Financial Assets, Money, Financial Transactions, Financial Institutions & Interest Rates

Money and Capital Markets

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.

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).

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. Their cost of transportation and storage is low, such that they have little or no value as a commodity. Financial assets are fungible (interchangeable) they can easily be changed in form and substituted for other assets.

Different Kinds of Financial Assets

Any

financial asset that is generally accepted in payment for the purchases of goods and services is a form of money. Examples include currency and checking accounts. Equities represent ownership shares in a business firm and are claims against the firms profits and proceeds from the sale of its assets. Common stock and preferred stock are equities.

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 are either 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.

The Creation Process for Financial Assets

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.

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. For example, a 10,000 Rs. financial asset held by a household that had lent money will be exactly matched by a 10,000 Rs. liability of the business firm that had borrowed the money. Volume of financial assets created for lenders = Volume of liabilities issued by borrowers

Financial Assets and the Financial System

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

Financial Assets and the Financial System

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.

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

What is Money?
M3
M2 M1 Institutional money funds and certain managed liabilities of depositories, namely large + time deposits, repurchase agreements, and Eurodollars.

The most liquid forms of money, namely currency and checkable deposits.

Household holdings of savings deposits, small time deposits, and retail money market mutual funds.

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 although the value of money can experience marked fluctuations.

The Functions of Money

Money

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

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.

The Evolution of Financial Transactions

Direct

Finance Direct lending gives rise to direct claims against borrowers.

Flow of funds Borrowers
(loans of spending power for an agreed-upon period of time)

Lenders )

Primary Securities
(stocks, bonds, notes, etc., evidencing direct claims against borrowers)

Simple Difficult to match & risky

The Evolution of Financial Transactions

Semidirect

Finance Direct lending with the aid of market makers who assist in the sale of direct claims against borrowers.
Primary Securities Primary Securities
(direct claims against borrowers) (direct claims against borrowers)

Borrowers

(less fees and commissions)

Proceeds of security sales

Security brokers, dealers, & investment bankers Flow of funds

Lenders

(loans of spending power)

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

The Evolution of Financial Transactions

Indirect Finance

Financial intermediation of
Secondary Securities
(indirect claims against ultimate borrowers issued by financial intermediaries in the form of deposits, insurance policies, retirement savings accounts, etc.)

funds.
Primary Securities
(direct claims against ultimate borrowers in the form of loan contracts, stocks, bonds, notes, etc.)

Ultimate borrowers

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

Ultimate lenders

Flow of funds
(loans of spending power)

Flow of funds
(loans of spending power)

Low risk & affordable

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.

Classification of Financial Institutions

Investment institutions sell shares to the public and invest the proceeds in stocks, bonds, and other assets.

Investment companies, money market funds, real estate investment trusts (REIT).

Services offered by Financial Institutions

Denomination matching
Households generally have small amounts of surplus funds to invest. They can put small amounts into savings at a time. Those who need loans usually require larger amounts of funds. They can borrow for business purposes, or to buy a home or automobile.

Services offered by Financial Institutions

Maturity Matching

Household and business savers generally want to lend for only a short time. Savings and checking accounts are usually available for immediate withdrawal.

Services offered by Financial Institutions

Maturity Matching
Household and business savers generally want to lend for only a short time. Savings and checking accounts are usually available for immediate withdrawal. Borrowers often want long-term financing. Institutions can give 30 year mortgages and longterm loans to businesses and government entities.

Services offered by Financial Institutions

Absorbing Credit Risk
Individual lenders cannot easily evaluate the credit risk of borrowers. They also cannot generally afford to take the risk of losing their limited savings. Institutions have the necessary expertise and also are in a better position to absorb an occasional loss.

Services offered by Financial Institutions

Intermediaries help to facilitate the flow of funds in the financial marketplace. Money Securities Financial Institution

Securities

Money

Types of Financial Institutions

Commercial Banks
The primary purpose of commercial banks is to take in business deposits and to lend funds to businesses.

Types of Financial Institutions

Savings and Loans
Savings and loans primary purpose is to take in deposits from households and to lend funds for home mortgages.

Types of Financial Institutions

Credit Unions
Credit Unions are owned by depositors (actually share owners) who are individuals, not businesses. Credit Unions take in funds and primarily make personal loans.

Types of Financial Institutions

Commercial Banks Savings and Loans Credit Unions

Depository Institutions

Take in deposits Make loans

Types of Financial Institutions

Finance Companies
Non-bank firms that borrow funds to make short and medium term loans to higher risk borrowers.

Types of Financial Institutions

Insurance Companies
Receive premiums for insurance policies. This pool of funds is used to reimburse policyholders who incur losses that are covered under the policy . Life Insurers: Insure against financial hardship caused by death. Property and Casualty: Insure against damage to person and property (health, autos, homes, theft, earthquake, etc.)

Types of Financial Institutions

Pension Funds
Workers and/or employers contribute funds for the pension fund to invest. The accumulated funds are used to pay benefits at retirement.

Types of Financial Institutions

Finance Companies Insurance Companies Pension Funds

NonDepository Institutions or Contractual Institutions

Funds come from borrowing, selling insurance policies, and other claims. Funds used to buy securities and make loans.

Interest Rates
The acts of saving and lending, and borrowing and investing, are significantly influenced by and tied together by the interest rate. The interest rate is the price a borrower must pay to secure scarce loanable funds from a lender for an agreed-upon time period.

 The interest rate helps guarantee that current savings will flow into investment to promote economic growth. It rations the available supply of credit, generally providing loanable funds to those investment projects with the highest return. It brings the supply of money into balance with the publics demand for money.

 The interest rate serves as an important tool for government policy through its influence on the volume of savings and investment.

Determinants of Interest Rate

Interest Rates Determined by
Real Rate of Interest Expected Inflation Default Risk Maturity Risk Liquidity Risk

Determinants of Interest Rate

Real Rate of Interest

Compensates for the lenders lost opportunity to consume.

Default Risk
For most securities, there is some risk that the borrower will not pay the interest and/or principal on time, or at all. The greater the chance of default, the greater the interest rate the investor demands and the issuer must pay.

Determinants of Interest Rate

Expected Inflation
Inflation erodes the purchasing power of money. Example: If you loan someone Rs. 1,000 and they pay it back one year later with 10% interest, you will have Rs.1,100. But if prices have increased by 5%, then something that would have cost Rs. 1,000 at the outset of the loan will now cost Rs. 1,000(1.05) = Rs. 1,050.

Determinants of Interest Rate

Maturity Risk
If interest rates rise, lenders may find that their loans are earning rates that are lower than what they could get on new loans. The risk of this occurring is higher for longer maturity loans.

Determinants of Interest Rate

Maturity Risk

Lenders will adjust the premium they charge for this risk depending on whether they believe rates will go up or down.

Liquidity
Investments that are easy to sell without losing value are more liquid. Illiquid securities have a higher interest rate to compensate the lender for the inconvenience of being stuck.

Financial Assets, Money, Financial Transactions, & Financial Institutions