Introduction to Monetary Economics

Frederic University2014

Financial System The financial system encompasses markets,

institutions, laws and regulations through which allocation of scarce resources is accomplished within the economy.

The financial system consists of five parts: money (to pay purchases and store wealth); financial instruments (to transfer wealth from savers to

investors and to transfer risk to those best equipped to bear it);

financial markets (buy and sell financial instruments); financial institutions (provide access to financial

markets); central bank (monitor financial institutions and stabilize

the economy)

Decision makers

People who need funds borrowers/issuers/sellers

People who have funds to give lenders/savers/buyers

Financial Instrumentssecurities, financial assets

definition = written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions

a security is an asset for the buyer/lender,but a liability for the issuer/borrower/seller

examples bank loans stocks bonds home mortgages asset-backed securities option and futures contracts insurance policies

example

shares of stock in ABC ltd.: shares of ownership in ABC a claim on the earnings/assets of

ABC a liability for ABC an asset for me

my mortgage: I am the borrower (liability) the bank is the buyer/holder

(asset) the bank has a claim on my house

uses of financial instruments means of payment

but much less liquid than money store of value

better than money over time, but also greater risk

transfer of risk buyer transfers risk to seller e.g. insurance policies, futures contract

Valuing financial instruments sizing, timing & certainty of promised

cash flows Size: how much is promised?

the larger the cash flows, the greater the value

Timing: when is it promised? the sooner the cash flows are received, the

greater the value

Attributes of financial assets Certainty: how likely is it that payments

will be made? the likelier the payments the greater the

value Under what conditions?

e.g. insurance, derivatives payments when we need them the most are

more valuable

Financial Markets

Financial markets are all markets, where buyers and sellers exchange financial assets. These assets present money saved and invested for profit.

The stock exchange is an organized market for financial assets.

Functions of Financial Markets

to provide: liquidity information through prices risk-sharing among buyers/sellers

Direct finance

Borrowers sell securities directly to lenders

e.g. corporate and Government bonds (Treasury bills in the US)

Indirect Finance

Borrowers and lenders meet through a financial intermediary (e.g. bank)

Loan is a liability for borrower and asset for a bank

Primary vs. Secondary Markets

primary market newly issued securities

-- investment banking secondary market

brokers match buyers and sellers dealers act as buyers and sellers

-- “market-makers”

Debt vs. Equity Markets

debt security cash flows are fixed bonds, loans

equity security cash flow variable, residual common stock

Exchanges vs. OTC Markets

exchange buying & selling of securities in

physical location CSE (Cyprus Stock Exchange)

OTC (over-the-counter) dealers in many locations buy & sell

securities

Financial Institutions Financial institutions are all firms with money as a

major asset in their balance sheet. These are: Banking institutions: The Central bank Commercial Banks Nonbanking: Insurance funds Pension funds Investment funds Mortgage funds Brokering houses Mutual funds

Financial Institutions

financial intermediariesWhy have them? Transactions costs

search costs to find borrower & lender contract costs economies of scale

Risk sharing intermediaries are experts at bearing

risk Asset transformation

short-term to long-term illiquid to liquid