‹#› Finance (Basics) Petr Malek Department of Finance Office 533 malek.petr@seznam.cz 99563@mail.muni.cz ‹#› 2 Structure of lectures n1.Introduction to finance; n2.Financial markets; n3.Banks and bank systems; n4.Other financial institutions; n5.Current value of money; n6.Private finance; n7.Investments; n8.Corporate finance; n9.International finance; n10.International financial system; n11.Macroekonomic and financial indicators and informations; n12.History of financial science; n13.Latest trends on financial markets. n n ‹#› 3 Lecture Introduction to finance, Financial markets nHouseholds, firms, financial intermediaries, and government all play a role in the financial system of every developed economy. n nFinancial intermediaries are institutions – banks, that collect money - the savings of individuals and corporations and funnel them to firms that use the money to finance their investments. ‹#› 4 1 Introduction to finance nFinance ≠ money ? qThe management of large amounts of money by governments or large companies qFunds to support an enterprise qThe money available to a state, organisation or person nThe financial system is complex, comprising many different types of private sector financial institutions , including banks, insurance companies, mutual funds, finance companies, and investment banks, all of which are heavily regulated by the government. ‹#› 5 Money – history and function nMoney (cash and credit) q..is defined as anything that is generally accepted in payment for goods, services or in the repayment of debts qThrough financial intermediaries nFunctions qExchange qAccounting qValue ‹#› 6 Why to study financial markets nFinancial markets – in which funds are transferred from people who have an excess of available funds to people who have a shortage nFinancial markets such as bond and stock markets are crucial to promoting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do ‹#› 7 Financial markets - terms nSecurity (also called a financial instrument) – claim on the issuer‘s future income n nAssets – any financial claim or piece of property that is subject to ownership n nBond – debt security that promises to make payments periodically for a specified period of time ‹#› 8 Financial markets – terms II. nInterest rate – cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental, per year) n nInflation – a continual increase in the price level, affects individuals, businesses, and the government qInflation is generally ragarded as an important problem to be solved and has often been a primary concern of politicians ‹#› 9 The stock market, the foreign exchange market nA common stock (typically just called a stock) represents a share of ownership in a corporation. qIt is security that is a claim on the earnings and assets of the corporation n nThe Foreign Exchange market (FOREX) is where this conversion takes place, and so it is instrumental in moving funds between countries qIt is also important, bcse it is where the foreign exchange rate is determined n ‹#› 10 Structure of financial system nThe financial system is complex, comprising many different types of private sector financial institutions, including banks, insurance companies, mutual funds, finance companies and investment banks nFinancial intermediaries – institutions that borrow funds from people who have saved and in turn make loans to others qFor example Banks are financial institutions that accept deposits and make loans ‹#› 11 Summary nActivities in financial markets have direct effects on individual‘s weralth, the behaviour of businesses, and the efficiency of our economy qThree financial markets deserve particular attention: nThe bond market nThe stock market nThe foreign exchange market nBanks and other financial institutions channel funds from people who might not put them to productive use to people who can do so and thus play a crucial role in improving the efficiency of the economy ‹#› 12 Questins nHas the inflation in the Czech Republic increased or decreased in the past two years? What about your country? n nWhy are financial markets important to the health of economy? ‹#› 13 Function of financial markets nFinancial markets (bond and stock markets) perform the essential economic function of channeling funds from households, firms, and governments that have saved surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income. ‹#› 14 Figure I – Financial System nHouseholds --- companies nGoods and services nLabour, field and capital nWages, rents, interests nPayment for good and services n nFinancial markets ‹#› 15 Figure II – Direct vs Indirect Finance nNote qThe most important borrower- spenders are businesses and the government qFunds flow from lender-savers to borrower-spenders via two routes: nIn Direct Finance – borrowers borrow funds directly from lenders in financial markets by selling them securities (=financial instruments) qSecurities are assets for the person who buys them but liabilities for the individual or firm that sells (issues) them nIndirect finance ‹#› 16 Financial markets nThe existence of financial markets is also beneficial even if someone borrows for a purpose other than increasing production in a business nWhy is financial market so important? qThey allow funds to move from people who lack productive investment opportunities to people who have such opportunities qFinancial markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy qWell-functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases better qFinancial markets that are operating efficiently improve the economic welfare of everyone in the society ‹#› 17 Structure of financial markets I nA firm or an individual can obtain funds in a financial markets in two ways: qThe most common method is to issue a debt instrument, such as bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals until a specified date when a final payment is made qThe second method of raising funds is by issuing equities, which are claims to share in the net income and the assets of a business n ‹#› 18 Structure of financial markets II. n1. The maturity of a debt instrument is the number of years until that instrument‘s expiration date. qA debt instrument is short-term if its maturity is less than a year qA debt instrument is long-term if its maturity is more than 10 years qOtherwise it is intermediate-term n2. Equities often make a periodic payments (dividends) to their holders and are considered long-term securities qDisadvantage of owning a corporation‘s equities rather than its debt is that an a equity holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays its equity holders ‹#› 19 Primary and secondary markets nA primary market is a financial market in which new issues of a security such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds nA secondary market is a financial market in which securities that have been previously issued (secondhand) can be resold ‹#› 20 Primary market nThe Primary market for securities are not well known to the public bcse the selling of securities to initial buyers often takes place behind close doors qIt does this by underwriting securities nBrokers are agents of investors who match buyers with sellers of securities nDealers link buyers and sellers by buying and selling securities at stated prices ‹#› 21 Secondary market nSecondary market can be organized in two ways qOne is to organize exchanges, where buyers and sellers of securities meet in one central location to conduct trades (NYSE,…) qOther method of organising a secondary market is to have an over-the-counter market (OTC), in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities OTC to anyone who comes to them and is willing to accept their prices q n ‹#› 22 Money and capital markets nThe money market is a financial market in which only short- term debt instruments are traded (maturity less than one year) nThe capital market is a financial market in which longer-term debt and equity instruments are traded (maturity of one year or longer) ‹#› 23 Financial intermediaries nThe process of indirect finance using financial intermediaries, called financial intermediation, is the primary route for moving funds from lenders to borrowers nFinancial intermediaries are a far more important source of financing for corporations than securities markets are ‹#› 24 Financial intermediaries nWhy are financial intermediaries and indirect finance so important in financial markets? qTo answer we need to understand the role of transaction costs, risk sharing and information costs in financial markets nTransaction costs, the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend qFinancial intermediaries can substantially reduce transaction costs bcse they have developed expertise in lowering them, bcse their large size allows them to take advantage of economic of scale ‹#› 25 Transaction costs, risk sharing nFinancial intermediaries are able to reduce transaction costs substantially, they make it possible for you to provide funds indirectly to people with productive investment opportunities n nAnother benefit made possible by the low transaction costs of financial institutions is that they can help reduce the exposure of investors to risk; that is, uncertainty about the returns investors will earn on assets ‹#› 26 Risk sharing nFinancial intermediaries do this through the process known as risk sharing qThey create and sell assets with risk characteristics that people are comfortable with, and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk nLow transaction costs allow financial intermediaries to do risk sharing at low cost, enabling them to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold qThis process of risk sharing is also sometimes referred to as asset transformation, bcse in a sense, risky assets are turned into safer assets for investors ‹#› 27 Assymetric information: Adverse selection and moral hazard nThe presence of transaction costs in financial markets explains, in part, why financial intermediaries and indirect finance play such an important role in financial markets, one party often does not know enough about the other party to make accurate decisions. qThis inequality is called asymmetric information. nAdverse selection is the problem created by asymmetric information before the transaction occurs. q Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable outcome- the bad credit risks-are the ones who most actively seek out a loan and are thus most likely to be selected ‹#› 28 Moral hazard nMoral hazard is the problem created by asymmetric information after the transaction occurs nMoral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender‘s point of view, bcse they make it less likely that the loan will be paid back ‹#› 29 Adverse selection and moral hazard nOne way to distinguish between AS and MH is to remember that adverse selection is a problem of asymmetric information before entering into a transaction nWhereas moral hazard is a problem of asymmetric information after the transaction has occured ‹#› 30 Financial intermediaries - basics nNow you know why financial intermediaries play such an important role in the economy qWhat about principals of them qHow they perform the intermediation function nDepository institutions qThese financial intermediaries raise funds primarily issuing checkable deposits, savings deposits and time deposits… ‹#› 31 Description of financial intermediaries ‹#› 32 Primary assets and liabilities of FI Type of intermediary Primary liabilities (sources of funds) Primary assets (uses of funds) Depository institutions (banks) Commercial Banks Deposits Business and consumer loans, mortgages, government securities Mutual saving banks Deposits Mortgages Credit unions Deposits Consumer loans Contractual saving institutions Life insurance companies Premiums from policies Corporate bonds and mortgages Premiums from policies Corporate bonds and stock Investment intermediaries Finance companies Commercial paper, stocks, bonds Consumer and businesses loans Mutual funds Shares Stocks, bonds Money market mutual funds Shares Money market instruments ‹#› 33 FI nLife insurance companies qLIC insure people against financial hazards following a death and sell annuities nPension funds (Government retirement funds) qPrivate pension funds and state retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan nFinance companies qFC raise funds by selling commercial paper (a short-term debt instrument) and by issuing stock and bonds nMutual funds qThese FI acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds n ‹#› 34 FI II nMoney market mutual funds qRelatively new financial institutions have the characteristics of a mutual fund but also function to someb extent as a depository institution, bcse they offer deposit-type account nRegulation of financial systém qCzech Republic qU.S. financial system ‹#› 35 Summary nThe basic function of financial markets is to channel funds from savers who have an excess of funds to spenders who have a shortage of funds nFinancial markets can do either through direct finance, in which borrowers borrow funds directly from lenders by selling them securities, or through indirect finance, which involves a FI that stands between the lender-savers and borrow-spenders and help transfer funds from one to the other. nThis channeling of funds improves the economic welfare of everyone in the society, bcse it allows funds to move from people who have no productive investment opportunities, thereby contributing to increased efficiency in the economy ‹#› 36 Summary nFinancial markets can be classified as a debt and equity markets, primary and secondary markets, exchanges and over the counter markets, and money and capital markets n nImportant trend in recent years is the growing internationalization of financial markets n nFIs are financial institutions that acquire funds by issuing liabilities and in turn use those funds to acquire assets by purchasing securities or making loans. FIs play an important role in the financial system , bcse they reduce transaction costs, allow risk sharing, and solve problems created by adverse selection and moral hazard ‹#› 37 Summary nThe principal financial intermediaries fall into three categories: qBanks – commercial banks, savings and loans association, mutual savings banks, etc. qContractual savings institutions – life insurance companies, pension funds, etc. qInvestment intermediaries – finance companies, mutul funds, and money market mutual funds ‹#› 38 Questions nSome economists suspect that one of the reasons that economies in developing countries grow so slowly is that they do not have well-developed financial markets . Does this argument make sense? nBcse corporations do not actually raise any funds in secondary markets, they are less important to the economy than primary markets. Comment… nIf there were no asymmetry in the information that a borrower and a lender had, could there still be a moral hazard problem? n ‹#› Thank you for you attention