Introduction to Money and the Financial System Chapters 1-3.

Introduction to Money and the Financial System

Chapters 1-3

Conduct in the ClassroomClassrooms are for learning. Teachers and students must work together so that the classroom is a good place to learn. You can help by following a few simple rules. These rules are mostly just common sense and common courtesy. By following them, you show respect to your fellow students as well as your teachers.

Please try to get to class on time. When you come in late, you disrupt your class. As a general rule, if you are more than 10 minutes late, you should not enter the classroom. If you arrive late, but need to see the instructor or pick up lecture notes, please return at the end of the class period.

Once in class, you should stay until the class is over. If you know you have to leave early, ask the instructor’s permission before the class starts.

Conduct in the Classroom

You should not do things during class that disrupt the class or distract your classmates – such as talking while the instructor is lecturing. If you have a pager or cellular phone, turn if off when you are in class.

And please pay attention to the signs that tell you not to eat or drink in the classrooms.

Assignments, tests and examinations are an integral part of the learning experience. Students who cheat disrupt this process. The instructor has a responsibility to make cheating difficult, but cheating is wrong even when you can get away with it. Don’t give in to the temptation to cheat, and be critical of those who do.

Conduct in the Classroom

Your instructor has the authority to make other rules that he or she feels are necessary to help you learn. For example, some instructors may require that you attend a minimum number or percentage of their classes. If you do not follow these rules, it may affect your grade.

You are investing several years of your life in your university education.

Learning to accept responsibility is an important part of that education.

The classroom is a good place to begin

showing that you are ready for the

responsibilities of being an adult.

Conduct in the Classroom

Specialization and Exchange

In a varied economy, producers will specialize in production of certain goods, yet consume a diverse set of goods which presents of problem of allocation of goods. There are three basic solutions.

1. Barter – Cumbersome. Difficult to overcome the double coincidence of wants.

2. Government Allocation. Inefficient use of information and incentives.

3. Money – Use of some good as a token of value as one side of all transactions.

Necessary Characteristics of Money

• Acceptable (Usable by most traders)• Standardized Quality • Durable• Valuable Relative to Weight• Divisible

Aspects of Money

1. Medium of Exchange – Token that can be offered as a payment for goods.

2. Unit of Account – All goods will have a value in money and, thus, can be used to measure all goods

3. Store of Value – If money is to be accepted for goods today it must have durable value. (Money is an Asset).

4. Standard of Deferred Payment – Money should be something that can be promised in the future in exchange for goods/money today.

Two categories of money

Definitive Money: Money that can be used immediately for transactions without conversion to more basic forms of money.

Broad Money: A set of assets, typically some form of bank deposit, which can be easily converted to definitive money.

Evolution of Definitive Money: Commodity MoneyMoney is a technology that has advanced in

sophistication over time. First types of money were Commodity Money which

were items of intrinsic value, durable, compact, divisible.

First recorded commodity money were Cowrie shells which were used in China in 1200 B.C. The Chinese word for money originally meant cowrie shells.

Only problem is standardization. In Lydia (now part of modern day Turkey) around 700

B.C., coins of electrum minted by city government. Approximately, the same time, base metal (iron,

copper) coins minted in china.

Further Evolution of Definitive Money: Fiat MoneyCommodity money is problematic since it requires use

of materials for transactions that might be used elsewhere.

Paper notes have been used as certificates indicating the ownership of metals.

Around 800 A.D., a severe shortage of Copper led Sung Dynasty Emperor Hien Tsung to declare government issued paper as legally settling debt contracts.

Fiat Money intrinsically worthless item that can be used as money by government declaration.

Evolution of Money

In more advanced societies with sophisticated banking systems, broad money may be used for transactions.

Checks: Paper promises to pay definitive money on demand.

Electronic Transfers: Funds can be transferred from account to account in banking system.

Debit Cards and ATM Cards can be used to transfer funds to definitive money or in direct exchange for goods.

HK Monetary Aggregates

HK$ MillionCash 94396Demand Deposits 133132M1 227528

Savings Deposits 752435Time Deposits 2510776NCD's 70316M2 3561055

Deposits: RLB & DTC 37545NCD's: RLB & DTC 5490M3 3604090

Intertemporal Allocation of Goods People may want to consume a value of goods different from the one they produce at a particular time.

Economic system must transfer goods from people who want to shift the value of their production from the present to the future (savers) to those who want to shift value from the future toward today (borrowers).

Matching of savers and borrowers is done by financial markets and financial intermediaries.

Typology of Financial Markets:Primary vs. Secondary Markets Primary Markets: Financial markets in which

newly issued debt or equity claims are sold to initial buyers by private borrowers or governments

Secondary Markets: Financial markets in which claims that have already been issued are sold by one investor to another.

Secondary Markets Larger than Primary Markets

New Funds Raised Relative to Turnover HKSE

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Typology of Markets: Debt & Equity Debt: A claim that requires a borrower to repay

the amount borrowed (the principal) plus a rental fee (interest).

1. Short-term debt instruments with maturity of less than 1 year are bills.

2. Intermediate-term debt instruments with maturity of between 1 and 10 years are notes.

3. Long-term debt instruments with maturity longer than 10 years are bonds.

Equity: A claim to a share in the profits and assets of a firm [Stocks].

Typology of Markets (Maturity): Money and Capital Money Markets: Debt instruments with an

original maturity of less than 1 year are said to be sold in money markets.

Capital Markets: Debt instruments with an original maturity of more than 1 year & equity are said to be sold in capital markets.

Money Market Instruments Short-term Government Bills

US: Treasury Bills HK: Exchange Fund Bills

Commercial Paper: Short-run private sector debt. Banker’s Acceptances: International Trade Credit Repurchase Agreements: Short-term Collateralized

Loans. Inter-bank Lending

US: Fed Funds HK: HIBOR (Hong Kong Interbank Offered Rate) International: LIBOR

Negotiable Certificates of Deposit (Fixed Maturity Deposit Instrument)

Capital Market Instruments

Government Debt US: Treasury Notes & Bonds HK: Exchange Fund Notes, Treasury Bonds

Corporate Debt Stocks Securitized Mortgages

US: FNMA, GNMA, FHLMC HK: HKMC

Hong Kong Debt Markets Dominated by Banks

HK Debt Market

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HK Dollar Bond Market by Borrower

Exchange Fund22%

Statutory Bodies10%

Multilateral Development Banks

5%Non MDB Overseas

Borrowers32%

Authorised Institutions

25%

Local Corporates6%

Foreign Currency Instruments play a significant part in HK Financial markets.

HK Loans by Currency

HK$77%

Foreign$23%

Market Capitalization by Sector:

HK 2004

Finance 37%

Utilities 7%Properties

11%

Consolidated Enterprises

28%

Industrial 16%

Hotels 1%

Trading Places: Auction vs. OTC Auction Markets – Large number of traders engage

in competitive bidding at centralized location. HK Clearing Exchanges Ltd runs all auction markets in HK

(HKSE & HKFE). Over the Counter – Markets for broker-dealers

connected electronically without centralized trading place. OTC markets main site for trading debt and foreign

exchange. In US, some stocks (for small or new firms) are traded on

the OTC market, not in HK.

Settlement: Cash and Derivative Markets Cash Markets – Claims are traded with immediate

(within several days) settlement. Hong Kong Stock Exchange is a cash market.

Derivative Markets – Claims are traded with settlement promised at some future date. Futures and options are traded on Hong Kong Futures

Exchange Futures and Forwards require settlement at a fixed future date Options confer one party an option to engage in transaction at

a future date.

Asset Holding/Portfolio Choice To think about the social contribution of

secondary markets it is useful to think about the various determinants of portfolio allocation or why agents choose the assets that they do.

One key determinant of the attractiveness of an asset is its expected return (i.e. the expected income generated by an asset relative to its initial price).

But other factors also determine the demand for an asset.

Risk Sensitivity Generally, we assume savers are risk averse.

Given a choice between two assets with the same average return, savers will prefer the one with the lowest level of unpredictable volatility.

Savers would prefer an asset that always pays $1.10 for each $1invested to one which pays nothing, 50% of the time and $2.20, 50% of the time.

In equilibrium, risky assets must pay higher returns.

Diversification By spreading their wealth into assets whose returns

are uncorrelated with each other, the overall risk of a portfolio can be minimized.

Consider two portfolios that cost $1 Million. Portfolio A is a million shares (each costing $1) which will

pay $2.2 million if a coin is flipped and comes up heads and 0 if tails.

Portfolio B is a million shares in a million different companies that will each flip a coin and pay $2.2 if heads and 0 if tails.

Both portfolios have equal expected returns and consist of assets with identical statistical properties but A is risky and B has no risk.

Diversification

In real world, portfolios cannot be perfectly diversified because borrowers do not earn money and pay returns by flipping coins.

Borrowers typically pay returns by earning money producing and selling goods, but since economies move up and down jointly through business cycles, returns have a common component called systemic risk.

Savers can use diversification to eliminate idiosyncratic risk.

In equilibrium, assets with more systemic risk must pay higher returns.

Liquidity

Liquidity is the cost, in terms of time and money of converting an asset into cash at any time.

Since no one is ever certain about their future cash needs for transactions, people prefer liquid assets.

Liquid assets are thought to be assets for which there are thick markets – I.e assets with many buyers or sellers.

Liquidity may be of different value to different investors. In particular, wealthy people are less likely to value liquidity.

Information

To correctly select their portfolio, savers must have information about the assets they buy as well as the overall financial markets.

Investors will prefer assets with low information costs.

Secondary Markets: Services of the Financial System1. Risk Sharing – Savers can reduce the risk in their

assets by diversifying their portfolio [exchange some assets for others].

2. Liquidity – Agents may face unexpected cash needs. Secondary markets allow investors to raise this cash with little cost.

3. Information – Savers and borrowers can get information about the value of assets, the cost of capital or expected returns cheaply by observing financial markets.

Financial Intermediaries Financial intermediaries also provide

important services to matching savers and borrowers. Types of Financial intermediaries include:

1. Securities Market Institutions

2. Investment Institutions

3. Contractual Savings

4. Depositary Institutions

5. Government Institutions

Securities Market Institutions Investment Banks (Merchant Banks) perform

underwriting services which help borrowers with the tasks and risks of bringing securities to primary markets.

Brokers match buyers and sellers in secondary markets and dealers provide liquidity to secondary markets by trading on their own account.

Investment Institutions Mutual Funds (Unit Trusts) provide liquidity,

diversification and information services by allowing investors to buy a small share of a larger portfolio. Some are index funds which buy a portfolio which matches the broad markets.

Hedge Funds are similar but limited to wealthy investors and may engage in exotic investment strategies.

Finance companies raise money in capital markets and make small individual loans to borrowers.

Contractual Savings

Insurance companies diversify idionsyncratic non-financial risk. Property and Casualty Life Insurance

Pension Funds take a certain contribution from peoples wages and invest them like mutual funds for retirement. In HK, workers without retirement plans must

participate in Mandatory Provident Fund (a forced saving plan).

Insurance in HK

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Depository Institutions

Banks. More later.

Government Financial Institutions Governments throughout the world set up financial

institutions which fill “gaps” in financial system. In USA and HK, institutions exist which securitize

mortgages which means that they issue bonds and use proceeds to buy bundles of mortgages from banks, using the payments of homeowners to pay-off bonds.

In Japan, Post Office provides risk-free bank deposits (which is used to by government bonds).

In Singapore, government collects proceeds of mandatory savings funds and puts them into government controlled investment fund, Temansek.

Regulation

Governments indirectly intervene in financial markets for a number of reasons.

1. An efficient financial market requires that all participants have equal and comprehensive access to information.

2. Various imperfections may cause financial markets to undergo periods of extreme instability. Government regulation seeks to prevent this.

3. Government may manipulate financial markets to address other societal problems.

Financial Regulation

Provision of Information – Government requires that financial market participants make some information public. HKCE Ltd {technically a private sector company} regulates

listings on stock market. Securities & Finance Commission regulates markets and

enforces laws. Maintenance of Financial Stability – Government

enforces a certain level of financial soundness among financial intermediaries HKMA regulates banking system (more later)

Outline for Class

InterestRates

Banks MonetaryPolicy