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