Lecture Money and capital markets: Chapter 2 – Peter S. Rose, Milton H.Marquis.ppt (Money Markets)

Chapter 2 Financial Assets, Money, Financial Transactions, and Financial Institutions 2-3  Learning Objectives  • To learn about the channels through which funds flow between lenders and borrowers within the global system of money and capital markets. • To discover the nature and characteristics of financial assets – how they are created and destroyed by decision-makers within the financial system. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-4  Learning Objectives  • To explore the critical roles played by money within the financial system and the linkages between money and inflation in the prices of goods and services. • To examine the important functions carried out by financial intermediaries in lending and borrowing and in creating and destroying financial assets. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-5 Introduction: The Role of Financial Assets • 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, thereby transforming savings into investment so that the economy can grow. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-6 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-7 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). McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-8 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. • They have little or no value as a commodity and their cost of transportation and storage is low. • Financial assets are fungible – they can easily be changed in form and substituted for other assets. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-9 Different Kinds of Financial Assets   Any financial asset that is generally accepted in payment for purchases of goods and services is money. Currency and checking accounts are forms of money. Equities represent ownership shares in a business firm and are claims against the firm’s profits and against proceeds from the sale of its assets. Common stock and preferred stock are equities. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 10 Different Kinds of Financial Assets   Debt securities entitle their holders to a priority claim over the holders of equities to the assets and income of an economic unit. They can be negotiable or nonnegotiable. Examples include bonds, notes, accounts payable, and savings deposits. Derivatives 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 11 How Financial Assets Are Born • 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 12 Balance Sheets of Units in a Simple Financial System McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 13 Unit Balance Sheets Following the Purchase of Equipment and the Issuance of a Debt Security McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 14 Unit Balance Sheets Following the Purchase of Equipment and the Issuance of Stock McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 15 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. • All financial assets are recorded as a liability or claim on some other economic unit’s balance sheet.  Volume of financial assets created for lenders = Volume of liabilities issued by borrowers McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 16 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 McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 17 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 18 Lending and Borrowing in the Financial System • Economists John Gurley and Edward Shaw 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 E FA D = = = = McGraw-Hill/Irwin Money and Capital Markets, 9/e Current income receipts Expenditures out of current income Change in holdings of financial assets Change in debt and equity outstanding © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 19 Lending and Borrowing in the Financial System • So, for any given time period, each economic unit must fall into one of three groups:  Deficit-budget unit (DBU): E > R, so D > FA (net borrower of funds)  Surplus-budget unit (SBU): R > E, so FA > D (net lender of funds)  Balanced-budget unit (BBU): R = E, so D = FA (neither net lender nor borrower) McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 20 Lending and Borrowing in the Financial The U.S. System Economy in 2003 ($ Billions) Major Sectors of the Economy Net Acquisitions Net Net Lender (+) of Financial Increase in or Net Assets Liabilities Borrower (-) Households Nonfinancial business firms State and local governments Federal government International sector: foreign investors and borrowers $770.9 $912.6 $ - 141.7 709.3 540.1 + 169.2 70.0 141.6 - 71.6 - 3.0 421.5 - 424.5 810.5 234.6 + 575.9 Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 21 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 22 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 financial asset, because all forms of money in use today are claims against some public or private institution. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 23 Alternative Definitions of Money M3 M2 M1 The most liquid forms of money, namely currency and checkable deposits. McGraw-Hill/Irwin Money and Capital Markets, 9/e + Household holdings of savings deposits, small time deposits, and retail money market mutual funds. Institutional money funds and certain managed liabilities of depositories, namely large + time deposits, repurchase agreements, and Eurodollars. © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 24 Alternative Definitions of Money Billions of Dollars Money Supply Measures 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 September 2004 September 2001 $6.3 trillion $5.3 trillion $9.3 trillion $7.8 trillion Euros & Repos Institutional MMFs Large Time Deposits Retail Money Funds Small Time Deposits $1.3 trillion $1.2 trillion Checkable Deposits Currency Savings Deposits M1 M2 M2 M1 M3 Source: http://www.ny.frb.org/aboutthefed/fedpoint/fed49.html McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 25 The Functions of Money    Money serves as a standard of value (or unit of account) for all goods and services. Money 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. Money serves as a store of value – a reserve of future purchasing power. However, the value of money can experience marked fluctuations. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 26 The Functions of Money  Money functions as the only perfectly liquid asset in the financial system. It exhibits price stability, ready marketability, and reversibility. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 27 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 money and capital 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 28 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 29 The Value of Money and Other Financial Assets and Inflation • Suppose the U.S. CPI rises from 100 to 125 over a five-year period.  Over the five-year period, the cost-of-living index climbed 125  100 0.25 or 25% ... 100 and the U.S. dollar’s relative purchasing power fell to 1 100 0.8 . 125 McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 30 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 31 The Evolution of Financial Transactions  Direct Finance – Direct lending gives rise to direct claims against borrowers. Flow of funds Borrowers (DBUs) (loans of spending power for an agreed-upon period of time) Primary Securities Lenders (SBUs) (stocks, bonds, notes, etc., evidencing direct claims against borrowers)  Simple  Difficult to match & risky McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 32 The Evolution of Financial Transactions  Semidirect Finance – Direct lending with the aid of market makers who assist in the sale of direct claims against borrowers. Primary Securities (direct claims against borrowers) Primary Securities (direct claims against borrowers) Security brokers, Borrowers dealers, & (DBUs) investment Proceeds of bankers Flow of funds (loans of security sales (less fees and commissions) Lenders (SBUs) spending power)  Lower search (information) costs  Risky & matching is still required McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 33 The Evolution of Financial Transactions  Indirect Finance – Financial intermediation of funds. Secondary Securities Primary Securities (indirect claims against ultimate (direct claims against ultimate borrowers in the form of loan contracts, stocks, bonds, notes, etc.) Ultimate borrowers (DBUs) borrowers issued by financial intermediaries in the form of deposits, insurance policies, retirement savings accounts, etc.) Financial intermediaries (banks, savings and loan associations, insurance companies, credit unions, mutual funds, finance companies, pension funds) Flow of funds (loans of spending power) McGraw-Hill/Irwin Money and Capital Markets, 9/e Ultimate lenders (SBUs) Flow of funds (loans of spending power)  Low risk & affordable © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 34 Relative Size and Importance of Major Financial Institutions Total Financial Assets Held by U.S. Financial Institutions ($ billions at year-end) 1970 1980 Financial intermediaries: Commercial banks $489 $1,248 S&L assoc. and savings banks 252 794 Life insurance companies 201 464 Private pension funds 110 413 Investment co. (mutual funds) 47 64 State & local gov’t pension funds 60 198 Finance companies 63 199 Property-casualty insurance co. 50 174 Money market funds –– 74 Credit unions 18 72 Mortgage companies –– 16 Real estate investment trusts 4 6 Other financial institutions: Security brokers and dealers 16 36 1990 2000 2004Q1 $3,340 1,358 1,357 1,629 602 820 611 534 498 202 49 13 $6,488 1,219 3,204 4,587 4,457 2,290 1,138 872 1,812 441 36 62 $8,044 1,557 3,849 4,260 4,890 2,303 1,401 1,069 1,972 635 32 133 262 1,221 1,725 McGraw-Hill/Irwin 2006 The McGraw-Hill Companies, All Rights Source: Board of Governors of the Federal©Reserve System, Flow of FundsInc., Accounts Money and Capital Markets, 9/e Reserved. 2 - 35 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 36 Classification of Financial Institutions • Investment institutions sell shares to the public and invest the proceeds in stocks, bonds, and other assets. - Mutual funds, money market funds, real estate investment trusts. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 37 Portfolio (Financial-Asset) Decisions by Financial Institutions Portfolio decisions – deciding what financial assets to buy or sell – are affected by:  The relative rate of return and risk attached to different financial assets.  The 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 38 Portfolio (Financial-Asset) Decisions by Financial Institutions  The 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.  Regulations and competition. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 39 Disintermediation of Funds • Disintermediation refers to the withdrawal of funds from a financial intermediary by the ultimate lenders (SBUs) and the lending of those funds directly to the ultimate borrowers (DBUs). • Disintermediation involves the shifting of funds from indirect finance to direct and semidirect finance. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 40 Disintermediation of Funds Financial Disintermediation Primary Securities Ultimate borrowers (DBUs) Financial intermediaries Ultimate lenders (SBUs) Loanable funds McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 41 Disintermediation of Funds • Some new forms of disintermediation have appeared in recent years.  Initiation by financial intermediaries: Some banks sold off some of their loans because of difficulties in raising capital.  Initiation by borrowing customers: Some borrowing customers learned how to raise funds directly from the open market. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 42 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 securitydominated 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. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 43 Markets on the Net • • • • • Bondsonline at www.bondsonline.com Encyclopedia.com at encyclopedia.com Federal Reserve Bank of Atlanta at www.frbatlanta.org Federal Reserve Bank of New York at www.ny.frb.org Moody’s Investor Service at www.moodys.com McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 44 Markets on the Net • • • • • Money Magazine at www.money.com New York Stock Exchange at www.nyse.com Standard & Poor’s Corporation at www.standardandpoor.com The Bond Market Association at www.investinginbonds.com U.S. Bureau of Economic Analysis at www.bea.gov McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 45 Markets on the Net • U.S. Bureau of Labor Statistics at www.bls.gov McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 46 Chapter Review • • • • • • Introduction: The Role of Financial Assets The Creation of Financial Assets Characteristics of Financial Assets Different Kinds of Financial Assets How Financial Assets Are Born Financial Assets and the Financial System McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 47 Chapter Review • Lending and Borrowing in the Financial System • Money as a Financial Asset - What is Money? - The Functions of Money • The Value of Money and Other Financial Assets and Inflation McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 48 Chapter Review • The Evolution of Financial Transactions - Direct Finance - Semidirect Finance - Indirect Finance and Financial Intermediation • Relative Size and Importance of Major Financial Institutions • Classification of Financial Institutions McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 - 49 Chapter Review • Portfolio (Financial-Asset) Decisions by Financial Intermediaries and Other Financial Institutions • Disintermediation of Funds - New Types of Disintermediation • Bank-Dominated Versus Security-Dominated Financial Systems McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Lecture Money and capital markets: Chapter 2 – Peter S. Rose, Milton H.Marquis

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