Financial Economics Chapter One

Chapter One
Financial Economics
Nature and role of Financial system

in economic development
1-1
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Why Study Money, Banking, and
Financial Markets
• To examine how financial markets such as
bond, stock and foreign exchange markets
work
• To examine how financial institutions such
as banks and insurance companies work
• To examine the role of money in the
economy
1-2
Financial Markets
• Financial Markets: Markets in which funds

are transferred from people who have an
excess of available funds to people who
have a shortage of funds.
1-3
The Bond Market and Interest
Rates
• A security (financial instrument) is a
claim on the issuer’s future income or
assets.
• A bond is a debt security that promises to
make payments periodically for a specified
period of time.
• An interest rate is the cost of borrowing
or the price paid for the rental of funds.
1-4
The Stock Market
• Common stock represents a share of

ownership in a corporation
• A share of stock is a claim on the earnings
and assets of the corporation
1-5
Financial Institutions and
Banking
• Financial Intermediaries: institutions
that borrow funds from people who have
saved and make loans to other people:
– Banks: accept deposits and make loans
– Other Financial Institutions: insurance
companies, finance companies, pension funds,
mutual funds and investment banks
• Financial Innovation: in particular, the
advent of the information age and e-
finance
1-6
Meaning of Money
• What is Money?
• Money (or the “money supply”): anything
that is generally accepted in payment for
goods or services or in the repayment of
debts.
3-7
Functions of Money
• Medium of Exchange:
– Eliminates the trouble of finding a double
coincidence of needs (reduces transaction costs)
– Promotes specialization
• A medium of exchange must
– be easily standardized
– be widely accepted
– be divisible
– be easy to carry
– not deteriorate quickly
3-8
Functions of Money
• Unit of Account:
– used to measure value in the economy
– reduces transaction costs
• Store of Value:
– used to save purchasing power over time.
– other assets also serve this function
– Money is the most liquid of all assets but loses
value during inflation
3-9
Evolution of the Payments
System
• Commodity Money: valuable, easily

standardized and divisible commodities (e.g.
precious metals, cigarettes).
• Fiat Money: paper money decreed by
governments as legal tender.
3-10
Evolution of the Payments
System
• Checks: an instruction to your bank to

transfer money from your account
• Electronic Payment (e.g. online bill pay).
• E-Money (electronic money):
– Debit card
– Stored-value card (smart card)
– E-cash
3-11
Financial Crises
• Financial crises : are major disruptions in

financial markets that are characterized by
sharp declines in asset prices and the
failures of many financial and nonfinancial
firms.
1-12
Money and Business Cycles
• Evidence suggests that money plays an

important role in generating business
cycles
• Recessions (unemployment) and
expansions affect all of us
• Monetary Theory ties changes in the money
supply to changes in aggregate economic
activity and the price level
1-13
Money and Inflation
• The aggregate price level is the average

price of goods and services in an economy
• A continual rise in the price level (inflation)
affects all economic players
• Data shows a connection between the
money supply and the price level
1-14
One Hundred Trillion Dollars
100,000,000,000,000
1-15
1-16
Money and Interest Rates
• Interest rates are the price of money

• Prior to 1980, the rate of money growth and
the interest rate on long-term Treasury
bonds were closely tied
• Since then, the relationship is less clear but
the rate of money growth is still an
important determinant of interest rates
1-17
Monetary and Fiscal Policy
• Monetary policy is the management of the

money supply and interest rates
– Conducted in the Ethiopia by the national bank of
Ethiopia
• Fiscal policy deals with government spending
and taxation
– Budget deficit is the excess of expenditures
over revenues for a particular year
– Budget surplus is the excess of revenues
over expenditures for a particular year
– Any deficit must be financed by borrowing
1-18
The Foreign Exchange
Market
• The foreign exchange market is where
funds are converted from one currency into
another
• The foreign exchange rate is the price of
one currency in terms of another currency
• The foreign exchange market determines
the foreign exchange rate
1-19
The Lowest World Currencies in 2021
1. Venezuelan Sovereign Bolívar
1 USD = 4,000,815 VES (US dollar to Venezuelan Sovereign Bolívar).

1 EUR = 4,745,513 VES (Euro to Venezuelan Sovereign Bolívar).
1-20
Cont.
2. Iranian Rial
•1 USD = 278,800 IRR (US dollar to Iranian rial – black market rate).

•1 USD = 42,025 IRR (US dollar to Iranian rial – official rate).
1-21
Highest currencies in the world in 2021
1. Kuwaiti Dinar
• 1 KWD = 3.30 USD

• 1 KWD = 2.73 EUR
1-22
Cont.
• 2. Bahraini Dinar
1 BHD = 2.66 USD

1 BHD = 2.20 EUR
1-23
International Finance
• Financial markets have become increasingly

integrated throughout the world.
• The international financial system has
tremendous impact on domestic economies:
– How a country’s choice of exchange rate policy
affect its monetary policy?
– How capital controls impact domestic financial
systems and therefore the performance of the
economy?
– What should be the role of international financial
institutions like the IMF?
1-24
Aggregate Output
and Aggregate Income
• Aggregate Output
– Gross Domestic Product (GDP) = market
value of all final goods and services produced in
the domestic economy during a particular year
• Aggregate Income
– Total income of the factors of production (land,
capital, labor) during a particular year
• Distinction Between Nominal and Real
– Nominal = values measured using current prices
– Real = quantities measured with constant prices
1-25
Aggregate Price Level
Aggregate price level is a measure of average prices

in the economy
One measure of the price level is the GDP Deflator
nominal GDP
GDP Deflator =
real GDP
Another measure is the Consumer Price Index (CPI)
The CPI is a measure of the average change over time in the
prices paid by urban consumers for a market basket of goods
and services
1-26
Growth Rates and the Inflation
Rate
A growth rate is the percentage change in a variable
x t - x t-1
Growth rate = (100)
x t-1
$9.5 trillion - $9 trillion
GDP growth rate = (100) = 5.6%
$9 trillion
113 - 111
Inflation rate = (100) = 1.8%
111
1-27
One Hundred Trillion Dollars
100,000,000,000,000
1-28
1-29
The Lowest World Currencies in 2021
1. Venezuelan Sovereign Bolívar
1 USD = 4,000,815 VES (US dollar to Venezuelan Sovereign Bolívar).

1 EUR = 4,745,513 VES (Euro to Venezuelan Sovereign Bolívar).
1-30
An Overview
of the Financial System
1-31
Function of Financial Markets
• Financial Markets : Perform the essential

function of channeling funds from
economic players that have saved surplus
funds to those that have a shortage of
funds.
• Direct finance: borrowers borrow funds
directly from lenders in financial markets
by selling them securities.
2-32
Function of Financial Markets
• Financial Markets : Promotes economic

efficiency by producing an efficient
allocation of capital, which increases
production
• Directly improve the well-being of
consumers by allowing them to time
purchases better
2-33
FIGURE 1 Flows of Funds Through the Financial
System
2-34
Structure of Financial
Markets
• Debt and Equity Markets
– Debt instruments (maturity)
– Equities (dividends)
• Primary and Secondary Markets

– Investment Banks underwrite securities in
primary markets
– Brokers and dealers work in secondary
markets
2-35
Difference Between Equity Market
and Debt Market
2-36
Cont.
• Exchanges and Over-the-Counter (OTC)

Markets
– Exchanges: is a market place where
securities, commodities, and other financial
instruments are traded.
– OTC Markets (Over-the-Counter): is
a decentralized market in which market
participants trade stock, commodities, currencies,
or other instruments directly between two parties
and without central exchange or broker.
2-37
Money and Capital Markets
– Money markets deal in short-term debt

instruments
The principal money market instrument
includes
 Bill of exchange or commercial bills
 Treasury bill (T-Bills)
 Commercial Papers (CPs)
 Certificates of Deposits (CD’s)
 Banker’s Acceptance (BA)
 Repurchasing Agreements
2-38
Cont.
– Capital markets deal in longer-term debt

and equity instruments.
The principal capital market instrument
includes
 Debt instruments
 Equities (common stock)
 Preference Shares
 Derivatives
2-39
Internationalization of
Financial Markets (Glossary)
• Foreign Bonds: sold in a foreign country and
denominated in that country’s currency. Or it is a
bond issued in a domestic market by a foreign
entity in the domestic market’s currency as a
means of raising capital.
• Eurobond: bond denominated in a currency other
than that of the country in which it is sold
• Eurocurrencies: foreign currencies deposited in
banks outside the home country
– Eurodollars: U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
2-40
Function of Financial
Intermediaries: Indirect Finance
• Lower transaction costs (time and money
spent in carrying out financial transactions).
– Economies of scale
– Liquidity services
• Reduce the exposure of investors to risk

– Risk Sharing (Asset Transformation)
– Diversification
E.g.: the two fundamental principles of Islamic banking are
the share of profit and loss, and the prohibition of the
collection and payments of interest by lenders and
investors.
2-41
Cont.
• Deal with asymmetric information problems

– (before the transaction) Adverse Selection:
try to avoid selecting the risky borrower.
• Gather information about potential
borrower.
– (after the transaction) Moral Hazard: ensure
borrower will not engage in activities that will
prevent him/her to repay the loan.
• Sign a contract with restrictive covenants.
2-42
Cont.
• Conclusion:
– Financial intermediaries allow “small”
savers and borrowers to benefit from the
existence of financial markets.
2-43
Regulation of the Financial
System
• To ensure the soundness of financial
intermediaries:
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control
holding of risky assets).
– Deposit Insurance or Reserve Requirment
(avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
• Restrictions on Interest Rates
2-44
Glossary
Federal (Fed) Funds: These instruments
are typically overnight loans between banks
of their deposits at the Federal Reserve.
•Federal funds rate: The interest rate on
overnight loans of deposits at the Federal
Reserve.
•Repurchase agreement (repo): An
arrangement whereby the Fed, or another
party, purchases securities with the
understanding that the seller will repurchase
them in a short period of time, usually less
than a week.
2-45
Glossary
• Risk sharing: The process of creating and
selling assets with risk characteristics
that people are comfortable with and then
using the funds acquired by selling these
assets to purchase other assets that may
have far more risk.
• The process of risk sharing is also
sometimes referred to as asset
transformation, because in a sense, risky
assets are turned into safer assets for
investors.
2-46

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Chapter One

Nature and role of Financial system

• Financial Markets: Markets in which funds

• Common stock represents a share of

• Commodity Money: valuable, easily

• Checks: an instruction to your bank to

• Financial crises : are major disruptions in

• Evidence suggests that money plays an

• The aggregate price level is the average

• Interest rates are the price of money

• Monetary policy is the management of the

1. Venezuelan Sovereign Bolívar

1 USD = 4,000,815 VES (US dollar to Venezuelan Sovereign Bolívar).

•1 USD = 278,800 IRR (US dollar to Iranian rial – black market rate).

• 1 KWD = 3.30 USD

1 BHD = 2.66 USD

• Financial markets have become increasingly

Aggregate price level is a measure of average prices

1. Venezuelan Sovereign Bolívar

1 USD = 4,000,815 VES (US dollar to Venezuelan Sovereign Bolívar).

• Financial Markets : Perform the essential

• Financial Markets : Promotes economic

• Primary and Secondary Markets

• Exchanges and Over-the-Counter (OTC)

– Money markets deal in short-term debt

– Capital markets deal in longer-term debt

• Reduce the exposure of investors to risk

• Deal with asymmetric information problems

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