruments are mostly interest-earning securities. Money markets are globally integrated and liquid.

29 Equity  The claim of the owners of a firm. Common stocks or shares are bought and sold in the stock market.  Common stock represents a residual claim on the assets of a corporation. Has the feature of limited liability.

30 Derivatives  Financial instruments that derive their value from the prices of one or more other assets such as equity securities, fixed-income securities, foreign currencies, or commodities.  They serve as tools for managing exposures to the risks associated with the underlying assets.

31 Derivatives  Options: call options, put options o Call option: gives its holder the right to buy some asset at a specified price on or before some specified expiration date. o Put option: the right to sell.  Forward contracts: oblige one party to the contract to buy, and the other party to sell.

32 Financial Market Rates 1. Interest Rates 2. Rates of Return on Risky Assets

33 Interest Rates  A promised rate of return.  Mortgage rate: the interest rate that home buyers pay on the loans they take to finance their homes.  Commercial loan rate: the rate charged by banks on loans made to businesses.

34 Interest Rates Depend on:  Unit of account: the medium in which payments are denominated. A currency, a commodity such as gold, or some standard “basket” of goods and services.  Maturity: the length of time until repayment of the entire amount borrowed.

35 Interest Rates Depend on:  Default risk: the possibility that some portion of the interest or principal on a fixed-income instrument will not be repaid in full.

36 Effect of Unit of Account  A fixed-income instrument is risk free only in terms of its own unit of account.  Although the bonds offer a risk-free rate of return in their own currency, the rate of return in any other currency is uncertain because it depends on the rate of exchange between the currencies when payments are received in the future.

37 Exchange Rate Example ¥ ¥ ¥ £100 £109 Time 3% ¥/¥ (direct) 1.73% ¥/£/£/¥ 150 ¥/£ 9%£/£ 140 ¥/£ Japan U.K.

38 Exchange Rate Example ¥ ¥ ¥ £100 £109 Time 3% ¥/¥ (direct) 8.27% ¥/£/£/¥ 150 ¥/£ 9%£/£ 149 ¥/£ JapanU.K.

39 Exchange Rate Example ¥ (borrowed) ¥ Repaid £100 Invested £109 Matures Time 3% ¥/¥ (direct) 3% ¥/£/£/¥ 150 ¥/£ 9%£/£ Forward ¥/£ JapanU.K.

40 Effect of Maturity

41 Effect of Default Risk

42 Computation of Return on Stock

43 Market Indexes  Dow Jones Industrial Index (DJI)  Standard and Poor’s 500 (S&P 500) DJI: Prices of 30 Stocks of Major Industrial Corporations S&P 500: 500 Stocks of the largest public corporations

44 Market Indexes

45 Inflation and Real Interest Rates  Nominal Price: in terms of some currency  Real price: in terms of purchasing power over goods and services  Nominal interest rate  Real interest rate: unit of account, the basket used to compute the national consumer price index (CPI)

46 Nominal to Real

47 Determinants of Rates of Return  Productivity of Capital Goods  Degree of Uncertainty about productivity  Time Preferences of People  Risk Aversion

48 Financial Intermediaries  Banks: Commercial, Investment  Insurance Companies  Pension and Retirement Funds  Mutual Funds  Venture Capital Firms  Asset Management Firms  Information Services

49 Regional and World Organizations  Bank for International Settlements (BIS)  International Monetary Fund (IMF)  International Bank for Reconstruction and Development (World Bank)