Chapter 4
Financial Economics
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What is the Purpose of a financial system?
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The financial system provides channels to transfer funds from
individuals and groups who have saved money to individuals and
groups who want to borrow money.
Savers are suppliers of funds, providing funds to borrowers in
return for promises of repayment of even more funds in the future.
Borrowers are demanders of funds for consumer durables,
houses, or business plant and equipment, promising to repay
borrowed funds based on their expectation of having higher
incomes in the future.
The promises of repayment that borrowers give to savers are
liabilities to the borrowers and assets to the savers.
Financial markets issue claims on individual borrowers directly to
savers.
Financial institutions or intermediaries act as go-betweens by
holding a portfolio assets and issuing claims based on that portfolio
to savers.
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Services
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Risk sharing - diversification
Liquidity – ease at which a financial instrument
can be turned into cash
Information
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Financial Markets – systems where
money flows from savers to borrowers
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Function
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Transfer funds from savers to borrowers
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Direct finance – Savers lend to the borrowers
Indirect finance – through a financial intermediary
Financial Intermediary – facilitates the flow
of funds
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Debt instruments – Bonds – a loan to borrower
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Bonds are debt instruments that may be issued by domestic
or foreign governments and corporations
Maturity date – expiration date
• short term – less than a year
• intermediate – 1 to 10 years
• long – 10+
Perpetuities – have no maturity dates, pay interest forever
Coupons – fixed interest paid on Bonds
Zero coupons – sold below stated value
Can be tax exempt – municipal bonds
Bonds are rated by Standards & Poor’s and Moody’s
Investors Service
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Mortgages – loans for property (real estate)
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Mortgages are long-term debt instruments used to purchase
residential, commercial, and farm properties. The underlying
property serves as collateral.
Fixed rate – fixed interest rate
Adjustable rate – interest rate changes with the market about
every six months
The principal and interest payments may be insured by the
Federal Housing Administration (FHA) or Veterans
Administration (VA), which are agencies of the federal
government.
Conventional loans have no federal insurance and are made
by financial institutions and mortgage brokers. Lenders may
require borrowers with conventional loans to obtain private
mortgage insurance.
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Equities – Stocks (Ownership): Stocks represent equity in a
corporation
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Firms issue stock to raise funds for long-term investment
spending.
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An initial public offering (IPO) is a public offering of newly
issued stocks by a corporation that has not previously sold
stocks to the public. A seasoned stock offering is an offering of
newly issued stocks by a firm that has publicly held stocks
outstanding.
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Program trading by institutional investors allows for the preprogramming of computers to buy or sell baskets of stocks.
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Buying stocks on the margin refers to putting up only a fraction
of the stock’s selling price and borrowing the rest. Currently, the
margin requirement set by the Fed is 50 percent.
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Stocks may be traded in organized markets such as the New
York Stock Exchange (NYSE), the American Stock
Exchange, or other regional stock exchanges. Organized
exchanges operate auction-type markets where a specialist
trades large blocks of shares.
• The NYSE is by far the largest organized exchange. Each stock is
traded at a specific post, which may trade up to several dozen
stocks.
• The NYSE also enforces circuit breakers to temporarily halt
market trading if stock prices change by a specified amount.
• The over-the-counter market is an informal network of market
makers who trade stocks via telephone or computer linkages.
• Stocks of over 30,000 companies are traded over the counter.
• The National Association of Securities Dealers (NASD), a
privately owned organization, regulates the over-the-counter
market under the supervision of the SEC.
• Large companies may also be National Association of
Securities Automated Quotation System (NASDAQ) members.
Stocks of NASDAQ members are traded on an advanced
computer system that provides price quotes for the members of
NASDAQ.
• Stock market indexes measure movements in overall stock
prices of the stocks included in the index.
• The Dow Jones Industrial Average (the Dow) is an index of
stocks of 30 of the largest companies in the country.
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The S&P 500 is a weighted average of stocks of 500 broadbased companies and is considered to be a more meaningful
index than the Dow.
Dividend Types
• Preferred stock – get fixed dividends and are paid first
• Common stock – get what is left if any
Beta measures the variability of a stock’s return relative to the
entire market. A beta of 1 means that if there is a 1 percent
price change in the overall market, this stock’s price also
changes by 1 percent. A beta of 2 means that if there is a 1
percent price change in the overall market, this stock’s price
changes by 2 percent and the stock is riskier than the market.
A beta less than 1 means that the price of the stock’s price
varies less than the overall market.
Types
• Rising – bull
• Falling – bear
Primary Market
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Primary – initial offering (IPO): Primary markets are those in which
newly issued claims are sold to initial buyers by the borrower
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The most commonly used claim is debt, which requires the borrower to
repay the principal plus interest.
The length of the period of time before a debt instrument expires is its
maturity.
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Short-term debt instruments have a maturity of less than one year.
Intermediate term debt instruments have a maturity between one year and 10
years.
Long-term debt instruments have a maturity of 10 years or more.
Debt instruments offer the advantage to the borrower that they need not pay
more than the amount promised, while lenders incur the risk of receiving back
less than the amount promised if borrowers default.
Equity allows for variable payments from the borrower to the lender.
Common stock is a good example of an equity.
Equity owners generally receive periodic payments from the firm, known
as dividends.
Done by an Investment bank (underwriter) who then sells it to the public
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Morgan Stanley, Merrill Lynch, Smith Barney
Act as brokers and dealers
Secondary Market
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Secondary – any additional trading of the financial instrument
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Risk-sharing, liquidity, and information services are provided in
secondary markets.
Smoothly functioning secondary markets make it easier for
investors to reduce their exposure to risk by holding a diversified
portfolio of stocks, bonds, and other assets.
Secondary markets promote liquidity by making it easier for
investors to sell financial instruments for cash.
Secondary markets convey information to both savers and
borrowers by determining the prices of financial assets.
New York Stock Exchange
Brokers – agents of investors
Dealers – link buyers and sellers
Bid ask spread
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Bid – price dealers will buy (low) $50
Ask or Offer – Price dealers will sell (high) $52
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Markets
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Auction Markets (Exchanges) – buyers and sellers
confront directly
• NYSE, Chicago commodity market, NASDAQ
Dealer Markets (Over the Counter) – Dealers carry an
inventory (like a store) in hopes of making a profit
• Use computerized trading
• Over the Counter (OTC) and NASDAQ
Brokered Market – dealers and brokers search for
buyers and sellers and earn a commission
• Municipal Bonds
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Time Markets – deal with maturity
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Money Market – short term instruments (less than 1
year)
• Less risky
• More liquid
• Lower information costs
Capital Market – long term instruments (1+ years)
Claims
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Cash market – immediate transaction and settlement
Derivative market- settlement is made later
• Financial futures – commodities and metals
• Options – the right to buy or sell and asset in the
future
Financial Instruments
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Money Markets
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U.S. Treasury Bills – short term Govt issues (3 to 12 months)
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Certificates of deposits – short term bank issue
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seller agrees to buy it back at a higher price
Federal Funds – overnight loans between banks
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largest
Banker’s Acceptances – international trade issue
Repurchase agreement – guaranteed issue of less than two weeks by large
corporations and governments with short term extra money (usually hours)
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second largest
$100,000
First issued by Citibank in 1971
Commercial paper – short term corporate issues
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No default – raise taxes or print currency
Used in Open Market Operations
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Third largest
Sell at discount
Federal Funds Rate
Eurodollars – US dollars in foreign banks
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Not Euros
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Capital Markets
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Stocks – ownership of a corporation
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Mortgages – loans to purchase homes or land
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Government agency securities are securities issued by government-sponsored enterprises and by the Federal Financing
Bank.
Government-sponsored enterprises such as Fannie Mae, Freddie Mac, and Ginnie Mae, are privately owned but have
been chartered by Congress to reduce the cost of borrowing in such sectors as housing, farming, and student loans
State and Local (municipal) Government Bonds – to finance schools and bridges etc.
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Types
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Treasury Notes – 1 to 10 years
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Treasury Bonds – 10+ years
Most liquid
US Government Agency Securities – issued by agencies to finance loans for housing, farm loans etc.
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Third largest
US Government securities – savings bonds
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Second largest
Corporate bonds – loans to corporations
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Price = f(interest rates, company earnings)
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Influenced by monetary policy which determines interest rates, GDP and inflation
Largest
The principal of inflation-indexed bonds is adjusted for inflation every six months. Although the interest rate doesn’t
change, the coupon payment is based on the inflation-adjusted amount and the investor receives the inflation-adjusted
principal at maturity.
Revenue – has specific goal
General Obligation bonds
Consumer and Commercial bank loans – to households and businesses
International Markets
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Foreign Bonds – from other countries
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Eurobond – recent type and most popular
World Stock markets
Financial Institutions
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Financial Intermediaries
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Financial Intermediaries in the Financial System
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Institutions that raise funds from savers and invest in the debt or
equity claims of borrowers are engaged in financial intermediation.
Financial intermediaries match savers and borrowers by pooling the
funds of many savers to lend to many individual borrowers.
Financial intermediaries provide risk-sharing, liquidity, and information
services.
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Banks provide risk-sharing to individual depositors by having a
large quantity of deposits and access to numerous borrowers
and investments.
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Bank deposits and other intermediary claims are liquid.
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Because banks collect and process information on behalf of
many depositors their costs for information gathering are lower
than would be those of individual depositors [d1]RSU Chapter 3
and 13
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Functions
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Reduce transactions costs – make trading easier
Provide risk sharing, liquidity and information
Volume of activity allows economies of scale
Portfolio Diversification – don’t put all of your eggs in
one basket
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Obstacles to Matching Savers and Borrowers
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Transactions costs are the costs of buying and selling
a financial instrument.
• Brokerage commissions, minimum investment
requirements, and lawyers’ fees are all examples of
transactions costs.
• Financial intermediaries reduce transactions costs
by exploiting economies of scale.
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Information costs are the costs that savers incur to
determine the credit-worthiness of borrowers and to monitor
how borrowers use the acquired funds.
• Asymmetric information describes the situation in
which one party in a transaction has better information
than the other. One party knows more than the other
(insurance).
• Adverse selection refers to a lender’s problem of
distinguishing the good-risk applicants from the bad-risk
applicants before making an investment. The people who
need money are generally those with bad credit
• Moral hazard refers to a lender’s verifying that borrowers
are using their funds as intended. Loan is said to be for
one purpose but actually used for another
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Depository Institutions
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Commercial banks are financial intermediaries that accept deposits and
make loans, offering risk-sharing, liquidity, and information services to
savers and borrowers.
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In the United States, savings institutions (such as savings and loan
institutions) originated as building and loan societies.
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Borrowers with small or medium-sized credit needs do not rely on stock or bond
markets because these markets have high transactions and information costs.
Savings institutions historically suffered from a maturity mismatch, which led to
a crisis in the U.S. deposit insurance system during the 1980s and early 1990s.
Credit unions take deposits from and make loans to individuals who
work at the same firm or in the same industry
Thrift institutions
Savings and loans – mortgages
Mutual savings banks – mortgages
Credit unions – consumer loans
Commercial banks (largest) – all types of loans
8,000
Declining percent of financial share
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Contractual Savings Institutions allow individuals to pay money to
transfer risk of financial hardship to someone else and to save in a
disciplined manner for retirement.
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Insurance companies are financial intermediaries that specialize in writing
contracts to protect their policyholders from the risk of financial loss
associated with particular events.
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Insurance companies are able to engage in risk pooling because the “law of large
numbers” states that the average occurrences of death, illness, or injury for large
groups of people can generally be predicted.
Insurance companies face problems of adverse selection and moral hazard, which
they attempt to alleviate through screening potential policyholders and through the
use of risk-based premiums, deductibles, coinsurance, and restrictive
covenants.
Life insurance companies provide insurance to protect against financial
hardship for the policyholder’s survivors.
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With “whole life insurance” policyholders can save for the future, withdrawing the
total “cash value” at retirement or turning that value into an “annuity.”
With “term life insurance” premiums rise with age and the policy pays off only at the
death of the policyholder.
Property and casualty insurance companies
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insure policyholders against events other than death.
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Life Insurance companies – corporate bonds and
mortgages
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Whole Life – builds cash value, constant premium
Term Life – no cash value, premium rises as you get older
(very low in the beginning)
Fire and casualty insurance companies – Government
bonds (all types)
Pension funds (largest) and government retirement
funds – corporate stocks and bonds
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Private funds growing the fastest
Pension funds invest contributions of workers and firms to
provide for pension benefit payments during workers’
retirements.
– Investment intermediaries – also growing
• Investment institutions, which raise funds to
invest in loans and securities, include mutual funds
and finance companies.
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Mutual funds are financial intermediaries that convert small individual
claims into diversified portfolios of stocks, bonds, mortgages, and money
market instruments.
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Mutual funds are investment companies that pool the funds of many
investors and purchase securities that allow for much greater diversification
than an investor could achieve on his/her own. Mutual funds pool the funds
of many investors to invest in several hundred or even thousands of stocks or
bonds offering greater safety and more diversification than investing in one or
a few stocks.
Mutual funds now offer indexed mutual funds that hold the same basket of
stocks as represented in a stock index. Returns to an indexed fund should
mirror returns to the index.
Exchange Traded Funds (ETFs) are securities created by a securities
firm that deposits a large basket of stocks into a fund. The basket of
stocks in the fund mirrors the holdings of stocks in an index. Shares in
an EFT are then issued against the basket of stocks, sold to individual
investors, and traded like shares of stock on an exchange. The return
on ETFs mirror the return of the index.
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In closed-end mutual funds, the mutual fund company issues a fixed
number of nonredeemable shares, which investors may then trade in overthe-counter markets. Closed-end investment companies sell a limited
number of shares that may be traded openly. The price is determined by
supply and demand and can differ from the net asset value.
Open-end mutual funds issue redeemable shares at a price tied to the
underlying value of the assets. An open-end fund continually sells new
shares or buys outstanding shares from the public at the net asset value.
The net asset value per share is the difference between the market value of
the shares of stock that the fund owns and the fund’s liabilities, all divided
by the outstanding number of shares
While most mutual funds are called no-load funds and earn income only
from management fees, some mutual funds are load funds and charge
commissions for purchases and sales.
Pooled funds that are invested by a manager
Families –different funds managed under the same umbrella) – Fidelity,
Vanguard Group
Specialized funds – growth, bond, index
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Finance companies are intermediaries that raise
large amounts of money through the sale of
commercial paper and securities in order to make
small loans to households and businesses.
Finance companies – consumer and business
loans
Money market mutual funds – Money market
instruments
Short term money market instruments
Money market mutual funds invest in securities
with an original maturity of one year or less
The greatest growth in mutual funds has been in
money market mutual funds, which hold highquality, short-term assets
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Securities market institutions
• Investment banks underwrite newly distributed stocks
and bonds
• Morgan Stanley, Merrill Lynch, Smith Barney
• Profit on a “spread” determined by risk
• Brokers and Dealers: Brokerage firms (brokers and
dealers) facilitate the trading of securities in secondary
markets. Dealers take positions in securities to insure
the smooth functioning of secondary markets.
• Market orders direct the broker or dealer to purchase
securities at the present market price.
• Limit orders instruct the broker or dealer either to
purchase the securities at the market price up to a
certain maximum if possible or to sell the securities at the
market price if it is above a certain minimum.
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Securities market institutions reduce the costs of
matching savers and borrowers and provide risksharing, liquidity, and information services.
Investment banks assist business in raising new
capital in primary markets and advise on the best
way to do so.
One way in which investment bankers earn income
is by underwriting a firm’s new stock or bond
issue.
Rather than guaranteeing the price of an issue, as
is done with underwriting, an investment bank
might sell the issue under other conditions, such as
on an “all-or-none” basis.
Large issues are sold by groups of underwriting
investment banks called syndicates.
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The ability to buy and sell issues at low cost after their original issue
increases their liquidity.
Brokers and dealers facilitate the exchange of securities in financial
markets by locating buyers when sellers want to convert securities to
cash.
Brokers earn commissions by matching ultimate buyers and sellers in a
particular market.
Dealers trade between ultimate buyers and sellers.
The SEC regulates dealers and brokers and restricts trading based on
insider information.
Securities may be traded through exchanges or in over-the-counter
markets.
An exchange is a physical location at which securities are traded.
In over-the-counter (OTC) markets broker-dealers match buyers and
sellers over the telephone and by computer.
While the market for U.S. Treasury bonds is the most liquid market in the
world, the market for most corporate bonds is relatively illiquid.
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Venture Capitalists – finance risky startups
• Nonpublic
Government Financial Institutions
• Federal credit agencies are government financial
institutions that make loans in the interest of public
policy.
• The U.S. government lends to farmers through the Farm
Credit System, to the housing market through the Federal
National Mortgage Association, the Federal Home Loan
Mortgage Company, and the Government National
Mortgage Association, and to students through the
Student Loan Market Association.
• The U.S. government also guarantees loans made by
private financial institutions
Financial Regulation
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Facts
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Governments around the world regulate financial markets and
institutions in order to promote the provision of information, the
maintenance of financial stability, and other policy objectives.
The federal government in the United States has intervened in
financial markets to require issuers of financial instruments to
disclose information about their financial condition.
Most regulation of the financial system is aimed at ensuring
financial stability in the sense of maintaining the ability of the
financial system to provide risk-sharing, liquidity, and information
services in the face of economic disturbance.
Other policy objectives advanced by financial regulation include
controlling the money supply and encouraging particular
activities.
Regulation affects the ability of financial markets to provide risksharing, liquidity, and information services
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Goals
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Provide information
Maintain financial stability
Control the money supply
Encourage particular activities
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Major agencies
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SEC – organized exchanges and financial markets
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NASD – National Association of Securities Dealers
FDIC – Commercial banks, Savings and loans and Mutual savings banks
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Established by the Securities Acts of 1933 and 1934
Primary Markets
Regulates
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Public Disclosure
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Insider Trading
$100,000 per account
Federal Reserve System (FED) – all depository institutions
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Functions
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Increase investor information
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Ensure soundness of the intermediaries
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Examines banks
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Restricts entry
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Disclosure – reporting requirements
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Restricts assets and activities
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Deposit insurance
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Limits competition
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Restricts interest rates – Regulation Q
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Reserve requirements
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Control Monetary Policy
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Competition and Change in the Financial System
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Financial markets and financial intermediaries compete for funds and
market share in the financial system by offering risk-sharing, liquidity, and
information services to savers and borrowers.
Financial innovation results from changes in the costs of providing risksharing, liquidity, and information services or from changes in demand for
these services.
The increasing ease of communicating information has allowed for greater
financial integration between U.S. financial markets.
In recent decades there has been global integration of financial markets.
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The easy flow of capital across national boundaries helps countries with productive
opportunities to grow.
Increasing financial integration around the world reduces the cost of allocating
savers’ funds to the highest-valued uses.
During the 1930s, laws and regulations built barriers that protected from
competition the services offered by each type of financial institution.
In the current environment, the provision of financial services is being
organized more by function than by the identity of the provider.
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999
removed many of the regulatory lines among financial institutions.