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Introduction to Monetary Economics

Introduction to Monetary Economics. Frederic University 2014. Financial System. The financial system encompasses markets, institutions, laws and regulations through which allocation of scarce resources is accomplished within the economy. The financial system consists of five parts:

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Introduction to Monetary Economics

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  1. Introduction to Monetary Economics Frederic University 2014

  2. Financial System The financial system encompasses markets, institutions, laws and regulations through which allocation of scarce resources is accomplished within the economy. The financial system consists of five parts: • money (to pay purchases and store wealth); • financial instruments (to transfer wealth from savers to investors and to transfer risk to those best equipped to bear it); • financial markets (buy and sell financial instruments); • financial institutions (provide access to financial markets); • central bank (monitor financial institutions and stabilize the economy)

  3. Decision makers • People who need funds • borrowers/issuers/sellers • People who have funds to give • lenders/savers/buyers

  4. Financial Instruments securities, financial assets definition = written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions a security is an asset for the buyer/lender, but a liability for the issuer/borrower/seller

  5. examples • bank loans • stocks • bonds • home mortgages • asset-backed securities • option and futures contracts • insurance policies

  6. example shares of stock in ABC ltd.: • shares of ownership in ABC • a claim on the earnings/assets of ABC • a liability for ABC an asset for me

  7. my mortgage: • I am the borrower (liability) • the bank is the buyer/holder (asset) • the bank has a claim on my house

  8. uses of financial instruments • means of payment • but much less liquid than money • store of value • better than money over time, but also greater risk • transfer of risk • buyer transfers risk to seller • e.g. insurance policies, futures contract

  9. Valuing financial instruments • sizing, timing & certainty of promised cash flows • Size: how much is promised? • the larger the cash flows, the greater the value • Timing: when is it promised? • the sooner the cash flows are received, the greater the value

  10. Attributes of financial assets • Certainty: how likely is it that payments will be made? • the likelier the payments the greater the value • Under what conditions? • e.g. insurance, derivatives • payments when we need them the most are more valuable

  11. Financial Markets • Financial markets are all markets, where buyers and sellers exchange financial assets. These assets present money saved and invested for profit. • The stock exchange is an organized market for financial assets.

  12. Functions of Financial Markets to provide: • liquidity • information through prices • risk-sharing among buyers/sellers

  13. Direct finance • Borrowers sell securities directly to lenders • e.g. corporate and Government bonds (Treasury bills in the US)

  14. Indirect Finance • Borrowers and lenders meet through a financial intermediary (e.g. bank) • Loan is a liability for borrower and asset for a bank

  15. Primary vs. Secondary Markets • primary market • newly issued securities -- investment banking • secondary market • brokers match buyers and sellers • dealers act as buyers and sellers -- “market-makers”

  16. Debt vs. Equity Markets • debt security • cash flows are fixed • bonds, loans • equity security • cash flow variable, residual • common stock

  17. Exchanges vs. OTC Markets • exchange • buying & selling of securities in physical location • CSE (Cyprus Stock Exchange) • OTC (over-the-counter) • dealers in many locations buy & sell securities

  18. Financial Institutions • Financial institutions are all firms with money as a major asset in their balance sheet. These are: • Banking institutions: • The Central bank • Commercial Banks • Nonbanking: • Insurance funds • Pension funds • Investment funds • Mortgage funds • Brokering houses • Mutual funds

  19. Financial Institutions financial intermediaries Why have them? • Transactions costs • search costs to find borrower & lender • contract costs • economies of scale

  20. Risk sharing • intermediaries are experts at bearing risk • Asset transformation • short-term to long-term • illiquid to liquid

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