Introduction to Money and
the Financial System
Chapters 1-3
Conduct in the Classroom
Classrooms are for learning. Teachers and students
must work together so that the classroom is a good
place to learn. You can help by following a few simple
rules. These rules are mostly just common sense and
common courtesy. By following them, you show
respect to your fellow students as well as your teachers.
Please try to get to class on time. When you
come in late, you disrupt your class. As a
general rule, if you are more than 10 minutes
late, you should not enter the classroom. If you
arrive late, but need to see the instructor or pick
up lecture notes, please return at the end of the
class period.
Conduct in the Classroom
Once in class, you should stay until the class is over. If
you know you have to leave early, ask the instructor’s
permission before the class starts.
You should not do things during class that disrupt the class or
distract your classmates – such as talking while the instructor is
lecturing. If you have a pager or cellular phone, turn if off when
you are in class.
And please pay attention to the signs that tell you
not to eat or drink in the classrooms.
Conduct in the Classroom
Assignments, tests and examinations are an integral part of
the learning experience. Students who cheat disrupt this
process. The instructor has a responsibility to make
cheating difficult, but cheating is wrong even when you
can get away with it. Don’t give in to the temptation to
cheat, and be critical of those who do.
Your instructor has the authority to make other
rules that he or she feels are necessary to help
you learn. For example, some instructors may
require that you attend a minimum number or
percentage of their classes. If you do not follow
these rules, it may affect your grade.
Conduct in the Classroom
You are investing several years of your life in your
university education.
Learning to accept responsibility is an important part of
that education.
The classroom is a good place to begin
showing that you are ready for the
responsibilities of being an adult.
Specialization and Exchange
In a varied economy, producers will specialize in
production of certain goods, yet consume a
diverse set of goods which presents of problem of
allocation of goods. There are three basic
solutions.
1.
Barter – Cumbersome. Difficult to overcome the
double coincidence of wants.
2.
Government Allocation. Inefficient use of
information and incentives.
3.
Money – Use of some good as a token of value as
one side of all transactions.
Necessary Characteristics of Money
•
•
•
•
•
Acceptable (Usable by most traders)
Standardized Quality
Durable
Valuable Relative to Weight
Divisible
Aspects of Money
1.
2.
3.
4.
Medium of Exchange – Token that can be offered
as a payment for goods.
Unit of Account – All goods will have a value in
money and, thus, can be used to measure all
goods
Store of Value – If money is to be accepted for
goods today it must have durable value. (Money is
an Asset).
Standard of Deferred Payment – Money should be
something that can be promised in the future in
exchange for goods/money today.
Two categories of money


Definitive Money: Money that can be used
immediately for transactions without
conversion to more basic forms of money.
Broad Money: A set of assets, typically some
form of bank deposit, which can be easily
converted to definitive money.
Evolution of Definitive Money:
Commodity Money
Money is a technology that has advanced in
sophistication over time.
 First types of money were Commodity Money which
were items of intrinsic value, durable, compact,
divisible.
 First recorded commodity money were Cowrie shells
which were used in China in 1200 B.C. The Chinese
word for money originally meant cowrie shells.
Only problem is standardization.
 In Lydia (now part of modern day Turkey) around 700
B.C., coins of electrum minted by city government.
 Approximately, the same time, base metal (iron,
copper) coins minted in china.
Further Evolution of Definitive Money:
Fiat Money
Commodity money is problematic since it requires use
of materials for transactions that might be used
elsewhere.
 Paper notes have been used as certificates
indicating the ownership of metals.
 Around 800 A.D., a severe shortage of Copper led
Sung Dynasty Emperor Hien Tsung to declare
government issued paper as legally settling debt
contracts.
Fiat Money intrinsically worthless item that can be
used as money by government declaration.
Evolution of Money
In more advanced societies with sophisticated banking
systems, broad money may be used for transactions.
 Checks: Paper promises to pay definitive money on
demand.
 Electronic Transfers: Funds can be transferred from
account to account in banking system.
 Debit Cards and ATM Cards can be used to transfer
funds to definitive money or in direct exchange for
goods.
HK Monetary Aggregates
Cash
Demand Deposits
M1
HK$ Million
94396
133132
227528
Savings Deposits
Time Deposits
NCD's
M2
752435
2510776
70316
3561055
Deposits: RLB & DTC
NCD's: RLB & DTC
M3
37545
5490
3604090



Intertemporal Allocation of Goods
People may want to consume a value of
goods different from the one they
produce at a particular time.
Economic system must transfer goods
from people who want to shift the value
of their production from the present to
the future (savers) to those who want to
shift value from the future toward today
(borrowers).
Matching of savers and borrowers is
done by financial markets and financial
intermediaries.
Typology of Financial Markets:
Primary vs. Secondary Markets


Primary Markets: Financial markets in which
newly issued debt or equity claims are sold to
initial buyers by private borrowers or
governments
Secondary Markets: Financial markets in
which claims that have already been issued
are sold by one investor to another.
Secondary Markets Larger than Primary
Markets
New Funds Raised Relative to Turnover HKSE
20.00%
18.00%
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
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Typology of Markets: Debt & Equity
Debt: A claim that requires a borrower to repay
the amount borrowed (the principal) plus a
rental fee (interest).

1.
2.
3.

Short-term debt instruments with maturity of less
than 1 year are bills.
Intermediate-term debt instruments with maturity of
between 1 and 10 years are notes.
Long-term debt instruments with maturity longer than
10 years are bonds.
Equity: A claim to a share in the profits and
assets of a firm [Stocks].
Typology of Markets (Maturity): Money
and Capital


Money Markets: Debt instruments with an
original maturity of less than 1 year are said
to be sold in money markets.
Capital Markets: Debt instruments with an
original maturity of more than 1 year & equity
are said to be sold in capital markets.
Money Market Instruments

Short-term Government Bills






Commercial Paper: Short-run private sector debt.
Banker’s Acceptances: International Trade Credit
Repurchase Agreements: Short-term Collateralized
Loans.
Inter-bank Lending




US: Treasury Bills
HK: Exchange Fund Bills
US: Fed Funds
HK: HIBOR (Hong Kong Interbank Offered Rate)
International: LIBOR
Negotiable Certificates of Deposit (Fixed Maturity
Deposit Instrument)
Capital Market Instruments

Government Debt





US: Treasury Notes & Bonds
HK: Exchange Fund Notes, Treasury Bonds
Corporate Debt
Stocks
Securitized Mortgages


US: FNMA, GNMA, FHLMC
HK: HKMC
Hong Kong Debt Markets Dominated by
Banks
HK Debt Market
1600000
1400000
Million HKD
1200000
1000000
800000
600000
400000
200000
0
Bonds
Bank Loans
2003
HK Dollar Bond Market by Borrower
Local Corporates
6%
Authorised
Institutions
25%
Exchange Fund
22%
Statutory Bodies
10%
Non MDB Overseas
Borrowers
32%
Multilateral
Development Banks
5%
Foreign Currency Instruments play a
significant part in HK Financial markets.
HK Loans by Currency
Foreign$
23%
HK$
77%
Market Capitalization by Sector:
HK 2004
Industrial
16%
Hotels
1%
Finance
37%
Consolidated
Enterprises
28%
Utilities
Properties
7%
11%
Trading Places: Auction vs. OTC

Auction Markets – Large number of traders engage
in competitive bidding at centralized location.


HK Clearing Exchanges Ltd runs all auction markets in HK
(HKSE & HKFE).
Over the Counter – Markets for broker-dealers
connected electronically without centralized trading
place.


OTC markets main site for trading debt and foreign
exchange.
In US, some stocks (for small or new firms) are traded on
the OTC market, not in HK.
Settlement: Cash and Derivative
Markets

Cash Markets – Claims are traded with immediate
(within several days) settlement.


Hong Kong Stock Exchange is a cash market.
Derivative Markets – Claims are traded with
settlement promised at some future date.

Futures and options are traded on Hong Kong Futures
Exchange


Futures and Forwards require settlement at a fixed future date
Options confer one party an option to engage in transaction at
a future date.
Asset Holding/Portfolio Choice



To think about the social contribution of
secondary markets it is useful to think about
the various determinants of portfolio allocation
or why agents choose the assets that they do.
One key determinant of the attractiveness of
an asset is its expected return (i.e. the
expected income generated by an asset
relative to its initial price).
But other factors also determine the demand
for an asset.
Risk Sensitivity



Generally, we assume savers are risk averse.
Given a choice between two assets with the
same average return, savers will prefer the
one with the lowest level of unpredictable
volatility.
Savers would prefer an asset that always
pays $1.10 for each $1invested to one which
pays nothing, 50% of the time and $2.20,
50% of the time.
In equilibrium, risky assets must pay higher
returns.
Diversification


By spreading their wealth into assets whose returns
are uncorrelated with each other, the overall risk of a
portfolio can be minimized.
Consider two portfolios that cost $1 Million.



Portfolio A is a million shares (each costing $1) which will
pay $2.2 million if a coin is flipped and comes up heads
and 0 if tails.
Portfolio B is a million shares in a million different
companies that will each flip a coin and pay $2.2 if heads
and 0 if tails.
Both portfolios have equal expected returns and
consist of assets with identical statistical properties
but A is risky and B has no risk.
Diversification




In real world, portfolios cannot be perfectly
diversified because borrowers do not earn money
and pay returns by flipping coins.
Borrowers typically pay returns by earning money
producing and selling goods, but since economies
move up and down jointly through business cycles,
returns have a common component called systemic
risk.
Savers can use diversification to eliminate
idiosyncratic risk.
In equilibrium, assets with more systemic risk must
pay higher returns.
Liquidity




Liquidity is the cost, in terms of time and money of
converting an asset into cash at any time.
Since no one is ever certain about their future cash
needs for transactions, people prefer liquid assets.
Liquid assets are thought to be assets for which
there are thick markets – I.e assets with many
buyers or sellers.
Liquidity may be of different value to different
investors. In particular, wealthy people are less likely
to value liquidity.
Information


To correctly select their portfolio, savers must
have information about the assets they buy
as well as the overall financial markets.
Investors will prefer assets with low
information costs.
Secondary Markets: Services of the
Financial System
1.
2.
3.
Risk Sharing – Savers can reduce the risk in their
assets by diversifying their portfolio [exchange
some assets for others].
Liquidity – Agents may face unexpected cash
needs. Secondary markets allow investors to raise
this cash with little cost.
Information – Savers and borrowers can get
information about the value of assets, the cost of
capital or expected returns cheaply by observing
financial markets.
Financial Intermediaries

1.
2.
3.
4.
5.
Financial intermediaries also provide
important services to matching savers and
borrowers. Types of Financial intermediaries
include:
Securities Market Institutions
Investment Institutions
Contractual Savings
Depositary Institutions
Government Institutions
Securities Market Institutions


Investment Banks (Merchant Banks) perform
underwriting services which help borrowers
with the tasks and risks of bringing securities
to primary markets.
Brokers match buyers and sellers in
secondary markets and dealers provide
liquidity to secondary markets by trading on
their own account.
Investment Institutions



Mutual Funds (Unit Trusts) provide liquidity,
diversification and information services by
allowing investors to buy a small share of a
larger portfolio. Some are index funds which
buy a portfolio which matches the broad
markets.
Hedge Funds are similar but limited to wealthy
investors and may engage in exotic
investment strategies.
Finance companies raise money in capital
markets and make small individual loans to
borrowers.
Contractual Savings

Insurance companies diversify idionsyncratic
non-financial risk.



Property and Casualty
Life Insurance
Pension Funds take a certain contribution
from peoples wages and invest them like
mutual funds for retirement.

In HK, workers without retirement plans must
participate in Mandatory Provident Fund (a forced
saving plan).
Insurance in HK
70000
60000
Million HKD
50000
40000
30000
20000
10000
0
Life Insurance Premium
Property & Casualty Premium
Hong Kong 2002
Depository Institutions

Banks. More later.
Government Financial Institutions




Governments throughout the world set up financial
institutions which fill “gaps” in financial system.
In USA and HK, institutions exist which securitize
mortgages which means that they issue bonds and
use proceeds to buy bundles of mortgages from
banks, using the payments of homeowners to payoff bonds.
In Japan, Post Office provides risk-free bank
deposits (which is used to by government bonds).
In Singapore, government collects proceeds of
mandatory savings funds and puts them into
government controlled investment fund, Temansek.
Regulation
Governments indirectly intervene in financial
markets for a number of reasons.

1.
2.
3.
An efficient financial market requires that all
participants have equal and comprehensive
access to information.
Various imperfections may cause financial
markets to undergo periods of extreme instability.
Government regulation seeks to prevent this.
Government may manipulate financial markets to
address other societal problems.
Financial Regulation

Provision of Information – Government requires that
financial market participants make some information
public.



HKCE Ltd {technically a private sector company} regulates
listings on stock market.
Securities & Finance Commission regulates markets and
enforces laws.
Maintenance of Financial Stability – Government
enforces a certain level of financial soundness
among financial intermediaries

HKMA regulates banking system (more later)
Outline for Class
Interest
Rates
Banks
Monetary
Policy