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Economics 370 Money and Banking


Where debt and equity securities are sold and traded ... Corporations must pay all their debt holders before they pay their equity holders ... – PowerPoint PPT presentation

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Title: Economics 370 Money and Banking

Economics 370Money and Banking
  • Instructor
  • Ryan Herzog

Daily Overview
  • Articles/Paper
  • Chapter 2 An Overview of the Financial System

Function of Financial Markets
  • Perform the essential function of channeling
    funds from economic players that have saved
    surplus funds to those that have a shortage of
  • Promotes economic efficiency by producing an
    efficient allocation of capital, which increases
  • Directly improve the well-being of consumers by
    allowing them to time purchases better

Financial System
Direct Finance
  • Financial Markets
  • Borrowers borrow directly from lenders by issuing
    financial instruments
  • Claims on future income/assets
  • Assets for lender
  • Liability for the seller
  • Repayment promises
  • Allow individuals to come together and improve
  • Allow many individuals to make investments that
    otherwise are not available (education, housing,

Structure of Financial Markets
  • Debt and Equity Markets
  • Primary and Secondary Markets
  • Where debt and equity securities are sold and
  • Investment Banks underwrite securities in primary
  • Brokers and dealers work in secondary markets
  • Exchanges and Over-the-Counter (OTC) Markets
  • Types of secondary markets
  • Money and Capital Markets
  • Money markets deal in short-term debt instruments
  • Capital markets deal in longer-term debt and
    equity instruments

Debt Markets
  • Entities use financial markets by issuing debt,
    usually through a bond or mortgage
  • Specify a fixed payment amount and the number of
    payments to the lender until maturity.
  • Maturity number of years until the instruments
    expiration date
  • Short-term less than one year
  • Long-term greater than ten years
  • Intermediate-term between one and ten years

Equity Markets
  • Equities
  • Claims to share in the net income and assets of a
  • Make periodic payments to their holders
  • Considered long-term because they do not have a
    maturity date

Debt vs. Equities
  • An equity holder is an residual claimant
  • Corporations must pay all their debt holders
    before they pay their equity holders
  • But equity holders benefit directly from an
    increase in the corporations profitability

Primary Markets
  • A financial market in which new issues of a
    security are sold to initial buyers from a
    corporation or government agency
  • Often times this takes place behind close doors
    usually assisted by an investment bank
  • The investment bank underwrites the securities,
    i.e. they guarantee a price for the corporations
    securities and then sells them to the public via
    the secondary markets

Secondary Markets
  • Common secondary equity markets are the NASDAQ
    and Dow Jones
  • Previously issued stocks are traded
  • Other examples of secondary markets are the bond,
    foreign exchange, futures, and options markets
  • Brokers are agents of investors who match buyers
    with sellers of securities
  • Dealers link buyers and sellers by buying and
    selling securities at a stated price

Secondary Market
  • When a transaction occurs
  • The buyer of the instruments pays money to the
    seller, but the initial issuer acquires no new
  • Make financial instruments more liquid
  • Determine the price of the instrument (via supply
    and demand)
  • As the price increases in the secondary market,
    the issuer will receive a higher price on new
    securities issued in the primary market

Secondary Markets
  • Secondary markets can be organized in two ways
  • Exchange market buyers and sellers meet in one
    central location to conduct trades
  • New York Stock Exchange, American Stock Exchange,
    Chicago Board of Trade
  • Over-the-counter market dealers at different
    locations have an inventory of securities
  • U.S. Government Bond Market, CDs, federal funds,
    bankers acceptances, and foreign exchange

Markets and Maturity
  • Money Market
  • A financial market in which short-term debt
    instruments are traded
  • More widely traded, more liquid
  • Used when entities have surplus funds for a short
  • Capital Market
  • Is the market in which longer-term debt and
    equity instruments are traded
  • Financial institutions (insurance companies and
    pension funds)

Money Market Instruments
  • United States Treasury Bills
  • 1, 3, and 6 month maturities
  • Pay a set amount at maturity, no interest
    payment, but are sold at a discount (Saving Bond)
  • Negotiable Bank Certificates of Deposit
  • Debt instrument sold by banks to depositors
  • Commercial Paper
  • Short-term debt issued by large banks and
    well-known corporations

Money Market Instruments cont.
  • Bankers Acceptance
  • Is a bank draft, similar to a check, issued by a
    firm, payable at some future date, and guaranteed
    for a fee by the bank that stamps it accepted
  • Allows firms to purchase goods abroad, the funds
    are guaranteed even if the corporation goes
  • Federal Funds
  • Typically overnight loans made by banks to other
  • Usually occurs when a bank falls below its
    required reserve amount

Money Market Instruments cont.
  • Repurchase Agreements (repos)
  • Short-term loans, less than two week maturity
  • A large firm may have excess funds it wants to
    lend for a week. The firm will buy treasury
    bills from the bank with an agreement that the
    bank will repurchase the t-bills in one weeks
  • The firm gets a small interest payment and the
    bank gets the use of the firms funds

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Capital Market Instruments
  • Stocks
  • Equity claims on the net income and assets of a
  • Mortgages
  • Loans to households or firms to purchase housing,
    land, or other real estate structures
  • The structural/land serves as collateral
  • Corporate Bonds
  • Long-term bonds issued by corporations with
    strong credit ratings
  • Sends an interest payments twice a year and pays
    off the face value of the bond at maturity

Capital Market Instruments
  • U.S. Government Securities
  • Long-term debt instruments issued by the U.S.
    Treasury to finance the government deficit
  • U.S. Government Agency Securities
  • Long-term bonds used to finance capital
  • State and Local Government Bonds
  • Municipal bonds, long-term debt issued by state
    and local governments. Interest payments are tax
  • Consumer and Bank Commercial Loans

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Internationalization of Financial Markets
  • Foreign Bondssold in a foreign country and
    denominated in that countrys currency
  • U.S. bonds sold in Europe and denominated in
  • Eurobondbond denominated in a currency other
    than that of the country in which it is sold
  • U.S. bonds sold in Europe and denominated in
  • Eurocurrenciesforeign currencies deposited in
    banks outside the home country
  • EurodollarsU.S. dollars deposited in foreign
    banks outside the U.S. or in foreign branches of
    U.S. banks
  • World Stock Markets

Function of Financial Intermediaries Indirect
  • Lower transaction costs
  • Reduce Risk
  • Asymmetric Information

Indirect Finance
  • Financial Intermediation
  • Primary route for moving funds from lenders to
  • Firms rely on financial intermediaries much more
    so than the securities markets
  • True for the U.S. and most other developed

Financial Intermediaries
  • Have lower transaction costs
  • Allows small lenders and borrowers to enter the
  • Very costly to write a loan contract
  • Economies of scales
  • Financial intermediaries write many loans, the
    average cost of doing so is much small than one
    individual writing one loan
  • Liquidity Services
  • Banks offer checking and savings accounts which
    all customers to earn interest on their savings,
    but also have access to their money to purchase
    goods and services

Financial Intermediaries cont.
  • Risk Sharing
  • Financial Intermediaries create and sell assets
    with less risk that customers are more
    comfortable with
  • Banks offer less risky assets (CDs, Money Market
    Accounts) and use these funds to purchase riskier
  • Allow investors to diversify their portfolio and
    lower risk

Financial Intermediaries cont.
  • Asymmetric Information
  • One party does not know everything about the
    other party
  • Adverse Selection
  • Occurs before the transaction takes place
  • Borrowers who are the most likely to produce an
    undesirable outcome are the ones most actively
    seeking the loan
  • Borrowers with a lot to gain and a little to lose
    are most likely to take out loans at a high
    interest rate

Financial Intermediaries cont.
  • Moral Hazard
  • Occurs after the transaction takes place
  • The risk that the borrower might engage in
    activities that are undesirable from the lenders
    point of view, i.e. it will be less likely the
    loan is paid back
  • The borrower uses the money for purposes other
    than agreed upon

Financial Intermediaries
  • Allows small savers the ability to provide funds
    to the financial markets
  • Financial intermediaries are more successful than
    individuals on earning returns because they can
    screen out bad credit risks from good ones
  • They are able to reduce the risks incurred from
    moral hazard

Types of Intermediaries
  • Depository institutions (banks)
  • Contractual savings institutions
  • Investment intermediaries

Depository Institutions
  • Commercial Banks
  • Raise funds via checking and saving deposits
  • Make commercial, consumer, and mortgage loans and
    buy U.S. securities
  • Savings and Loan Associations and Mutual Savings
  • Raise funds via checking, time, and saving
  • Initially, constrained to just mortgage loans,
    but now very similar to banks
  • Credit Unions
  • Smaller than banks and organized around a
    particular group

Contractual Savings Institutions
  • Life Insurance Companies
  • Acquire funds through premiums by selling
    annuities once the individual is retired
  • Buy corporate bonds, mortgages, and some
    restricted stocks
  • Fire and Casualty Insurance Companies
  • Similar to life insurance companies, but
    experience a greater probability of losses
  • Pension Funds and Government Retirement Funds
  • Acquire funds through employee and employer
  • Purchase corporate bonds and stocks

Investment Intermediaries
  • Finance Companies
  • Sell commercial paper and issue stocks and bonds
  • Make loans to consumers
  • Mutual Funds
  • Sell shares to individuals and use the funds to
    purchase diversified portfolios of stocks and
  • Money Market Mutual Funds
  • Sell shares to purchase money market instruments,
    interest is paid to shareholders, and
    shareholders can write checks against their
  • Investment Banks
  • Advises corporations on the type of securities to
    issue and purchases them at a predetermined price
  • Also participate in mergers and acquisitions

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Regulation of the Financial System
  • To increase the information available to
  • Reduce adverse selection and moral hazard
  • Reduce insider trading
  • To ensure the soundness of financial
  • Restrictions on entry
  • Disclosure
  • Restrictions on Assets and Activities
  • Deposit Insurance
  • Limits on Competition
  • Restrictions on Interest Rates

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