MGT411

         

                                        Financial System:

For developing r economy we need strong financial system.

Processes and procedures used by a firm's management to exercise financial control and accountability. These measures include recording, verification, and timely reporting of transactions that affect revenues, expenditures, assets, and liabilities.

Five Parts of the Financial System

•  Money
•  Financial Instruments
•  Financial Markets
•  Financial Institutions
•  Central Banks

                  FIVE CORE PRINCIPLES OF MONEY AND BANKING

1. Time has Value

• Time affects the value of financial instruments
• Interest payments exist because of time properties of financial instruments

 Reason: you are compensating the lender for the time during which you use the funds

2. Risk Requires Compensation

• To deal effectively with risk we must consider the full range of possibilities

3. Information is the basis for decisions

The collection and processing of information is the basis of foundation of the financial system.

• Stock exchanges are organized to eliminate the need for costly information gathering and thus facilitate the exchange of securities
• One way or another, information is the key to the financial system

4. Markets set prices and allocate resources

5. Stability improves welfare

·         By stabilizing the economy as whole monetary policymakers eliminate risks that individuals can’t and so improve everyone’s welfare in the process.

Stabilizing the economy is the primary function of central banks

Financial System Promotes Economic Efficiency

1. Facilitate Payments
• Cash transactions
• Financial intermediaries provide checking accounts, credit cards, debit cards, ATMs
• Make transactions easier.
2. Channel Funds from Savers to Borrowers

Savers: have more funds than they currently need; would like to earn capital income

Borrowers: need more funds than they currently have; willing and able to repay with interest in the Future

3. Enable Risk Sharing

·         Two principal forms of trade in risk are insurance and forward contracts

                                 MONEY & THE PAYMENT SYSTEM

Money:  Money is an asset that is generally accepted as payment for goods and services or repayment of debt. Money is a component of wealth that is held in a readily- spend able form

Distinctions among Money, Wealth, and Income

·         People have money if they have large amounts of currency or big bank accounts at a point in time.

·         Someone earns income (not money) from work or investments over a period of time. (Flow variable)

·         People have wealth if they have assets that can be converted into more currency than is necessary to pay their debts at a point in time. (Stock variable)

Characteristics of Money

A means of payment: The primary use of money is as a means of payment.

Barter requires a “double coincidence of wants,” meaning that in order for trade to take place both parties must want what the other has. Money finalizes payments so that buyers and sellers have no further claim on each other.

A unit of Account

Money is the unit of account that we use to quote prices and record debts.

Under barter the general formula for n goods, we will have n (n - 1) / 2 prices

          100 goods> 100(100-1)/2= 4,950 prices

A Store of Value

The means of payment has to be durable and capable of transferring purchasing power from one day to the next. We hold money because it is liquid, meaning that we can use it to make purchases.

An asset is liquid if it can be easily converted into money and illiquid if it is costly to convert.

The payment system is a web of arrangements that allows for the exchange of goods and services.

Money is at the heart of payment system

Types of Money

·         Commodity Money – Things that have intrinsic value (gold has been the most common commodity money its usable, durable; high value relative to their weight and size, divisible into small units)

·         Fiat Money – Today we use paper money that is fiat money, meaning that its value comes from government decree (or fiat).

Chequs:

Cheques are instructions to the bank to take funds from your account and transfer those funds to the person or firm whose name is written in the “Pay to the Order of” line.

They are not legal tender not even money.

           OTHER FORMS OF PAYMENTS

A debit card (also known as a bank card or check card) is a plastic card that provides an alternative payment method to cash when making purchases. Functionally, it can be called an electronic cheque, as the funds are withdrawn directly from either the bank account or from the remaining balance on the card. In some cases, the cards are designed exclusively for use on the Internet, and so there is no physical card.

Credit card

•  It is a promise by a bank to lend the cardholder money with which to make purchases.
• When the card is used to buy merchandise the seller receives payment immediately
• The money that is used for payment does not belong to the buyer
• Rather, the bank makes the payment, creating a loan that the buyer must repay.
• So, they do not represent money; rather, they represent access to someone else’s money

Electronic Funds Transfer

• Move funds directly from one account to another

Like fee payments or bills

Stored-value card

• The term stored-value card means the funds and or data are physically stored on the card. prepaid cellular cards, Internet scratch cards, calling cards etc

One major difference between stored value cards and prepaid debit cards is that prepaid debit cards are usually issued in the name of individual account holders, while stored value cards are usually anonymous.

The Future of Money:

A dramatic reduction in the number of units of account because of safe and secure system

Money as a store of value is clearly on the way out as many financial instruments have become highly liquid.

Measuring Money

Different Definitions of money based upon degree of liquidity. Federal Reserve System defines monetary aggregates.

Changes in the amount of money in the economy are related to changes in interest rates, economic growth, and most important, inflation.

 Money supply or money stock is the total amount of money available in an economy at a particular point in time. There is several ways to define "money," but standard measures usually include currency in circulation and demand deposit

v  Monetary aggregates:

Various measures of a country's money supply, such as M1, M2, M3, M4, M5

• M1 is the narrowest definition of money and includes only currency and various deposit accounts on which people can write Cheques.

M1 = Currency in the hands of the public + Traveler’s Cheques+ Demand deposits and+ other chequeable deposits

• M2 includes everything that is in M1 plus assets that cannot be used directly as a means of payment and are difficult to turn into currency quickly.

M2 = M1+Small-denomination time deposits+ Money market deposit accounts+ Money market mutual fund shares

M2 is the most commonly quoted monetary aggregate since its movements are most closely related to interest rate and economic growth

• M3:

M3=  M2 + large time deposits+ repurchase agreements+ institutional money market mutual fund balances+ Eurodollars

v  Eurodollars: dollar account held out side the US BANKING SYSTEM

Inflation is a sustained rise in the general price level. Inflation makes money less valuable.

The primary cause of inflation is the issuance of too much money

Measures of Inflation

 Fixed-weight Index – CPI:

Measure of the overall level of prices used to

CPI in any month equals:

100*Cost of basket in that month/ Cost of basket in base period

 Deflator – GDP or Personal Consumption Expenditure Deflator

The GDP deflator, also called the implicit price deflator for GDP, measures the price of output relative to its price in the base year. It reflects what’s happening to the overall level of prices in the economy

GDP Deflator = (Nominal GDP / Real GDP) ×100

               

Financial Development is measured by the commonly used ratio of broadly defined money to GDP. Economic development is measured by the real GDP per capita.

FINANCIAL Instruments:

A financial instrument is the written legal obligation (it is subject to government enforcement) of one party to transfer something of value usually money to another party at some future date, under certain conditions, such as stocks, loans, or insurance.

Uses of Financial Instruments

1. Means of Payment: Purchase of Goods or Services

2. Store of Value: Transfer of Purchasing Power into the future

3. Transfer of Risk: Transfer of risk from one person or company to another

         Value of Financial Instruments

1. Size: Payments that are larger are more valuable

2. Timing: Payments that are made sooner are more valuable

3. Likelihood: Payments that are more likely to be made are more valuable

4. Circumstances: Payments that are made when we need them most are more valuable

Examples of Financial Instruments

Primarily Stores of Value

• Bank Loans:  A borrower obtains resources from a lender immediately in exchange for a promised set of payments in the future
• Bonds:  A form of a loan, whereby in exchange for obtaining funds today a government or corporation promises to make payments in the future
• Home Mortgages:  It is a specific asset pledged by the borrower in order to protect the interests of the lender in the event of nonpayment.
• Stocks:  An owner of a share owns a piece of the firm and is entitled to part of its profits.

Primarily to transfer risk

·         Insurance Contracts The primary purpose is to assure that payments will be made under particular (and often rare) circumstances

·         Futures Contracts: An agreement to exchange a fixed quantity of a commodity, such as wheat or corn, or an asset, such as a     bond, at a fixed price on a set future date.

 It is a derivative instrument since its value is based on the price of some other asset.

 It is used to transfer the risk of price fluctuations from one party to another

·         Options

 Derivative instruments whose prices are based on the value of some underlying asset. They give the holder the right (but not the obligation) to purchase a fixed quantity of the underlying asset at a predetermined price at any time during a specified period.

Financial Markets: Financial Markets are the places where financial instruments are bought and sold.

Role of Financial Markets

Liquidity: Ensure that owners of financial instruments can buy and sell them cheaply and easily

Information: Pool and communicate information about the issuer of a financial instrument

Risk Sharing: Provide individuals with a place to buy and sell risk, sharing them with individuals

Structure of Financial Markets:

·         Primary vs. Secondary Markets

In a primary market a borrower obtains funds from a lender by selling newly issued securities.

In the secondary markets people can buy and sell existing securities

·         Centralized Exchanges vs. Over-the-counter Markets

In the centralized exchange the trading is done “on the floor”

OTC markets are electronic networks of dealers who trade with one another from wherever they are located

Equity markets are the markets for stocks, which are usually traded in the countries where the companies are based.

    Debt instruments:

• Money market (maturity of less than one year)
• Bond markets (maturity of more than one year)

Characteristics of a well-run financial market

1. Low transaction costs.

2. Information communicated must be accurate and widely available (If not, the prices will not be correct)

3. Investors must be protected

4. A lack of proper safeguards dampens people’s willingness to invest

Financial Institutions

Financial institutions are the firms that provide access to the financial markets.

They sit between savers and borrowers and so are known as financial intermediaries.

 Banks, insurance companies, securities firms and pension funds

Role of Financial Institutions:

Reduce transactions cost by specializing in the issuance of standardized securities

·         Reduce information costs of screening and monitoring borrowers.

·         Curb information asymmetries, helping to ensure that resources flow into their most productive uses

·         Make long-term loans but allow savers ready access to their funds.

·         Provide savers with financial instruments that savers would purchase directly in financial markets

The structure of the financial industry

Financial institutions or intermediaries can be divided into two broad categories

• Depository institutions - take deposits and make loans.

 (Commercial banks, savings banks, and credit unions)

• Non depository institutions

 Insurance companies, securities firms, mutual fund companies, finance companies, and pension funds

Time Value of Money

They link the present to the future, allowing us to compare payments made on different dates.

 Interest rates also tell us the future reward for lending today, as well as the cost of borrowing now and repaying later. The main reason for the enduring unpopularity of interest comes from the failure to appreciate the fact that lending has an opportunity cost.

Future Value: Future Value is the value on some future date of an investment made today.

FV = PV*(1+i)

Compound Annual Rates

FV_n = PV*(1+i) ⁿ

Future value of $100 in 18 months at 5% is FV = 100 *(1+.05)1.5

Present Value

Present Value is the amount that must be invested today in order to realize a specific amount on a given future date.

FV = PV*(1+i)

The rule of 72

 For reasonable rates of return, the time it takes to double the money, is given approximately by

                              t = 72 / i%

Present Value is higher:

• The higher the future value (FV) of the payment
• The shorter the time period until payment (n)
• The lower the interest rate (i)
• Increasing or decreasing FV_n by any percentage will change PV by the same percentage in the same direction

The Interest rate (i)

A rate which is charged or paid for the use of money, the interest rate used in the present value calculation is often referred to as the discount rate

o   Higher interest rates are associated with lower present values, no matter what size or timing of the payment

o   At any fixed interest rate, an increase in the time until a payment is made reduces its present value

Another term that is used for the interest rate is yield.

Higher interest rates mean higher saving

Internal Rate of Return: The Internal Rate of Return is the interest rate that equates the present value of an investment with it cost.

The internal rate of return must be compared to a rate of interest that represents the cost of funds to make the investment.

An investment will be profitable if its internal rate of return exceeds the cost of borrowing.

 Risk: Risk is a measure of uncertainty about the future payoff of an investment, measured over some time horizon and relative to a benchmark.

Characteristics of risk

• Risk can be quantified.
• Risk arises from uncertainty about the future.
• Risk has to do with the future payoff to an investment, which is unknown.

Probability is a measure of likelihood that an even will occur.

• Its value is between zero and one
• The closer probability is to zero, less likely it is that an event will occur.
• No chance of occurring if probability is exactly zero
• The closer probability is to one, more likely it is that an event will occur.
• The event will definitely occur if probability is exactly one
• Probabilities can also be expressed as frequencies

Expected Value = Sum of (Probability*Payoff)

Investment payoffs are usually discussed in percentage returns instead of in dollar amounts

A wider payoff range indicates more risk.

Measuring Risk

A financial instrument with no risk at all is a risk-free investment or a risk-free asset; its future value is known with certainty.

We can measure risk by measuring the spread among an investment’s possible outcomes. There are two measures that can be used:

Variance: The variance is defined as the probability weighted average of the squared deviations of the possible outcomes from their expected value.

To calculate the variance of an investment, following steps are involved:

 Compute expected value

 Subtract expected value from each possible payoff

 Square each result

 Multiply by its probability

 Add up the results

Standard Deviation

The standard deviation is the square root of the variance

The greater the standard deviation, the higher the risk It more useful because it is measured in the same units as the payoffs

Value at Risk

Value at risk measures risk at the maximum potential loss.

Risk Aversion

Buying insurance is paying someone to take our risks, so if someone wants us to take on risk we must be paid to do so, so most of us are risk averse.

Risk Premium

The higher the risk, the higher the expected return.

The risk premium= expected return on the risky investment- risk-free return.

How to Evaluate Risk

Risk evaluation allows you to determine the significance of risks to the business and decide to accept the specific risk or take action to prevent or minimize it.

Sources of Risk

Regardless of the source, risks can be classified as either idiosyncratic or systematic

Idiosyncratic, or unique, risks affect only a small number of people, Example: Higher oil prices

Systematic risks affect everyone. Example: change in general economic conditions

Reducing Risk through Diversification

Risk can be reduced through diversification, the principle of holding more than one risk at a time.

There are two ways to diversify your investments:

Hedging Risk

• Hedging is the strategy of reducing overall risk by making two investments with opposing risks.
• When one does poorly, the other does well, and vice versa.
• So while the payoff from each investment is volatile, together their payoffs are stable.

Spreading Risk

You can lower risk by simply spreading it around and finding investments whose payoffs are completely unrelated. The more independent sources of risk you hold the lower your overall risk. Adding more and more independent sources of risk reduces the standard deviation until it becomes negligible.

v  Bonds:

Virtually any financial arrangement involving the current transfer of resources from a lender to a borrower, with a transfer back at some time in the future, is a form of bond.

A standard bond specifies the fixed amount to be paid and the exact dates of the payments

Bond Prices

• Zero-coupon bonds: These are pure discount bonds since they sell at a price below their face value, such as a Treasury bill.

 The difference between the selling price and the face value represents the interest on the bond

Price of a $100 face value zero-coupon bond = $100/ (1+i)ⁿ

Where

i is the interest rate in decimal form

n is time until the payment is made in the same time units as the interest rate

n, the price of a bond and the interest rate move in opposite directions

The most common maturity of a T-bill is 6 months. 6 month T-bills have a higher price that a one-year T-bill

• Fixed Payment Loans: They promise a fixed number of equal payments at regular intervals. Home mortgages and car loans are examples of fixed payment loans.

Value of a Fixed Payment Loan = Fixed Payment/ (1+i) + Fixed Payment/ (1+i)² +…….+ Fixed Payment/ (1+i)ⁿ

• Coupon Bond: The value of a coupon bond is the present value of the periodic interest payments plus the present value of the principal repayment at maturity.

P_CB = [Coupon payment/ (1+i) + Coupon payment/ (1+i)² +…….+ Coupon payment/ (1+i)ⁿ]+ Face value/ (1+i)ⁿ

• Consoles: A consol offers only periodic interest payments, only governments can credibly promise to make payments forever. The price of a consol is the present value of all the future interest payments, which is a bit complicated because there are an infinite number of payments.

Bond yield: The bond yield is essentially the amount or percentage of return that an investor can anticipate to receive from a bond issue within a specified period of time.

If there is a change in interest rates that leads to a shift in the current price of the bond, the bond yield may indicate a capital loss. Interest rate and yield are used interchangeably.

Yield to Maturity: The most useful measure of the return on holding a bond to its maturity when the final principal payment is made is called the yield to maturity (YTM).

It can be calculated from the present value formula

Price of One-Year 5 percent Coupon Bond = $5/ (1+i) + $100/ (1+i)

The value of i that solves this equation is the yield to maturity

General Relationships:

• Yield to maturity = coupon rate, the price of the bond is the same as its face value.
• Yield>coupon rate, the price is lower;
• yield < coupon rate, the price is greater
• If bond price< its face value then you have a higher return than the coupon rate. You will receive its interest and a capital which is the difference between the price and the face value
• When the price> face value, the bondholder incurs a capital loss and the bond’s yield to maturity falls below its coupon rate.

Current Yield:  Current yield is a commonly used, easy-to-compute measure of the proceeds the bondholder receives for making a loan. It ignores the capital gain or loss that arises when the bond’s price differs from its face value.

Current Yield Yearly Coupon Payment/ Price Paid

The current yield moves inversely to the price.

Relationship between a Bonds’s Price and its Coupon Rate, Current Yield and Yield to Maturity

• Bond Price < Face Value:

Coupon Rate < Current Yield < Yield to Maturity

• Bond Price = Face Value:

Coupon Rate = Current Yield = Yield to Maturity

• Bond Price > Face Value:

Coupon Rate > Current Yield > Yield to Maturity

Holding Period Returns:

=Yearly Coupon Payment/Price Paid +Change in Price of the Bond/Price of the Bond=Current Yield Capital Gain (as a %)

Bond Supply

The Bond supply curve is the relationship between the price and the quantity of bonds people are willing to sell, all other things being equal.

Bond Demand

The bond demand curve is the relationship between the price and quantity of bonds that investors demand, all other things being equal.

Equilibrium in the bond market is the point at which supply equals demand.

If the price is too high (above equilibrium) the excess supply of bonds will push the price back down.

If the price is too low (below equilibrium) the excess demand for bonds will push it up

Factors that shift Bond Supply

• Changes in government borrowing,

An increase in the government’s desired expenditure relative to its revenue: Bond Supply shifts to the right, Bond prices decrease and interest rates increase

• Changes in business conditions

An improvement in general business conditions: Bond Supply shifts to the right, Bond prices decrease and interest rates increase

• Changes in expected inflation

An increase in expected inflation, reducing the real cost of repayment Bond Supply shifts to the right, Bond prices decrease and interest rates increase.

Factors that shift Bond Demand

• Wealth:

An increase in wealth increases demand for all assets, including bonds: Bond demand shifts to the right, Bond prices increase and interest rates decrease.

• Expected inflation

 A fall in expected inflation shifts the bond demand curve to the right, increasing demand at each price and lowering the yield and increasing the Bond’s price.

• Expected return on stocks and other assets

If the return on bonds rises relative to the return on alternative investments, the demand for bonds will rise. This will increase bond prices and lower yields.

• Risk relative to alternatives

If a bond becomes less risky relative to alternative investments, the demand for the bond shifts to the right.

• Liquidity of bonds relative to alternatives

 When a bond becomes more liquid relative to alternatives, the demand curve shifts to the right

Shifts in Equilibrium

An increase in expected inflation:

An increase in expected inflation shifts bond supply to the right and bond demand to the left.

The two effects reinforce each other, resulting in a lower bond price and a higher interest rate

A business-cycle downturn:

A business-cycle downturn shifts the bond supply to the left and the bond demand to the left.

In this case the bond price can rise or fall, depending on which shift is greater.

But interest rates tend to fall in recessions, so bond prices are likely to increase