Ch02

Chapter 2

Financial Assets, Money,Financial Transactions, and

Financial Institutions

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McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Learning Objectives

• To learn about the channels through which funds flow between lenders and borrowers within the global system of money and capital markets.

• To discover the nature and characteristics of financial assets – how they are created and destroyed by decision-makers within the financial system.

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Learning Objectives

• To explore the critical roles played by money within the financial system and the linkages between money and inflation in the prices of goods and services.

• To examine the important functions carried out by financial intermediaries in lending and borrowing and in creating and destroying financial assets.

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Introduction: The Role of Financial Assets

• 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, thereby transforming savings into investment so that the economy can grow.

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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.

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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).

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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.

• They have little or no value as a commodity and their cost of transportation and storage is low.

• Financial assets are fungible – they can easily be changed in form and substituted for other assets.

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Different Kinds of Financial Assets

Any financial asset that is generally accepted in payment for purchases of goods and services is money. Currency and checking accounts are forms of money.

Equities represent ownership shares in a business firm and are claims against the firm’s profits and against proceeds from the sale of its assets. Common stock and preferred stock are equities.

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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 can be 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.

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How Financial Assets Are Born

• 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.

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Balance Sheets of Units in a Simple Financial System

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Unit Balance Sheets Following the Purchase of Equipment and the Issuance of a Debt Security

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Unit Balance Sheets Following the Purchase of Equipment and the Issuance of Stock

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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.

• All financial assets are recorded as a liability or claim on some other economic unit’s balance sheet.

Volume of financial assets created for lenders= Volume of liabilities issued by borrowers

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• 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

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• 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.

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Lending and Borrowing in the Financial System

• Economists John Gurley and Edward Shaw pointed out that each business firm, household, or unit of government active in the financial system must conform to:

R – E = FA – Dwhere R = Current income receipts

E = Expenditures out of current incomeFA = Change in holdings of financial assetsD = Change in debt and equity outstanding

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• So, for any given time period, each economic unit must fall into one of three groups:

Deficit-budget unit (DBU): E > R, so D > FA (net borrower of funds)

Surplus-budget unit (SBU): R > E, so FA > D (net lender of funds)

Balanced-budget unit (BBU): R = E, so D = FA (neither net lender nor borrower)

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Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts

Households $770.9 $912.6 $ - 141.7

Nonfinancial business 709.3 540.1 + 169.2firms

State and local 70.0 141.6 - 71.6governments

Federal government - 3.0 421.5 - 424.5International sector:

foreign investors 810.5 234.6 + 575.9and borrowers

Net Acquisitions of Financial

Assets

Net Increase in Liabilities

Net Lender (+)or Net

Borrower (-)

Major Sectorsof the

Economy

The U.S. Economy in 2003($ Billions)

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• 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.

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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 financial asset, because all forms of money in use today are claims against some public or private institution.

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Institutional money funds and certain managed

liabilities of depositories, namely large time deposits,

repurchase agreements, and

Eurodollars.

+

M 3

Household holdings of

savings deposits,

small time deposits, and retail money

market mutual funds.

+

M 2

Alternative Definitions of Money

The most liquid forms

of money, namely

currency and checkable deposits.

M 1

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Source: http://www.ny.frb.org/aboutthefed/fedpoint/fed49.html

Alternative Definitions of Money

Money Supply Measures

Savings Deposits

Small Time Deposits

Retail Money Funds

$5.3 trillion

M2

Large Time Deposits

Institutional MMFsEuros & Repos

$7.8 trillion

M2 M3

Bill

ion

s of

Dol

lars

9,000

8,000

7,000

6,000

5,000

4,000

3,000

2,000

1,000

0

$1.2 trillion

M1

M1CurrencyCheckable Deposits

September 2001September 2004

$1.3 trillion

$6.3 trillion

$9.3 trillion

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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. However, the value of money can experience marked fluctuations.

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The Functions of Money

Money functions as the only perfectly liquid asset in the financial system. It exhibits price stability, ready marketability, and reversibility.

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The Value of Money and Other FinancialAssets 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 money and capital 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.

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• 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.

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• Suppose the U.S. CPI rises from 100 to 125 over a five-year period.

Over the five-year period, the cost-of-living index climbed

... 25%or 25.0

100

100125

and the U.S. dollar’s relative purchasing power fell to

. 80100125

1.

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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.

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Direct Finance – Direct lending gives rise to direct claims against borrowers.

Borrowers(DBUs)

Lenders(SBUs)

Flow of funds(loans of spending power for an

agreed-upon period of time)

Primary Securities(stocks, bonds, notes, etc.,

evidencing direct claims against borrowers)

Simple Difficult to match & risky

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Semidirect Finance – Direct lending with the aid of market makers who assist in the sale of direct claims against borrowers.

Lower search (information) costs Risky & matching is still required

Borrowers(DBUs)

Lenders(SBUs)

Flow of funds(loans of

spending power)

Security brokers,

dealers, & investment

bankers

Primary Securities(direct claims

againstborrowers)

Primary Securities(direct claims

againstborrowers)

Proceeds ofsecurity sales

(less fees and commissions)

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Indirect Finance – Financial intermediation of funds.

Low risk & affordable

Ultimate borrowers

(DBUs)

Ultimate lenders(SBUs)

Flow of funds(loans of spending power)

Financial intermediaries(banks, savings and loan associations, insurance companies, credit unions, mutual funds, finance companies,

pension funds)

Secondary Securities(indirect claims against ultimate

borrowers issued by financial intermediaries in the form of deposits, insurance policies,

retirement savings accounts, etc.)

Primary Securities(direct claims against

ultimate borrowers in the form of loan contracts,

stocks, bonds, notes, etc.)

Flow of funds(loans of spending power)

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Relative Size and Importance ofMajor Financial Institutions

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts

($ billions at year-end) 1970 1980 1990 2000 2004Q1

Financial intermediaries: Commercial banks $489 $1,248 $3,340 $6,488 $8,044 S&L assoc. and savings banks 252 794 1,358 1,219 1,557 Life insurance companies 201 464 1,357 3,204 3,849 Private pension funds 110 413 1,629 4,587 4,260 Investment co. (mutual funds) 47 64 602 4,457 4,890 State & local gov’t pension funds 60 198 820 2,290 2,303 Finance companies 63 199 611 1,138 1,401 Property-casualty insurance co. 50 174 534 872 1,069 Money market funds –– 74 498 1,812 1,972 Credit unions 18 72 202 441 635 Mortgage companies –– 16 49 36 32 Real estate investment trusts 4 6 13 62 133Other financial institutions: Security brokers and dealers 16 36 262 1,221 1,725

Total Financial Assets Held by U.S. Financial Institutions

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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.

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Classification of Financial Institutions

• Investment institutions sell shares to the public and invest the proceeds in stocks, bonds, and other assets.- Mutual funds, money market funds, real estate investment trusts.

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Portfolio (Financial-Asset) Decisions by Financial Institutions

Portfolio decisions – deciding what financial assets to buy or sell – are affected by:

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.

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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.

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Disintermediation of Funds

• Disintermediation refers to the withdrawal of funds from a financial intermediary by the ultimate lenders (SBUs) and the lending of those funds directly to the ultimate borrowers (DBUs).

• Disintermediation involves the shifting of funds from indirect finance to direct and semidirect finance.

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Primary Securities

Ultimate borrowers

(DBUs)

Ultimate lenders(SBUs)

Financial intermediaries

Loanable funds

Financial Disintermediation

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• Some new forms of disintermediation have appeared in recent years.

Initiation by financial intermediaries: Some banks sold off some of their loans because of difficulties in raising capital.

Initiation by borrowing customers: Some borrowing customers learned how to raise funds directly from the open market.

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Bank-Dominated Versus Security-Dominated Financial Systems

• Lesser-developed financial systems are often bank-dominated financial systems, in which banks and other similar institutions dominate in supplying credit and attracting savings.

• The more mature systems today are becoming security-dominated financial systems, in which traditional intermediaries play lesser roles and growing numbers of borrowers sell securities to the public to raise the funds they need.

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Markets on the Net

• Bondsonline at www.bondsonline.com• Encyclopedia.com at encyclopedia.com• Federal Reserve Bank of Atlanta at www.frbatlanta.org• Federal Reserve Bank of New York at www.ny.frb.org• Moody’s Investor Service at www.moodys.com

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Markets on the Net

• Money Magazine at www.money.com• New York Stock Exchange at www.nyse.com• Standard & Poor’s Corporation at www.standardandpoor.com• The Bond Market Association at www.investinginbonds.com• U.S. Bureau of Economic Analysis at www.bea.gov

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Markets on the Net

• U.S. Bureau of Labor Statistics at www.bls.gov

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Chapter Review

• Introduction: The Role of Financial Assets• The Creation of Financial Assets• Characteristics of Financial Assets• Different Kinds of Financial Assets• How Financial Assets Are Born• Financial Assets and the Financial System

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Chapter Review

• Lending and Borrowing in the Financial System • Money as a Financial Asset

- What is Money?- The Functions of Money

• The Value of Money and Other Financial Assets and Inflation

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Chapter Review

• The Evolution of Financial Transactions- Direct Finance- Semidirect Finance- Indirect Finance and Financial Intermediation

• Relative Size and Importance of Major Financial Institutions• Classification of Financial Institutions

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Chapter Review

• Portfolio (Financial-Asset) Decisions by Financial Intermediaries and Other Financial Institutions

• Disintermediation of Funds- New Types of Disintermediation

• Bank-Dominated Versus Security-Dominated Financial Systems

Ch02

Documents

Transcript of Ch02