Chapter 1
Overview of chapter:
Quick recap of Money and Banking
Financial System
Why have financial intermediaries?
To Lower transaction costsTypes of markets
Common themes in market discussion: the Financial SystemThe financial system is made up of those who need money and those who have money to lend.
Those that have the money are called surplus spending units (SSUs) while those who need money are called Deficit Spending units (DSUs). Traditionally, households are thought of as SSUs and corporations thought of as DSUs but this is not always the case. There are times when any party can be either a DSU or a SSU.
Most of what we will talk about this semester deals with how these two parties "get together."Indeed, the existence of all financial intermediaries (of which financial markets and other institutions are included) lies in their ability to lower transactions costs associated with SSUs and DSUs getting together.
Overview of Financial markets
There are many ways to classify markets
For example:
Money vs capital marketsPrimary vs Secondary
Organized vs. Over-the-Counter
Equity vs Debt
Spot vs Future
Financial market themes
1. Risk and Return tradeoff
- Most investors are risk averse, thus to buy risky investments, must be coerced with higher returns
2. Market efficiency3. Market Regulation may be a necessary evil
Forms of market efficiency
- based on the idea that it is extremely difficult (nearly impossible?) to CONSISTENTLY beat the market
- Market price is on average correct
- Competition for higher returns and less risk will drive markets to efficient price
- Weak
- Semistrong form
- Strong form
Regulations may be government imposed or self-imposed by the market and/or participants.Many of the regulations come about from abuses within the financial system. For example, to protect investors from fraudulent firm offerings and other "unfair" practices, the SEC was formed.
Attempt to level the playing field, but with every regulation comes a change in behavior. An example that we should be familiar with from Money and Banking is that of bank regulations harming the banking industry.
Usually the role of government is to provide a clearinghouse of impartial information or to punish after the fact
Regulations also attempt to limit risks (example circuit breakers that limit the amount an asset (often thought of in terms of a stock exchange).
4. Globalization
Have seen a tremendous trend towards globalization of all financial markets. This trend has come in part due to technology but also in part because of deregulation.
5. Role of Financial Intermediaries
To lower transaction costsExample do not need to travel door to door to find a place to invest money.Types of Financial intermediariesLower information search costs
Depository Institutions
- Commercial Banks
- Saving Institutions
- Credit Unions
- They offer deposit accounts that can accommodate the amount and liquidity desires of SSUs
- Repackage funds and make loans to DSUs
Finance Companies
Mutual funds-hugely successful
Security Firms-Investment bankers, brokers, and dealers
Pension Funds
Insurance Companies
Relative sizes
See exhibit 1.3
More competition
Deregulation has increased competition
As the financial world has become more international, so too have the intermediaries. Example most of the major Investment bankers in Europe are US based.
As the world becomes more tightly aligned, events in one nation have
repercussions across borders and across markets. For example, the Stock
Market Crash of 1987 hurt bond markets as well. The Asian crisis on 1998
hurt stock markets worldwide.
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