Econ 160 Lecture 1:

Introduction to Money and

Financial Markets
Ioannis Kospentaris
UCLA Summer 2016, Session A
The Federal Reserve’s Monetary
Aggregates
Growth Rates of the M1 and M2 Aggregates, 1960–
2014

Source: Federal Reserve Bank of St. Louis, FRED database:

http://research.stlouisfed.org/fred2
What Financial Markets
are?
• Financial markets are markets in which funds are transferred
from people and firms who have an excess of available funds to
people and firms who have a need of funds (i.e. the market
places for borrowers and lenders)
• What is traded? The participants trade financial instruments
(securities) which are claims on the borrower’s future income or
assets
• What is the price? The interest rate is the price paid for the
rental of funds (it represents the cost of borrowing and the
benefit of lending)
Examples of Securities
• Bonds: debt contracts promising to make payments for a
specified period of time
• Stocks: shares of ownership of a corporation; they are claims
on the earnings and assets of the corporation
• Derivatives: contracts that specify conditions (based on some
underlying asset or economic variable) under which
payments are to be made between the parties trading the
contract
Why are Financial Markets important?
• They allow funds to move from people with no productive
investment opportunities to people who have such
opportunities.
• Examples: start-ups; expanding firms; housing
• Also, they allow consumers and firms to “smooth” their
purchases over time: financial markets help people to make
purchases when they need them most
• Examples: student loans; mortgages; pension funds
• Hence, financial markets contribute to economic efficiency and
welfare of everyone in society
The Financial System
Direct vs Indirect Finance
• Direct finance: borrowers borrow funds directly from lenders in
financial markets by selling the lenders securities
• Indirect finance: a financial intermediary borrows funds from
lenders and then uses these funds to make loans to borrowers
• Examples of financial intermediaries: banks; pension funds;
mutual funds; hedge funds; investment banks
• NOTE: the securities are assets for the person who buys them
(lender) but liabilities (debts) for the entity who issues or sells
them (borrower)
Classification of Financial Markets : Debt vs
Equity
• Debt instruments: contractual agreements by the borrower to
pay the holder of the security fixed dollar amounts until a
specified date (maturity date), when a final payment is made
(e.g. bonds, mortgages)
• Short-term vs intermediate-term vs long-term maturities
• Equities: claims to share in the net income and the assets of a
business (stocks); usually equities make periodic payments to
their holders (dividends) .
• “Insurance” vs “Risk”
Classification of FM: Primary vs
Secondary
• Primary market is a financial market in which new issues of a
security are sold to initial buyers
• Secondary market is a financial market in which securities that
have been previously issued are resold
• Investment banks are the main intermediaries that assist in the
initial sale of securities in the primary market (underwriting)
• Brokers, Dealers and Traders are crucial for the well-functioning
of secondary markets (traders and dealers buy and sell
securities for their own account; brokers are agents of investors)
Classification of FM: Exchange vs Over-the-
Counter
• Exchanges are secondary markets which operate in one central
location in which buyers and sellers of securities meet to
conduct trades (e.g. the New York Stock Exchange)
• OTC markets are secondary markets in which participants at
different locations (e.g. banks or individual dealers) buy and sell
securities to anyone who comes to them and is willing to accept
their prices
Classification of FM: Money vs Capital

• Money market is a financial market in which only short-term debt

instruments (with original maturity less than a year) are traded
• Capital market is a financial market in which long-term debt
instruments (with original maturity over a year) and equity
instruments are traded
Financial Market Instruments: Money
Market
Financial Market Instruments: Capital
Market
What do Intermediaries contribute?
• The main contribution of financial intermediaries is that they
help small savers and lenders to participate in financial markets
and benefit from them
• How do they do that?
1. Reduce transaction costs due to their expertise, reputation and
size (economies of scale).
2. Pool risk and help small investors diversify (“Never put all eggs
in one basket)
3. Alleviate information problems in financial markets using their
expertise and reputation
Note: asymmetric information problems
• Adverse selection (“Who is this guy?”): the potential borrowers
who most actively seek a loan are those who are most likely to
produce an adverse outcome
• Moral hazard (“What is he going to do with the money?”): the
borrower may engage in risky activities making it less likely to repay
the loan
• Problem: Because of these risks lenders may decide not to make
any loans and financial markets would break down
• Financial intermediaries cope with these issues by screening out
bad risks and monitoring their borrowers
Main Financial Intermediaries
The need for regulation of FM and Intermediaries

• Government regulates financial markets through legislation activities of

several commissions
• Their main goals are:
1. Increase the information available to investors: requirements for
corporations issuing securities to disclosure information about their
assets, sales and earnings to the public
2. Cope with the conflict of interests of intermediaries: restrictions on
who can be an intermediary, on what assets intermediaries can hold
3. Ensure the soundness of the financial system: deposit insurance,
information disclosure, limits on competition of financial intermediaries