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University of Waterloo
ECON 304
Jean- Paul Lam

Economics 304: Monetary Economics Jean-Paul Lam Lecture 1, January 10, 2013 Financial Assets and Financial Markets - An Introduction Contents 1 Introduction 2 1.1 Financial assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2. . . . . . 1.2 Debt versus equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2. . . . . 1.3 Price of financial asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 . . . . . 1.4 Role of financial assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 . . . . . 2 Financial Markets 4 2.1 Classification of financial markets . . . . . . . . . . . . . . . . . . . . . . . . 4 . . . . 2.2 Globalization of financial markets/medskip . . . . . . . . . . . . . . . . . . . . 5 . . 2.3 Regulation of financial markets/medskip . . . . . . . . . . . . . . . . . . . . . .6. . . 3 Financial institutions and financial intermediaries 7 4 Conclusion 8 1 1 Introduction Monetary economics is concerned with the effects of monetary/financial institutions and policy actions on important economic variables such as inflation, output, interest rates, unemployment, commodity prices, etc. The study of monetary economics as a special field is important as money, although one of many commodities, plays a special role in the economy. Moreover, the recent financial crisis has shown that disruptions in the financial markets can lead to costly recessions and extreme hardships. It has also shown that governments and particularly central banks have an important role and even a duty to intervene when such catastrophic events occur. In this lecture, before discussing in details the role and importance of money, we present a brief overview of the financial system. Throughout the course we will present in more details certain aspects of the financial system. In a market economy, the decisions of private agents and prices usually dictate how the limited amount of resources should be allocated. In a market economy, there are broadly, there are two types of markets: the goods markets and the factor market. In the goods market, manufactured goods and services are sold/bought. In the factor markets, factors of production (land, labour and capital) are the commodities that are sold. The market for financial assets is one part of the factor market and this market is known as the financial market. 1.1 Financial assets What is an asset? An asset is simply any good/commodity/possession that has some value in an exchange. Assets can be tangible, that is they depend on physical properties such as houses, buildings, cars or intangible such as a claim on the future profits of a firm. Intangible assets do not depend on any physical form of the property or object but rather it represents a legal claim on some future revenue/cash/profits/benefits. Financial assets are intangible assets as they represent a legal claim on some future rev- enue/profits/cash. Financial assets are also known as financial instruments or financial securities. The entity that buys and owns the financial asset is known as the investor. On the other hand, the entity that issue the financial asset and promises to make a future cash payment is known as the issuer. For example, the Government of Canada sells Canada Savings bond (CSB). The issuer of those bonds is the Government of Canada who promises to pay the holder/investor given a return annually until the bond matures. At the maturity date, the full amount is repaid. The investors are anyone who bought these CSBs. When a bank makes a loan to a customer, the latter is the issuer who. The customer/borrower promises to repay the principal with interests to the Bank, where the latter is the investor. Investors do not need to be only individuals. Corporations and governments can also buy financial assets from other financial entities. 1.2 Debt versus equity Securities can be classified into two categories. The claim that the holder of a financial asset has may be either a fixed dollar amount at regular intervals until a specified date (the maturity date) or an amount that varies, usually known as a residual amount. If the claim is in fixed dollar amount, 2 the financial asset is usually referred to as a debt instrument. These instruments are also known as fixed-income instruments. The maturity of a debt instrument is simply the number of years until the principal is fully repaid. Debt instruments that mature within one year are usually known as short-term debt whereas those with maturities longer than ten years are considered long-term debt. Debt instrument with maturities between one and ten years are known as intermediate or medium-term debt instruments. Government bonds issued by the Government of Canada or any other government, bank loans, corporate bonds, municipal bonds are examples of a debt instrument since the claim is usually in fixed amounts. Holders of debt are first in line to receive payments and the rest goes to holders of equity. This is why an equity instrument is also known as a residual claim. A common stock in a public company is an example of an equity instrument. Equities do not have maturity dates and holders of equities are usually the owners of the entity whereas holders of debt are usually considered creditors. 1 1.3 Price of financial asset Pricing financial assets is not easy. However, economic principle simply states that the price of financial asset depends on the present value of its expected cash flow or streams of payments over time. Present value is simply the value at a given period in time of a stream of payments over time. If one knows the maturity date and the fixed payment on an asset, it is very easy to compute the present value of a given asset. In general, financial assets are so easy to price as basic economic principle lead us to believe, This is simply because the future stream of payments is not known with certainty as there are many risks associated with holding the asset. There are broadly four types of risks: inflation, liquidity, default or credit and if the asset is denominated in foreign currency, exchange rate risk. We will come back to those concepts in more details in subsequent lectures. 1.4 Role of financial assets Financial assets provide two important economic functions. The first is risk-sharing. Financial assets allow risks to be spread among different parties instead of one party bearing all the risks. The second is to transfer funds from entities who have surplus funds to invest to those who need funds to invest in tangible assets. These two functions can be illustrated by this simple example. Suppose that I want to invest and start a company that manufactures toys and the initial investment that is required is $500,000. Suppose that I have $200,000 in cash and savings that I could invest in the start-up. However, I am risk-averse and want to enjoys my savings in another way and therefore I am reluctant to invest my whole savings in this endeavour. Suppose I met two investors, Larry and Mary. Larry is willing to invest $250,000 for 50% of the company and Mary is willing to lend me $150,000 for ten years at a rate of 6% per annum. This example illustrates very well the two important economic functions of a financial asset. First, I am able to transfer part of the risk associated with the investment in this business to Larry and Mary. Larry shares with me the business risk since he holds 50% of the shares of the company whereas Mary shares with me the credit risk. The shifting of risks from one party to other parties is a fundamental function of a financial asset. 1 Some securities such as preferred stocks, convertible bonds are actually a debt and an equity instrument. Holders of preferred stocks are entitled to a fixed amount only after payments to holders of debt instrument have been made. Holders of convertible bonds can convert their debt into equity under certain circumstances. 3 The second function of a financial asset is also very clear. Larry and Mary had surplus funds whereas I had a shortage of funds. By issuing equities to Larry and a debt instrument to Mary, this transfer of funds allowed the investment to take place. Thus, financial assets allow surplus funds to flow from savers to those seeking funds, that is borrowers. In other words, the existence of financial assets facilitate the matching of savers and borrowers. 2 Financial Markets A financial market is simply a market where financial assets are traded. The vast majority of financial assets are traded in some type of financial market. Financial assets are often traded for immediately delivery. This type of market is known as the spot or cash market. Financial markets play a key role in our modern financial system. The latter would not function without financial markets. Financial markets essentially provide three economic functions. Financial markets allows the prices at which the asset should be traded to be revealed. This is known as the price discovery process. If we assume that markets are efficient, then the price of an asset should reflect all information (even hidden ones) available to the buyer and seller. This is essentially what the Efficient Market Hypothesis (EMH) (strong form) would predict. Second, financial markets offers liquidity to owners of financial assets. Financial markets allow owners of assets to sell their securities at any point in time, provided they can have a buyer. Hence owners of financial assets do not have to hold debt instruments until maturity or equities as long as the company exists. Different assets have different degree of liquidity and different markets have different degrees of liquidity. For example, stocks listed on the NYSE or Nasdaq are more liquid than those listed on the Australian Securities Exchange (ASX). Moreover, short-term debt instruments tend to be more liquid than medium or long-term debt instruments. Third, the existence of a financial market reduces transaction costs, in particular search and information costs. Because financial markets are meeting places for buyers and sellers of financial assets, search costs are greatly reduced since buyers and sellers do not have to spend time to locate a counter party or advertise to find another party. Put simply, the existence of financial markets allows savers/lenders to be more easily matched with borrowers. The price of the asset will determine whether a match can happen. Moreover, since the price of an asset usually contains all available information, there is little need for buyers or sellers of an asset to spend time researching the potential value of the asset. The price simply reflects all available information held by market participants. 2.1 Classification of financial markets There are many ways one can classify financial markets. Financial markets can be classified by the nature of claims as we discussed above. For example, financial markets can be classified as debt or equity market. Financial markets can be classified based on the length of the maturity of the debt. For example, the market for short-term debt is usually known as the money market whereas the market for debt with longer maturities is known as the capital market. Money market securities are generally more liquid and safer than capital market securities. Examples of money market instruments are short-term treasury bills with maturities ranging from 1 to 12 months, commercial paper, repos (short-term loan where collateral is posted), overnight funds (banks lending to other 4 other banks). On the other hand, in
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