ECON 304 Lecture Notes - Australian Securities Exchange, Canada Savings Bond, Investment Banking

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Published on 21 Apr 2013
School
University of Waterloo
Department
Economics
Course
ECON 304
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
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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,
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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 nancial 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.
1Some 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.
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Document Summary

Financial assets and financial markets - an introduction. Monetary economics is concerned with the e ects of monetary/ nancial institutions and policy actions on important economic variables such as in ation, output, interest rates, unemployment, commodity prices, etc. The study of monetary economics as a special eld is important as money, although one of many commodities, plays a special role in the economy. Nancial crisis has shown that disruptions in the nancial 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 nancial system. Throughout the course we will present in more details certain aspects of the nancial system.

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