The financial system transfers funds from
savers to borrowers. The savers and borrowers can be anybody. Some households, businesses,
and governments are net savers; they spend less than their income. Other households,
businesses, and governments are net borrowers. The spend more than their income. For
example, many college students are net borrowers. Students' income tends to be lower than
their yearly expenses and use student loans to pay the difference. Then the students enter
the workforce and begin to pay off their loans. As the former students' income continually
increases over time, the former students will pay back their loans and become net savers,
saving funds for retirement. Another example is governments. Many local and state
governments have laws, requiring them to have balanced budgets. This fiscal responsibility
causes many local and state governments to be net savers, while the U.S. Federal
government has been a net borrower for the last 30 years.
How Savers and Borrowers are Linked
There are two routes that connect the savers to the borrowers.
Financial intermediation -
this is the process of transferring funds through financial institutions. The most common
financial intermediaries are banks, mutual funds, and insurance companies. For example,
you purchased fire insurance for your home. When you pay your premium, the insurance
company will transfer your payment to the financial markets, and invest in financial
securities. The financial intermediaries only provide this function for one reason - to
earn profits. For example, banks transfer your funds to borrowers and the banks' profit
occur when the interest rate paid by the borrowers is greater than the interest rate the
bank pays on your accounts.
Direct finance - The net
savers, like households, can lend directly to businesses through the financial markets.
There are two broadly defined financial instruments.
Common stock - If you buy common
stock, you have partial ownership in a corporation. (The ownership is also referred to as
equity). You and the stockholders have the right to vote on certain corporate policies and
elect the Board of Directors. Each share of stock you own entities you to one vote. If you
own 100 shares of stock and this corporation has sold a billion shares, your vote will
have little impact on corporate policy. Also, you and the stockholders receive a share of
the profits, called dividends.
Bond - A bond is essentially an IOU.
All it is a fancy paper giving you legal rights that the corporation promises to pay back
a long-term loan (+ interest) to the people who hold the bonds.
Key Financial Markets
There are two broadly defined markets for direct finance.
Primary market - Only new
securities are bought and sold in this market. The investment banks are the key
institution. Investment banks are not like commercial banks; they are more like brokers.
Investment banks help corporations and government issue new securities and market the
securities. Investment banks tend to have a lot of financial capital. For example, IBM
wants to issue new bonds, so they go to an investment bank. The bank comes up with the
face value and interest rate on the bond, and sells them for IBM, The investment bank will
guarantee the face value of the bond and will buy any bonds not sold out of their own
funds. An investment bank is really a marketing agent for new securities. In some
countries, investment and commercial banks may be the same bank. In the United State,
federal law split these two business activities. If a business wants to be a commercial
banker, then federal law prevents that business from also being a investment banker.
Secondary market - In this
market, existing financial securities are exchanged. For example, you own 100 shares of
Coca-Cola and you want to sell them. You can only sell them in a secondary market, which
would be the New York Stock Exchange. If Coca-Cola wanted to raise more funds, then it can
issue more stock, which would be sold through the primary market. The only difference
between these two markets is the first time a financial instrument is sold, it is sold
through the primary market. If the same financial instrument is sold again, then it is
sold through the secondary market. The secondary market is extremely important, because it
performs three functions.
|The Derivatives Market
There are two methods for completing a
transaction. Up to this point, you can assume that when a buyer and seller complete
a financial transaction, money is immediately exchanged for the financial
instrument. This is referred to as cash markets.
A transaction can be completed in another
manner. The buyer and seller of a financial instrument can negotiate a price today,
but money is exchanged for the financial instrument on a future specific date. This
is referred to as the derivatives market.
For example, you negotiate a price today
to buy 10 T-bills from a seller for $9,000 each in 6 months. You are entering into a
contract with the seller for a future transaction. These contracts can be sold on
secondary markets. Do not worry about derivatives now, you will extensively learn
them in Lesson 7.
Increased liquidity - The existence
of a secondary market increases liquidity for the securities traded there. The securities
are a more attractive investment, because investors can easily resell their securities if
they no longer want them.
Price setting - The price of
securities in the secondary market sets the price of the securities sold in the primary
Information provided - The secondary
market provides information to the investment banks.
Why would savers want to deposit their
money into banks, instead of investing directly into the financial markets? The financial
intermediaries provide three functions, which were discussed in Lesson 1.
Liquidity - a
bank account has liquidity. If an emergency arises, you can easily withdraw funds from
your account. If you directly purchased stock and bonds from the financial markets, there
could be time delays and a transaction cost to retrieve yours funds.
financial intermediaries have specialist who collect information about borrowers. The
financial intermediaries will only lend to borrowers who have a low chance of defaulting
on their loan.
Low risk - the
financial intermediaries lower risk. They will lend to a variety of borrowers. This
process is called diversification. For example, banks will issue credit
cards, grant mortgages, grant loans to a variety of businesses, and buy U.S. government
securities. If several credit card holders default, several households stop paying their
mortgages, and one business bankrupts, over all, the banks could still earn profits,
because the majority of their loans are being paid. If you directly invested in a company
that bankrupts, then you lose all of your investment.
Another process can occur which is called
financial disintermediation. It occurs when savers take their money out of the financial
intermediaries and invest directly in the financial markets, such as buying U.S.
government securities. There are two reasons for investing directly in government.
The government may offer a higher interest
rate than a bank. You savings account may earn 2% interest, while a U.S. Treasury bill can
earn 5% interest.
The U.S. government has a low risk of
default, because governments have the power to tax and "print" money (i.e.
seigniorage). If the government gets into financial trouble, it can raise taxes, issue
more government securities, or print money. One problem does occur. If government is
running up a massive debt, it usually gets money for loans first. Businesses usually come
second. If there are limited funds, businesses might not get the money that they need for
investing in machines and equipment. A large government debt could have a large impact in
the financial markets and hamper business investment.
Innovation and Regulation
The financial markets and institutions are
constantly changing. Let's look at several examples.
- if a new financial instrument lowers risk, increases liquidity, or increases
information, then investors will be attracted to the new security. For example, mutual
funds were one financial innovation. A mutual fund pools together money from many
people into a fund and the fund manager invests the fund in a variety of stocks. This
method lowers investors' risk through diversification of stocks. For example, you started
you own mutual fund and bought 30 different corporate stock. Your Coca-Cola stock may go
up one day, while the value of your IBM stock goes down. Overall the average of the fund's
30 stocks will probably earn a return to the fund investors. If you bought only one type
of corporate stock, like Kodak, your investment can bankrupt, when this corporation
in the last 30 years, savers and borrowers are being linked through international
financial markets. For example, a Japanese bank transfers funds from savers in Japan to
build a new factory in China. There are three reasons for the rise of international
Repealed laws - many countries repealed
laws that restricted savers from investing in foreign countries.
Increased savings - the industrialized
countries have been growing. As countries grow, people earn higher incomes and save more.
The increase in savings is funneled into the financial markets.
International corporations - corporations
became global. A corporation produces goods in one country and transports the goods to
another country. The corporation needs financing to build the new factory and needs
financing to transport goods to other countries. The international financial markets are a
source of funds for international business investment.
The transfer of funds from savers to
borrowers is very important for the economy. If the borrowers invest the funds by
purchasing machines and equipment, the borrowers can produce more goods and services. When
more goods and services are produced, the economy grows. Consumers buy more goods and
services, causing the living standards to increase. The beauty in the U.S. financial
system is if there are 10,000 savers that have $200 in their savings accounts, the bank
can potentially loan a business $2 million. The business can buy new machines and
equipment and increase its production level, causing the U.S. economy to grow.
The financial sector is extremely
important sector of the economy and every country around the world regulates its financial
markets. There are three reasons for government regulations.
- the financial markets depends on accurate information. Governments want to ensure
borrowers are providing accurate information to the investors. In the United States, the
Securities and Exchange Commission (SEC) requires publicly traded companies (i.e. sells
stock to the public) to disclose financial information based on acceptable accounting
governments want the financial system to be stable. Many economists believe the Great
Depression would not have been so severe, if there was not a massive bankruptcy of
the money supply and financial markets are intertwined. If the central bank influences the
money supply in order to indirectly influence the inflation, business cycle, or interest
rates, the central bank also influences the financial markets. Government regulations are
needed for central banks to effectively use monetary policy.
Financial instruments are categorized into two broadly defined classes.
Money market - it
only includes short-term securities that have a maturity less than 1 year. (Maturity is
the expiration date of a security). These type of securities are very popular and are
simply a loan of funds from party to another.
Capital market -
it includes long-term securities that have a maturity of one year or more. The capital
market includes common stock, because stock has no expiration date and is considered a
You do need to memorize the following
securities, because throughout this course, we will be continually refer to these
financial instruments. The key to understanding these securities is who issues the
security and does it belong in the money market or capital market. All these securities
have one purpose -one party owes another party money plus interest. There is only one
exception, which is stocks. Stocks are ownership in a corporations and are not a loan.
Every financial instrument, except stock, will have a principal,. interest, and maturity stated on the security.
Principal - how much money the borrower received from the lender.
Interest- the periodic payments paid to the lender, because the lender is allowing the borrower to use
the funds. The interest is a cost to the borrower, but income to the lender.
Maturity - the date when the final payment of all the principal plus interest is paid to the
|Money Market Instruments - securities that have a maturity less than one year.
|Treasury bills (T-bills)
- Loans to the U.S. Government.
- Maturity is 15 days to 1 year.
- They do not state the interest rate.
- Minimum denomination is $10,000.
- I bought a $20,000 T-bill (face value) with
a maturity of 6 months for $19,000. Six months later, the government gives me $20,000. The
$1,000 reflects the interest rate.
- Short-term loans.
- Bank sells T-bills to a customer and promises to buy it back the next day for a higher price (reflects interest).
- For example, IBM has excess funds in their
checking account. The bank uses these funds and sells IBM T-bills. The next day the bank
deposits the funds back into IBM's account. plus interest, and takes the T-bills back.
- The REPO was a way to get around the law,
so banks could pay businesses interest on their checking accounts.
- Loans to well-known banks and corporations for a short-time period.
- An alternative to raise funds, instead of selling more stock and bonds.
- A form of direct finance and the loan has no collateral.
|Federal (Fed) Funds
- Overnight loans between banks.
- A bank that has excess funds deposited at the central bank can lend these funds to another bank.
- Market analysts and the Fed scrutinize the interest rate in this market closely.
- Used for international trade.
- A firm wants to buy from a foreign
exporter. The firm deposits money at a bank, and the bank guarantees payment by issuing
- If the firm does not deposit money at the
bank and the bank guarantees payment, then the bank has to pay the foreign exporter, even
if the firm bankrupts.
- These securities are liquid, because they
are sold on the secondary market.
- U.S. dollars that are deposited in foreign
commercial banks outside the U.S. and in foreign branches of U.S. banks.
- Important source of funds in the
|Negotiable Bank Certificates of Deposit
- Loans to banks and sold to depositors.
- The CD has a fixed time period.
- If the CD is withdrawn early, then the
investor does not receive the interest.
- CDs tend to pay a higher interest rate than
a savings account.