ECON 2035 01 21 2014 Function of Financial Markets Preform the essential function of channeling funds from econ players that have saved surplus funds to those that have a shortage of funds Direct finance borrowers borrow funds directly from lenders in financial markets by selling them securities FIGURE 1 FLOWS OF FUNDS Promotes econ efficiency by producing an efficient allocation of capital which increases production Directly improve the wellbeing Structures of Financial Markets Debt and equity markets debt instruments maturity Equities dividends Primary and secondary markets Investment banks underwrites securities in primary markets Brokers n dealers work in secondary markers TABLE 1 INSTRUMENTS Principal money market instruments U S treasury bills negotiable bank certificates of deposit commercial paper fed funds and security repurchase agreements Exchanges and over the counter OTC exchanges NYSE Chicago board of trade OTC markets foreign exchange fed funds Money and capital markets Money markets deal in short term debt instruments Capital markets deal in longer term debt and equity instruments TABLE 2 PRINCIPAL CAPITAL MARKET INSTRUMENTS Corporate stock residential mortgages corporate bonds us gov secui Regulation of financial system To ensure the soundness of financial intermediaries Restrictions on entry chartering process disclosure of info restrictions on assets and activities control holding of risky assets deposit insurance avoid bank runs limits on competition mostly in the past branching restriction on interest rates Alt measures of money Economist have developed different measures of money Two are m1 n m2 M1 a measure of the money supply it consists of currency in the hands of the public plus checking accounts and travelers checks M2 a measure of the money supply it consitis of M1 plus other relativiley liquid assets Measuring money How do we measure money Which assers can be called money Construct monetary aggregates using the concept of liquidity M1 most liquid assets currency M1 the narrowest definition of the money supply the sum of the following Currency paper money coins that are in circulation Checking accounts Travelers checks M2 includes everything in M1 plus savings account balance small denominational time deposits balances in deposit accounts non intuitional money marker mutual funds shares Money supply consistis of both currency and checking deposits Banks play an important role in the process by which the way money supply increase n decrease Credit cards are not money the cc user Cc holders carry less cash a checkbook Cc balances are assets of a bank in the form a prearranged loan n liablitles of A debit card is part of the monetary system bc it serves the same function as chapter 3 01 21 2014 What is money and why do we need it Money assets that people are generally willing to accept in exchange for goods and services or for payment of debts Asset anything of value owned by a person or a firm Money a stock concept is different from Wealth the total collection of pieces of property that serve to store value Income flow of earning per unit of time a flow concept Barter and the invention of money Commodity money a good used as money that also has value Anything used as money whether a deerskin a seashell joes or a dollar bill independent of its use as money The functions of money should fulfill the four functions Medium of exchange Unit of account Store of value Standard of deferred payment FORMULA FOR BARTER PRICES CHAP 3 UNDER UNIT OF ACCOUNT N N 1 2 N 10 10 10 1 2 45 N 100 100 100 1 2 4950 The functions of money Medium of exchange money serves as a medium of exchange when sellers are willing to accept it in exchange for goods and services Unit of account Store of value in a barter system each good has many prices money allows value to be stored easily if you do not use all your dollars to buy goods and services today Standard of deferred payment money is useful b c it can serve as a standard of deferred payment in borrowing and lending Medium of exchange Eliminates the trouble of finding a double coincidence of needs reduces transaction costs Promotes specialization A medium of exchange must Be easily standardized Be widely accepted Be divisible Be easy to carry Not deteriorate quickly Unit of account Used to measure value in the economy Reduces transaction costs Store of value Other assets Used to save purchasing power over time Evolution of the payments system Commodity money valuable easily standardized and divisible Fiat money paper money decreed by governments as legal tender Checks an instruction to your bank to transfer money from your commodities account Electrionic payment E money debit card e cash storevalue CHAP 4 01 21 2014 WHY DO LENDERS CHARGE INTEREST ON LOANS The interest rate on a loan should cover the opp cost of supplying credit particularly the costs associated with three factors Compensation for inflation The importance of the interest rate comes from the fact that most financial transcations involve payments in the future Future i the interest rate FV the future value principal the amount of your investment Principal x 1 i FV Compound Principal x 1 i n FVn 1 000 The process of earning interest on interest as savings accumulate over time CD1 CD2 4 per year for 3 years 1000x 1 04 3 1124 86 10 for the first year 1 the second and third year 1122 11 A dollar paid to you one year from now is less valuable than a dollar paid to Why A dollar deposited today can earn interest and become 1x 1 i one CD1 is better Present value you today year from today Let i 10 One year 110 Two year 121 3 years 133 n is number of years 100x 1 i n the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today PV todays present value CF future cash flow payment i interest rate PV CF 1 i n Compounding PV x 1 i n FV Discounting PV FVn 1 i n Debt instruments methods of finacing debt including simple loans discount bonds coupon bonds and fixed payment loans Equity a claim to part ownership of a firm 4 types of credit market instumrnts Simple loan the borrower receives from the lender an amount called the principal and agrees to repay the lender the principal plus interest on a specific date when the loan matures PV CF 1 i n Fixed payment loans Yield to maturity the interest rate that makes the present value of the payments from an asset equal to the assets price today Same as cash flow payment every