Topic 1 - Overview

• The five parts of the financial system( MIMIC )

  • Money
  • Financial instruments
  • Financial markets
  • Financial institutions
  • Central banks
• The five core principles of the financial system

  • Time has value
  • Risk requires compensation
  • Information is the basis for decisions
  • Markets determine prices and allocate resources
  • Stability improves welfare
• Flows of funds through the financial system

  1. Direct finance: Borrowers sell securities directly to lenders in the financial markets

  2. Indirect finance: An institution stands between lender and borrower

  
• Asset


  Something of value that you own
• Liability


  Something you owe
• Users of the financial system( income / expenditure)

  • Ultimate lenders: Agents whose excess of income over expenditure creates a financial surplus which they are willing to lend
  • Ultimate borrowers: Agents whose excess of expenditure over income creates a financial deficit which they wish to meet by borrowing

  
• Money


  An asset that is generally accepted as payment for goods and services or repayment of debt
• Functions of money( pus 


  • Means of payment: used in exchange for goods and services
  • Unit of account: used to quote prices
  • Store of value: used to transfer purchasing power into the future
• Liquidity


  Measure of the ease with which an asset can be turned into a means of payment
• Market liquidity is the ability to sell assets
• Funding liquidity is the ability to borrow money
• Changes in the quantity of money

  Related to inflation
• Inflation


  The process of prices rising
• Inflation rate


  Measurement of the process of prices rising
• The primary cause of inflation is too much money
• Monetary aggregates

  • M1 - Narrow Money: currency in circulation and overnight deposits
  • M2 - Intermediate Money: M1 + short-term time deposits + deposits redeemable at notice of up to 3 months
  • M3 - Broad Money: M2 + long-term time deposits
• CPI measures "How much more would it cost for people to purchase today the same basket of goods and services that they actually bought at some fixed time in the past"
• Calculating CPI

  1. Survey people to see what they bought

  2. Figure out what it would cost to buy the same basket of goods and services today

  3. Compute the percentage change in the cost of the basket of goods
• Financial instruments

  The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions
• Types of financial instruments

  • Tangible assets: Value is based on physical properties
  • Intangible assets: Claim to future income generated (ultimately) by tangible asset(s)
• Fundamental classes of financial instruments

  • Underlying instruments
  • Derivative instruments
• Principal economic functions of financial assets

  • Act as a means of payment
  • Act as a store of value
  • Allow for the transfer of risk
• Financial instruments used primarily as store of value


  • Bank loans
  • Bonds
  • Home mortgages
  • Stocks
• Financial instruments used primarily to transfer risk


  • Insurance contracts
  • Futures contracts
  • Options
• Economic functions of financial markets

  • Market liquidity: Ensure that owners of financial instruments can buy and sell them cheaply and easily
  • Information: Pool and communicate information about the issuer of a financial instrument
  • Risk sharing: Provide individuals a place to buy and sell risk
• Types of financial intermediaries


  • Deposit-takers: Retail banks, Commercial banks
  • Non-deposit takers: Insurance companies, Pension funds, Securities firms, Finance companies
• Functions of financial intermediaries

  • Pooling the resources of small savers
  • Providing safekeeping and accounting services, as well as access to payments system
  • Supplying liquidity by converting savers' balances directly into a means of payment whenever needed
  • Providing ways to diversify risk
  • Collecting and processing information in ways that reduce information costs
• By accepting many small deposits, banks empower themselves to make large loans
• Financial intermediaries, by providing us with a reliable and inexpensive payments system, help our economy to function more efficiently
• Financial intermediaries help us to manage our finances by providing bookkeeping and accounting services
• Liquidity


  Measure of the ease and cost with which an asset can be turned into a means of payment
• Banks can structure their assets accordingly, keeping enough funds in short-term, liquid financial instruments to satisfy the few people who will need them and lending out the rest
• By collecting funds from a large number of small investors, the bank can reduce the cost of their combined investment, offering each individual investor both liquidity and high rates of return
• Intermediaries offer both individuals and businesses lines of credit, which provides customers with access to liquidity
• A financial intermediary must specialise in liquidity management, designing its balance sheet to sustain sudden withdrawals
• Banks take deposits from thousands of individuals and make thousands of loans with them. Thus, each depositor has a very small stake in each one of the loans
• All financial intermediaries provide a low-cost way for individuals to diversify their investments
• Information asymmetry


  The fact that the borrower knows whether he or she is trustworthy, while the lender faces substantial costs to obtain that information
• If the cost of information is too high, markets cease to function

  
• Adverse selection


  Arises before the transaction occurs, when lenders need to know how to distinguish good credit risks from bad