ECO 204 - Financial System Overview

• ECO 204 - Introduction to Finance, Lecture 1: Overview of the Financial system by Hugues Dastarac on February 14th, 2024.

General Information

• Contact Hugues Dastarac at [email protected].
• Suggested references include Cochrane's "Asset Pricing", Tirole's "The Theory of Corporate Finance" and Duffie's "Dynamic Asset Pricing", chap. 1-2.

Course Evaluation

• The evaluation includes 2 exams which comprise 35% each for the mid-term and final.
• There is one empirical project, accounting for 20% and participation is 10%.

Course Outline

• What is finance about
• Preliminary: assets, liabilities, balance sheet
• Overview of the financial system, including various asset markets, savings vs. investment when markets are intermediated, and typology of major players
• Topics in financial economics
• Conclusion

What is Finance About

• Finance relates to matching saving needs and investment.
• Saving is when individuals or companies have more money than needed for current expenditures.
• Wealth is transferred across periods for future income needs ie retirement.
• Wealth can be hedged against future risk, acting as a buffer, Insurance helps when risk materializes.

How To Transfer Wealth

• Storage involves goods for future use or resale like food, gold, or raw materials.
• The future resale price is uncertain.
• Setting up a business involves investing in machines, hiring staff for bakeries, or rental properties.
• Financial contracts involve commitments to give money to someone who promises to return what was given back at some stage.
• A failure to do so can result in bankruptcy.
• The most basic type is debt, the borrower promises to fully repay plus interest, either in years or in fixed monthly installments.
• Money can be used by industrial/service companies to manufacture products, governments to build infrastructure, or even just individuals buying homes/PCs.

Financial Contracts

• In Equity, investors bring money to the company trading the right to vote, and receive dividends.
• Flows between two parties depend on on events ie prices of assets or things such as inflation.
• A Derivative is based on an underlying commodity, currency, equity,rate etc.

Case of Money

• Money can be stored by any individual in any location and takes the form of commodities such as shells or metals.
• Nowadays it is debt by instituions.
• Central banks issue banknotes and coins that are not redeemable which are useful for direct exchanges.

What is Finance About

• Finance involves the behavior of savers and borrowers, including intermediaries in the financial system.

Assets

• Anything that brings income in the future ie financial contracts or having the ability to resell ie gold, silver, land.
• This extends to individual skills (human capital), company skills (organizational), and reputation.

Liabilities

• Any obligation a person must pay in the future like debt contracts and insurance damages.

Balance Sheet

• An entity (person, company, or state) owns assets and has liabilities, is often required to assess if the the assets are "enough" for liabilities.
• It takes the form of tables, with Assets on the left showing "type of assets + a value for each" and Liabilities on the right doing same.
• It is conceptually relevant for all entities however is mainly used by companies with rules.
• Liabilities included "net worth" as some companies are owned by multiple people who brought money/shareholders. Value of Assets = Value of Liabilities.

Equity

• Equity is sometimes counted among liabilities.
• Many companies are owned by several people and formalized through contracts which gives the owners shares, which has the owners bring money to the company, with voting rights to influence company strategy, including payouts = dividend.
• The equity gives the company the asset, but in return is an obligation to pay

The Balance Sheet

• Balance sheets show financial health, and comparisons ie leverage ratio of an entity along with alternative equivalent definitions, and what backs up liabilities.
• These are not comprehensive and require additional questions, and do not reflect timing of future cash flows.

Valuing Assets

• This considers how much an acquirer paid (historic cost) and their current market value.
• Some assets have uncertain values ie mandatory BS exclude company reputation.

Balance Sheets

• There are legal triggers when thresholds are missed. for bankruptcy.
• Used to inform company investors, regulators ie assets to include and how to value
• It is of particular use in for corporate raising funds through financial markets.
• There are stylized\simplified balance sheets to guide reasoning.

Overview of the Financial System

• This includes various asset markets, savings vs investment when markets are intermediated and the typology of major players.

Asset Market

• Investors entering an asset market can either enter a new contract with a company (loans, debts, derivatives);
• Or the trading on an existing contract ie equity, bonds which could include derivatives.
• Tradable contracts are securities. Banks Loans and derivatives are non-tradable contracts.

Financial Markets

• Some companies and entities choose to go public for equity, debt.
• This offers the benefit of more liquidity but causes an administrative burden and exposes them to bad news.
• Remaining private can be difficult to resell for investors as some companies equity is already owned by executives.

Intermediaries

• Stock and bonds in non financial companies can be contracted directly.
• It is common to contract with financial institutions which include banks, mutual and insurance companies.
• Investment requires expertise.
• Investment requires effort ie screening, building deals, and monitoring.
• Intermediaries can take too much risk and show products that are less profitable than other bigger clients.
• Intermediaries are useful, but require fees.

Intermediaries

• Intermediaries can transform savers's needs in borrowers' needs; savers want to withdraw an unlimited amount at anytime whereas companies want longer ones.
• Financial markets are used in insurance companies to transform funds for companies.

Preview of the Financial System

• Non-financial companies that make goods and services
• Financial intermediaries ie banks and insurance companies
• Public sector entities ie states and central banks

Banks

• Banks manage deposits, payment services, and loans to all types of clients where deposits are for storage of money.
• Payments are transfers between deposit accounts including activities in financial markets.
• Activities choose the asset allocation of investors.

Banks Balance Sheet

• Their assets are central bank money which funds loans and bond to the non financial sector and financial market activities.
• Their liabilities are Equity, deposits from the non financial sector, and longer term debt

Insurance Companies and Funds

• Insurance contracts provide like life, pension and health.
• Premiums are received and damages are paid where some of of the original sum is reinvested.
• Insurer’s technical reserves reflect the insurance liability as of 2023Q4, for example France had €2.0tn where 90% was from life insurance and Euro area has €5.8tn

Insurance Companies Balance Sheet

• The assets are stocks, commercial real estate, government bonds corporate bonds and cash.
• Liabilities are equity including the technical provisions for future insurance claims.

Mutual Funds

• Investors own fraction of a fund's assets where portfolio is chosen by banking groups and it is independent.
• If an investor is unhappy, they can freely sell stocks where many funds invest in stocks in market bonds, commodities, private equity derivatives and assets and foreign assets.
• Euro Area is approximately €16.6tn asset under management.

Mutual Fund Balance Sheet

• Fund portfolios comprise their assets in cash, while redeemable shared held by investors comprises their equity.

States/Government

• Government issues debt to fund spending and provide the financial states with assets, the EU had €10.3tn as of 2020.
• Assets used to back the debt were real estate which is underwritten by future generations.

Balance Sheet

• Rarely exhibited, states' equity is poorly defined but critical to assess default risk.

Central Banks

• Banks issue money and ensure stability while limiting their severity.
• Their tool include short term interest assets which allows asset purchase ECB goal is limited inflation however the Federal reserve aims is a tradeoff of inflation and GPD.

Central Bank Balance Sheet

• Bank assets are government bonds and loans to banks.
• The liabilities are corporate debt, foreign exchange reserves and gold, which are all part of equity.
• To ensure stable value of money.

Topics In Financial Economics

• This includes how to determine the right price of traders, and consistency with each other.

Pricing Assets

• Much practical use for corporations and financial institutions.
• At time t, prices of different assets should be consistent with each other.

Security Design

• The company or entity will issue debt, equity or something else depending the security risk and what will hedge it.

Financial Markets

• Markets should be work socially, this occurs through explained explanations, how the market deal with its duties and what public issues intervene and restore outcome with better asset values.

Conclusion

• Essential concepts include assets, liabilities, and balance sheets in addition to understanding the big picture.
• Exercises will be released every friday.