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CHAPTER 1

Financial Assets, Money,


Financial market

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu


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.
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.
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.
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.
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).
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.
Different Kinds of Financial Assets
Any 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.
Equities 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.
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 are either 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.
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.
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
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
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.
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
Lending and Borrowing in the Financial System

So, for any given period of time, the individual


economic unit falls into one of three groups:
Deficit-budget unit (DBU): E > R, D > FA
i.e. net borrower of funds
Surplus-budget unit (SBU): R > E, FA > D
i.e. net lender of funds
Balanced-budget unit (BBU): R= E, D=FA
i.e. neither net lender nor net borrower
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.
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.
What is Money?

M3
M2
Institutional
M1 Household money funds and
holdings of certain managed
The most savings liabilities of
liquid forms deposits, depositories,
of money, small time namely large
namely + deposits, and + time deposits,
currency and retail money repurchase
checkable market agreements, and
deposits. mutual funds. Eurodollars.
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 although the value
of money can experience marked fluctuations.
The Functions of Money
Money functions as the only perfectly liquid
asset in the financial system. It exhibits price
stability, ready marketability, and reversibility.
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.
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.
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.
The Evolution of Financial Transactions

Direct Finance Direct lending gives rise to


direct claims against borrowers.
Flow of funds
(loans of spending power for an
agreed-upon period of time)
Borrowers Lenders
(DBUs) (SBUs)
Primary Securities
(stocks, bonds, notes, etc.,
evidencing direct claims against
borrowers)

Simple Difficult to match & risky


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 Primary Securities
(direct claims (direct claims
against Security against
Borrowers
borrowers) brokers, borrowers)
Lenders
dealers, & (SBUs)
(DBUs) investment
Proceeds of bankers Flow of funds
security sales (loans of
(less fees and commissions) spending power)

Lower search (information) costs


Risky & matching is still required
The Evolution of Financial Transactions
Indirect Finance Financial intermediation of
funds.
Secondary Securities
Primary Securities (indirect claims against ultimate
(direct claims against borrowers issued by financial
ultimate borrowers in the intermediaries in the form of
form of loan contracts, deposits, insurance policies,
stocks, bonds, notes, etc.) retirement savings accounts, etc.)
Financial intermediaries
Ultimate (banks, savings and loan associations, Ultimate
borrowers insurance companies, credit unions, lenders
(DBUs) mutual funds, finance companies, (SBUs)
pension funds)
Flow of funds Flow of funds
(loans of spending power) (loans of spending power)

Low risk & affordable


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.
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.
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.
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.
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.
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.
What is financial markets???
Place that Facilitate the transfer of
funds between investors and firms

Assist firm that have excess funds


and wish to invest their funds

Assist investors who want to


liquidate their investments.

Consist of primary vs secondary


market, money vs capital market

Liquidate: to converts assets into cash or equivalents by selling them in


market
Primary Secondary
market market

First offering of Facilitate the


stock to the public
trading of
Refer as an initial
public offering existing
(IPO) securities

Facilitate the Sale of share


issuance of new between
securities investors
Money market Capital market
Facilitate the flow of short term funds
Facilitate the flow of long term
funds (maturities more than 1 year)

Consist of:
Securities that are traded are called money
market securities Bonds
stocks

Consist of:
Treasury bill
Commercial paper
Negotiable certificate of deposit