Finance and Money

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					           Finance and Money
• In next couple of weeks we will be concerned with
  one of the more difficult subjects in economics-
  financial markets and monetary systems
• Most of you undoubtedly have some idea of the
  basic concepts of finance and money, but for the
  most part people find the whole subject either
  boring and/or confusing at least until you begin to
  actively participate in these markets
• Nevertheless the role of financial markets in the
  global economy is central to an understanding of
  what is going on out there-particularly in light of
  recent global financial crisis
      Globalization and Finance
• A large part of globalization debate is concerned with the
  role of financial markets-what Tom Friedman calls the
  ‘electronic herd’-in today’s global economy
• Much of the debate about whether ‘globalization’ is good
  or bad centres around the role of global finance
• In order to make any assessment of these ideas we first
  have to understand some the basics of financial markets
• The heart of the issue is how investment is determined in
  an economy-do we build houses or invest in new drug
  development? In market economies the financial system is
  at the core of the investment allocation process
          Let’s start with IOU’s
• The origins of financial markets (also called credit markets
  or capital markets) is based on the basic IOU
• One person-the borrower-needs current real resources from
  the economy beyond those she already has claim to—for
  eg. To consume more than she earns, or to invest in some
  activity (eg. drill for oil or start up a coffee shop)
• Another person –the lender--who has more resources than
  they need for current uses—is willing to give the borrower
  these resources in return for a promise—the promise to pay
  back what is borrowed plus some additional amount at
  some time in the future
• An interest rate on the IOU is just the additional amount
  paid back expressed as an annual percent of the amount
  borrowed
       IOU’s-trust and contracts
• The IOU is simply a piece of paper or a verbal statement in
  which the details of the promise are laid out; the IOU is a
  form of contract or credit contract
• From the lender’s point of view trust in the borrower is
  essential—because the IOU is promise about the future
  there is lots of opportunity for fraudulent behavior or
  outright theft—the borrower may simply take the lender’s
  resources and run away
• For this reason most credit market relationships in
  primitive economies and even many today involve people
  who have close personal relationships—the idea being that
  if you borrow from your brother or father you are more
  likely to pay it back
           Capitalism and Finance
• The history of capitalism parallels the development of more formal
  market like relationships for dealing with the problem of creating and
  then trading IOU’s amongst unrelated individuals
• Today we call the problem of matching borrowers and lenders
  financial intermediation and the markets where most of this occurs
  financial markets (families still do a lot of this as you no doubt are
  aware)
• Financial intermediation began with the local Shylock (money lender),
  extended to the emergence of banks, then regional and national
  financial markets, and most recently have extended to global finance
• Another way of saying this is that the process of getting funds from
  savers to investment is mediated by the financial system which is to a
  substantial degree organized by the private sector (but not completely)
   What do financial markets do?
• Modern financial markets are just more sophisticated
  versions of creating and then trading IOUs—they provide
  3 basic functions
• They match borrowers and lenders so as to more
  effectively use a society’s resources (savings) for
  investment purposes
• They also facilitate more efficient allocation of risk by
  spreading large risks (eg. Drilling for oil) across thousands
  of people (risk sharing)
• They also provide liquidity; if a particular lender wants to
  get his money back quickly it is usually possible to do so
  in a modern financial market; if you want to get back
  money lent to your brother today that might not be so easy
  –ie we say the loan is illiquid
        Information –a driver for
            financial markets
• What makes financial markets different than most other
  markets is the important role of information
• Because the underlying contract (IOU) involves
  uncertainty about the future, information pertaining to that
  future and the parties involved in the contract is extremely
  important; information is unevenly distributed-some know
  more than others
• Most financial markets are characterized by information
  asymmetry—the borrower typically knows more about
  what they will do with the money than the lender
• Because of this there is a long history of governments
  providing legal frameworks which govern relationships
  between the borrowers, lenders and intermediaries (like
  banks)
     Today’s Financial Markets
• Financial markets are bewildering in the diversity
  and complexity with which the basic finance
  problem is addressed
• Here are a few of the most important types of
  financial instruments
• A financial instrument is any type of contract of
  an IOU nature which details who pays what, under
  what circumstances, and when
               Debt Instruments
• Traditional loans –ie borrow fixed amount with a promise
  to pay back on a given schedule and with a fixed rate of
  interest
• Lines of credit (eg your credit card) typically given to
  business or individuals by a bank and when exercised at
  the discretion of the borrower create a debt
• Commercial paper—these are relatively short term IOU’s
  (3 months to one year issued by large companies and pay a
  fixed rate of interest)
• Private sector bonds-basically a piece of paper issued by a
  corporation which pays back the principal plus interest –
  bonds come in various maturities-ie the length of time
  until the bond must be re-paid (including interest);
  typically from 2 years to 30 years
              Debt and Default risk
• Government bonds—same as private bonds only issued by
  governments—go by various names-treasuries in US, gilts in UK,
  bunds in Germany, JPG in Japan etc. In emerging markets government
  issued bonds referred to as Sovereign Debt instruments
• All of above are called Debt instruments because when created in the
  financial market they create a debt—they also create credit—the means
  to finance
• A debt instrument can be defaulted on—default occurs when the
  borrower does not pay back the loan or bond principle; therefore all
  these type of financial market instruments involve what is called credit
  or default risk to the lender—interest rates paid on debt instrument
  therefore reflect the underlying probability of default to the lender—
  this is one of the reasons credit card interest rates are so high and why
  small emerging market economies have to pay high interest rates to
  borrrow—eg. Argentina defaulted on it debt in 2002 and therefore will
  have to pay higher interest if and when it goes back to the bond market
                   Equities (stocks)
• In the corporate world equity claims are a very important type of
  financial instrument which emerged along with the limited liability
  corporate organization in the 18th century
• Equities are what are traded on the stock market—these are legal
  claims to a share of a firm’s profits or earnings after all interest on debt
  is paid —equity holders are the legal owners of the firm but also only
  get paid a residual ( called a dividend payment)
• As a residual claimant equity owners face a large amount of risk in
  what they might get paid
• Note that firms often directly invest their profits—are these investment
  decisions sound? Maybe and maybe not.
• If shareholders don’t like what managers are doing they can throw out
  management or in some cases do a hostile takeover—equity markets
  very important to overall efficiency of the corporate sector
                      Insurance
• Another very important type of financial instrument is
  insurance
• Individuals purchase an insurance contract against a
  specific type of risk (eg. Your house burning down) from
  insurance companies; the price paid for the insurance is the
  premium
• Insurance clearly shifts a specific risk from the policy
  holder to the insurance company
• Credit insurance is a very important—you buy insurance
  against the possibility that someone you lent money to will
  default (credit default swaps)-this instrument is at the heart
  of the current crisis
                    Derivatives
• Another very important type of financial instrument are
  derivatives (puts, calls, swaps, futures, forwards, etc etc)
• A derivative is basically any financial instrument whose
  payoff depends upon the price of another financial
  instrument
• Derivatives have become very important in the last two
  decades as a means of trading risk in financial markets—
  blamed for 1987 stock market crash and still controversial
• Huge growth in derivatives markets in last ten years
Types of financial intermediaries
• Your basic BANK—take deposits from people who want
  to save and turn around and lend this money to borrowers.
  Pay one interest rate on what you pay to depositors and
  charge another (higher) interest rate to borrower—the
  difference is profit; loans once made are illiquid
• Some borrowers will default so banks have to cover the
  cost of default out of their profits
• Banks have been around forever—banks now heavily
  regulated and depositors given deposit insurance by the
  government in many countries
• Deposit Insurance introduced after Great Depression -a lot
  of banks went broke and the depositors lost all their
  savings
       Other Financial Institutions
• Banks have gone from being local to regional to national to global—
  eg. Bank of Montreal or HSBC
• Investment banks are banks which underwrite securities—new bonds
  and new stock issue-Lehman Bros was an investment bank which went
  bankrupt in early September 2008
• Pension funds are very important in the financial markets as
  representative of the largest pools of savings in most industrial
  economies
• Insurance companies both provide insurance and are large holders of
  other financial securities
• Mortgage companies issue mortgages on real estate, mostly homes, to
  individuals and raise capital by issuing bonds or other debt instruments
• Debt rating agencies grade debt instrument by probability of default
  (investment grade to high risk) S&P, Moody’s, Fitch
        Why is finance different?
• Financial market attract a lot more attention than most
  other markets—why? A number of reasons
• A) participation in these markets is by definition risky—
  you exchange something certain today for something
  uncertain tomorrow—this creates winners and losers—the
  consequences of which are both a social concern or as the
  source of interest group lobbying
• B) the potential for fraud, theft , scam artists etc etc. seems
  to be unlimited---consequences of this is disastrous for
  people who lose their savings
            Problem with Leverage
•    a lot of financial market activity uses leverage or gearing; leverage
    occurs when you make an investment of one type which in turn is
    financed by going into debt or taking on a loan at the same time –eg.
    borrow money to buy shares in Google—lose twice if Google stock
    price falls -- stock worth less and still have to pay back the loan
•   Leverage is very common but it creates additional risks which at a
    large enough scale can becomes a societal problem
•   Most common form of leverage use by individuals is mortgage
    financed real estate purchases
•   Hedge Funds are typically higher levered investment funds
•   When a leveraged investor makes a big mistake his creditors suddenly
    become involuntary participants in the original investment—this
    happened with banks like Lehman who used leverage to invest in
    subprime mortgages which turned out to be very risky
           Why Financial ‘crises’ occur
• Large scale financial market failure or what we call a financial crisis
  seems to be a familiar part of the free market landscape—in recent
  years had the Asian crisis, LTCM and Russian default, the high tech
  stock bubble burst and now talk of a real estate bubble and burst in
  many countries
• Financial crises can occur because of loss of confidence of market
  participants—if a lender loses confidence that his borrower can repay
  he may choose to call in the loan—this in turn may trigger a decline in
  the confidence in other borrowers-which triggers more loan
  withdrawals etc.---we effectively get a chain event which spirals out of
  control
• Financial markets seem very prone to these these type of contagions –
  classic case is a bank run ; run on a bank occurs when depositors
  worry about security of their deposit and withdraw their deposit—as
  deposits withdrawn bank must call in loans to pay back deposits—
  other depositors get wind of this and try to withdraw funds; bank
  cannot meet all depositors demands at once and you get a bank
  failure
                   What to do?
• Critics argue that financial market should be more tightly
  regulated to avoid these boom-bust cycles or government
  should directly control the investment process
• Opponents argue that financial markets not perfect, but
  much better than having governments dictate who gets the
  resources—lead to more productive investments and to
  greater democratization of the investment process
• Moreover if you bail out people it creates ‘moral hazard’
  problem—people will engage in risky behaviour because
  they do not face the full consequences of their decisions
                Global Finance
• Finance would be controversial even if it were not global
• But Post Cold War huge growth in the extent of integration
  across and between formerly isolated national financial
  markets
• Growth Facilitated by a) new technology especially
  communications technologies b) growth of market
  economic systems and c) desire by many developing and
  emerging economies to access sources of capital in the
  developed world
• Global integration has been most extensive with respect to
  commercial bank lending, bond markets both private and
  public, and most recently equity or stock markets