Economics 304: Monetary Economics
Lecture 1, January 10, 2013
Financial Assets and Financial Markets - An Introduction
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
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.
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
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