Money and Capital Markets

2
C h a p t e r
Eighth Edition
Financial Institutions and Instruments in a Global Marketplace
Peter S. Rose
McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu
Financial Assets, Money,
Financial Transactions, and
Financial Institutions
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
2 - 2
Learning Objectives
To learn about the channels through which
funds flow between lenders and borrowers
within the global financial system.
To discover the nature and characteristics of
financial assets how they are created and
retired by decision-makers within the financial
system.
To explore the critical roles played by money
and the linkages between money and inflation.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Learning Objectives
To examine how financial intermediaries and
other financial institutions lend and borrow
funds and create and retire financial assets
within the global system of markets.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
2 - 4
Introduction
The financial system is the mechanism through
which loanable funds reach borrowers.
Through the operation of the financial markets,
money is exchanged for financial claims in the
form of stocks, bonds, and other securities,
effectively transforming savings into
investment so that production, employment,
and income can grow.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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The Creation of Financial Assets
A financial asset is
a claim against the income or wealth of a
business firm, household, or unit of
government,
represented usually by a certificate, receipt,
computer record file, or other legal document,
and usually created by or related to the lending
of money.
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Characteristics of Financial Assets
Financial assets are sought after because they
promise future returns to their owners and
serve as a store of value (purchasing power).
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Characteristics of Financial Assets
They do not depreciate like physical goods,
and their physical condition or form is usually
not relevant in determining their market value.
Their cost of transportation and storage is low,
such that they have little or no value as a
commodity.
Financial assets are fungible they can easily
be changed in form and substituted for other
assets.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Different Kinds of Financial Assets
CAny financial asset that is generally accepted
in payment for the purchases of goods and
services is a form of money. Examples include
currency and checking accounts.
CEquities represent ownership shares in a
business firm and are claims against the firms
profits and proceeds from the sale of its assets.
Common stock and preferred stock are
equities.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Different Kinds of Financial Assets
CDebt securities entitle their holders to a
priority claim over the holders of equities to
the assets and income of an economic unit.
They are either negotiable or nonnegotiable.
Examples include bonds, notes, accounts
payable, and savings deposits.
CDerivatives have a market value that is tied to
or influenced by the value or return on a
financial asset. Examples include futures
contracts, options, and swaps.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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The Creation Process for Financial Assets
To acquire assets, households and business
firms may use current income and accumulated
savings internal financing.
An economic unit may also raise funds by
issuing financial liabilities (debt) or stock
(equities), provided that a buyer can be found
external financing.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Financial Assets and the Financial System
The act of borrowing or of issuing new stock
simultaneously gives rise to the creation of an
equal volume of financial assets.
For example, a $10,000 financial asset held by
a household that had lent money will be
exactly matched by a $10,000 liability of the
business firm that had borrowed the money.
Volume of financial assets created for lenders
= Volume of liabilities issued by borrowers
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Financial Assets and the Financial System
For the balance sheet of any economic unit,
Total assets = Total liabilities + Net worth
where assets = real assets + financial assets
For the whole economy and financial system,
Total financial assets = Total liabilities
So, for the economy as a whole,
Total real assets = Total net worth
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Financial Assets and the Financial System
So, society increases its wealth only by saving
and increasing the quantity of its real assets,
for these assets enable the economy to produce
more goods and services in the future.
However, the financial system provides the
essential channel necessary for the creation
and exchange of financial assets between
savers and borrowers so that real assets can be
acquired.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Lending and Borrowing in the Financial System
Economists John Gurley and Edward Shaw
(1960) pointed out that each business firm,
household, or unit of government active in the
financial system must conform to:
R E = FA D
where R = Current income receipts
E = Current expenditures
FA = Change in holdings of financial assets
D = Change in debt and equity outstanding
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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Lending and Borrowing in the Financial System
So, for any given period of time, the individual
economic unit falls into one of three groups:
CDeficit-budget unit (DBU): E > R, D > FA
i.e. net borrower of funds
CSurplus-budget unit (SBU): R > E, FA > D
i.e. net lender of funds
CBalanced-budget unit (BBU): R = E, D = FA
i.e. neither net lender nor net borrower
Lending and Borrowing in the Financial System
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
Households $857.8 $853.1 $ 4.7
Nonfinancial business 216.0 247.2 - 31.2
firms
State and local 29.2 68.6 - 39.4
governments
Federal government 179.5 252.2 - 72.7
International sector: 435.4 58.6 376.8
foreign investors
and borrowers
Net
Acquisitions
of Financial
Assets
Net
Increase
in
Liabilities
Net Lender (+)
or Net
Borrower (-)
of Funds
Major
Sectors
of the
Economy
The U.S. Economy, 3
rd
Quarter of 2001 (Annualized)
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Lending and Borrowing in the Financial System
The global financial system permits
businesses, households, and governments to
adjust their financial position from that of net
borrower (DBU) to net lender (SBU) and back
again, smoothly and efficiently.
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What is Money?
All financial assets are valued in terms of
money, and flows of funds between lenders
and borrowers occur through the medium of
money.
Money itself is a true financial asset, because
all forms of money in use today are claims
against some institution, public or private.
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Institutional
money funds and
certain managed
liabilities of
depositories,
namely large
time deposits,
repurchase
agreements, and
Eurodollars.
+
M 3
Household
holdings of
savings
deposits,
small time
deposits, and
retail money
market
mutual funds.
+
M 2
What is Money?
The most
liquid forms
of money,
namely
currency and
checkable
deposits.
M 1
Source: http://www.ny.frb.org/pihome/fedpoint/fed49.html
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U.S. Money Aggregates
Money Supply Measures
September 2001
Savings Deposits
Small Time Deposits
Retail Money Funds
$5.3 trillion
M2
Large Time Deposits
Institutional MMFs
Euros & Repos
$7.8 trillion
M2 M3
B
i
l
l
i
o
n
s

o
f

D
o
l
l
a
r
s

9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
$1.2 trillion
M1
M1
Currency
Checkable Deposits
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The Functions of Money
CMoney serves as a standard of value (or unit of
account) for all goods and services.
CMoney serves as a medium of exchange, such
that buyers and sellers no longer need to have
an exact coincidence of wants in terms of
quality, quantity, time, and location.
CMoney serves as a store of value a reserve of
future purchasing power although the value
of money can experience marked fluctuations.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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The Functions of Money
CMoney functions as the only perfectly liquid
asset in the financial system. It exhibits price
stability, ready marketability, and reversibility.
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The Value of Money and Other Financial
Assets and Inflation
Inflation refers to a rise in the average price
level of all goods and services.
Inflation lowers the value or purchasing power
of money and is a special problem in the
financial markets because it can damage the
value of financial contracts.
The opposite of inflation is deflation, where
the average level of prices for goods and
services actually declines.
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The Value of Money and Other Financial
Assets and Inflation
Inflation is commonly measured using price
indices, such as:
the Consumer Price Index (CPI),
the Producer Price Index (PPI), or
the Gross Domestic Product (GDP) Deflator Index.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
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The Evolution of Financial Transactions
Financial systems change constantly in
response to shifting demands from the public,
the development of new technology, and
changes in laws and regulations.
Over time, the ways of carrying out financial
transactions have evolved in complexity.
In particular, the transfer of funds from savers
to borrowers can be accomplished in at least
three different ways.
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The Evolution of Financial Transactions
CDirect Finance Direct lending gives rise to
direct claims against borrowers.
Borrowers
(DBUs)
Lenders
(SBUs)
Flow of funds
(loans of spending power for an
agreed-upon period of time)
Primary Securities
(stocks, bonds, notes, etc.,
evidencing direct claims against
borrowers)
- Simple Difficult to match & risky
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The Evolution of Financial Transactions
CSemidirect Finance Direct lending with the
aid of market makers who assist in the sale of
direct claims against borrowers.
- Lower search (information) costs
Risky & matching is still required
Borrowers
(DBUs)
Lenders
(SBUs)
Flow of funds
(loans of
spending power)
Security
brokers,
dealers, &
investment
bankers
Primary Securities
(direct claims
against
borrowers)
Primary Securities
(direct claims
against
borrowers)
Proceeds of
security sales
(less fees and commissions)
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The Evolution of Financial Transactions
CIndirect Finance Financial intermediation of
funds.
- Low risk & affordable
Ultimate
borrowers
(DBUs)
Ultimate
lenders
(SBUs)
Flow of funds
(loans of spending power)
Financial intermediaries
(banks, savings and loan associations,
insurance companies, credit unions,
mutual funds, finance companies,
pension funds)
Secondary Securities
(indirect claims against ultimate
borrowers issued by financial
intermediaries in the form of
deposits, insurance policies,
retirement savings accounts, etc.)
Primary Securities
(direct claims against
ultimate borrowers in the
form of loan contracts,
stocks, bonds, notes, etc.)
Flow of funds
(loans of spending power)
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Relative Size and Importance of
Major Financial Institutions
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
($ billions at year-end) 1960 1970 1980 1990 2000
Financial intermediaries:
Commercial banks $224 $489 $1,248 $3,340 $6,488
S&L assoc. and savings banks 111 252 794 1,358 1,219
Life insurance companies 116 201 464 1,357 3,204
Private pension funds 38 110 413 1,629 4,587
Investment co. (mutual funds) 17 47 64 602 4,457
State & local govt pension funds 20 60 198 820 2,290
Finance companies 28 63 199 611 1,138
Property-casualty insurance co. 26 50 174 534 872
Money market funds 74 498 1,812
Credit unions 6 18 72 202 441
Mortgage companies 16 49 36
Real estate investment trusts 4 6 13 62
Other financial institutions:
Security brokers and dealers 7 16 36 262 1,221
Total Financial Assets Held by U.S. Financial Institutions
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Classification of Financial Institutions
Depository institutions derive the bulk of their
loanable funds from deposit accounts sold to
the public.
Commercial banks, savings and loan associations,
savings banks, credit unions.
Contractual institutions attract funds by
offering legal contracts to protect the saver
against risk.
Insurance companies, pension funds.
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Classification of Financial Institutions
Investment institutions sell shares to the public
and invest the proceeds in stocks, bonds, and
other assets.
Investment companies, money market funds, real
estate investment trusts.
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Portfolio (Financial-Asset) Decisions by
Financial Institutions
A number of factors affect the making of
portfolio decisions deciding what financial
assets to buy or sell.
CThe relative rate of return and risk attached to
different financial assets.
CThe cost, volatility, and maturity of incoming
funds provided by surplus-budget units.
Hedging principle the approximate matching of
the maturity of financial assets held with liabilities
taken on.
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Portfolio (Financial-Asset) Decisions by
Financial Institutions
CThe size of the individual financial institution.
Larger financial institutions tend to have greater
diversification in their sources and uses of funds
and economies of scale.
CRegulations and competition.
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Disintermediation of Funds
Disintermediation refers to the withdrawal of
funds from a financial intermediary by the
ultimate lenders (savers) and the lending of
those funds directly to the ultimate borrowers.
Disintermediation involves the shifting of
funds from indirect finance to direct and
semidirect finance.
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Disintermediation of Funds
Ultimate
borrowers
(DBUs)
Ultimate
lenders
(SBUs)
Financial
intermediaries
Primary Securities
Loanable funds
Financial Disintermediation
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Disintermediation of Funds
Some new forms of disintermediation have
appeared over the past two decades.
CInitiation by financial intermediaries: Some
banks sell off their loans because of difficulties
in raising capital.
CInitiation by borrowing customers: Some
borrowing customers learned how to raise
funds directly from the open market.
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Bank-Dominated Versus Security-Dominated
Financial Systems
Lesser-developed financial systems are often
bank-dominated financial systems, in which
banks and other similar institutions dominate
in supplying credit and attracting savings.
The more mature systems today are becoming
security-dominated financial systems, in which
traditional intermediaries play lesser roles and
growing numbers of borrowers sell securities
to the public to raise the funds they need.
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Money and Capital Markets in Cyberspace
One popular money management site is Money
Magazines http://money.cnn.com/, which helps
individuals track the assets they already hold
or wish to hold.
To determine how much things are worth after
the effects of inflation and to work our way
back into the past to see how the purchasing
power of our money has changed over time,
visit http://www.westegg.com/inflation/.
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2 - 39
Chapter Review
Introduction
The Creation of Financial Assets
Characteristics of Financial Assets
Different Kinds of Financial Assets
The Creation Process for Financial Assets
Financial Assets and the Financial System
Lending and Borrowing in the Financial
System
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
2 - 40
Chapter Review
Money as a Financial Asset
What is Money?
The Functions of Money
The Value of Money and Other Financial
Assets and Inflation
The Evolution of Financial Transactions
Direct Finance
Semidirect Finance
Indirect Finance
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2 - 41
Chapter Review
Relative Size and Importance of Major
Financial Institutions
Classification of Financial Institutions
Portfolio (Financial-Asset) Decisions by
Financial Intermediaries and Other Financial
Institutions
Disintermediation of Funds
New Types of Disintermediation
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2 - 42
Chapter Review
Bank-Dominated Versus Security-Dominated
Financial Systems