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Introduction to Finance

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Introduction to Finance Phillip LeBel, Ph.D. Professor of Economics School of Business Montclair State University Upper Montclair, New Jersey 07043 – PowerPoint PPT presentation

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Title: Introduction to Finance


1
Introduction to Finance
Phillip LeBel, Ph.D. Professor of
EconomicsSchool of Business Montclair State
UniversityUpper Montclair, New Jersey
07043Lebelp_at_mail.montclair.edu
2
The Significance of Financial Institutions
  • Finance is an essential tool in the creation of
    capital goods
  • Financial institutions serve as intermediaries
    between savers and investors for the efficient
    allocation of resources
  • Financial institutions include government
    agencies, banks, private equity markets, as well
    as individual savings organizations
  • Interactions between savers and investors are
    governed by the pricing of credit, and which is
    reflected in given rates of interest
  • While central banks are major players in the
    determination of interest rates, other actors
    play important roles as well, notably, the World
    Bank, the IMF, and other financial institutions.

3
The Determination of Interest Rates
  • Interest rates are set by a combination of market
    and public intervention decisions
  • Central banks typically set interest rates equal
    to the opportunity cost of capital, namely, what
    it costs the central bank to obtain a given level
    of credit
  • Interest rates can be distorted in the presence
    of market imperfections, with the result that
    capital flows are inefficient, thus reducing an
    economys potential rate of growth.

4
Market Forces in Interest Rate Determination
  • When central banks intervene in capital markets
    they can do so by a variety of means
  • One is through open market operations, by which
    the buying of government securities increases
    their price and lowers the underlying rate of
    interest - however, for this to work efficiently
    depends on the orderly functioning of a
    securities market
  • A second instrument is through the setting of
    required reserve ratios across the banking
    systems. Higher reserve ratios mean fewer
    lendable reserves, in which case banks ration
    credit through higher interest rates.

5
  • In addition, central banks can also use selective
    credit controls to favor some sectors over
    others. Such was the case with the conversion of
    the U.S. economy from producing civilian to
    military goods during the Second World War, and
    in the now abandoned use of Regulation Q to favor
    housing construction in the U.S.
  • Apart from the question of an orderly functioning
    of a securities market, one additional problem is
    if government treasury operations require the
    issuance of new debt to cover obligations while
    the central bank may be pursuing a contractionary
    monetary policy - there will be no effect on the
    supply of money as long as the private sector
    purchases all new government debt, whereas if the
    central bank does so, there will be an
    expansionary effect on the supply of money, thus
    undercutting a contractionary central bank
    monetary policy.
  • Private equity markets are an important
    complement to debt institutions. Transparency in
    the structure and operation of equity markets is
    an essential condition for their role in the
    efficient allocation of resources

6
The Mix of Financial Institutions
  • While a securities market is an important type of
    financial institution, other institutions enable
    capital flows to be priced according to different
    levels of risk.
  • Risk reflects financial, economic, political, and
    environmental factors that influence the level
    and efficiency of capital flows.
  • In addition, to government securities markets,
    other institutions include private equity
    markets, along with a mix of financial risk
    management products such as derivatives.

7
Financial Risk Management Products
  • The Black-Scholes Option Pricing Model
  • Value at Risk Models
  • Earnings at Risk Models
  • Economic Value Added Models
  • Expected Default Frequency Models

8
Fundamental Principles in Finance
  • Financial institutions are essential to the
    efficient allocation of resources
  • Distortions in capital markets exist from a
    combination of factors the absence of financial
    intermediation, the inefficiency of capital
    markets, and mis-placed government intervention
    designed to accomplish other ends
  • Financial risk management products can improve
    the functioning of capital markets but they can
    not eliminate risk. Diversification is an
    essential step in risk management, but works
    better in the presence of derivative contracts
    than in their absence.
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