Lecture Notes
Lecture Notes
Lecture Notes
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Money as a medium of exchange and store of wealth Financial instruments to transfer resources and risk Financial markets allow trading in financial instruments Financial institutions provide services, including access to financial markets Central banks monitor and stabilise the economy
Financial Instruments
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Financial instrument
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Is the legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions, e.g. stocks, loans, insurance
Standardization financial instruments are homogenous Information summarise essential information about issuer. Resolve problem of information asymmetry Examples of financial instruments:
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Financial instruments used as store of value include: bank loans, bonds, mortgages, stocks Financial instruments used to transfer risk include: insurance contracts, futures contracts, options, swaps
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Financial markets provide for financial intermediation-financial savings (Surplus Units) to investment (Deficit Units) Financial markets provide payments system Financial markets provide means to manage risk Financial markets pool and communicate information about the issuers of financial instrument, summarising in the form of price
Money versus Capital Markets Primary versus Secondary Markets Organized versus Over-the-Counter Markets
Money
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Capital
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Short-Term, < 1 Year High Quality Issuers Debt Only Primary Market Focus Liquidity Market-Low Returns
Long-Term, >1Yr Range of Issuer Quality Debt and Equity Secondary Market Focus Financing Investment--Higher Returns
PRIMARY
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SECONDARY
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New Issue of Securities Exchange of Funds for Financial Claim Funds for Borrower; an IOU for Lender
Organized
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OTC
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Visible Marketplace
Members Trade
Securities Listed
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GSE, NYSE
Derivative Securities
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Financial contracts whose value is derived from the values of underlying assets Used for hedging (risk reduction) and speculation (risk seeking)
Valuation of Securities
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Future cash flows When cash flows are received Risk of cash flows
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Present value of cash flows discounted at the market required rate of return Value determined by market demand/supply Value changes with new information
Economic Conditions
Industry Conditions
Direct lending provide credit on more favourable terms Guarantees guarantee the payment of principal and interest in whole or in part, in the event that the borrower defaults Sponsored enterprises govt. may sometimes provide capital for the formation of these firms
To Promote Efficiency
High level of competition u Efficient payments mechanism u Low cost risk management contracts
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Forms of Regulation
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Disclosure Regulation Financial Activity Regulation Regulation of Financial Institutions Regulation of Foreign Participants Banking and Monetary Regulation
Financial Institutions
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Financial institutions are firms that provide access to the financial markets, both to savers who wish to purchase financial instruments directly and to borrowers who want to issue them. Sit between savers and borrowers financial intermediaries e.g. banks, insurance companies, securities firms, pension funds etc.
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Transforming financial assets Exchanging financial assets on behalf of customers Exchanging financial assets for own account Assisting in the creation of financial assets Providing investment advice Managing portfolios
Information processing Serve special needs of lenders (liabilities) and borrowers (assets)
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Commercial Banks
Insurance companies Mutual funds Pension funds Securities companies Finance companies Security pools
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Focused on capital market Longer-term, higher risk intermediation Less focus on liquidity Less regulation Greater focus on equity investments
Rapid growth of mutual funds and pension funds Increased consolidation of financial institutions via mergers Increased competition between financial Institutions Growth of financial conglomerates
International expansion International mergers Impact of the single European currency Emerging markets
Dollarization
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One country formally adopts the currency of another country for use in all its financial transactions, completely eliminating its own monetary policy. Need not be based on the dollar. Monaco adopted the French franc in 1865 and uses the euro today. Ecuador, El Salvador. Panama has been dollarized since 1904.
With no exchange, there is no risk of an exchange rate crises. Integration into the world markets increasing trade and investment By rejecting the possibility of inflationary finance, a country can reduce the risk premium it must pay on loans and generally strengthen its financial institutions. The benefits of dollarization is balanced against the loss of revenue that comes from issuing currency
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