FINA 4000 Financial Institutions & Markets Course PDF Fall 2024

Course FINA 4000 Financial Institutions and Markets Professor Ralph E. Steuer Terry College of Business Fall 2024 1 Purpose of Course To understand an economy’s financial system how it finances the economy how...

Course FINA 4000 Financial Institutions and Markets Professor Ralph E. Steuer Terry College of Business Fall 2024 1 Purpose of Course To understand an economy’s financial system how it finances the economy how it oversees the economy’s money supply A financial system provides for efficient flow of funds from savers to borrowers by bringing savers and borrowers together via financial institutions and financial markets. 2  1. Financial Institutions commercial banks, a nation’s central bank, government sponsored enterprises, insurance companies, mutual fund companies, pension funds, … Other than for central bank, goal is to bring money in at a low rate and deploy it at a higher rate. Institutions cover costs and make profits mostly by means of the interest rate spread. 3  2. Financial Markets New York Stock Exchange, bond market, US Treasuries market, commercial paper market, Fed Funds market, credit default swaps market, … Venues where people buy and sell financial claims (financial instruments or securities). Cover costs and make profits for owners of the markets mostly by means of the commissions and fees. Cannot have an advanced economy as in the US, Japan, Germany, Canada… without an efficient financial system. 4 Money Markets & Capital Markets Money Markets Capital Markets < 1 year ≥ 1 year corporate stock short-term long-term debt bond debt Bottom two boxes are this course Short- and long-term debt instruments much more analytical than stocks. 5  Public Money Markets & Capital Markets US Money Markets US Capital Markets ~$11 trillion ~$110 trillion short term debt instruments stocks bonds (marketcap) (face value) Roughly 1/10-th the size. ~52/48 split Split depends upon whether stock market is up or down, but bond side always bigger. 6  Financial Claims With financial claims, there is an issuer and a holder. A financial claim is a claim on the issuer’s income or assets. While issuer remains the same, the holder may change many times. In our society, if drawn up properly, legislation and regulation give financial claims strength – that is, renders them legally enforceable. 7  Best Known Financial Instruments A bond is a long-term loan you can buy. It contractually obligates the issuer to make specific payments at specific times to the holder. Otherwise, there are legal consequences. A stock is a claim on the income and assets of a corporation. While stocks are the most widely followed, world of debt instruments actually larger. Course is mostly about debt instruments. 8 How Big is $1 billion? $1 trillion? Annual revenue of UGA is roughly $2 billion. Examples of large numbers: Annual Rev / Marketcap Apple 381B / 3.343T Microsoft 245B / 3.036T Nvidia 79B / 2.639T Amazon 590B / 1.762T JPMorgan Chase 158B / 566B Wells Fargo 82B / 181B CVS 360B / 74B 9 Millions, billions, trillions 10 $1 million 11 $100 million 12 $1 billion 13 $1 trillion 14  Drill: Small %-ages of Huge Numbers Million 1000 times thousand 1% of Million = 10 thousand Billion 1000 times Million 1% of Billion = 10 Million Trillion 1000 times Billion 1% of Trillion = 10 Billion 2% of 1 Billion = 20 Million 4% of 1 Trillion = 40 Billion 3% of 1 Billion = 30 Million 4% of 2 Trillion = 80 Billion 2.5% of 1 Billion = 25 Million.25% × 1 Trillion = 2.5 Billion.05 times 1 Billion = 50 Million 2% of 20 T = 400 B Drill: Do in head only 1% of 6 B = __________ 3% of 2 B = _________ 2.3% of 1 T = _________ 2% of 27 T = ________ 0.75% of 1 B = _______.5% of 2 T = ________ 1% of 1.7 T = ________ 3% of 1 M = ________.0075 × 1B = _________ 5% of 7 M = _________.2 × 1B = ____________ 16% of 1 M = ________ 15  Some Comments about Money Although amount of US currency (bills and coin) outstanding is growing, usage of it in decline. Currency in domestic use less than 2% of GDP (which is $29 trillion). While US Mint not producing as many 1’s, 5’s and 10’s, demand for 100’s has exploded. Total US paper money outstanding $2.3 trillion. $100 bills about 80% of US paper currency. Of the $100 bills, about 80% are held outside the US. “legal tender” Says this on all US paper currency. Means by law people have to accept it in payment of a debt. 16  Details about Lending & Borrowing Imagine economy broken down into Economic Units (each of which has a budget over a period). Fall into three categories: Households Business firms Governments In any period, an economic unit is either in a Surplus position when income > spending. Called a surplus spending unit (SSU) when this happens. Deficit position when spending > income. Called a deficit spending unit (DSU) when this happens. Balanced position. 17  SSUs and DSUs DSUs issue financial claims to SSUs to obtain the funds they need, but SSUs only let someone borrow their money if the terms (characteristics) of the financial claims they receive are to their satisfaction. Similarly, DSUs only accept money if the terms (characteristics) of the financial claims they issue are to their satisfaction. There has to be a match. 18  Challenge of Financial System Two classical ways of matching up SSUs with DSUs to carry out the financing. 1. Direct financing -- No middleman. Ideally, one’s first choice. Often better this way if possible. 2. Indirect financing – Involves a middleman, called an intermediary. Most financing is done in this way because direct financing often not practical. 19  Direct Financing SSU DSU Households Households Business firms Business firms Governments Governments SSU and DSU must be able to find each other for SSU to swap money for financial claim. But to work, terms (characteristics) must be agreeable to both parties denomination (amount) maturity (when to be paid back) risk (what money is to be used for) ability to sell financial claim to someone else anything else that might come up Any problem here is a deal breaker. 20  Direct Financing Balance Sheets SSU DSU Assets Liabilities Assets Liabilities A financial claim is an asset to its holder, and a liability to its issuer. 21  Direct Financing Balance Sheets SSU DSU Assets Liabilities Assets Liabilities -Money +Money A financial claim is an asset to its holder, and a liability to its issuer. 22  Direct Financing Balance Sheets SSU DSU Assets Liabilities Assets Liabilities -Money +Money Fin Claim Fin Claim to SSU from DSU A financial claim is an asset to its holder, and a liability to its issuer. 23  Indirect Financing SSUs DSUs Households Households Business firms Business firms Governments Governments Financial intermediary (e.g., bank) Financial intermediation means selling financial claims to SSUs with one set of characteristics (typically short-term in small denominations), and buying financial claims from DSUs with another set of characteristics (typically long-term in large denominations). In this way, a financial intermediary transforms the characteristics of financial claims. 24  Importance of Indirect Financing Since the terms an SSU is willing to accept usually differ from the terms a DSU is willing to offer, fin intermediation plays a big role in getting SSU savings lent out and spent by a DSU. This is the social benefit of fin intermediation. Thus, to have a good economy, we need a good financial system to get all idle cash lent out and spent. And to have a good financial system, we must have good financial institutions & markets to get the job done. 25  Indirect Financing Balance Sheets SSU DSU Assets Liabilities Assets Liabilities Financial Intermediary Assets Liabilities 26  Indirect Financing Balance Sheets SSU DSU Assets Liabilities Assets Liabilities -Money Fin Claim from Inter Financial Intermediary Assets Liabilities +Money Fin Claim to SSU 27  Indirect Financing Balance Sheets SSU DSU Assets Liabilities Assets Liabilities -Money +Money Fin Claim Fin Claim to Inter from Inter Financial Intermediary Assets Liabilities +Money Fin Claim to SSU -Money Fin Claim from DSU A financial claim is an asset to a lender, and a liability to a borrower. 28  Indirect Financing Consider a commercial bank. The financial claims it issues to SSUs are typically statements pertaining to checking accounts, savings accounts, and other products the bank may offer. Whereas the financial claims held by SSUs from an intermediary score high on liquidity, financial claims held by a financial intermediary from DSUs are typically not liquid. 29  Marketability as a Work-Around More likely to buy a financial claim if you can sell it off whenever you wish. Here is where marketability makes a deal possible. SSU has $2 million a DSU needs $2 to lend for 3 yrs. million for 20 yrs. denomination, okay risk, okay maturity, not okay. If the SSU knows financial claim can be sold off in 3 years no problem, SSU will supply money to the DSU so DSU can use it immediately to start providing employment. Other things equal, the better a security’s marketability, the more it is worth. 30  Liquidity and Marketability Something has good liquidity if it can be quickly converted to cash without sacrificing value. Liquid investments Illiquid investments Marketability: Ease with which a financial asset may be sold to another SSU at a fair price. With good marketability: If SSU time horizon < DSU maturity. Sell at SSU time horizon. If SSU time horizon > DSU maturity. With money paid at DSU maturity, go to market and reinvest in something else. 31 11 Types of Financial Intermediaries 32 4 Categories of Financial Intermedaries Assets Liabilities 33  Intermediation Services 1. Denomination Divisibility. Able to pool the small savings of many SSUs to enable large investments. 2. Currency Conversion. Buy and sell financial claims denominated in various currencies. 3. Maturity Flexibility. Maturities, from 1 day to 30 years or more, to both DSUs and SSUs. 4. Credit Risk (probability money not paid back as promised) Diversification. Enables SSUs to not have all of their money put in one basket. 5. Liquidity. SSU savings at an intermediary are usually immediately or very quickly convertible into cash – generally accept low rates for the privilege. 34  Risks Faced by Financial Institutions 1. Credit risk 2. Interest rate risk – security price fluctuations as a result of changes in interest rates 3. Liquidity risk – risk that a financial institution may be unable to disburse required cash outflows 4. Foreign exchange risk – if deal in foreign currencies or have investments abroad 5. Political risk – risk of harmful government or regulatory action 35  Brokers vs. Dealers Brokers do not take a position. They specialize in matching buyers with sellers. Make money by charging commissions and fees. Dealers “make markets” by buying at any time for inventory, and selling at any time from inventory. Make money by buying low and selling high. At a dealer there a “bid price” and an “ask price”. Ask is what you pay if buying, bid is what you get if selling. 36 OTC When people say over-the-counter (OTC), means going through a dealer. OTC markets generally have no central location like organized exchanges. Vast majority of debt instruments are traded OTC. 37 Primary Market vs. Secondary Market Primary market is where new stocks and bonds are sold to initial buyers. Secondary market is where people buy and sell already existing financial claims. People are more likely to buy a financial claim in the primary market if there is a secondary market. If there is a secondary market for your financial claim, it is where you can convert it into cash. 38  Est 2024 GDP (Nominal), and Populations country trillions millions pop rank 1. United States 29 340 (3) 2. China 19 1,425 (2) 3. Japan 5 123 (12) 4. Germany 4 83 (19) 5. India 4 1,428 (1) 6. UK 3 68 (21) 7. France 3 65 (23) 8. Brazil 2 216 (7) 9. Italy 2 59 (25) 10. Canada 2 39 (28) Nominal (determined by currency exchange rates) (Source: International Monetary Fund) 39  Estimated 2024 GDP (PPP) country trillions millions pop rank 1. China 36 2. United States 29 3. India 15 4. Japan 7 5. Germany 6 6. Russia 5 144 (9) 7. Indonesia 5 277 (4) 8. Brazil 4 9. UK 4 10. France 4 PPP is Purchasing Power Parity (how much you can buy) (Source: International Monetary Fund) 40  Numbers to Know Throughout Course US pop 340 million UGA revenues 2 billion China/India pop 1.4 billion each World pop 8 billion US coin in circulation 50 billion US paper money outstanding 2.3 trillion US student loan debt 1.7 trillion Size Fed Reserve Bal Sheet 7+ trillion Money Markets ~11 trillion Capital Markets ~110 trillion US GDP 29 trillion Total US national debt 35 trillion Assets held in fin intermediaries 105 trillion Capital markets split 52/48 41  Deposits at FDIC-insured Institutions Standard insurance amount is $250,000 per depositor/per institution is as follows: Single Accounts (owned by one person) $250,000 per owner Joint Accounts (two or more persons) $250,000 per co-owner What happens if a married couple has $1 million to deposit? Can do at one bank, but must open 3 accounts. Can go over $1 million, but involves non-spousal beneficiaries. Best to open additional accounts at additional institutions. 42  Credit Unions Credit unions are non-profit, tax-exempt, organizations. Take in money from members with the idea of making consumer loans to members. Must be some common bond among members to operate (like having a family member who was in the Navy to be a member of Navy Credit Union). Mutual ownership – “owned” by depositor members. 43  Comments 1. Casualty vs. life insurance companies: Since casualty claims less predictable, a greater proportion of a casualty insurance company’s investments must be in much more marketable securities. 2. Thrift institutions also known as “Savings and Loans.” Like a bank, but chartered under different set of rules. Not as many around since the S&L crisis 1986-1995. The government had to mop up this crisis, but it was not nearly as bad as the financial crisis of 2008. 44  Comments (con’t) 3. Since inflow and outflows of pension funds can be predicted with a considerable accuracy, can invest (like life insurance companies) in long-term projects like private equity, hedge funds, venture capital, and stands of timber. 4. University endowments are also big investors in such long-term projects. 45