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Lenders and borrowers can also decide to deal via intermediaries (bank, building society, life insurance, pension fund):

  • lenders receive an asset
  • asset cannot be traded
  • return to intermediary possible

Intermediaries make use of markets:

  • issue securities to finance their activities
  • buy shares/bonds for their asset portfolio
  • bank: raises funds from deposits (they borrow) and lend to other borrowers
  • earn difference in interest rate
  • Primary markets: shares issued for the first time (lend directly to issuer)
  • Secondary markets: subsequent sales of securities by investors (buy/sell existing security)
  • Money market: short term maturity, safer assets, low & steady return (bills)
  • Capital markets: longer term, higher risk investment (Equity market, Corporate debt market, Government debt market)
  • Traditional investment market: publicly traded debt & equities & shares in pooled investment vehicles
  • Alternative market: not the trading of stocks more risky assets, hedge funds, private equities, commodities, real estates, derivatives (derivative market)...

Financial Markets and the Economy

FINANCIAL MARKETS

  • Financial assets allow us to make the most of real assets

Markets

Allocation of Risk

Financial Markets

  • Connects buyers and sellers
  • May or may not have a physical location (trading floor or technology connects dealers over dispersed geographical regions)
  • Main functions:
  • Move money across time based on individual needs (connect surplus units to deficit units)
  • provide liquidity (trade financial assets before maturity)

Consumption Timing

THE STOCK MARKET

  • Real assets involve risk
  • Maruti needs to raise funds to build auto parts: issues shares and bonds
  • more risk tolerant- buy shares (higher risks, potential higher rewards)
  • less risk tolerant- buy bonds (fixed payment)
  • Investor chooses risk that suits his preference
  • each security sold for best possible price
  • benefits firm who raises maximum capital
  • helps building real assets of economy
  • Want to shift puchasing power from high earning period to low earning period?
  • Earning more than what you wish to spend?
  • Retirees spending more than what they earn?
  • put wealth into financial assets in high earning period
  • Sell assets to get funds for future consumption needs
  • Shifting consumption so as to provide greatest satisfaction

FINANCIAL INSTRUMENTS

  • Primary market (newly issued shares)
  • Secondary market/official market (deals with existing shares).
  • The main roles of the stock market are:
  • Transfer of risk : The stock market enables risk to be transferred easily via the secondary market
  • Transfer of waiting : Secondary market makes the assets more liquid, thus increasing the transferability of any given stock
  • Source of capital raising: permits the firm to raise additional capital unlike the secondary market which only transfers ownership.

  • Invest in financial markets by investing into financial products
  • Financial Product: asset or liability

REAL ASSETS:

  • land; knowledge; buildings; machines
  • used to produce goods + workers whose skills are necessary to produce such resources
  • physical and human asset used to generate output consumed by society
  • wealth of economy

FINANCIAL ASSETS:

  • Do not directly contribute to productive capacity of the economy.
  • Contribute to economy indirectly- separate ownership and management; facilitates transfer of funds
  • contribute to wealth of individual/firm holding them- claims of income generated by real assets/claims on income generated by government

Separation of Ownership and Management

STOCK MARKET SIZE

STOCK MARKET LIQUIDITY

Efficient financial markets ensures:

  • greater capital intensity
  • funnel funds to most efficient use
  • greater output in future
  • higher level of consumption
  • higher growth rate
  • better standard of living
  • Market capitalization: total value at market prices of the securities at issue for a company or a stock market or sector of the stock market
  • number of shares issued * market price per share
  • Stock market capitalization ratio: value of listed shares divided by ​​​​​​
  • country with a well-developed stock market tends to have a larger stock market relative to the size of its economy
  • The ability to buy and sell securities easily.
  • Total value traded shares ratio: product of market price and the number of shares traded expressed as a percentage of GDP
  • Turnover ratio: value of transactions carried out on a stock exchange (value of securities changing hands)
  • measures trading relative to the size of the stock market.
  • value of total traded shares expressed as a percentage of total market capitalization

Financial Assets

Physical Assets

  • Tata assets: $120.6 billion in 2016
  • Too big to have just one owner to operate
  • Big portion of shares owned by financial institutions and public
  • all of them cannot take part in decision making
  • elect BOD- hires managers
  • Firm is stable even if some owners decide to sell their shares- no impact on management

Derivatives/Contracts

Securities

Real assets

  • real estate
  • machinery
  • illiquid but have a diversification benefit
  • Exchange agreements
  • A synthetic security providing specific future rights that derives its price from:
  • a physical market commodity
  • gold and oil
  • financial security
  • Interest-rate-sensitive debt instruments, currencies and equities

Commodities

  • precious metals
  • energy products
  • agricultural products
  • trade in spot, future and forward markets
  • DEBT/FIXED INCOME SECURITIES
  • pays a specific cash flow over a specific period of time
  • Promise to repay borrowed money
  • contractual claim to periodic interest payments and repayment of principal
  • Maturities: short term/intermediate term/long term (bills/notes/bonds)
  • Issued by government or companies
  • convertible debt
  • Ranks before equity
  • EQUITY SECURITIES
  • Ownership interest in a company
  • Common stock/Ordinary share
  • Hybrid shares- Preferred stock; Convertible notes
  • Residual claim on earnings and assets
  • Riskier

Forward Contracts: agree to buy or sell at a predetermined price in the future

Future Contracts: standardized futures

Swap Contracts: exchange return of one instrument for another

Options: right to buy or sell at a predetermined exercise price, at or before a specific maturity time.

FINANCIAL INSTITUTIONS/INTERMEDIARIES

A financial asset represents an entitlement to future cash flows (bonds, shares issued by firms)

  • Assist both sides of the market
  • Most people have used the services of a financial institution at some stage- basic bank account
  • Financial institutions may specialise in:
  • taking deposits, lending, providing advice to corporate and government clients or offering financial contracts such as insurance
  • Financial institutions are essential to the operation of the modern financial system- permit the flow of funds between borrowers and lenders by facilitating financial transactions
  • Institutions may be categorised by differences in the sources and uses of funds
  • Depository financial institutions
  • Investment banks and merchant banks
  • Contractual savings institutions
  • Finance companies
  • Unit trusts

WELL FUNCTIONING FINANCIAL SYSTEMS

THE FINANCIAL SYSTEM

  • INVESTORS: easily move money from present to future while obtaining a fair rate for risk they take
  • BORROWERS: easily obtain funds to realise projects if they promise to repay
  • HEDGERS: easily trade away/offset risk
  • TRADERS: easy trading of currencies for other currencies or commodities

  • Complete market: all contracts needed to solve all these problems are available
  • Operationally efficient: low cost for arranging these trades
  • informationally efficient: prices of assets and contracts reflect all available information related to fundamental value

FUNCTIONS OF A FINANCIAL SYSTEM

Well functioning financial systems are characterised by:

  • existence of well developed markets that trades instruments to help solve financial problems for markets to be complete
  • liquid markets with low costs of trading for markets to be operationally efficient
  • timely financial disclosures for markets to be informationally efficient
  • prices reflect fundamental values- prices should not change based on demand for liquidity but based on change in fundamental value for markets to be informationally efficient

FUNCTIONS

CAPITAL ALLOCATION EFFICIENCY

TYPES OF INVESTORS OF FINANCIAL MARKETS

THE FINANCIAL SYSTEM

  • Accurate market information helps efficient capital allocation
  • Financial system allocates capital to the most efficient use
  • Company funds the best project

SAVING

market place where financial securities are traded.

  • Move money from present to future (from savers to lenders)
  • Different vehicles: Notes, Bonds, Stocks, Mutual funds, Real Assets
  • Compensation for risk
  • Future value depends on risk

DETERMINING THE RATE OF RETURN

RAISING OF EQUITY CAPITAL

  • depends on supply of saving and demand for borrowing
  • If demand for borrowing is higher than supply for saving, the rate of return is expected to increase
  • Equilibrium between amount saved and amount borrowed

BORROWING

  • Company raises money for projects by selling ownership interests - facilitated by financial systems
  • Investment banks: help raise capital
  • Analysts: value securities issued

INFORMATION MOTIVATED TRADING

  • Make profit from information that allows the prediction of future prices
  • Anticipate price change
  • Buy undervalued & sell overvalued
  • Active trading
  • Through debts (Issue bonds)/Bank
  • Rate of return for lenders depend on uncertainty regarding payment
  • Cost of borrowing decreases by supplying collateral

WHY DO THEY NOT DEAL DIRECTLY WITH EACH OTHER??

What can be done?

  • Costly-find counter party (small investor advertise that lend on newspaper?)
  • Risky- guarantee to get money back?
  • Inefficient- cost of borrowing?

RISK MANAGEMENT

IMF: A financial system consists of institutional units (a household/corporation/government agency capable in its own right of owning assets, incurring liabilities, and engaging in economic activities and transactions with other entities) and markets that interact, for the purpose of mobilizing funds for investment and providing facilities (including payment systems, for the financing of commercial activity). The role of financial institutions within the system is primarily to intermediate between those that provide

funds and those that need funds, and typically involves

transforming and managing risk

  • Risks: interest rates, currency values, commodity values, default on debt
  • decrease risk: hedging
  • hedging instruments: investment banks, insurance firms...

INSTITUTIONAL INVESTORS

  • Pension funds, Mutual funds, insurance companies, investment funds, offshore funds,..
  • Managed by professionals.
  • Individuals or companies can invest in these funds and benefit from the expertise of a professionals.

INDIVIDUAL INVESTORS

  • Individuals consume part of their income and save the remaining for future consumption. (HOUSEHOLD SECTOR)
  • How to invest money?
  • This saving can be in the form of Savings Account, Fixed Deposit Account, and purchase of T-Bills, bonds and shares.
  • Individual investors rely basically on their personal skills to invest

Other clients of the financial system

Business sector:

  • How to raise money to finance investment in real assets?
  • banks? directly from households by issuing bonds? take new partners by issuing shares?

Government Sector:

  • Finance expenditures by borrowing
  • do not sell equity
  • raise when tax revenues are not sufficient
  • can print money BUT: limited because of inflation implications

Bring opposite parties together- link savers and borrowers

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