Chapter 3 1 FINANCIAL INSTRUMENTS MARKETS AND INSTITUTIONS

Chapter 3 1 FINANCIAL INSTRUMENTS, MARKETS, AND INSTITUTIONS

Flow of Funds 2 Financial system provides a transmission mechanism between borrower-spenders. Savers saver-lenders and benefit—earn interest Investors benefit—access to money otherwise not available Economy benefits—efficient means of bringing savers and borrowers together

Flow of Funds (Cont. ) 3 Funds flow indirectly from ultimate lenders [households] through financial intermediaries [banks or insurance companies] or directly through financial markets [stock exchange/bond markets] to ultimate borrowers [business firms, government, or other households] (See Figure 3. 1) In order for financial system to function smoothly, must be adequate information about the markets and their operation

Figure 3. 1 Flow of funds from lenders to borrowers 4

Financial Instruments and Markets 5 Primary Markets Market for issuing a new security and distributing to saver-lenders. Investment Banks—Information and marketing specialists for newly issued securities. Secondary Markets Market where existing securities can be exchanged New York Stock Exchange American Stock Exchange

Financial Instruments and Markets (Cont. ) 6 Bonds Represent Borrowing Agreement by issuer to pay interest on specified dates and redeem (buy back) the bond upon maturity. Consols—Bond with no maturity date, pay interest forever Coupon Securities—Attached to bond and sent in to collect interest [generally semi-annually] (A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures). Zero-coupon—Sold at price well below face value. Collect “interest” when the bond matures (is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity).

Financial Instruments and Markets (Cont. ) 7 Stocks Represent Ownership Stockholder owns part of the corporation and receives dividends (a distribution of a portion of a company's earnings, decided by the board of directors) from the issuer. No government stock—individuals cannot “own” part of the government Types of Corporate stocks Preferred Stock—Fixed dividends, priority over common stock Common Stock—Variable dividends, based on company’s profits. Convertible—Convert preferred into common

Financial Instruments and Markets (Cont. ) 8 Stocks Represent Ownership (Cont. ) Existing stock may be exchanged through secondary markets. Capital Gains—Difference between price initially paid and amount received when stock is sold. Measures of trends in overall common stock prices Standard & Poor’s 500 Stock Index—based on prices of 500 individual stocks NASDAQ Composite Index—based on all stocks listed in NASDAQ Dow Jones Industrial Average—based on price of 30 “blue-chip” (the largest and most widely held public companies in the United States) stocks

Financial Instruments and Markets (Cont. ) 9 Both stocks and bonds [securities] represent a claim to a stream of payments [cash flows] in the future Bonds—Interest payment and face value at maturity Stocks—Dividends and sales price when sold

Financial Instruments and Markets (Cont. ) 10 Options and Futures Contracts Contractual agreement between two parties to exchange a third asset in the future at a stated price Often called derivative financial instruments because they derive value from underlying assets Long—Buyer of the contract, receive commodity in the future Short—Seller of the contract, provide commodity in the future Gamble on price fluctuations and hope to profit Eliminate the risk of price fluctuations

Financial Instruments and Markets (Cont. ) 11 The Capital Market The market for relatively long-term (greater than one year original maturity) financial investment instruments like bonds, stocks. The primal role of this market is to make investment from investors who have surplus funds to the ones who are running a deficit. Stock market—Largest part of capital market and held by private and institutional investors Corporate bond market—Held by insurance companies, pension and retirement funds Government securities—Held by commercial banks, the Fed, individual Americans/foreigners

Financial Instruments and Markets (Cont. ) 12 The Money Market Exchange of short-term instruments—less than one year Highly liquid Use of a temporary surplus of funds by banks or businesses U. S. Treasury bills—short-term debts of US government (Issued to meet the short-term needs of the U. S. government) Bank Certificates of Deposits—liabilities of issuing bank, interest bearing to corporations that hold them Federal Funds—Exchange of excess/deficient reserves between banks on an overnight basis.

Financial Intermediaries: Purposes and Profile 13 Role of Financial Intermediaries Engage in process of indirect finance Act as agents in transferring funds from savers-lenders to borrowersspenders. Earn profits on difference between interest paid and earned Diversify portfolios and minimize risk (Risk Sharing e. g. insurance companies) Lower transaction costs (Financial intermediaries make profits by reducing transactions costs by developing expertise and taking advantage of economies of scale) Competition lowers interest rates—beneficial to economic growth

Financial Intermediaries: Purposes and Profile (Cont. ) 14 Financial Institutions in Profile Commercial Banks Most prominent Range in size from huge (Bank. America) to small (local banks) Purchase wide variety of assets short-term government securities long-term business loans home mortgages

Financial Intermediaries: Purposes and Profile (Cont. ) 15 Commercial banks collect the savings of individuals as well as businesses and then lend those pooled savings to other individuals and businesses. They make money by charging a rate of interest to borrowers that exceeds the rate they pay to savers.

Financial Institutions in Profile Investment Banks Investment banks are specialized financial intermediaries that: help companies and governments raise money provide advisory services to client firms on major transactions such as mergers Firms that provide investment banking services include Bank of America, Goldman Sachs, Morgan Stanley and JP Morgan Chase.

Financial Institutions in Profile Investment Companies Investment companies are financial institutions that pool the savings of individual savers and invest the money in the securities issued by other companies purely for investment purposes.

Financial Institutions in Profile Mutual Funds and Exchange Traded Funds (ETFs) Mutual funds are professionally managed according to a stated investment objective. Individuals can invest in mutual funds by buying shares in the mutual fund at the net asset value (NAV). NAV is calculated daily based on the total value of the fund divided by the number of mutual fund shares outstanding.

Financial Institutions in Profile Mutual Funds and Exchange Traded Funds (ETFs) (cont. ) Mutual funds can either be load or no-load funds. The term load refers to the sales commission that you pay when acquiring ownership shares in the fund. These commissions typically range between 4. 0 to 6. 0%. A mutual fund that does not charge a commission is referred to as a no-load fund.

Financial Institutions in Profile Mutual Funds and Exchange Traded Funds (ETFs) (cont. ) An exchange-traded fund (ETF) is similar to a mutual fund except that the ownership shares in the ETF can be bought and sold on the stock exchange. Most ETFs track an index, such as the Dow Jones Industrial Average or the S&P 500, and generally have relatively low expenses.

Financial Institutions in Profile Mutual Funds and Exchange Traded Funds (ETFs) (cont. ) Mutual funds and ETFs provide a cost-effective way to diversify and reduce risk. If you had only $10, 000 to invest, it would be difficult to diversify since you will have to pay commission for each individual stock. However, by buying a mutual fund that invests in S&P 500, you can indirectly purchase a portfolio that tracks 500 stocks with just one transaction. Alternatively, you might purchase an ETF, such as SPDR S&P 500 (SPY), which tracks S&P 500.

Financial Institutions in Profile (Cont. ) Hedge Funds Hedge funds are similar to mutual funds but they tend to take more risk and are generally open only to high net worth investors. Management fees also tends to be higher for hedge funds and most funds include an incentive fee based on the fund’s overall performance, which typically runs at 20% of profits.

Financial Intermediaries: Purposes and Profile (Cont. ) 23 Financial Institutions in Profile (Cont. ) Life Insurance Companies Insure against death Receive funds in form of premiums Use of funds is based on mortality statistics— predict when funds will be needed Invest in long-term securities—high yield such as long-term corporate bonds

Financial Intermediaries: Purposes and Profile (Cont. ) 24 Financial Institutions in Profile (Cont. ) Pension and Retirement Funds Concerned with long run Receive funds from working individuals building “nestegg” (A substantial sum of money that has been saved or invested for a specific purpose) Accurate prediction of future use of funds Invest mainly in long-term corporate bonds and highgrade stock (A security issued by a leading corporation with a very high rating)

The Basics: How Central Banks Originated and Their Role Today The central bank started out as the government’s bank and over the years added various other functions. A modern central bank not only manages the government’s finances but provides an array of services to commercial banks. 15 -25

The Government’s Bank In 1900, only 18 countries had a central bank. The U. S. Federal Reserve began operation in 1914. As the importance of a government and the financial system grew, the need for a central bank grew along with it. 15 -26

The Government’s Bank As the government’s bank, the central bank has a privileged position: It has the monopoly on the issuance of currency. The central bank creates money. Early central banks kept sufficient reserves to redeem their notes in gold. Today, the Fed has the sole legal authority to issue U. S. dollar bills. 15 -27

The Government’s Bank The central bank can control the availability of money and credit in a country's economy. Most central banks go about this by adjusting shortterm interest rates: monetary policy. They use it to stabilize economic growth and information. The primary reason for a country to create its own central bank, then, is to ensure control over its currency. Giving the currency-printing monopoly to someone else could be disastrous. 15 -28

The Government’s Bank Without a stable currency it is difficult for an economy to run efficiently. This is why preserving the value of a nation’s currency is one of the central bank’s most important responsibilities. 15 -29

The Banker’s Bank As the banker’s bank, the central bank took on the roles it plays today: 1. 2. 3. To provide loans during times of financial stress, To manage the payments system, and To oversee commercial banks and the financial system. The ability to create money means that the central bank can make loans even when no one else can. 15 -30

The Banker’s Bank No bank, no matter how well managed, can withstand a run. To stave off such a crisis, the central bank can lend reserves or currency to sounds banks. By ensuring that sound banks and financial institutions can continue to operate, the central bank makes the whole financial system more stable. 15 -31

The Banker’s Bank Every country needs a secure and efficient payments system. Financial institutions need a cheap and reliable way to transfer funds to one another. The fact that all banks have account at the central bank makes the it the natural place for interbank payments to be settled. In 2009, an average of more than $2. 5 trillion per day was transferred over Fedwire. 15 -32

The Banker’s Bank Finally, someone has to watch over commercial banks and nonbank financial institutions so that savers and investors can be confident these institutions are sound. Those who monitor the financial system must have sensitive information. Government examiners and supervisors are the only ones who can handle such information without conflict of interest. 15 -33

The Banker’s Bank As the government’s bank and the banker’s bank, central banks are the biggest, most powerful players in a country’s financial and economic system. However, an institution with the power to ensure that the economic and financial systems run smoothly also has the power to create problems. 15 -34

The Banker’s Bank It is essential that we understand what a central bank is not. It does not control securities markets, though it may monitor and participate in bond and stock markets. It does not control the government’s budget. That is determined by Congress and the president through fiscal policy. The Fed only acts as the Treasury’s bank. 15 -35

The Functions of a Modern Central Bank 15 -36

Central Bank Objectives: 15 -37