LSU ECON 2035 - Function of Financial Markets

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Function of Financial MarketsPreform the essential function of channeling funds from econ players that have saved surplus funds to those that have a shortage of fundsDirect 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 productionDirectly improve the wellbeingStructures of Financial MarketsDebt and equity markets-debt instruments(maturity)-Equities(dividendsPrimary 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 fundsMoney and capital marketsMoney markets deal in short term debt instrumentsCapital markets deal in longer term debt and equity instrumentsTABLE 2 PRINCIPAL CAPITAL MARKET INSTRUMENTSCorporate stock, residential mortgages, corporate bonds, us gov secuiRegulation of financial systemTo 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 ratesAlt measures of moneyEconomist have developed different measures of moneyTwo are m1 n m2M1- a measure of the money supply; it consists of currency in the hands of the public plus checking accounts and travelers checksM2- a measure of the money supply; it consitis of M1 plus other relativiley liquid assetsMeasuring moneyHow do we measure money? Which assers can be called moneyConstruct monetary aggregates using the concept of liquidityM1(most liquid assets)= currencyM1 the narrowest definition of the money supply, the sum of the followingCurrency paper money, coins that are in circulationChecking accountsTravelers checksM2 includes everything in M1 plus savings account balance, small denominational time deposits, balances in deposit accounts, non-intuitional money marker mutual funds sharesMoney supply consistis of both currency and checking depositsBanks play an important role in the process by which the way money supply increase n decreaseCredit cards are not moneyCc balances are assets of a bank in the form a prearranged loan n liablitles of the cc userCc holders carry less cashA debit card is part of the monetary system bc it serves the same function as a checkbookWhat 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 debtsAsset- anything of value owned by a person or a firmMoney(a stock concept) is different from:Wealth- the total collection of pieces of property that serve to store valueIncome- flow of earning per unit of time(a flow concept)Barter and the invention of moneyCommodity money- a good used as money that also has value independent of its use as moneyThe functions of moneyAnything used as money- whether a deerskin, a seashell, joes, or a dollar bill -should fulfill the four functionsMedium of exchangeUnit of accountStore of valueStandard of deferred paymentFORMULA FOR BARTER PRICES CHAP 3 UNDER UNIT OF ACCOUNTN(N-1)/2N=10 10(10-1) / 2 = 45N=100 100(100-1)/2 = 4950The functions of moneyMedium of exchange- money serves as a medium of exchange when sellers are willing to accept it in exchange for goods and servicesUnit of account- in a barter system, each good has many pricesStore of value- money allows value to be stored easily: if you do not use all your dollars to buy goods and services todayStandard of deferred payment- money is useful b/c it can serve as a standard of deferred payment = in borrowing and lendingMedium of exchangeEliminates the trouble of finding a double coincidence of needs(reduces transaction costs)Promotes specializationA medium of exchange mustBe easily standardizedBe widely acceptedBe divisibleBe easy to carryNot deteriorate quicklyUnit of account:Used to measure value in the economyReduces transaction costsStore of valueUsed to save purchasing power over timeOther assetsEvolution of the payments systemCommodity money: valuable, easily standardized and divisible commoditiesFiat money: paper money decreed by governments as legal tenderChecks: an instruction to your bank to transfer money from your accountElectrionic paymentE-money- debit card, e-cash, storevalueWHY 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 factorsCompensation for inflationThe importance of the interest rate comes from the fact that most financial transcations involve payments in the futureFuturei= the interest rateprincipal- the amount of your investmentFV- the future valuePrincipal x ( 1+i) = FVCompoundThe process of earning interest on interest as savings accumulate over timePrincipal x ( 1+i )^n= FVn$1,000CD14% per year for 3 years = 1000x(1+.04)^3 = $1124.86CD210% for the first year, 1% the second and third year = 1122.11CD1 is betterPresent valueA dollar paid to you one year from now is less valuable than a dollar paid to you todayWhy? A dollar deposited today can earn interest and become 1x(1+i) one year from todayLet i= .10One year 110Two year 1213 years 133n is number of years100x(1+i)^nthe interest rate that equates the present value of cash flow payments received from a debt instrument with its value todayPV= todays(present) valueCF= future cash flow(payment)i= interest ratePV = CF(1+i)^nCompounding: PV x (1+i)^n = FVDiscounting: PV= FVn / (1+i)^nDebt instruments- methods of finacing debt, including simple loans, discount bonds, coupon bonds, and fixed payment loansEquity- a claim to part ownership of a firm4 types of credit market instumrntsSimple 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 maturesPV = CF(1+i)^nYield to maturity- the interest rate that makes the present value of the payments from an asset equal to the assets price todayFixed payment loans-Same as cash flow payment every period throughout the life of the


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LSU ECON 2035 - Function of Financial Markets

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