Finance and Money

1
Finance and Money

• In next couple of weeks we will be concerned with
  one of the more difficult subjects in
  economics-financial markets and monetary systems
• Most of you undoubtedly have some idea of the
  basic concepts of finance and money, but for the
  most part people find the whole subject either
  boring and/or confusing at least until you begin
  to actively participate in these markets
• Nevertheless the role of financial markets in the
  global economy is central to an understanding of
  what is going on out there-particularly in light
  of recent global financial crisis

2
Globalization and Finance

• A large part of globalization debate is
  concerned with the role of financial markets-what
  Tom Friedman calls the electronic herd-in
  todays global economy
• Much of the debate about whether globalization
  is good or bad centres around the role of global
  finance
• In order to make any assessment of these ideas we
  first have to understand some the basics of
  financial markets
• The heart of the issue is how investment is
  determined in an economy-do we build houses or
  invest in new drug development? In market
  economies the financial system is at the core of
  the investment allocation process

3
Lets start with IOUs

• The origins of financial markets (also called
  credit markets or capital markets) is based on
  the basic IOU
• One person-the borrower-needs current real
  resources from the economy beyond those she
  already has claim tofor eg. To consume more than
  she earns, or to invest in some activity (eg.
  drill for oil or start up a coffee shop)
• Another person the lender--who has more
  resources than they need for current usesis
  willing to give the borrower these resources in
  return for a promisethe promise to pay back what
  is borrowed plus some additional amount at some
  time in the future
• An interest rate on the IOU is just the
  additional amount paid back expressed as an
  annual percent of the amount borrowed

4
IOUs-trust and contracts

• The IOU is simply a piece of paper or a verbal
  statement in which the details of the promise are
  laid out the IOU is a form of contract or
  credit contract
• From the lenders point of view trust in the
  borrower is essentialbecause the IOU is promise
  about the future there is lots of opportunity for
  fraudulent behavior or outright theftthe
  borrower may simply take the lenders resources
  and run away
• For this reason most credit market relationships
  in primitive economies and even many today
  involve people who have close personal
  relationshipsthe idea being that if you borrow
  from your brother or father you are more likely
  to pay it back

5
Capitalism and Finance

• The history of capitalism parallels the
  development of more formal market like
  relationships for dealing with the problem of
  creating and then trading IOUs amongst unrelated
  individuals
• Today we call the problem of matching borrowers
  and lenders financial intermediation and the
  markets where most of this occurs financial
  markets (families still do a lot of this as you
  no doubt are aware)
• Financial intermediation began with the local
  Shylock (money lender), extended to the emergence
  of banks, then regional and national financial
  markets, and most recently have extended to
  global finance
• Another way of saying this is that the process of
  getting funds from savers to investment is
  mediated by the financial system which is to a
  substantial degree organized by the private
  sector (but not completely)

6
What do financial markets do?

• Modern financial markets are just more
  sophisticated versions of creating and then
  trading IOUsthey provide 3 basic functions
• They match borrowers and lenders so as to more
  effectively use a societys resources (savings)
  for investment purposes
• They also facilitate more efficient allocation of
  risk by spreading large risks (eg. Drilling for
  oil) across thousands of people (risk sharing)
• They also provide liquidity if a particular
  lender wants to get his money back quickly it is
  usually possible to do so in a modern financial
  market if you want to get back money lent to
  your brother today that might not be so easy ie
  we say the loan is illiquid

7
Information a driver for financial markets

• What makes financial markets different than most
  other markets is the important role of
  information
• Because the underlying contract (IOU) involves
  uncertainty about the future, information
  pertaining to that future and the parties
  involved in the contract is extremely important
  information is unevenly distributed-some know
  more than others
• Most financial markets are characterized by
  information asymmetrythe borrower typically
  knows more about what they will do with the money
  than the lender
• Because of this there is a long history of
  governments providing legal frameworks which
  govern relationships between the borrowers,
  lenders and intermediaries (like banks)

8
Todays Financial Markets

• Financial markets are bewildering in the
  diversity and complexity with which the basic
  finance problem is addressed
• Here are a few of the most important types of
  financial instruments
• A financial instrument is any type of contract of
  an IOU nature which details who pays what, under
  what circumstances, and when

9
Debt Instruments

• Traditional loans ie borrow fixed amount with a
  promise to pay back on a given schedule and with
  a fixed rate of interest
• Lines of credit (eg your credit card) typically
  given to business or individuals by a bank and
  when exercised at the discretion of the borrower
  create a debt
• Commercial paperthese are relatively short term
  IOUs (3 months to one year issued by large
  companies and pay a fixed rate of interest)
• Private sector bonds-basically a piece of paper
  issued by a corporation which pays back the
  principal plus interest bonds come in various
  maturities-ie the length of time until the bond
  must be re-paid (including interest) typically
  from 2 years to 30 years

10
Debt and Default risk

• Government bondssame as private bonds only
  issued by governmentsgo by various
  names-treasuries in US, gilts in UK, bunds in
  Germany, JPG in Japan etc. In emerging markets
  government issued bonds referred to as Sovereign
  Debt instruments
• All of above are called Debt instruments because
  when created in the financial market they create
  a debtthey also create creditthe means to
  finance
• A debt instrument can be defaulted ondefault
  occurs when the borrower does not pay back the
  loan or bond principle therefore all these type
  of financial market instruments involve what is
  called credit or default risk to the
  lenderinterest rates paid on debt instrument
  therefore reflect the underlying probability of
  default to the lenderthis is one of the reasons
  credit card interest rates are so high and why
  small emerging market economies have to pay high
  interest rates to borrroweg. Argentina defaulted
  on it debt in 2002 and therefore will have to pay
  higher interest if and when it goes back to the
  bond market

11
Equities (stocks)

• In the corporate world equity claims are a very
  important type of financial instrument which
  emerged along with the limited liability
  corporate organization in the 18th century
• Equities are what are traded on the stock
  marketthese are legal claims to a share of a
  firms profits or earnings after all interest on
  debt is paid equity holders are the legal owners
  of the firm but also only get paid a residual (
  called a dividend payment)
• As a residual claimant equity owners face a large
  amount of risk in what they might get paid
• Note that firms often directly invest their
  profitsare these investment decisions sound?
  Maybe and maybe not.
• If shareholders dont like what managers are
  doing they can throw out management or in some
  cases do a hostile takeoverequity markets very
  important to overall efficiency of the corporate
  sector

12
Insurance

• Another very important type of financial
  instrument is insurance
• Individuals purchase an insurance contract
  against a specific type of risk (eg. Your house
  burning down) from insurance companies the price
  paid for the insurance is the premium
• Insurance clearly shifts a specific risk from the
  policy holder to the insurance company
• Credit insurance is a very importantyou buy
  insurance against the possibility that someone
  you lent money to will default (credit default
  swaps)-this instrument is at the heart of the
  current crisis

13
Derivatives

• Another very important type of financial
  instrument are derivatives (puts, calls, swaps,
  futures, forwards, etc etc)
• A derivative is basically any financial
  instrument whose payoff depends upon the price of
  another financial instrument
• Derivatives have become very important in the
  last two decades as a means of trading risk in
  financial marketsblamed for 1987 stock market
  crash and still controversial
• Huge growth in derivatives markets in last ten
  years

14
Types of financial intermediaries

• Your basic BANKtake deposits from people who
  want to save and turn around and lend this money
  to borrowers. Pay one interest rate on what you
  pay to depositors and charge another (higher)
  interest rate to borrowerthe difference is
  profit loans once made are illiquid
• Some borrowers will default so banks have to
  cover the cost of default out of their profits
• Banks have been around foreverbanks now heavily
  regulated and depositors given deposit insurance
  by the government in many countries
• Deposit Insurance introduced after Great
  Depression -a lot of banks went broke and the
  depositors lost all their savings

15
Other Financial Institutions

• Banks have gone from being local to regional to
  national to globaleg. Bank of Montreal or HSBC
• Investment banks are banks which underwrite
  securitiesnew bonds and new stock issue-Lehman
  Bros was an investment bank which went bankrupt
  in early September 2008
• Pension funds are very important in the financial
  markets as representative of the largest pools of
  savings in most industrial economies
• Insurance companies both provide insurance and
  are large holders of other financial securities
• Mortgage companies issue mortgages on real
  estate, mostly homes, to individuals and raise
  capital by issuing bonds or other debt
  instruments
• Debt rating agencies grade debt instrument by
  probability of default (investment grade to high
  risk) SP, Moodys, Fitch

16
Why is finance different?

• Financial market attract a lot more attention
  than most other marketswhy? A number of reasons
• A) participation in these markets is by
  definition riskyyou exchange something certain
  today for something uncertain tomorrowthis
  creates winners and losersthe consequences of
  which are both a social concern or as the source
  of interest group lobbying
• B) the potential for fraud, theft , scam artists
  etc etc. seems to be unlimited---consequences of
  this is disastrous for people who lose their
  savings

17
Problem with Leverage

• a lot of financial market activity uses leverage
  or gearing leverage occurs when you make an
  investment of one type which in turn is financed
  by going into debt or taking on a loan at the
  same time eg. borrow money to buy shares in
  Googlelose twice if Google stock price falls --
  stock worth less and still have to pay back the
  loan
• Leverage is very common but it creates additional
  risks which at a large enough scale can becomes a
  societal problem
• Most common form of leverage use by individuals
  is mortgage financed real estate purchases
• Hedge Funds are typically higher levered
  investment funds
• When a leveraged investor makes a big mistake his
  creditors suddenly become involuntary
  participants in the original investmentthis
  happened with banks like Lehman who used leverage
  to invest in subprime mortgages which turned out
  to be very risky

18
Why Financial crises occur

• Large scale financial market failure or what we
  call a financial crisis seems to be a familiar
  part of the free market landscapein recent years
  had the Asian crisis, LTCM and Russian default,
  the high tech stock bubble burst and now talk of
  a real estate bubble and burst in many countries
• Financial crises can occur because of loss of
  confidence of market participantsif a lender
  loses confidence that his borrower can repay he
  may choose to call in the loanthis in turn may
  trigger a decline in the confidence in other
  borrowers-which triggers more loan withdrawals
  etc.---we effectively get a chain event which
  spirals out of control
• Financial markets seem very prone to these these
  type of contagions classic case is a bank run
  run on a bank occurs when depositors worry about
  security of their deposit and withdraw their
  depositas deposits withdrawn bank must call in
  loans to pay back depositsother depositors get
  wind of this and try to withdraw funds bank
  cannot meet all depositors demands at once and
  you get a bank failure

19
What to do?

• Critics argue that financial market should be
  more tightly regulated to avoid these boom-bust
  cycles or government should directly control the
  investment process
• Opponents argue that financial markets not
  perfect, but much better than having governments
  dictate who gets the resourceslead to more
  productive investments and to greater
  democratization of the investment process
• Moreover if you bail out people it creates moral
  hazard problempeople will engage in risky
  behaviour because they do not face the full
  consequences of their decisions

20
Global Finance

• Finance would be controversial even if it were
  not global
• But Post Cold War huge growth in the extent of
  integration across and between formerly isolated
  national financial markets
• Growth Facilitated by a) new technology
  especially communications technologies b) growth
  of market economic systems and c) desire by many
  developing and emerging economies to access
  sources of capital in the developed world
• Global integration has been most extensive with
  respect to commercial bank lending, bond markets
  both private and public, and most recently equity
  or stock markets