CHAPTER 1

PAGE 9

Chapter 1: An Overview of Financial Markets and Institutions

There are Three Types of Economic Units:

1. Households : They Receive Income and make expenditures

2. Business Firms: They Sell Goods and Services and Receive Income, Pay for wages.

3. Government: They Receive Tax and pay for government purchases.

- Budget Position: it can be one of the following:

1. Deficit Position: Income < Expenditure.

2. Balance Position: Income = Expenditure.

3. Surplus Position: Income > Expenditure.

Financial System is transferring purchasing power from SSU to DSU.

Financial Claims (IOU):

Is written promise by DSU to pay sum of money plus interest, it is an assets for SSU and liability for DSU, if IOU can be resold, it called "marketability".

If the borrower wants to borrow, he issuing financial claims.

If the lender wants to lend, he buying financial claims.

Types of financial claims:

There are two types of financial claims:1. Debt financing: loans and bonds (just lend and borrow), also called fixed-income securities.

- Bonds can be trading (liquid).

- Loans cannot be trading.

2. Equity financing: stocks (ownership stocks).

- There net income is divided into two parts, either dividend (receive money now), or Retained earnings (invest the existing money now to receive more in the future).

Types of Investment:There are two types of investment:

1. Financial Investment: Lend your money to a borrower and receive interest.

2. Economic Investment: Borrowing a money and invest it.

Transferring Funds from SSU to DSU:

It done either by using direct financing or indirect financing.Direct Financing: DSU's is issues financial claims (it will be their liability), SSU's is buying these financial claims (it will be their asset) directly or through an institutional arrangements. The financial claims issued by direct financing called "Direct Claims" and their sold in "Direct Credit Market".

SSU's

DSU's

AssetsLiabilitiesAssetsLiabilities

- Money

+ Direct Claims

+ Money

+ Direct Claims

Institutional Arrangements:Private Placement: Simplest method of transferring funds through sells an entire security issued by DSU to single institutional investor or small group of such investors. It is faster than IPO and has low transaction cost.Brokers and Dealers: to aid in the search processes to bringing buyers and sellers together.

Brokers: execute their clients transactions at best possible price, their profits is the commission fee charged from their services.

Dealers: primary function to "make a market" for securities, they buying securities at bid-price and sell it at ask-price for the investors, their profits is called bid-ask spread. Bid-price: higher price by dealers to purchase a given security.

Ask-price: lowest price at which dealers will sell the security.

Bid-ask spread: the differences between bid and ask prices, also called Dealers Gross Profit.

Investment Bankers: they helps DSU's newly to create a market, their important economic function is the Risk Bearing, also called "Underwriting". Underwriting: is the process of purchase an entire issue of stocks or bonds from the DSU's at a guaranteed fixed price, and resell it individually to investors either by IPO or Private Placement.

Underwriting spread: is the difference between the fixed price paid for the securities, and the price at which they resold, it is the profit of investment bankers.Problems with Direct Financing:1. Large denomination of the securities sold in direct credit market.

2. DSU's must find SSU's that want primary claims with precisely of characteristics they can and willing to sell (double coincidence of wants).

Indirect Financing: is the financing through financial intermediaries.Financial Intermediaries: firms that specialize in intermediation.Intermediation: Purchase direct claims (their asset) with one set of characteristics from DSU's and transform it into indirect claims (their liability) with different set of characteristics, which they sell to the SSU. (Look at the following balance sheets)SSU's

Financial IntermediariesDSU's

AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities

- Money

+ Indirect Claims

+ Direct Claims

+ Indirect Claims

+ Money

+ Direct Claims

The Benefits of Financial Intermediaries: Financial Intermediaries can achieve economies of scale because of their specialization.

Financial Intermediaries can reduce transaction cost involved in searching for credit information.

Financial Intermediaries can reduce the problem of unreliable information because of its intimate knowledge about the borrowers.

Intermediation Services: 1. Denomination divisibility: produce wide range of denomination by pooling funds of many individuals and investing them in direct securities of varying size (borrow small amount and lend large amount).2. Currency transformation: buying in one currency and selling in another.3. Maturity flexibility: borrow short-term and lend long-term.4. Credit risk diversification: invest in many portfolios.5. Liquidity: manage our liquidity through maturity flexibility and denomination divisibility and ability to convert assets into cash without losing value.6. Information Intermediation: deal with problem of asymmetric information. Asymmetric information: different information between lenders and borrowers

Problems with asymmetric information:

1. Before Transaction: Adverse Selection (Lend to wrong person).

2. After Transaction: Moral hazard (Make bad choice which will make repayment of loan difficult).

Types of Financial Intermediaries:

- Depository Institutions: most commonly recognized intermediaries because most people use their services on a daily basis. The deposits are devoid of any risk of loss of principal and ate highly liquid. Commercial Banks: 1. Largest and most diversified intermediaries based on range of assets.

2. Their liabilities are in the form of checking accounts, saving accounts and various time deposits.

3. Their assets are loans in different denomination and maturities

4. highly regulated

5. Play a very important role in the economic growth.

6. To manage their liquidity, they keep reserves and invest it in short-term bond or treasury bills [T-Bills: short-term, safe and very liquid]. Thrift Institutions: they issue saving accounts and use funds for long-term investment to finance mortgage. Credit Unions: small, non-profit, cooperative, consumer organized institutions owned entirely by their member-customers. - Contractual Saving Institutions: obtain funds under long-term contractual arrangement and invest the funds in the capital market, these institutions have a steady cash inflow from contractual commitments with their insurance policyholders and pension fund participation. Life Insurance: obtain funds by selling insurance policies that protect against loss of income from premature death or retirement. 1. Predictable inflow of funds.

2. Predictable outflow

3. invest in high yielding long-term assets Causality Insurance: sell protection against loss of property from fire, theft, and accident.1. Predictable inflow.

2. not very predictable outflow3. Invest in short-term and highly marketable securities. Pension Funds: obtain funds from employer and employee contributions during employee's working years and provide monthly payment upon retirement.1. Predictable inflow and outflow

2. Invest in highly yielding long-term assets.

Note: In insurance companies, the fund received called Premiums.

Note2: In Causality Insurance, there is More Liquid Problem.

- Investment Funds: sell shares to investors and use these funds to purchase financial claims. They offer investors the benefits of both denomination flexibility and default risk intermediation. Mutual Funds: sell equity shares to investors and use these funds to purchase stock or bonds. Advantages of Mutual Funds over direct investment:

1. Provides small investors access to reduced investment risk resulted from diversification.

2. Economies of scale.

3. Professional Financial Managers. Money Market Mutual Funds: Are the mutual funds that invest in short-term with low default risk securities.- Other Types of Financial Intermediaries:

Finance Companies: make loans to consumers and small businesses, unlike commercial banks, they do not accept saving deposits from consumers but they obtain funds from issuing commercial papers(short term claims). Federal Agencies: the primary purposes of federal agencies are to reduce the cost of funds and increase the availability of funds to target sectors in the economy by selling debt instruments called agency securities, most of the funds provided by the federal agencies support agriculture and housing because of these sectors to the nation's well being.Types of financial Markets:

1. Primary and Secondary Markets: in Primary market, they create claims, but in secondary market, they trading with the existing claims.2. Money and Capital Markets: Money is short-term (maturity 1 year) and it is market for liquidity with higher efficiency. Types of Money Market: T-Bills, Commercial Papers, and CD's (Certificate of Deposits: issued by high banks, you can deposit your money within one year with large denomination (Time Deposits), with Interactive Interest rate, and you can negotiate with them on interest).

Note: CD's can be Short-Term or Long-Term.

Characteristics of Money Market Securities:

1. Short-Term.2. Large Denomination amount, whole sale market (for big investors/players).3. Low Default Risk.4. High marketability "Liquidity".5. Close Substitute, Short-term interest rate are similar.6. Sold at a discount (below face value). Capital is long-term (maturity > 1 year) and it is market for economic investment, it leads to economic growth.

Types of Capital Market: T-Bonds, Corporate Bonds, Loans (Mortgages), Stocks.

3. Organized Exchanges and Over-The-Counter Markets: Organized Security Exchange provide a physical meeting place and communication facilities for members to conduct their transaction under a specific rules and regulations. Only members of the exchange may use the facilities (exclusive), and only securities listed on the exchange can be traded. Financial Claims also can be traded "over the counter" by visiting of phoning an "over the counter" dealer or by computer system. "over the counter" is available for any licensed dealer (inclusive).4. Debt and Equity Markets:Equity is Stocks and Debt is Loans and Bonds, for a company bond financing are riskier, but they dont depend on stocks 100% because if they continuing to issue a stocks, that leads stock price to go down (financial leverage).

Some Points regarding to this chapter:

Federal Funds is Short-Term loans between banks. Repurchase Agreement (REPO) sells a security (at low price for lending) and buys it back (at high price for borrowing). Bankers Acceptance: Bank Guarantee to . . Real Investment is Long-Term Investment. Capital market is finance Long-Term Investment. Money Market helps lenders and borrowers to manage their liquidity. Capital Market is finance Economic investment. Commodities is not a financial claims, it is financial goods.Risks faced by financial institutions:1. Credit (Default) Risk: default risk of borrowing because the lender is accepting the possibility that the borrower will fail to repay the loan plus interest. We can reduce this risk by diversification, conduct a careful credit analysis of the borrower to measure default risk exposure, and monitor the borrower over time of the loan or investment to detect any critical changes in financial health2. Interest Rate Risk: risk of fluctuation in a securities price or reinvestment income. It is applicable only to bonds but also to financial institutions balance sheet.Note: There is negative relationship between stock price and interest rate.

3. Liquidity Risk: is the risk that a financial institution will be unable to generate sufficient inflow to meet cash outflow. We can reduce this risk by invest in money market securities.4. Foreign Exchange Risk: is the fluctuation un the value of financial institution that arises from fluctuation in exchange rates. We can reduce this risk by diversification and currency hedging.Currency Hedging: enter into forward contracts with fixed rate now and the delivery in the future.5. Political Risk: risk of fluctuation in value of financial institutions because of government action. We can reduce this risk by diversification.Chapter Key Points 1.The role of the financial system is to collect funds from lenders and to allocate them to borrowers for real (economic) investment or for current consumption. The key elements of the financial system are financial markets, financial institutions (intermediaries) and financial claims. 2.Financial markets exist to facilitate the transfer of funds from lenders who have a surplus of funds to borrowers who have a shortage of funds. Financial markets can do this either through direct finance, in which borrowers borrow funds directly from lenders by selling them securities, or through indirect finance, which involves a financial intermediary who stands between the lender and the borrower and helps transfer funds from one to the other.

3.Business firms and government are the major issuers of financial claims (deficit spending units), and households are the major holders of financial claims (surplus spending units). 4.Financial intermediaries acquire financial claims with funds obtained by issuing their own liabilities. The type of financial claims that each intermediary acquires depends on its business objectives, its tax status, and the type of liabilities it has issued to obtain its funds.

5.Financial intermediaries can be classified, based on their sources of funds (liabilities) and uses of funds (assets), as:

i.Depository Institutions - commercial banks and credit unions

ii.Savings Institutions - life insurance companies, casualty insurance companies, and pension funds

iii.Investment Institutions - mutual funds and finance companies

6.The benefits of financial intermediaries include (a) reduce transaction costs because of economies of scale, (b) reduce risk through diversification, and (c) solve the asymmetric of information problems - adverse selection (before the transaction) and moral hazard (after the transaction). 7.The key services that financial intermediaries provide to investors are (a) denomination divisibility, (b) currency transformation, (c) maturity flexibility, (d) risk diversification, and (e) liquidity.

8.Financial markets can be classified as (a) primary and secondary markets, (b) organized and over-the-counter markets, (c) money and capital markets, and (d) debt and equity. 9.The secondary market allows investors to adjust their portfolios and change their risk exposure. An active secondary market enhances the primary market as investors are encouraged to buy new securities if the secondary market provides liquidity.10.The economic role of the money market is to provide an efficient means for investors to adjust their liquidity positions. The economic role of the capital market is to provide financing for long-term capital investments.11.The general characteristics of money market securities are (a) short-term maturity, (b) low default risk, and (c) high marketability (liquidity).12.The risks faced by financial institutions are credit risk, interest rate risk, liquidity risk, foreign exchange risk, and political risk.Basic Options Concepts

An option give you the right to buy (call) or sell(put) the underlying asset at a specified price (strike price) during a specified period (until the 3rd Friday of the expiration month). Options are available in several strike prices above and below the current price of the underlying asset. Stocks priced below $25 per share usually have strike prices at 2 dollar intervals. Stocks priced above $25 per share usually have strike prices at 5 dollar intervals.

The price of an option (called the option premium) is determined by the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility of the underlying asset.

Each stock has a corresponding cycle of months that it offers options in. There are three fixed expiration cycles available. Each cycle has a 4-month interval:

1.January, April, July, and October

2.February, May, August, and November

3.March, June, September, and December The option premium is priced on a per share basis. Each option on a stock corresponds to 100 shares. Therefore, if the option premium is priced at $2, the option on the stock (the total option premium) would be $200 ($2 x 100 = $200).

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