introductory finance for economics (lecture 10)

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  • 1. Lecture 10 Financial Markets & Institutions Introductory Finance for Economics (ECN104) Module Leader: Farzad Javidanrad Based on: Principle of Cooperate Finance by Brealey, Myers and Allen (2014) (Spring 2013-2014) Department of Economics The University of Sheffield

2. Financial System & Financial Markets Financial system is a system that allows moneys to be transferred from the individuals and companies with the surplus funds to those who have the shortage of funds. The system can be defined at the global, regional or even specific firm level. The regional financial systems is a set of banks and other financial institutions, financial markets, financial services at a regional level. A healthy regional financial system directs funds to where that increase productivity and promote economic stability and growth. At a global level, financial system comprises of the International Monetary Fund (IMF), central banks, World Bank and major banks that work internationally. Financial market is a market that money and financial securities (such as stocks and bonds) and some commodities (such as some agricultural goods and precious metals) are traded. Some financial markets are small in terms of participants and number of transactions but some of them are very active such as London Stock Exchange and New York Stock Exchange with over trillion dollars trade in a day. 3. Financial Markets There are different types of financial markets: 1. Capital Markets; where money can be borrowed or lent for a long-period in order to finance the projects of corporations through issuing bonds and stocks. This market is subdivided to: 1.1 Bond Markets 1.2 Stock Markets Each of them are subdivided to the Primary Market; where new issues are first offered and the Secondary Market; where old issues are offered for another trade. 2. Money Markets; where money is borrowed and lent for a short-period of time (from several days up to a year), mostly through interbanking lending. Types of securities in this market are Certificates of Deposits (CDs), government bonds, commercial papers and etc. Adopted from 4. Financial Markets 3. Commodity Markets; where large amount of commodities such as gold, silver, oil, wheat, coffee, sugar and etc. are being traded. 4. Insurance Markets; where buyers transfer risk of heavy loss to sellers in exchange for payments. 5. Derivatives Markets; where financial instruments such as future contracts and options are being traded. 6. Foreign Exchange Markets; where different currencies are exchanged. The main participants of these markets are banks. Flow of funds through the financial system can happen in two ways: a) Direct Finance: Funds move directly from lender/savers (investors) to borrower/spenders via financial markets in exchange with financial instruments (securities). b) Indirect Finance: Funds moves first to the financial institutions (financial intermediaries) and then lent to the borrowers. Graph in the next slide help to visualise these relations. 5. Flow of Fund Through the Financial System Financial Institutions Financial Market Lenders/Savers: Households Firms Governments Foreign Investors Borrowers/Spenders: Households Firms Governments Foreign Borrowers Indirect Finance Direct Finance 6. Types of Financial Institutions There are six types of financial institutions (intermediaries): I. Commercial banks II. Investment banks III. Insurance companies IV. Pension funds V. Mutual funds VI. Hedge funds Commercial banks accept deposits and offer loan to individual and firms. They also serve as payment agents to facilitate the money transfer between different individuals, companies and organisations. Investment banks do not take deposits and usually do not serve the general public. They help companies to raise money, for example, by underwriting companies' stocks and distributing (or reselling) them to potential investors in the market. They also advice companies on takeovers (purchase of one company by another), mergers (combination of two or more companies) and acquisitions (buying most, if not all, of another company's ownership) 7. Types of Financial Institutions Insurance companies make profit by insuring a large number of people or companies at the same time. They are one of the important sources of funds for corporations. They provide long- term loans directly for companies through buying their bonds and stocks. Pension funds are one of the largest fund providers around the world and designed for long-term investments. They have tax advantageous meaning the returns of their investment are not taxed before the final withdrawn. Mutual funds are the professionally managed investment schemes that raise money from different investors in order to invest in a portfolio of securities. For many investors it is more efficient to buy securities from a mutual fund than investing directly in individual securities as these institutions try to find those stocks that generate return better than the average returns. 8. Types of Financial Institutions Hedge funds like mutual funds pool money from different investors to invest on their behalf but they do not serve the general public but the big investors such as pension funds or very rich individuals. They have limited liabilities and require a very large level of minimum investment. Adopted from Failing or closing a very large hedge fund may put the financial system in the risk of instability either through drying out the credit channel or through selling the collaterals simultaneously (needed for hedge funds transactions). Hedge funds use leverage to increase the size of the positions taken in financial markets. In some cases, the use of leverage allows them to become large enough to suggest they could impact the wider financial system in certain situations. Hedge funds obtain leverage either by borrowing money or securities from counterparties (known as financial leverage) or by using derivative instruments such as options, futures or swaps. . the largest proportion of total leverage used by hedge funds in the UK is acquired using derivatives. Derivative transactions allow hedge funds to acquire market/economic exposures (which this report refers to as the Gross Notional Exposure) that are many times bigger than the capital of the fund: for example a hedge fund may pay or receive USD 1m to buy or sell an option with an underlying market exposure of USD 100m.(Financial Conduct Authority, March 2014, Hedge Fund Survey, p.4) 9. Asymmetric Information & Free-Rider Problem A healthy financial system must overcome two problems: A. Asymmetric information: A situation in which one side (party) of a transaction (for example, seller) has more or better information compared to another (here; the buyer) and causes imbalance of power. Asymmetric information leads to two problems: A.1. Adverse selection (before a transaction is completed) arises because the party who is most eager to engage in a transaction is the one most likely to produce an undesirable (adverse) outcome for another party. For example, in the health insurance market, buyers with health problems have an incentive to hide their health problems in order to pay lower insurance premium. So, at any level of premium, there are some buyers who are willing to be covered as they know the cost of treatment is higher than the cost of premium. Adopted from 10. Asymmetric Information & Free-Rider Problem A.2. Moral hazard (after a transaction is completed) arises when one party is engaged in activities that are undesirable from other partys point of view. For example, when financial institutions are bailed out by the state (in order to protect peoples deposits) some financial institutions carelessly enter into some risky investments. B. Free-rider problem: A situation when a party is benefited from something but does not pay the price of that. For example, an individual who can get a profit from a stock trade without using any of his or her own money (Arbitrage Opportunity). Another example is the people who get benefited from the defence budget but do not pay their taxes. Adopted from Adoptedfrom 11. Financial Development & Economic Growth Financial institutions are important as they theoretically 1. Promote economic growth through facilitating trade and capital movement 2. Provide credit for individual and firms 3. Identify creditworthy firms 4. Pool the risks of the individual entities 5. Mobilise savings to investment projects 6. Reallocating capital with a low transactions costs The relationship between financial development and economic growth has received great attention during the last few decades. Many economists have emphasised the significance of financial sector development in the process of economic growth, whereas other economists believe that this importance is over-stressed. However, the debate is not new in the economics development literature and can be traced back to Bagehot (1873) and Hicks (1969) which argued that financial development was an important channel in the industrialisation of England, by helping the movement of large amounts of funds for immense works.(Javidanrad, Causal Relationship between Financial Development & Economic Growth, p. 11) 12. Financial Development & Economic Growth How much are they good practically? It is naive to think that the private financial institutions are committed to boost the economic growth. Private financial institutions do not lend money to create jobs or to facilitate transactions in economy but to make a bigger profit. They have great interest to expand their business [through lending] in order to have a bigger share of t