Financial Markets and Assets

• Financial markets transfer funds from those with excess funds to those with shortages
• They promote economic efficiency by channeling funds to productive uses
• They are a key factor in producing economic growth
• Poorly performing financial markets are a reason many countries remain poor

Assets

• Assets are anything of value owned by a person or firm
• They include any financial claim or piece of property subject to ownership
• Real assets include items like gold, houses, and paintings

Financial Assets

• Financial assets represent a claim on someone else for a payment
• Instruments are issued by a borrower and bought by an investor who wants to use their money productively
• A claim on a future financial cash flow
• Examples include bank checking accounts
• Cash can be seen as a financial asset

Securities

• Security is a financial asset that can be bought and sold in a financial market
• It is a tradable investment instrument, such as stocks, bonds, or financial derivatives
• It is a financial instrument representing a claim on the issuer's future income or assets
• Financial markets are places or channels for buying or selling securities like bonds and stocks

Money

• Money is anything generally accepted as payment for goods, services, or debts
• The money supply is the total quantity of money
• Money plays an important role in the economy
• There are questions about how to measure it

Bonds

• Bonds are debt securities that promise to make payments periodically for a specified time
• They are issued by corporations or governments as a promise to repay a fixed amount of money
• Interest is the cost of borrowing funds or the payment for lending funds
• Coupons are interest paid as a fixed amount
• Maturity is the end of the bond's lifetime, when the seller repays the principal
• Short-term maturity is less than 1 year, long-term maturity is greater than 10 years

Stocks

• Common stocks are also known as equities
• They represent a share of ownership in a corporation
• They are a security that is a claim on the earnings and assets of the corporation
• If the firm creates value through profit, equity and stock value increase
• If there are losses, equity value and stock value decrease
• Buying stock makes you a shareholder, with a legal claim to a share of the firm's assets and profits, if there are any
• Dividends are payments a corporation makes to its shareholders
• Retained earnings are profits kept in the firm

Foreign Exchange

• Foreign exchange is units of a foreign currency
• The most important buyers and sellers are large banks
• Foreign exchange is for investors buying foreign financial assets, importing/exporting goods/services, or investing in physical assets in foreign countries

Securitized Loans

• Securitization is the process of converting non-tradable loans and other financial assets into securities that are traded
• Banks grant mortgages (loans to buy a home) and sell them to financial firms that bundle mortgages from different banks
• The portfolio of mortgages is the basis of a new security which is a mortgage-backed security (MBS) that works as a bond
• The bank that originates the mortgages still collects the interest, but sends it to the financial firm to distribute to MBS investors

Financial Liabilities

• The financial asset of a saver is a financial liability for a borrower
• A financial liability is a financial claim owed by a person or firm
• For a loan, the asset is to the bank, and the liability is to the borrower.

Debt Markets

• Debt markets are the bond market
• Debt markets are especially important to economic activity
• They enable corporations and governments to borrow to finance activities
• Interest rates are also determined here
• Interest rate is the cost of borrowing, expressed as a percentage of the rental of $100 per year

Interest Rates

• High interest rates encourage saving and deter buying assets
• Interest rates affect consumer spending/saving and business investment decisions
• Interest rates tend to move in unison, but often differ substantially
• Spreads between interest rates fluctuate
• Debt markets allow governments, corporations, and individuals to borrow
• Borrowers issue a security, called a bond, offering interest and principal over time
• Interest rate is the cost of borrowing
• There are many types of market interest rates, like mortgage, car loan, and credit card rates
• The levels of these rates are important; for example, mortgage rates exceeded 13% in early 1983

Stock Markets

• The stock market is where stocks are traded
• Companies initially sell stock in the primary market to raise money
• Stocks are then traded among investors
• The stock market receives the most attention from the media
• Companies, not just individuals, watch the stock market
• Companies often seek additional funding
• CEO success is dependent on the company's stock
• A higher price for a firm's shares results in raising a larger amount of funds
• A higher price for a firm's shares allows buying more production facilities and equipment

Financial Intermediaries

• Financial firms, such as banks, borrow funds from savers and lend them to borrowers
• Commercial banks are financial firms that serve as a financial intermediary by
  • Taking in deposits
  • Investing the deposits by making loans or buying securities
  • Being the most important financial intermediary

Nonbank Financial Intermediaries

• Savings and loans, savings banks, and credit unions are legally different from banks
• However, savings and loans, savings banks, and credit unions operate similarly by taking in deposits and making loans
• Other financial intermediaries: insurance companies, pension funds, mutual funds, hedge funds, and investment banks
• Other financial intermediaries do not look similar to banks but fulfill similar function of moving funds from savers to borrowers

Insurance Companies

• Write contract to protect policy holders from risk of financial losses at certain events like accident or fire
• Collect premiums
• Invest to obtain the funds necessary to pay claims to policyholders and cover their costs

Pension Funds

• Receive contributions from workers and firms
• Invest in stocks, bonds, and mortgages to earn the money necessary to pay pension benefit payments during worker's retirement
• Very important source of demand for financial securities

Mutual Funds

• Obtain money by selling shares to investors
• Invest the money in a portfolio of financial assets
• Charge a (small) management fee for its services
• Attractive to investors because they allow diversification and cost reduction

Hedge Funds

• Hedge funds are similar to mutual funds
  • They accept money from investors
  • They buy a portfolio of assets
• Hedge funds have a limited number of investors which are wealthy individuals or institutions
• They typically make riskier investments than mutual funds and charge higher fees

Investment Banks

• Investment banks do not take in deposits
• Investment banks rarely lend directly to households
• Investment banks concentrate on giving advice to firms by issuing stocks and bonds, considering mergers, and securitizing loans
• Investment bank underwriting guarantees a price to a firm issuing stocks or bonds and making a profit by selling at a higher price

Why Study Financial Markets and Institutions?

• Includes structure of the financial system which helps funds move from savers to investors through financial intermediaries
• Includes understanding financial markets and products
• Includes role of insurance companies, mutual funds, pension funds, etc.
• Includes managing risk in the financial institution