Chapter 2 Financial Markets and Financial Institutions
1. Financial system
The financial system includes financial markets , intermediaries , service firms , and other institutions used to carry out the financial decisions of households, businesses, and governments
1. Financial markets
Financial market: the sum of the supply and demand relationship and its mechanism formed with financial assets as trading objects
- Financial markets can be divided into those with a specific location and those without a specific location .
Some financial markets have specific geographic locations, such as stock exchanges.
Some financial markets often do not have a specific location, such as the over-the-counter trading market of stocks, securities and foreign exchange, also known as the over-the-counter market, whose essence is to connect the computers and telecommunication systems of securities firms and other customers around the world.
2. According to the classification of transaction period, the financial market can be divided into money market and capital market .
Money market: A short-term financial market in which financial assets with a maturity of one year or less are the subject of transactions.
Capital market: financial asset trading market with a maturity of more than one year
2. Financial Intermediation
Financial intermediaries: those whose primary business is the provision of financial services and products , including banks, investment firms, and insurance companies
Their products include checking accounts, business loans, mortgages, mutual funds, and a host of insurance contracts
2. Fund flow
The figure shows the relationship between different participants in the financial system. Funds flow from entities with surpluses through the financial system to entities with deficits. Part of the funds from the surplus sector flows to the deficit sector through financial intermediaries such as banks, and part of the funds directly flows to the deficit sector through the financial market.
Arrows pointing from financial intermediaries to financial markets indicate that financial intermediaries channel funds to financial markets .
Arrows pointing from financial markets to financial intermediaries indicate that some financial intermediaries also receive funds from financial markets .
3. Functions of the financial system
Starting from the most basic function of allocating funny resources, the six basic core functions performed by the financial system are listed :
(1) Provide a way to transfer economic resources across time, borders and industries;
(2) Provide ways to manage risk;
(3) Provide clearing payment and settlement payment methods for facilitating transactions;
(4) Provide mechanisms for pooling resources and subdividing ownership among different enterprises;
(5) Provide price information to help coordinate decentralized decision-making in different economic sectors;
(6) Provide ways to solve incentive problems that arise when one party to a transaction has information that the other party does not, or one party acts as an agent for the other.
4. Financial innovation and the "invisible hand" The
basic economic driving force behind financial innovation is competition.
Reasons for financial innovation include:
(1) Technological progress;
(2) Rapid development and fierce competition in the financial industry;
(3) Increased risk in the economic environment;
(4) Consumer demand;
(5) Changes in the financial management environment.
V. Financial Market
The basic types of financial assets are debt, equity and derivatives .
Financial markets are divided by the maturity of the claims being traded, the short-term debt market (less than 1 year) is called the money market ;
The long-term debt market and the equity securities market are called capital markets .
1. Debt instruments (bonds)
A bond is a credit-debt contract for investors to provide funds to the government, company or financial institution. Taking the most common interest-paying bond as an example, the contract specifies the issuer's commitment to pay interest on a specified date and repay the principal on the due date.
Assets traded in the debt market include corporate bonds, government bonds, residential and commercial mortgages, and consumer loans, among others.
Because debt instruments promise to pay a fixed amount of cash in the future, they are also known as fixed-income securities.
2. Stocks
A stock is an equity contract for investors to provide capital to a company and is a certificate of ownership for the company .
In terms of profit and asset distribution, shareholders' rights and interests are manifested as claiming the residual income after the company repays the debt with interest , that is, the residual claiming right. In the case of company bankruptcy, shareholders usually get nothing, but they only bear limited liability, that is, when the company's assets are not enough to pay off all debts, shareholders' personal property is not pursued. At the same time, shareholders have the right to vote to decide the company's major business decisions, such as the selection of managers, the determination of major investment projects, mergers and anti-mergers, etc.
Stock is divided into common stock and preferred stock .Common stock is a stock contract that participates in the company's profit and asset distribution after the preferred stock claim is satisfied . It represents the final residual claim. Its dividend income is not capped or guaranteed, and the amount of dividends at each stage is also uncertain. Ordinary shareholders generally have the right to attend shareholders' meetings, vote, vote, and be elected, and they exercise residual control by voting.
Preferred stock is stock that has priority over common stock in terms of residual claims by receiving fixed dividends and receiving dividends ahead of common stock. However, preferred shares are inferior to ordinary shares in terms of residual control rights. Preferred shareholders usually have no voting rights, and only have temporary voting rights in some special cases.
3. Derivatives
A derivative is a financial instrument whose value is determined by the price of one or several assets such as capital securities, fixed income securities, foreign exchange or commodities. Their primary function is to manage risk exposures associated with underlying assets.
The most common derivatives are options and forward contracts .
①A call option gives its holder the right to buy a certain asset at a certain price on or before the expiration date; a sell option gives its holder the right to sell a certain asset at a certain price on or before the expiration date.
②The forward contract requires that one party to the contract buy and the other party sell an asset at a certain time and at a certain price. Contracts enable buyers and sellers of assets to eliminate uncertainty about future asset transaction prices.
6. Ratios in financial markets
1. Interest rates
The interest rate refers to the ratio of the interest amount to the principal within a certain period of time. The interest rate is the promised rate of return, and there are as many different interest rates as there are different kinds of loans.
Loan and fixed income security rates depend on a variety of factors, the three most important of which are unit of account, maturity, and default risk .
(1) Accounting unit
The accounting unit is the unit of the payment instrument. The unit of account is usually a currency, such as the US dollar, Japanese yen, etc. Sometimes the unit of account is a commodity such as gold, silver, or a standard basket of goods and services. Interest rates vary according to the unit of account.
Bonds offer a risk-free rate of return in the home currency, but the rate of return in other currencies is uncertain because it depends on the exchange rate between the different currencies when future payments are made.
(2) Maturity
The maturity of a fixed-income security is the length of time until all borrowings are paid off. Interest rates on short-term securities may be higher, lower, or equal to those on longer-term securities. A yield curve is a curve that describes the relationship between the interest rate (yield) of a fixed-income security and the maturity of the fixed-income security.
(3) Default risk
Default risk is the possibility that the principal or part of the interest of a fixed-income security cannot be fully repaid. The risk of default is high, and the issuer must promise a higher interest rate in order for investors to buy the security.
All else being equal, the greater the risk of default on a fixed-income security, the higher the interest rate. Typically, Treasuries have the lowest interest rates, high-quality corporate bonds have moderate interest rates, and lower-quality corporate bonds have the highest interest rates.
2. Return on risky assets
The benefits of maintaining wealth in the form of stocks come from two channels:
The first channel is cash dividends paid to shareholders by companies that issue shares .
The second channel is the increase (or decrease) in the market price of the stock during the period the stock is held, which is a capital gain or loss .
The holding period for measuring stock returns can be as short as 1 day or as long as 10 years.
The rate of return r on holding the stock for 1 year is:
or:
3. Market index and market indexation
Indexing is an investment method that locks in the investment income of a specific stock market index .
Indexing is based on the simple fact that the aggregate of all investors cannot outperform the stock market as a whole. However, there are some actively managed funds that outperform index funds.
When using an indexing approach, investors attempt to replicate the investment results of a target index by holding all of the securities in the index or a representative sample in a large index, without employing active money management or betting on individual stocks or industries in hopes of outperforming the index. Thus, indexing is a passive investment approach that emphasizes broad diversification and low frequency portfolio trading behavior.
Cost advantage of indexed funds: indexed funds only need to pay the least consulting fees, operating expenses are kept at the lowest possible level, and transaction costs for asset portfolios are also the lowest.
Over the long run, broad stock index funds outperform the average general capital fund.
4. Inflation and real interest rates
The nominal interest rate on a bond is the promised money back for each unit of currency lent.
The real interest rate is the interest rate adjusted to the nominal interest rate according to changes in the purchasing power of money.
The general formula for real and nominal interest rates and inflation is:
or equivalently:
Note that nominally risk-free fixed income securities are not actually risk-free.
In order to guard against inflation risks, real goods and services can be used as the interest rate unit.
5. Interest rate equalization
Competition in financial markets ensures that interest rates on similar assets are the same.
If other institutions have the ability to borrow at different rates under the same conditions (e.g., maturity, risk of default), they can engage in interest rate arbitrage: borrow at a low rate and lend at a high rate. The existence of arbitrage behavior leads to the equalization of interest rates.
6. Basic Determinants of Yield
In a market economy, there are four main factors that determine the rate of return:
(1) Expected production capacity of capital goods
The higher the expected rate of return on capital, the higher the level of interest rates in the economy.
The productive capacity of capital can be expressed as the rate of return on capital. Return on capital is the source of dividends to stockholders and interest rates to holders of bonds and other financial instruments issued by the company. These securities represent claims on returns on capital. The expected rate of return on capital will vary over time and place, depending on the state of technology, the endowment of factors of production such as natural resources and labor, and the demand for the goods and services produced by capital.
(2) The degree of uncertainty in the production capacity of capital goods
Returns on capital are often uncertain for a number of reasons. Capital securities represent claims on profits earned on capital goods. The higher the degree of uncertainty in the production capacity of capital goods, the higher the risk-added value of capital securities.
(3) People's time preference
People's preference for immediate consumption and future consumption is also an important factor in determining the rate of return. The stronger people's preference for current consumption relative to future consumption, the higher the interest rate in the economy.
(4) Degree of risk aversion
Risk aversion refers to the amount people are willing to give up in order to reduce their risk exposure. The higher people's risk aversion, the higher the additional risk required, and the lower the risk-free rate will be.
7. Financial intermediaries
The main business of financial intermediaries is to provide customers with financial products and services that cannot be obtained through direct transactions in the securities market . The main intermediaries include banks, investment companies and insurance companies.
1. Bank
Banks are the largest (in terms of assets) and oldest of all financial intermediaries today, performing two functions: taking deposits and making loans . In the United States, they are called commercial banks.
In some countries, banks are effectively full-fledged financial intermediaries, providing not only transaction services and loans to customers, but also mutual fund services and various types of insurance.
2. Other deposit savings institutions
"Depository thrift institutions" or "thrift institutions" are savings banks, savings and loan associations (S&Ls), credit unions, etc. In the United States, they compete with commercial banks for both savings and credit, and specialize in home mortgages and consumer loans . In other countries, there are also various professional savings institutions similar to the thrift institutions and credit unions in the United States.
3. Insurance company
An insurance company is a financial intermediary organization that bears risks and will compensate or pay the policyholder or the insured according to the contract when the risk occurs .
The main types of insurance are property and accident insurance, health and pension insurance, and life insurance.
An insurance policy is an asset of the home or business that buys it and a liability of the insurance company that sells it. The fee paid to an insurance company to obtain coverage is called a premium.
4. Pensions and retirement funds
The function of the pension plan is to combine the social security pension and private savings to rearrange the individual's pre-retirement income.
Pension schemes can be sponsored by employers, unions or individuals.
Pension plans are divided into two types: defined contribution pension plans and defined benefit pension plans.
5. Mutual Funds
Mutual funds are a collective investment method of benefit sharing and risk sharing, that is, through the issuance of fund units, investors' funds are concentrated, managed by fund custodians, managed and used by fund managers, and engaged in financial instruments such as stocks, bonds, foreign exchange, and currency investments to obtain investment income and capital appreciation.
Investment fund is an indirect financial investment institution or tool, and its mechanism features are: investment portfolio, risk diversification, expert financial management, and economies of scale.
Mutual funds are divided into open-end and closed-end.
Open-end mutual funds can redeem or issue fund shares at any time at net asset value (NAV), which is the market price of all securities held divided by issued fund shares. The circulating shares of open-end funds change daily as investors purchase new fund shares or redeem old fund shares.
Closed-end mutual funds do not redeem or issue fund shares at NAV. Shares in closed-end funds trade through brokers like other common shares, so their price is different from net asset value.
6. Investment Banking
The main function of investment banks is to help corporations, governments, and other entities raise funds through the issuance of securities to finance their operations .
Investment banking services include securities issuance, securities trading, corporate mergers and acquisitions, fund management, financial consulting, venture capital, project financing, and financial engineering services.
7. Venture capital companies
Venture capital firms primarily provide funding and advice to start-up companies , helping management teams grow the company to the point where it can "go public," that is, sell shares to the investing public.
Once this goal is reached, the typical venture capital firm will sell its interest in the company and move on to the next new company.
8. Asset management companies
Asset management firms, also known as investment management firms , advise individuals, corporations and governments and manage mutual funds, pension funds and other portfolios.
9. Information service enterprises
Securities industry rating agencies include Moody's and Standard & Poor's.
Well-known institutions that provide financial data include Bloomberg and Reuters.
8. Financial infrastructure and financial regulation
Financial infrastructure includes legal and accounting procedures, trading institutions and clearing facilities, and the body of regulations that regulate relationships among users of the financial system.
Securities trading regulations are often established by organized exchanges and sometimes require legal sanction. These regulations standardize transaction procedures so that transaction costs are kept to a minimum.
To be useful, financial information must be presented in a standard format. The accounting system is probably the most important part of the financial system's infrastructure.
9. Government and quasi-government organizations
1. Central Bank
The main function of a central bank is to contribute to the achievement of public policy objectives by influencing certain financial market parameters, such as the supply of its own currency. In some countries, the central bank is directly controlled by the executive branch of the government; in others, it is more independent.
The central bank is usually at the heart of the payment system, supplying the national currency and operating the bank's clearing system.
The central bank's main objective is to maintain price stability, in addition to promoting full employment and economic growth.
2. Intermediary of special functions
The function of government agencies that provide loans or loan guarantees is to provide financing facilities or provide guarantees for various bonds. The main function of bank deposit insurance institutions is to promote economic stability by preventing partial or total collapse of the financial system.
3. Regional and global organizations
The purpose of the Bank for International Settlements (BIS) is to promote harmonization of banking regulations .
The main functions of the International Monetary Fund (IMF) : Supervise the economic and financial conditions of member countries, provide technical assistance, establish international trade and financing guidelines, provide a forum for international consultations, and provide resources for individual member countries to correct the "imbalance" of other countries' balance of payments .
The main function of the International Bank for Reconstruction and Development (World Bank) : to provide financing for investment projects in developing countries .