Econ3011 Economics of Financial Institutions Lecture 1 PDF

ECON3011 Economics of Financial Institutions Textbook:  CHAPTER 1 Why Study Financial Markets and Institutions? © 2012 Pearson Prentice Hall. All rights reserved. 1-4 Chapter Preview The evening news features a segment about interest rates, the BoJ Governor, an...

ECON3011 Economics of Financial Institutions Textbook:  CHAPTER 1 Why Study Financial Markets and Institutions? © 2012 Pearson Prentice Hall. All rights reserved. 1-4 Chapter Preview The evening news features a segment about interest rates, the BoJ Governor, and liquidity in credit markets. What does all this mean? Do I care about interest rates? What is the “BoJ?” Will this impact my firm’s ability to get a bank loan? Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-4 © 2012 Pearson Prentice Hall. All rights reserved. 1-5 Chapter Preview These are good questions. And this course will help you answer these questions by addressing a variety of topics ranging from the functioning of the bond and stock markets to the behaviour of the central bank and banks. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-5  Chapter Preview We start our analysis with the proposition that financial markets and institutions have a significant impact on important questions concerning our financial well-being. Topics include: Why Study Financial Markets? Why Study Financial Institutions? Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-6  Why Study Financial Markets? Financial markets, such as bond and stock markets, are crucial in our economy. 1. They channel funds from those who do not have a productive use for them (SAVERS) to those who do (INVESTORS), thus promoting higher economic efficiency. 2. Market activity affects: personal wealth (distribution of wealth), business firms, and economy 3. Well functioning financial markets are key factors in producing high economic growth. HOW? Recall the National Income Identity We will briefly examine these financial markets and their functions. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-7  Other names for Savers and Investors? Lenders and Borrowers Deficit Units and Surplus Units Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-8  National Income Identity National Income Identity: The national income identity says that gross domestic product is given by consumption expenditures, plus investment expenditures, plus government expenditures, plus exports, minus imports. In Short: GDP = C + I + G + (X − M) Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-9  Types of Financial Markets? A. Debt Market B. Stock Market C. Foreign Exchange Market Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-10  Why Study Financial Markets? A. Debt Markets & Interest Rates What are debt markets? Debt markets (often referred to generally as bond markets or credit markets) are a financial marketplace where debt securities are traded, whether government-issued or corporation-issued. Governments typically issue bonds in order to raise capital to pay down debts or fund infrastructural improvements. Publicly-traded companies issue bonds when they need to finance business expansion projects or maintain ongoing operations. Importance 1: Debt markets, or bond markets, are especially important to economic activity because they enable governments, corporations, and individuals to borrow to finance activities. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-11  Why Study Financial Markets? A. Debt Markets & Interest Rates Where participants issue new debt, this is known as the primary market, and where they buy and sell debt securities this is known as the secondary market. What is a bond? A bond is a debt security that promises to make periodic payments of interest and principal over some specific time horizon. What is a security? A security (also called a financial instrument) is a claim on the issuer’s future income or assets. Importance 2: Bond Markets are the markets where interest rates are determined. [For more information on understanding the bond market check out this link: https://slideplayer.com/slide/4184208/] Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-12  Why Study Financial Markets? A. Debt Markets & Interest Rates There are many different types of market interest rates, including mortgage rates, car loan rates, credit card rates, etc. The level of these rates are important to both individuals and businesses, thus making interest rates important to understand. For example:  On a personal level, high interest rates could deter you from buying a house or a car because the cost of financing it would be high  Conversely, high interest rates could encourage you to save because you can earn more interest income by putting aside some of your earning as savings Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-13  Why Study Financial Markets? B. Stock Market Stock markets are the markets in which claims on the assets and earnings of corporations (share of stock) are traded. A common stock (typically just called a stock) is a security that represents a share of ownership in a corporation. It is a claim on the earnings and assets of the corporation. Holders of stocks are in this way known as residual claimants – who are remunerated after the corporation has satisfied all other financial obligations (i.e. after all other factors of production/service have received their remuneration inclusive of taxes and other expenses or overheads). Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-14  Why Study Financial Markets? B. Stock Market Companies initially sell stock (in the primary market) to raise funds to finance their activities. But after that, the stock is traded among investors (in the secondary market). Of all the active markets, the stock market receives the most attention from the media, probably because it is the place where people get rich (and poor) quickly. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-15  Why Study Financial Markets? B. Stock Market Figure 1.2 Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2013 The level of the Dow Jones Industrial Average over the last 55 years, shows how volatile stock prices have been, especially over the last five years The level of access to and availability of information has drastically increased,. and since stock prices respond quickly to new information in the marketplace, markets have become more risky and volatile. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-16  Why Study Financial Markets? B. Stock Market What about the Jamaican Stock Market? The Jamaican stock market (touted by many as the best stock market in the world) has been on a four-year increasing trend providing excellent rates of return for investors. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-17  Why Study Financial Markets? B. Stock Market According to Bloomberg (2019), over the last 5 years, the Jamaican stock market has advanced by 233 per cent, the most in the world Why? coupled with improving macroeconomic parameters, low inflation, low interest rates, a falling debt to GDP ratio, lower than usual unemployment, expanding logistics and road work infrastructure provides a decent platform for business and industry expansion. Volatile: YES!! Even though characterized by some short periods of sharp expansions over 4yr period from 2014-2019, markets are still vulnerable to potential external shocks such as natural disasters. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-18  Why Study Financial Markets? C. The Foreign Exchange Market An over-the-counter (OTC) market is decentralize and where participants trade stocks, commodities, currencies, or other instruments directly between two parties, without a central exchange or broker. The foreign exchange market is an over-the-counter (OTC) marketplace that i. Facilitates/enables the transferal of funds from one country to another (across borders) – for funds to be transferred across borders, they must be converted to the currency of the country receiving the funds. ii. determines the price of one country’s currency in terms of another (i.e. the exchange rate). Participants are able to buy, sell, exchange and speculate on currencies. Over-the-counter (OTC) refers to the process of financial instruments (securities, currencies etc.) being traded via a broker- dealer network as opposed to an centralized exchange. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-19  Broker versus Dealer Dealers are people or firms who buy and sell securities for their own account, whether through a broker or otherwise. A dealer acts as a principal in trading for its own account, as opposed to a broker who acts as an agent who executes orders on behalf of its clients. A broker is an individual or firm that charges a fee or commission for executing buy and sell orders submitted by an investor. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-20  Why Study Financial Markets? C. The Foreign Exchange Market Fluctuations in exchange rates matter! ─ Over the past 2 decades, Jamaican consumers have found that vacationing in far parts of the world, in particular Europe, is expensive, due to a weakening JMD dollar relative to the USD & Euro. [So the vast majority go to Florida – cheap flights!] ─ When the JMD dollar weakens (increase in exchange rate), imports become more expensive – thus they should fall - and exports cheaper - thus they should rise! At least in theory. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-21  Why Study Financial Markets? C. The Foreign Exchange Market Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-22 23 Money Markets versus Capital Markets Money Markets – markets that trade debt securities with maturities of one year or less (e.g. U.S. 90 Day Treasury bills) Capital Markets – markets that trade debt (bonds) instruments with maturities of more than one year. Also, includes the stock (equity) market. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-23  Financial Markets are interconnected! Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-24  Why Study Financial Institutions? Financial institutions are crucial in the operation of financial markets. 1. Financial Institutions are the institutions that make financial markets work 2. “Financial Institutions are the intermediaries, that take funds from the people who save and lend it to people who have productive investment opportunities”. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-25 © 2012 Pearson Prentice Hall. All rights reserved. 1-26 Why Study Financial Institutions? We will also spend considerable time discussing financial institutions—the corporations, organizations, and networks that operate the so- called “ marketplaces.” 1. Structure of the Financial System – Helps get funds from savers to investors 2. Financial Crises – The financial crises of 2007–2009 was the worst financial crisis since the Great Depression. Why did it happen? 1939 Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-26 © 2012 Pearson Prentice Hall. All rights reserved. 1-27 Why Study Financial Institutions? 3. Banks and Other Financial Institutions ─ Includes the role of insurance companies, mutual funds, pension funds, etc. 4. Financial Innovation ─ Focusing on the improvements in technology and its impact on how financial products are delivered 5. Managing Risk in Financial Institutions ─ Focusing on risk management in the financial institution. Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-27  ACTIVITY Can you find the data on average monthly interest rates for Commercial Banks in Jamaica for the past year? Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-28 Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-29 Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-30 Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-31 Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-32 Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-33