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Provides for efficient flow of funds from saving to investment by bringing savers and borrowers together via financial markets and financial institutions.
Exhibit 1.1 – Transfer of Funds
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Basic components of the financial system: Markets and institutions.
Financial markets are markets for financial instruments, also called financial claims or securities.
Financial institutions (also called financial intermediaries) facilitate flows of funds from savers to borrowers.
Economic units with financial needs: Households, Businesses, Governments.
Households supply labor, demand products, and save for the future.
Businesses demand labor, supply products, and invest in productive assets.
Governments collect taxes and provide “public goods” (e.g. education, defense).
Budget positions creating financial needs of economic units: Surplus or deficit.
Surplus spending units ( SSUs) have income for the period that exceeds spending, resulting in savings.
Other words for “SSU” are saver, lender, or investor. Most SSUs are households.
Deficit spending units (DSUs) have spending for the period that exceeds income.
Another word for “DSU” is “borrower”. Most DSUs are businesses or governments.
Financial claims arise as SSUs lend to DSUs.
SSU’s claim against DSU is liability to DSU and asset to SSU.
One’s liability is another’s asset: What is payable by one is receivable by another.
Assets arising this way are “financial assets.” The financial system “balances”-total financial assets equal total liabilities.
Marketability: Ease with which a financial asset may be sold to another SSU.
Ability to resell financial claims makes them
more liquid by giving SSUs choices:
Match maturity of claim to planned investment period;
Buy claim with longer maturity, but sell at end of period; or
Buy claim with shorter maturity, then reinvest.
Direct Financing: The simplest way forfunds to flow.
DSU and SSU find each other and bargain
SSU transfers funds directly to DSU
DSU issues claim directly to SSU
Preferences of both must match as to--Amount
-Maturity
-Risk
-Liquidity
Direct Financing: efficient for large transactions if preferences match.
DSUs and SSUs “seize the day”—
DSUs fund desired projects immediately.
SSUs earn timely returns on savings.
Direct markets are “wholesale” markets.
Transactions typically $1 million or more.
Institutional arrangements common.
Institutional arrangements common in direct finance.
Private placements are simplest.
Investment bankers “underwrite” new issues of securities.
Brokers and dealers bring buyers and sellers of direct claims together.
Private placements are simplest.
DSU sells whole security issue to one investor or investor group.
Advantages include speed and low transactions costs.
Investment bankers “underwrite” new issues of securities.
Buy entire issues of securities from DSUs
Find SSUs to buy securities at higher price
Profit from difference - “underwriting spread”
Brokers and dealers
Brokers buy or sell at best possible price for their clients.
Dealers “make markets” by carrying inventories of securities.
buy at “bid price;” sell at “ask price”“Bid-ask spread” is dealer’s gross profit
Problem with direct financing: DSUs and SSUs cannot always match preferences.
Not every SSU can afford “wholesale” denominations of $1 million or more.
DSUs and SSUs often prefer different terms to maturity.
Indirect Financing (“Financial Intermediation”):
Financial intermediaries “transform” claims:
raise funds by issuing claims to SSUs;
use funds to buy claims issued by DSUs.
Claims can have unmatched characteristics:
SSU has claim against intermediary;
Intermediary has claim against DSU.
Financial intermediaries transform claims
Familiar forms of financial intermediation
Commercial Banking
Insurance
Commercial Banks
Take deposits and make loans -Depositors are SSUs
Borrowers are DSUs.
Insurance Companies
Issue policies, collect premiums, and invest in stocks and bonds.
Policyholders are SSUs;
Businesses or governments are DSUs.
Benefits of financial intermediation are a primary rationale for the financial system.
Financial intermediaries lower the cost of financial services as they pursue profit.
Financial intermediaries perform 5 basic services as they transform claims.
Intermediaries lower the cost of financial services as they pursue profit.
3 sources of comparative advantage:
Economies of scaleTransaction cost controlRisk management expertise
Competition pulls interest rates down
Financing less costlyProjects have higher NPVsInvestment in real assets boosts economy
Intermediaries perform 5 basic services as they transform claims.
Denomination Divisibility – pool savings of many small SSUs into large investments.
Currency Transformation – buy and sell financial claims denominated in various currencies.
Maturity Flexibility – Offer different ranges of maturities to both DSUs and SSUs.
Intermediation Services, cont.
Credit Risk Diversification – Assume credit risks of DSUs; spread risk over many different types of DSUs.
Liquidity – Give SSUs and DSUs different choices about when, to what extent, and for how long to commit to financial relationships.
4 Major types of financial intermediaries transform claims to meet various needs.
Deposit-type or “Depository” Institutions
Contractual Savings Institutions
Investment Funds
“Other” Institutions
Depository Institutions take deposits and make loans.
Physical trading floor and facilities available to members of exchange, for securities listed on exchange.
New York Stock Exchange Chicago Board of Trade (futures)
OTC Markets: virtual, relatively inclusive.Decentralized network available to any licensed dealer willing to buy access and obey rules, for wide range of securities.The NASDAQ is a famous OTC market.
Capital markets: where “capital goods” are permanently financed through long-term financial instruments (“Capital goods”—real assets held long-term to
produce wealth—land, buildings, equipment, etc.)
Money Markets
Help participants adjust liquidity—DSUs borrow short-term to fund current operations
SSUs lend short-term to avoid holding idle cash
Common characteristics of money market instruments—
Short maturities (usually 90 days or less)
High liquidity (active secondary markets)
Low risk (and consequently low yield)
Dealer/OTC more than organized exchange
Examples of Major Money Market Instruments
Treasury Bills
Negotiable Certificates of Deposit
Commercial Paper
Federal Funds (“Fed Funds”)
Exhibit 1.4—Major Money Market Instruments
Money Market Balance Sheet Position of Major Participants
COMMERCIAL
BANKS
FEDERAL
RESERVE
SYSTEM
TREASURY
DEPARTMENT
INVESTMENT
BANKS,DEALERS,
AND BROKERS CORPORATIONS
INSTRUMENT A L A L A L A L A LTreasury bills Agency securities Negotiable CDs Commercial paper Banker’s acceptances Federal Funds Repurchase agreements
Capital Markets
Help participants build wealth DSUs seek long-term financing for capital projects SSUs seek highest possible return for given risk
Differences from money markets— Long maturities (5 to 30 years) Less liquidity
(secondary markets active but more volatile) Higher risk in most cases
(with higher potential yield) Traded “wholesale” and “retail” on organized
exchanges and in OTC markets
Examples ofMajor Capital Market Instruments
Common stock
Corporate bonds
Municipal bonds
Mortgages
Exhibit 1.5—Major Capital Market Instruments
Efficiency in financial markets
Allocational Efficiency: highest/best use of fundsDSUs try to fund projects with best cost/benefit ratios SSUs try to invest for best possible return for given maturity and risk
Informational Efficiency: prices reflect relevant information
Informationally efficient markets reprice quickly on new information; informationally inefficient markets offer opportunities to buy “underpriced” assets or sell “overpriced” assets