Financial development is Link to economic growth Explain the Statement

Answer: Policymakers and economists generally agree that financial developmentthat is, well-
functioning financial institutions and markets, such as commercial and investment banks, and
bond and stock exchangescontribute to economic growth. More debatable, however, have been
issues about how financial development promotes growth. These issues would have an impact on
choosing the design for financial policies and regulations.
In this Economic Letter, I discuss recent empirical studies on the relationship between financial
development and growth. I begin with a review of studies indicating that financial sector
development does improve growth. Then I address two fundamental questions. First, does
financial sector development help growth through faster capital accumulation, or does it also
improve sustained productivity growth? Second, what is the impact of financial regulation on the
relationship between financial sector development and growth? These empirical studies consider
a range of data, including aggregated, national level data (e.g., gross domestic product and the
size of the overall financial sector), and disaggregated, industry-level and firm-level data (e.g.,
earnings and borrowing by firms). Aggregate data are more useful in studying the overall impact
of financial sector development on growth across countries, while the added detail of
disaggregated data is useful in identifying the particular channels by which financial
development affects growth and in studying the importance of financial regulation.
Does financial development cause growth?
The prevailing view in economics is that financial development contributes to growth in various
ways. For example, financial institutions are better suited than individuals to identify potentially
successful projects because these institutions are big enough to pay large fixed costs of collecting
information about individual projects and to analyze this information more efficiently. In
addition, once a project has started, they can better monitor its managers to ensure that savers
resources are used productively. Financial markets also can enhance growth. First, they help
collect resources from many savers necessary to invest in large projects. Second, they facilitate
the pooling and hedging of risk inherent in individual projects and industries. Finally, secondary
financial markets also reduce securities holders liquidity risk by allowing them to sell their
securities without affecting firms access to the funds initially invested. Thus, well-developed
financial markets and institutions can generate growth by increasing the pool of funds and by
reducing the risk and enhancing the productivity of fund transfers from savers to investment
projects.
Economists have found empirical evidence that countries with developed financial systems tend
to grow faster. King and Levine (1993) find that growth is positively related to the level of
financial development. Looking at the evidence from 80 countries from 1960 to 1989, they show
that the relative size of the financial sector in 1960 is positively correlated with economic growth
over the period. However, positive correlation may simply reflect the fact that faster growing
countries have larger financial sectors because of the increase in the number of financial
transactions conducted. By measuring financial sector development at the beginning of the
period, in 1960, King and Levine try to mitigate concerns about possible reverse causation
between financial development and economic growth.
However, this evidence does not necessarily prove that financial development causes growth.
The size of the financial sector in 1960 may depend on the expectation of future economic
growth. Subsequent work using statistical techniques to control for the endogenous effect of
economic growth on financial development as well as for country-specific factors that are not
explicitly considered, and using both time series and cross-sectional data to extract more
information from the data, has shown that the effect of financial development is robust (For
example, Levine, Loayza, and Beck 2000, Benhabib and Spiegel 2000).
What are the transmission channels?
The economics profession has evolved in its views of the primary factors driving economic
growth. Traditionally, economic growth theory focused on labor usage and capital accumulation
as the main engines of long-run growth. This approach, however, has been unable to explain
sustained growth without also assuming ongoing productivity growth, because the impact of
capital accumulation is limited by diminishing returns for a given labor force; each unit of capital
added in the economy will have a smaller marginal improvement on output. Beyond some point,
the marginal return on adding new capital will be smaller than the marginal cost of adding new
capital. Therefore, growth would stop at this point without increases in productivity.
New growth theory has focused on the ongoing technological change that raises productivity
as the main engine of growth. In principle, technological development could lead to sustained
long-term growth because the increases in productivity would be enough to offset the decreases
in productivity from diminishing returns to capital accumulation. New growth theory models
the production of new and better technologies through research and development in an
imperfectly competitive sector, for example. Thus, it can generate growth as a result of the
economic structure. Thus, it is often termed endogenous growth theory.
The question then becomes whether financial sector development affects growth through the
channel of capital accumulation, as in the old growth theory, or through the channel of
productivity increases engendered by knowledge creation, as in the endogenous growth theory.
The second channel is potentially more important because it implies that growth may be
sustainable for long periods. Benhabib and Spiegel (2000) find that both channels are present:
financial development improves capital accumulation as well as productivity growth.
To assess which channel is more important, it is useful to look at the relationship between
financial development and growth at the industry and firm level, because it is much more likely
that the level of a countrys financial development affects the behavior of particular firms rather
than the other way around. In a study using firm-level data, Rajan and Zingales (1998) find that
younger firms in higher productivity sectors tend to depend more on external finance and
therefore benefit more from the lower cost of financing in a developed financial system than do
more established firms. This finding suggests that if these younger firms represent the units of
production where new and more efficient technologies are created, then financial development
may improve productivity growth, thus potentially sustaining long-run growth.
Some economists have focused on events that have led to large changes in the size and
development of the financial sector in a short period of time to isolate the impact of financial
development on growth within a country over time. These studies are usually called event
studies. A study by Galindo, Schiantarelli, and Weiss (2002) evaluates whether financial
liberalizations in 12 developing countries are accompanied by an improvement in the allocation
of capital to firms. Of course, because financial liberalizations usually are not implemented in
isolation, it is important to control for other changes in the economic and legal environment that
also may affect growth. The authors find an increase in the efficiency with which investment
funds are allocated following reform. This effect holds for most countries in the study and
persists after controlling for other possible sources of improvements of resource allocation, such
as trade reform or other macroeconomic structural reforms.
What is the role of regulation?
How do financial regulations affect the relationship between financial sector development and
growth? A common finding of the studies by Rajan and Zingales (1998) and Galindo,
Schiantarelli, and Weiss (2002) is that the positive impact of financial development on growth
depends on the quality of financial regulations and supervision. Rajan and Zingales find the
quality of corporate governance predicts higher growth in financially dependent firms. Galindo,
Schiantarelli, and Weiss also find that financial liberalization has more beneficial effects if there
is better regulation and supervision. Levine, Loayza, and Beck (2000) find that cross-country
differences in legal and accounting systems are important factors in determining financial sector
development. In particular, countries with regulations that give creditors priority in receiving
their claims on corporations, encourage publication of more comprehensive and accurate
financial statements, and are more efficient at imposing compliance with financial regulations
have better functioning financial systems. They also find that contract enforcement, for example,
in the case of property rights, is even more important than the formal regulatory code in financial
development. Thus, strengthening financial regulations and enforcement has a positive effect on
long-run growth.
Conclusions
Recent economic literature has documented that financial development is associated with higher
economic growth. Moreover, there is strong cross-country and industry-level evidence that
financial development causes growth through increases in the rate of capital accumulation and
through the allocation of funds to more productive firms, leading to overall improvement in
productivity. Finally, financial regulation is an important determinant of the development of the
financial sector, which improves the relationship between financial development and growth.
Understanding how financial development promotes growth is important for designing financial
policies and regulations. For instance, financial liberalization in emerging markets often is
followed by an expansion of the financial sector. Depending on the channel of transmission
between financial sector development and growth, policies may be designed to make the channel
more effective. For example, if financial sector development affects growth mainly through
improved monitoring of managers of individual projects, then establishing and enforcing
regulations that prevent conflicts of interest that may arise when a person in charge of evaluating
a firm has a financial stake in the same firm may improve the health of the financial system.
The long-run benefits of having a better financial system still must be weighed against possible
short-run costs. One way for countries to develop their financial systems is to open up the sector
to foreign competition and liberalize international capital flows. However, many countries are
reluctant to do so because it also may expose them to more foreign shocks. Moreover, many
economists also argue that if the institutional framework in which the banks operate is not well
enough developed, the costs of liberalization may be high. A poorly regulated financial system
may increase a countrys susceptibility to bank runs and balance of payments crises (due to more
external shocks), crony capitalism (due to poor enforcement of regulations), and excessive risk-
taking by banks (due to implicit government guarantees). Thus, the costs of having a larger
financial system could overwhelm the benefits from higher growth. However, the strength of the
evidence indicates that financial development, if accompanied by well-designed regulations and
enforcement, plays an important role in channeling savers resources to more productive firms,
thus resulting in sustainable long-run growth.
How one can survey the financial system?
Answer: We will survey the financial system in three steps:
1. Financial instruments or securities:
I. Stocks, bonds, loans and insurance.
II. What is their role in our economy?
2. Financial Markets:
I. New York Stock Exchange, Nasdaq.
II. Where investors trade financial instruments.
3. Financial institutions:
I. What they are and what they do.
Give a list of top 10 Finance Theory.
Answer:
1. Capital asset pricing model (CAPM):
In finance, the capital asset pricing model (CAPM) is used to determine a theoretically
appropriate required rate of return of an asset, if that asset is to be added to an already well-
diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the
asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often
represented by the quantity beta () in the financial industry, as well as the expected return of the
market and the expected return of a theoretical risk-free asset.
The model was introduced by Jack Treynor (1961, 1962),[1] William Sharpe (1964), John
Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry
Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton
Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field
of financial economics.
2. Modern portfolio theory (MPT)
Modern portfolio theory (MPT) is a theory of investment which tries to maximize return and
minimize risk by carefully choosing different assets. Although MPT is widely used in practice in
the financial industry and several of its creators won a Nobel prize for the theory, in recent years
the basic assumptions of MPT have been widely challenged by fields such as behavioral
economics.
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of
selecting a collection of investment assets that has collectively lower risk than any individual
asset. This is possible, in theory, because different types of assets often change in value in
opposite ways. For example, when the prices in the stock market fall, the prices in the bond
market often increase, and vice versa. A collection of both types of assets can therefore have
lower overall risk than either individually.
More technically, MPT models an asset's return as a normally distributed random variable,
defines risk as the standard deviation of return, and models a portfolio as a weighted combination
of assets so that the return of a portfolio is the weighted combination of the assets' returns. By
combining different assets whose returns are not correlated, MPT seeks to reduce the
total variance of the portfolio. MPT also assumes that investors are rational and markets
are efficient.
MPT was developed in the 1950s through the early 1970s and was considered an important
advance in the mathematical modeling of finance. Since then, much theoretical and
practical criticism has been leveled against it. These include the fact that financial returns do not
follow a Gaussian distribution and that correlations between asset classes are not fixed but can
vary depending on external events (especially in crises). Further, there is growing evidence that
investors are not rational and markets are not efficient.
3. Annuity
The term annuity is used in finance theory to refer to any terminating stream of fixed payments
over a specified period of time. This usage is most commonly seen in discussions of finance,
usually in connection with the valuation of the stream of payments, taking into account time
value of money concepts such as interest rate and future value.
Examples of annuities are regular deposits to a savings account, monthly home mortgage
payments and monthly insurance payments. Annuities are classified by payment dates. The
payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other interval of
time.
4. Value investing
Value investing is an investment paradigm that derives from the ideas on investment and
speculation that Ben Graham & David Dodd began teaching at Columbia Business School in
1928 and subsequently developed in their 1934 text Security Analysis. Although value investing
has taken many forms since its inception, it generally involves buying securities whose shares
appear underpriced by some form(s) of fundamental analysis. As examples, such securities may
be stock in public companies that trade at discounts to book value or tangible book value, have
high dividend yields, have low price-to-earning multiples or have low price-to-book ratios.
High-profile proponents of value investing, including Berkshire Hathaway chairman Warren
Buffett, have argued that the essence of value investing is buying stocks at less than their
intrinsic value. The discount of the market price to the intrinsic value is what Benjamin Graham
called the "margin of safety". The intrinsic value is the discounted value of all future
distributions.
However, the future distributions and the appropriate discount rate can only be assumptions.
Warren Buffett has taken the value investing concept even further as his thinking has evolved to
where for the last 25 years or so his focus has been on "finding an outstanding company at a
sensible price" rather than generic companies at a bargain price.

5. Gordon growth model

The Gordon growth model is a variant of the discounted cash flow model, a method for valuing a
stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax
planning, and business transactions that are currently off market. It is named after Myron J.
Gordon, who originally published it in 1959.[1] It assumes that the company issues a dividend
that has a current value of D that grows at a constant rate g. It also assumes that the required rate
of return for the stock remains constant at k which is equal to the cost of equity for that company.
It involves summing the infinite series which gives the value of price current P.
6. put-call parity
In financial mathematics, put-call parity defines a relationship between the price of a call option
and a put optionboth with the identical strike price and expiry. To derive the put-call parity
relationship, the assumption is that the options are not exercised before expiration day, which
necessarily applies to European options. Put-call parity can be derived in a manner that is largely
model independent.
7. Arbitrage pricing theory (APT)
Arbitrage pricing theory (APT), in finance, is a general theory of asset pricing, that has become
influential in the pricing of stocks. APT holds that the expected return of a financial asset can be
modeled as a linear function of various macro-economic factors or theoretical market indices,
where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
The model-derived rate of return will then be used to price the asset correctly - the asset price
should equal the expected end of period price discounted at the rate implied by model. If the
price diverges, arbitrage should bring it back into line.
The theory was initiated by the economist Stephen Ross in 1976.
8. Cumulative Prospect Theory
Cumulative Prospect Theory is a model for descriptive decisions under risk which has been
introduced by Amos Tversky and Daniel Kahneman in 1992 (Tversky, Kahneman, 1992). It is a
further development and variant of prospect theory. The difference from the original version of
prospect theory is that weighting is applied to the cumulative probability distribution function, as
in rank-dependent expected utility theory, rather than to the probabilities of individual outcomes.
In 2002, Daniel Kahneman received the Bank of Sweden Prize in Economic Sciences in Memory
of Alfred Nobel for his contributions to behavioral economics, in particular the development of
Cumulative Prospect Theory (CPT).
9. Brownian motion models
The Brownian motion models for financial markets are based on the work of Robert C. Merton
and Paul Samuelson, as extensions to the one-period market models of Harold Markowitz and
William Sharpe, and are concerned with defining the concepts of financial assets and markets,
portfolios, gains and wealth in terms of continuous-time stochastic processes.
Under this model, these assets have continuous prices evolving continuously in time and are
driven by Brownian motion processes. This model requires an assumption of perfectly divisible
assets and that no transaction costs occur either for buying or selling (i.e. a frictionless market).
Another assumption is that asset prices have no jumps, that is there are no surprises in the
market.
10. Post-modern portfolio theory
Post-modern portfolio theory (or "PMPT") is an extension of the traditional modern portfolio
theory (MPT, also referred to as Mean-Variance Analysis or MVA). Both theories propose
how rational investors should use diversification to optimize their portfolios, and how a risky
asset should be priced.
11. undervalued stock
An undervalued stock is defined as a stock that is selling at a price significantly below what is
assumed to be its intrinsic value (finance). For example, if a stock is selling for $50, but can be
determined to be worth $100 based on predictable future cash flows, then it is an undervalued
stock.
Numerous popular books discuss undervalued stocks. Examples are The Intelligent Investor by
Benjamin Graham, also known as "The Dean of Wall Street," and The Warren Buffett Way by
Robert Hagstrom.
The Intelligent Investor puts forth Graham's principles that are based on mathematical
calculations such as the price/earning ratio. He was less concerned with the qualitative aspects of
a business such as the nature of a business and its management. Graham's ideas had a significant
influence on the young Warren Buffett, who later became a famous US billionaire.
Warren Buffett, also known as "The Oracle of Omaha," stated that the value of a business is the
sum of the cash flows over the life of the business discounted at an appropriate interest rate.[1]
This is in reference to the ideas of John Burr Williams. Therefore, one would not be able to
predict whether a stock is undervalued without predicting the future profits of a company and
future interest rates. Buffett stated that he is interested in predictable businesses and he uses the
interest rate on the 10-year treasury bond in his calculations.
Therefore, an investor has to be fairly certain that a company will be profitable in the future in
order to consider it to be undervalued. For example, if a risky stock has a PE ratio of 5 and the
company becomes bankrupt, this would not be an undervalued stock.
12. Strategic Sustainable Investing (SSI)
Strategic Sustainable Investing (SSI) is an investment strategy that recognizes and rewards
leading companies that are moving society towards sustainability. SSI relies on a consensus-
based scientific definition of sustainability, and the assumption that Backcasting from Principles
of Sustainability , whereby a vision of a sustainable future is set as the reference point for
developing Strategic Actions, is the preferred approach to strategically move a company towards
sustainability. It was developed by researchers at the Blekinge Institute of Technology in
Sweden.
13. Fama-French three factor model
In the portfolio management field, Eugene Fama and Kenneth French developed the Fama-
French three factor model to describe market behavior.
CAPM uses a single factor, beta, to compare the excess returns of a portfolio with the excess
returns of the market as a whole. But it oversimplifies the complex market. Fama and French
started with the observation that two classes of stocks have tended to do better than the market as
a whole: (i) small caps and (ii) stocks with a high book-to-market ratio (BM, customarily called
value stocks, and different from growth stocks). They then added two factors to CAPM to reflect
a portfolio's exposure to these two classes:[1]
r=R_{f}+\beta_{3}(K_{m}-R_{f})+bs\cdot SMB+bv\cdot HML+\alpha
Here r is the portfolio's rate of return, Rf is the risk-free return rate, and Km is the return of the
whole stock market. The "three factor" is analogous to the classical but not equal to it, since
there are now two additional factors to do some of the work. SMB stands for "small (market
capitalization) minus big" and HML for "high (book-to-price ratio) minus low"; they measure the
historic excess returns of small caps over big caps and of value stocks over growth stocks. These
factors are calculated with combinations of portfolios composed by ranked stocks (BM ranking,
Cap ranking) and available historical market data. Historical values may be accessed on Kenneth
French's web page.
Moreover, once SMB and HML are defined, the corresponding coefficients bs and bv are
determined by linear regressions and can take negative values as well as positive values. The
Fama-French Three Factor model explains over 90% of the diversified portfolios returns,
compared with the average 80% given by the CAPM. The signs of the coefficients suggested that
small cap and value portfolios have higher expected returnsand arguably higher expected risk
than those of large cap and growth portfolios.
The three factor model is gaining recognition in portfolio management. Morningstar.com
classifies stocks and mutual funds based on these factors. Many studies show that the majority of
actively managed mutual funds underperform broad indexes based on three factors if classified
properly. This leads to more and more index funds and ETFs being offered based on the three
factor model.
14. Vasicek model
In finance, the Vasicek model is a mathematical model describing the evolution of interest rates.
It is a type of "one-factor model" (more precisely, one factor short rate model) as it describes
interest rate movements as driven by only one source of market risk. The model can be used in
the valuation of interest rate derivatives, and has also been adapted for credit markets, although
its use in the credit market is in principle wrong, implying negative probabilities (see for
example Brigo and Mercurio (2006), Section 21.1.1). It was introduced in 1977 by Oldrich
Vasicek.
15. Rational pricing
Rational pricing is the assumption in financial economics that asset prices (and hence asset
pricing models) will reflect the arbitrage-free price of the asset as any deviation from this price
will be "arbitraged away". This assumption is useful in pricing fixed income securities,
particularly bonds, and is fundamental to the pricing of derivative instruments.
16. Black model
The Black model (sometimes known as the Black-76 model) is a variant of the Black-Scholes
option pricing model. Its primary applications are for pricing bond options, interest rate caps /
floors, and swaptions. It was first presented in a paper written by Fischer Black in 1976.
Black's model can be generalized into a class of models known as log-normal forward models,
also referred to as LIBOR market model.
17. International Fisher effect
The International Fisher effect is a hypothesis in international finance that says that the
difference in the nominal interest rates between two countries determines the movement of the
nominal exchange rate between their currencies, with the value of the currency of the country
with the lower nominal interest rate increasing. This is also known as the assumption of
Uncovered Interest Parity.
18. T-Model
The T-Model is a formula that states the returns earned by holders of a company's stock in terms
of accounting variables obtainable from its financial statements[1]. Specifically, it says that:
(1) \mathit T = \mathit g + \frac{\mathit ROE - \mathit g} {\mathit PB} + \frac{\Delta PB}
{PB} \mathit(1 + g)
where T = total return from the stock over a period (appreciation + "distribution yield" see
below);
g = the growth rate of the company's book value during the period;
PB = the ratio of price / book value at the beginning of the period.
ROE = the company's return on equity, i.e. earnings during the period / book value;
The T-Model connects fundamentals with investment return, allowing an analyst to make
projections of financial performance and turn those projections into an expected return that can
be used in investment selection.
When ex post values for growth, price/book, etc. are plugged in, the T-Model gives a close
approximation of actually realized stock returns. Unlike some proposed valuation formulas, it
has the advantage of being correct in a mathematical sense (see derivation); however, this by no
means guarantees that it will be a successful stock-picking tool.
Still, it has advantages over commonly used fundamental valuation techniques such as
price/earnings or the simplified dividend discount model: it is mathematically complete, and
each connection between company fundamentals and stock performance is explicit, so that the
user can see where simplifying assumptions have been made.
Some of the practical difficulties involved with financial forecasts stem from the many
vicissitudes possible in the calculation of earnings, the numerator in the ROE term. With an eye
toward making forecasting more robust, in 2003 Estep published a version of the T-Model driven
by cash items: cash flow, gross assets and total liabilities.
Note that all fundamental valuation methods differ from economic models such as the Capital
Asset Pricing Model and its various descendants; financial models attempt to forecast return
from a company's expected future financial performance, whereas CAPM-type models regard
expected return as the sum of a risk-free rate plus a premium for exposure to return variability.
19. Time-weighted return (TWR)
The time-weighted return (TWR) (or true time-weighted rate of return (TWRR)) is a method of
calculating investment return. To apply the time-weighted return method, combine the return
over sub-periods, by compounding them together, resulting in the overall period return. The rate
of return over each different sub-period is weighted according to the duration of the sub-period.
20. Risk Factor
A risk factor is a concept in finance theory such as the CAPM, arbitrage pricing theory and other
theories that use pricing kernels. In these models, the rate of return of an asset (hence the
converse its price) is a random variable whose realization in any time period is a linear
combination of other random variables plus a disturbance term or white noise. In practice, a
linear combination of observed factors included in a linear asset pricing model (for example, the
FamaFrench three-factor model) proxy for a linear combination of unobserved risk factors if
financial market efficiency is assumed. In the Intertemporal CAPM, non-market factors proxy
for changes in the investment opportunity set.