financial assets lec#2

Financial Assets, Money,Financial Assets, Money,Financial Transactions, Financial Transactions,

and Financial Institutionsand Financial Institutions

The Role of Financial AssetsThe Role of Financial Assets The financial system is the mechanism The financial system is the mechanism

through which loanable funds reach through which loanable funds reach borrowersborrowers

Operation of the financial marketOperation of the financial market Money exchanged for financial claimsMoney exchanged for financial claims

StocksStocks BondsBonds Other securitiesOther securities

Transforms savings into investment Transforms savings into investment Permits the economy to growPermits the economy to grow

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The Nature and Characteristics of The Nature and Characteristics of Financial AssetsFinancial Assets

A financial asset A financial asset A A claimclaim against the income or wealth of a against the income or wealth of a

business firm, household, or unit of business firm, household, or unit of governmentgovernment

Represented usually by a certificate Represented usually by a certificate receipt, computer record file, or other legal receipt, computer record file, or other legal document document

Usually related to the lending of moneyUsually related to the lending of money Examples include stocks, bonds, Examples include stocks, bonds,

deposits, and othersdeposits, and others

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Characteristics of Financial AssetsCharacteristics of Financial Assets

Financial assets are sought after Financial assets are sought after because they promise because they promise futurefuture returns to returns to their owners and serve as a their owners and serve as a store of store of valuevalue (purchasing power). (purchasing power).

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Characteristics of Financial AssetsCharacteristics of Financial Assets

Financial asset value based on faith that Financial asset value based on faith that issuer honors contractual promise to payissuer honors contractual promise to pay

Financial assets characteristicsFinancial assets characteristics Do not Do not depreciatedepreciate like physical goods like physical goods Physical condition or form usually not relevant Physical condition or form usually not relevant

in determining market valuein determining market value Have little or no value as a commodity Have little or no value as a commodity Cost of transportation and storage is lowCost of transportation and storage is low Financial assets are Financial assets are fungiblefungible – can easily be – can easily be

changed in form and substituted for other changed in form and substituted for other assetsassets

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Types of Financial AssetsTypes of Financial Assets

MoneyMoney Financial asset accepted in payment for Financial asset accepted in payment for

purchases of goods and servicespurchases of goods and services Examples are currency and checkingExamples are currency and checking

EquitiesEquities Ownership shares in a business firmOwnership shares in a business firm Claims against the firm’s profitsClaims against the firm’s profits Claims against proceeds from the sale of its Claims against proceeds from the sale of its

assets assets Examples are common stock and preferred Examples are common stock and preferred

stockstock2-6

Types of Financial AssetsTypes of Financial Assets

Debt SecuritiesDebt Securities Priority claim over the holders of equities to the Priority claim over the holders of equities to the

assets and income of an economic unitassets and income of an economic unit Can be negotiable or nonnegotiableCan be negotiable or nonnegotiable Examples include bonds, notes, accounts payable, Examples include bonds, notes, accounts payable,

and savings depositsand savings depositsDerivativesDerivatives

Market value tied to or influenced by the value or Market value tied to or influenced by the value or return on a financial asset return on a financial asset

Examples include futures contracts, options, and Examples include futures contracts, options, and swapsswaps

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How Financial Assets Are CreatedHow Financial Assets Are Created Internal financing to acquire assetsInternal financing to acquire assets

Use current incomeUse current income Use accumulated savingsUse accumulated savings

External financing to acquire assetsExternal financing to acquire assets Raise funds by issuing financial liabilities Raise funds by issuing financial liabilities

(debt) (debt) Raise funds by issuing stock (equities)Raise funds by issuing stock (equities)

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Balance Sheets of Units in a Balance Sheets of Units in a Simple Financial SystemSimple Financial System

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Unit Balance Sheets Following the Unit Balance Sheets Following the Equipment Purchase and Debt IssuanceEquipment Purchase and Debt Issuance

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Unit Balance Sheets Following Equipment Unit Balance Sheets Following Equipment Purchase and Stock IssuancePurchase and Stock Issuance

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Financial Assets and the Financial SystemFinancial Assets and the Financial System

The act of borrowing or of issuing new The act of borrowing or of issuing new stock simultaneously gives rise to the stock simultaneously gives rise to the creation of an equal volume of financial creation of an equal volume of financial assets.assets.

All financial assets are recorded as a All financial assets are recorded as a liability or claim on some other liability or claim on some other economic unit’s balance sheet.economic unit’s balance sheet.Volume of financial assets for lendersVolume of financial assets for lenders= Volume of liabilities issued by borrowers= Volume of liabilities issued by borrowers

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For the balance sheet of For the balance sheet of any economic unitany economic unit,,Total assets = Total liabilities + Net WorthTotal assets = Total liabilities + Net WorthWhere Where Assets = Real assets + Financial assetsAssets = Real assets + Financial assets

For the For the wholewhole economy and financial economy and financial system,system,Total financial assets = Total liabilitiesTotal financial assets = Total liabilities

So, for the economy as a whole,So, for the economy as a whole, TTotalotal real assets = Total net worth real assets = Total net worth

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Society can increase its wealthSociety can increase its wealth Saving and increasing the quantity of its Saving and increasing the quantity of its

real assetsreal assets Real assets enable the economy to Real assets enable the economy to

produce more goods and servicesproduce more goods and services The financial system provides the The financial system provides the

essential channel essential channel Necessary for the creation and exchange Necessary for the creation and exchange

of financial assets of financial assets Exchange is between savers and Exchange is between savers and

borrowers so that real assets can be borrowers so that real assets can be acquiredacquired

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Financial System MattersFinancial System Matters

Strong financial system helps societyStrong financial system helps society Reducing barriers to external financingReducing barriers to external financing Lowering cost of capitalLowering cost of capital Accelerating economic growthAccelerating economic growth

Nations with more fully developed Nations with more fully developed financial systemsfinancial systems Tends to grow fasterTends to grow faster Tends to enjoy a higher standard of livingTends to enjoy a higher standard of living

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Lending and Borrowing in the Lending and Borrowing in the Financial SystemFinancial System

Economists John Gurley and Edward Shaw Economists John Gurley and Edward Shaw pointed out that each business firm, pointed out that each business firm, household, or unit of government active in household, or unit of government active in the financial system must conform to:the financial system must conform to:

R - E = R - E = FA - FA - DDwherewhereR =R = Current income receipts Current income receiptsE = E = Expenditures out of current incomeExpenditures out of current incomeFA =FA = Change in holdings of financial assets Change in holdings of financial assetsD = D = Change in debt and equity outstandingChange in debt and equity outstanding

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So, for any given time period, each So, for any given time period, each economic unit must fall into one of economic unit must fall into one of three groups:three groups:

Deficit-budget unit (DBU):Deficit-budget unit (DBU):E > R, so E > R, so D > D > FA (net borrower of FA (net borrower of

funds)funds) Surplus-budget unit (SBU):Surplus-budget unit (SBU):

R > E, so R > E, so FA > FA > D (net lender of funds)D (net lender of funds) Balanced-budget unit (BBU):Balanced-budget unit (BBU):

RR == E, so E, so DD == FA (neither net lender nor FA (neither net lender nor borrower)borrower)

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The global financial system permits The global financial system permits businesses, households, and businesses, households, and governments to adjust their financial governments to adjust their financial position from that of net borrower position from that of net borrower (DBU) to net lender (SBU) and back (DBU) to net lender (SBU) and back again, smoothly and efficiently.again, smoothly and efficiently.

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What is Money?What is Money?

All financial assets are valued in terms All financial assets are valued in terms of money, and flows of funds between of money, and flows of funds between lenders and borrowers occur through lenders and borrowers occur through the medium of money.the medium of money.

Money itself is a financial asset, Money itself is a financial asset, because all forms of money in use because all forms of money in use today are claims against some public today are claims against some public or private institution.or private institution.

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The Functions of MoneyThe Functions of Money Money serves as a Money serves as a standard of valuestandard of value

(or (or unit of accountunit of account)) Money serves as a Money serves as a store of valuestore of value

Reserve of future purchasing powerReserve of future purchasing power Value of money can fluctuate with Value of money can fluctuate with

inflationinflation Money serves as a Money serves as a medium of medium of

exchangeexchange Buyers and sellers no longer need to Buyers and sellers no longer need to

have an exact coincidence of wantshave an exact coincidence of wants 2-20

The Value of Money and Other FinancialThe Value of Money and Other FinancialAssets and InflationAssets and Inflation

Inflation Inflation Rise in the average price level of all goods Rise in the average price level of all goods

and servicesand services Lowers purchasing power of moneyLowers purchasing power of money Can damage value of financial contractsCan damage value of financial contracts

DeflationDeflation The opposite of inflation The opposite of inflation Fall in the average price level of all goods Fall in the average price level of all goods

and servicesand services

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The Value of Money and Other FinancialThe Value of Money and Other FinancialAssets and InflationAssets and Inflation

Inflation is commonly measured Inflation is commonly measured using using price indicesprice indices, such as:, such as: the Consumer Price Index (CPI),the Consumer Price Index (CPI), the Producer Price Index (PPI), orthe Producer Price Index (PPI), or the Gross Domestic Product (GDP) the Gross Domestic Product (GDP)

deflator Index.deflator Index.

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Impact on Purchasing PowerImpact on Purchasing Power

Changes in purchasing power can be Changes in purchasing power can be dramaticdramatic Due to inflationDue to inflation Even in the United StatesEven in the United States Provides a warning about measuring valueProvides a warning about measuring value

Need to think in terms of real valuesNeed to think in terms of real values Purchasing power adjustedPurchasing power adjusted Nominal values can be misleadingNominal values can be misleading

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The Evolution of Financial The Evolution of Financial TransactionsTransactions

Financial systems change constantly Financial systems change constantly Shifting demands from the publicShifting demands from the public Development of new technologyDevelopment of new technology Changes in laws and regulationsChanges in laws and regulations

The ways of carrying out financial The ways of carrying out financial transactions have evolvedtransactions have evolved

In particular, the transfer of funds In particular, the transfer of funds from savers to borrowers can be from savers to borrowers can be accomplished in at least three accomplished in at least three different waysdifferent ways

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Direct FinanceDirect Finance – Direct lending gives rise – Direct lending gives rise to direct claims against borrowersto direct claims against borrowers

Borrowers(DBUs)

Lenders(SBUs)

Flow of funds and other financial services(loans of spending power for an

agreed-upon period of time)

Primary Securities(stocks, bonds, notes, etc., evidencing

direct claims against borrowers)

Simple Simple Difficult to match & risky Difficult to match & risky2-25


Semidirect FinanceSemidirect Finance – Direct lending with the – Direct lending with the aid of market makers who assist in the sale aid of market makers who assist in the sale of direct claims against borrowersof direct claims against borrowers

Lower search (information) costsLower search (information) costs Risky & matching is still requiredRisky & matching is still required

Borrowers(DBUs)

Lenders(SBUs)

Flow of funds and other

financial services(loans of spending

power)

Security brokers,

dealers, & investment

bankers

Primary Securities(direct claims

againstborrowers)

Primary Securities(direct claims

againstborrowers)

Proceeds ofsecurity sales and other

financial services(less fees and commissions)

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Indirect FinanceIndirect Finance – Financial intermediation of – Financial intermediation of fundsfunds

Low risk & affordableLow risk & affordable

Ultimate borrowers

(DBUs)

Ultimate lenders(SBUs)

Flow of funds and other financial services

(loans of spending power)

Financial intermediaries(banks, savings and loan associations, insurance companies, credit unions, mutual funds, finance companies,

pension funds)

Secondary Securities(indirect claims against ultimate

borrowers issued by financial intermediaries in the form of deposits, insurance policies,

retirement savings accounts, etc.)

Primary Securities(direct claims against ultimate borrowers in the form of loan contracts, stocks, bonds, notes,

etc.)

Flow of funds and other financial services

(loans of spending power)

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Classifying Financial InstitutionsClassifying Financial Institutions

Depository institutionsDepository institutions Bulk of their loanable funds from deposit Bulk of their loanable funds from deposit

accounts sold to the publicaccounts sold to the public Commercial banks, savings and loan Commercial banks, savings and loan

associations, savings banks, credit unionsassociations, savings banks, credit unions Contractual institutionsContractual institutions

Funds from offering legal contracts to Funds from offering legal contracts to protect the saver against riskprotect the saver against risk

Insurance companies, pension fundsInsurance companies, pension funds

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Classifying Financial InstitutionsClassifying Financial Institutions

Investment institutionsInvestment institutions Sell shares to the publicSell shares to the public Invest the proceeds in stocks, bonds, and Invest the proceeds in stocks, bonds, and

other assetsother assets Mutual funds, money market funds, real Mutual funds, money market funds, real

estate investment trustsestate investment trusts

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Portfolio (Financial-Asset) Portfolio (Financial-Asset) Decisions by Financial InstitutionsDecisions by Financial Institutions Deciding what financial assets to buy Deciding what financial assets to buy

or sellor sell Depends on various asset factorsDepends on various asset factors

Different financial assets Different financial assets relative rate of relative rate of returnreturn

Different financial assets Different financial assets riskrisk Cost Cost of incoming fundsof incoming funds VolatilityVolatility of incoming funds of incoming funds MaturityMaturity of incoming funds of incoming funds

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Portfolio (Financial-Asset) Portfolio (Financial-Asset) Decisions by Financial InstitutionsDecisions by Financial Institutions

Also depends on financial institution Also depends on financial institution sizesize Larger financial institutions tend to have Larger financial institutions tend to have

more diversified sources and usesmore diversified sources and uses Larger financial institutions also enjoy Larger financial institutions also enjoy

economies of scale.economies of scale.Regulations and competitionRegulations and competition

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The Disintermediation of FundsThe Disintermediation of Funds Disintemediation processDisintemediation process

Withdrawal of funds from a financial Withdrawal of funds from a financial intermediary by the ultimate lenders intermediary by the ultimate lenders (SBUs)(SBUs)

Lending of those funds to ultimate Lending of those funds to ultimate borrowers (DBUs)borrowers (DBUs)

Disintermediation shifts fundsDisintermediation shifts funds Away from indirect financeAway from indirect finance To direct financeTo direct finance

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The Disintermediation of FundsThe Disintermediation of Funds

Primary Securities

Ultimate borrowers

(DBUs)

Ultimate lenders(SBUs)

Financial intermediaries

Loanable funds

Financial Disintermediation

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The Disintermediation of FundsThe Disintermediation of Funds

Disintermediation is not a foregone Disintermediation is not a foregone conclusionconclusion

ReintermediationReintermediation Reversal of flow of fundsReversal of flow of funds Back to a “safe haven” of financial Back to a “safe haven” of financial

intermediariesintermediaries Interest rates are low or decliningInterest rates are low or declining Or riskiness of financial instruments appear Or riskiness of financial instruments appear

to be rising to be rising

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New Forms of DisintermediationNew Forms of Disintermediation Initiation by financial intermediariesInitiation by financial intermediaries

Banks sell off loansBanks sell off loans Difficulty in raising capitalDifficulty in raising capital

Initiation by borrowing customersInitiation by borrowing customers Customer learn alternate financing conduitsCustomer learn alternate financing conduits Nonfinancial retail and industrial firms Nonfinancial retail and industrial firms

attempting to draw financial services attempting to draw financial services customerscustomers

Raise funds in the open marketRaise funds in the open market

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Bank-Dominated Versus Security-Bank-Dominated Versus Security-Dominated Financial SystemsDominated Financial Systems

Bank-dominated financial systemsBank-dominated financial systems Banks and other similar institutions Banks and other similar institutions

dominatedominate Supply of creditSupply of credit Attracting savingsAttracting savings

Common in economies with less Common in economies with less protection of investor rights or less well-protection of investor rights or less well-defined rulesdefined rules

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Bank-Dominated Versus Security-Bank-Dominated Versus Security-Dominated Financial SystemsDominated Financial Systems

Security-dominated financial systemsSecurity-dominated financial systems Traditional intermediaries are less Traditional intermediaries are less

importantimportant More borrowers sell securities to the publicMore borrowers sell securities to the public Many economies are gradually moving Many economies are gradually moving

toward a more security-dominated financial toward a more security-dominated financial systemsystem

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financial assets lec#2

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