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Lecture 10 Financial Markets & Institutions Introductory Finance for Economics (ECN104) Module Leader: Farzad Javidanrad Based on: Principle of Cooperate Finance by Brealey, Myers and Allen (2014) (Spring 2013-2014) Department of Economics The University of Sheffield

Introductory Finance for Economics (Lecture 10)

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Page 1: Introductory Finance for Economics (Lecture 10)

Lecture 10

Financial Markets

& Institutions

Introductory Finance for

Economics (ECN104)

Module Leader: Farzad Javidanrad

Based on: Principle of Cooperate Finance by Brealey, Myers and Allen (2014)

(Spring 2013-2014)

Department of Economics

The University of Sheffield

Page 2: Introductory Finance for Economics (Lecture 10)

Financial System & Financial Markets• Financial system is a system that allows moneys to be transferred from the

individuals and companies with the surplus funds to those who have the shortage of funds.

• The system can be defined at the global, regional or even specific firm level. The regional financial systems is a set of banks and other financial institutions, financial markets, financial services at a regional level.

• A healthy regional financial system directs funds to where that increase productivity and promote economic stability and growth.

• At a global level, financial system comprises of the International Monetary Fund (IMF), central banks, World Bank and major banks that work internationally.

• Financial market is a market that money and financial securities (such as stocks and bonds) and some commodities (such as some agricultural goods and precious metals) are traded. Some financial markets are small in terms of participants and number of transactions but some of them are very active such as London Stock Exchange and New York Stock Exchange with over trillion dollars trade in a day.

Page 3: Introductory Finance for Economics (Lecture 10)

Financial Markets• There are different types of financial markets:1. Capital Markets; where money can be borrowed or lent for a long-period in

order to finance the projects of corporations through issuing bonds and stocks. This market is subdivided to: 1.1 Bond Markets1.2 Stock Markets

Each of them are subdivided to the Primary Market; where new issues are first offered and the Secondary Market; where old issues are offered for another trade.

2. Money Markets; where money is borrowed and lent for a short-period of time (from several days upto a year), mostly through interbanking lending. Types of securities in this market are Certificates of Deposits (CDs), government bonds, commercial papers and etc.

Adopted from http://crackmba.com/financial-markets/

Page 4: Introductory Finance for Economics (Lecture 10)

Financial Markets3. Commodity Markets; where large amount of commodities such as gold,

silver, oil, wheat, coffee, sugar and etc. are being traded. 4. Insurance Markets; where buyers transfer risk of heavy loss to sellers in

exchange for payments. 5. Derivatives Markets; where financial instruments such as future contracts

and options are being traded.6. Foreign Exchange Markets; where different currencies are exchanged. The

main participants of these markets are banks.

• Flow of funds through the financial system can happen in two ways:

a) Direct Finance: Funds move directly from lender/savers (investors) to borrower/spenders via financial markets in exchange with financial instruments (securities).

b) Indirect Finance: Funds moves first to the financial institutions (financial intermediaries) and then lent to the borrowers.

Graph in the next slide help to visualise these relations.

Page 5: Introductory Finance for Economics (Lecture 10)

Flow of Fund Through the Financial System

Financial Institutions

Financial Market

Lenders/Savers:• Households• Firms• Governments• Foreign Investors

Borrowers/Spenders:• Households• Firms• Governments• Foreign Borrowers

Indirect Finance

Direct Finance

Page 6: Introductory Finance for Economics (Lecture 10)

Types of Financial Institutions• There are six types of financial institutions (intermediaries):I. Commercial banks II. Investment banksIII. Insurance companiesIV. Pension fundsV. Mutual fundsVI. Hedge funds

Commercial banks accept deposits and offer loan to individual and firms. They also serve as payment agents to facilitate the money transfer between different individuals, companies and organisations.

Investment banks do not take deposits and usually do not serve the general public. They help companies to raise money, for example, by underwriting companies' stocks and distributing (or reselling) them to potential investors in the market. They also advice companies on takeovers (purchase of one company by another), mergers(combination of two or more companies) and acquisitions (buying most, if not all, of another company's ownership)

Page 7: Introductory Finance for Economics (Lecture 10)

Types of Financial Institutions Insurance companies make profit by insuring a large number of

people or companies at the same time. They are one of the important sources of funds for corporations. They provide long-term loans directly for companies through buying their bonds and stocks.

Pension funds are one of the largest fund providers around the world and designed for long-term investments. They have tax advantageous meaning the returns of their investment are not taxed before the final withdrawn.

Mutual funds are the professionally managed investment schemes that raise money from different investors in order to invest in a portfolio of securities. For many investors it is more efficient to buy securities from a mutual fund than investing directly in individual securities as these institutions try to find those stocks that generate return better than the average returns.

Page 8: Introductory Finance for Economics (Lecture 10)

Types of Financial Institutions Hedge funds like mutual funds pool moneyfrom different investors to invest on their behalf but they do not serve the generalpublic but the big investors such as pensionfunds or very rich individuals. They have limited liabilities and require a very largelevel of minimum investment.

Adopted from www.fca.org.uk/static/documents/hedge-fund-survey.pdf

• Failing or closing a very large hedge fund may put the financial system in the risk of instability either through drying out the credit channel or through selling the collaterals simultaneously (needed for hedge funds transactions).

• “Hedge funds use leverage to increase the size of the positions taken in financial markets. In some cases, the use of leverage allows them to become large enough to suggest they could impact the wider financial system in certain situations. Hedge funds obtain leverage either by borrowing money or securities from counterparties (known as financial leverage) or by using derivative instruments such as options, futures or swaps. …. the largest proportion of total leverage used by hedge funds in the UK is acquired using derivatives. Derivative transactions allow hedge funds to acquire market/economic exposures (which this report refers to as the Gross Notional Exposure) that are many times bigger than the capital of the fund: for example a hedge fund may pay or receive USD 1m to buy or sell an option with an underlying market exposure of USD 100m.”(Financial Conduct Authority, March 2014, Hedge Fund Survey, p.4)

Page 9: Introductory Finance for Economics (Lecture 10)

Asymmetric Information & Free-Rider Problem • A healthy financial system must overcome two problems:

A. Asymmetric information: A situation in which one side (party) of a transaction (for example, seller) has more or better information compared to another (here; the buyer) and causes imbalance of power. Asymmetric information leads to two problems:

A.1. Adverse selection (before a transaction is completed) arises because the party who is most eager to engage in a transaction is the one most likely to produce an undesirable (adverse) outcome for another party.

For example, in the health insurance market, buyers with health problems have an incentive to hide their health problems in order to pay lower insurance premium. So, at any level of premium, there are some buyers who are willing to be covered as they know the cost of treatment is higher than the cost of premium.

Adopted from http://dutchhealthcare.wordpress.com/2011/01/26/adverse-selection/

Page 10: Introductory Finance for Economics (Lecture 10)

Asymmetric Information & Free-Rider Problem A.2. Moral hazard (after a transactionis completed) arises when one party isengaged in activities that are undesirablefrom other party’s point of view. For example, when financial institutionsare bailed out by the state (in order toprotect people’s deposits) some financialinstitutions carelessly enter into somerisky investments.

B. Free-rider problem: A situation when a party is benefited from something but does not pay the price of that. For example, an individual who can get a profit from a stock trade without using any of his or her own money (Arbitrage Opportunity). Anotherexample is the people who get benefited from thedefence budget but do not pay their taxes.

Adopted from http://www.michaelwdean.com/

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Page 11: Introductory Finance for Economics (Lecture 10)

Financial Development & Economic Growth• Financial institutions are important as they theoretically1. Promote economic growth through facilitating trade and capital movement2. Provide credit for individual and firms 3. Identify creditworthy firms4. Pool the risks of the individual entities5. Mobilise savings to investment projects6. Reallocating capital with a low transactions costs

• “The relationship between financial development and economic growth has received great attention during the last few decades. Many economists have emphasised the significance of financial sector development in the process of economic growth, whereas other economists believe that this importance is over-stressed. However, the debate is not new in the economics development literature and can be traced back to Bagehot(1873) and Hicks (1969) which argued that financial development was an important channel in the industrialisation of England, by helping the movement of large amounts of funds for “immense” works.”(Javidanrad, Causal Relationship

between Financial Development & Economic Growth, p. 11)

Page 12: Introductory Finance for Economics (Lecture 10)

Financial Development & Economic Growth• How much are they good practically?

• It is naive to think that the private financial institutions are committed to boost the economic growth. “Private financial institutions do not lend money to

create jobs or to facilitate transactions in economy but to make a bigger profit. They

have great interest to expand their business [through lending] … in order to have a

bigger share of the cake” (Javidanrad, The Impact of the Size of Financial Sector on Real Sector, (2013), P. 1)

Adopted from http://www.toonpool.com/cartoons/Stock%20Markets%20fall_100913

Page 13: Introductory Finance for Economics (Lecture 10)

Financialisation of the Economy• “In a modern economy real sector activities are heavily reliant on the

financial sector services. Even in a simple transaction between individual buyers and sellers financial institutions and their instruments, such as debit/credit cards and overdraft facilities, play a central and imperative role. Many financial instruments have been created and encouraged to be accepted by households and firms just to enable financial institutions to have a bigger share of capital in economy. Some economists, such as Stockhammer (2012), use the term “financialisation” to indicate on this dominance.” (Ibid, p. 2)

• “He argues that financialisation has changed the non-financial actors’ perceptions about themselves and their motives and has led to the shift of power from labour to capital in one hand and from company to lenders/shareholders on the other hand. The main outcome of this shift is the firms’ concentration on profit growth, in order to make lenders and shareholders more satisfied, while the reinvestment of the profit shows a slow growth.” (Ibid, p. 2)

Page 14: Introductory Finance for Economics (Lecture 10)

Growth of the Financial Sector• The financial sector’s share of aggregate income, which reflects the concept of

financialisation, has had a rapid growth compare to the same in the real part of the economy.

• Data collected from the Blue Book (2013) in the UK shows that the percentage share of GDP (income approach) has increased for financial corporations from 1.96% in 1999 to 2.55% in 2012 while the same percentage share has dropped for the private non-financial corporations in the UK from 19% in 1999 to 16.56% in 2012. The picture is more evident when the 8.58%average of yearly growth rate of the financial corporations in 14 years (1999-2012) is compared with 3.03% average yearly growth rate of non-financial corporations.

0

20

40

60

80

100

120

140

160

180

1990 1995 2000 2005 2010 2015

Pe

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nta

ge

Years

UK's Net Debt as a % of GDP

Source : ONS

Increasing the number of profitable financial institutions has no meaning just the expansion of debt because with the expansion of credit and increasing debt they can survive.

Page 15: Introductory Finance for Economics (Lecture 10)

Financial Crisis & Minsky Moment • Most macroeconomists work with "equilibrium models" meaning the

economy is moving from one stable situation to another stable situation. So, instability occurs when there is an external shock such as a disaster, war, dramatic rise in oil prices or even something good such as technological changes.

• Minsky believed that the economic system could generate shocks through its own internal dynamics. Through his theory of financial instability hypothesis he explains the formation of instability during the periods of economic stability (when firm’s cash flow is more than the total amount of their debt) when agents become less rational in their activities.

• They assume that the good times will continue and begin to take greater risks in order to increase their profit. Financial institutions and big corporations start to increase their speculative activities. The root of the future crisis starts from here.

• He defines three types of financing that firms could choose according to their risk tolerance : Hedge Finance, Speculative Finance and Ponzi Finance. The terms hedge, speculative, and Ponzi finance are used to indicate the relative difficulties that economic units have in repaying their debt.

Page 16: Introductory Finance for Economics (Lecture 10)

Financial Crisis & Minsky Theory• He believes that the accumulation of debt is the major element that

leads an economy towards a crisis. Hedge borrowers will be able to repay their debt and interest. With the rise of speculative financing, speculative borrowers know that profits will not cover all their liabilities,

however, they believe that more investment leads to more profits and there

will be no problem.

• lenders also start thinking that they will get back all the money they have lent

or alternatively they can use their acquisition rights to own the firm/house.

Therefore, they are ready to lend to firms, households or even other financial

institutions (perhaps more short term with higher level of interest) without

full guarantees of success. Lenders know that such borrowers might have

problems repaying but they still believe their borrowers will refinance from

elsewhere and repayment will continue. This is Ponzi financing where the

economy has entered into a very risky and unstable situation. Now it is only

a question of time before default of borrowers happen in an industrial scale.

Lenders stop giving credit so easily, so the financial institutions return to

hedge finance.

Page 17: Introductory Finance for Economics (Lecture 10)

Financial Crisis & Minsky Theory

Hedge FinanceLenders and borrowers are cautious

Less lending / less borrowing

Speculative FinanceAssuming good situation & continuation of that

Starting risky borrowing /lending

Ponzi FinanceToo much risky borrowing / lending

Soaring asset prices / Forming bubbles

Start of the bankruptcy