Introduction to Money and the Financial System

1. Introduction to Money and the Financial System Chapters 1-3

2. Conduct in the Classroom Classrooms are for learning. Teachers and students must work together so that the classroom is a good place to learn. You can help by following a few simple rules. These rules are mostly just common sense and common courtesy. By following them, you show respect to your fellow students as well as your teachers. Please try to get to class on time. When you come in late, you disrupt your class. As a general rule, if you are more than 10 minutes late, you should not enter the classroom. If you arrive late, but need to see the instructor or pick up lecture notes, please return at the end of the class period.

3. Conduct in the Classroom You should not do things during class that disrupt the class or distract your classmates – such as talking while the instructor is lecturing. If you have a pager or cellular phone, turn if off when you are in class. Once in class, you should stay until the class is over. If you know you have to leave early, ask the instructor’s permission before the class starts. And please pay attention to the signs that tell you not to eat or drink in the classrooms.

4. Conduct in the Classroom Assignments, tests and examinations are an integral part of the learning experience. Students who cheat disrupt this process. The instructor has a responsibility to make cheating difficult, but cheating is wrong even when you can get away with it. Don’t give in to the temptation to cheat, and be critical of those who do. Your instructor has the authority to make other rules that he or she feels are necessary to help you learn. For example, some instructors may require that you attend a minimum number or percentage of their classes. If you do not follow these rules, it may affect your grade.

5. Conduct in the Classroom You are investing several years of your life in your university education. Learning to accept responsibility is an important part of that education. The classroom is a good place to begin showing that you are ready for the responsibilities of being an adult.

6. Intertemporal Allocation of Goods • People may want to consume a value of goods different from the one they produce at a particular time. • Economic system must transfer goods from people who want to shift the value of their production from the present to the future (savers) to those who want to shift value from the future toward today (borrowers). • Matching of savers and borrowers is done by financial markets and financial intermediaries.

8. Typology of Financial Markets:Primary vs. Secondary Markets • Primary Markets: Financial markets in which newly issued debt or equity claims are sold to initial buyers by private borrowers or governments • Secondary Markets: Financial markets in which claims that have already been issued are sold by one investor to another.

9. Secondary Markets Larger than Primary Markets

10. Typology of Markets: Debt & Equity • Debt: A claim that requires a borrower to repay the amount borrowed (the principal) plus a rental fee (interest). • Short-term debt instruments with maturity of less than 1 year are bills. • Intermediate-term debt instruments with maturity of between 1 and 10 years are notes. • Long-term debt instruments with maturity longer than 10 years are bonds. • Equity: A claim to a share in the profits and assets of a firm [Stocks].

11. Typology of Markets (Maturity): Money and Capital • Money Markets: Debt instruments with an original maturity of less than 1 year are said to be sold in money markets. • Capital Markets: Debt instruments with an original maturity of more than 1 year & equity are said to be sold in capital markets.

12. Money Market Instruments • Short-term Government Bills • US: Treasury Bills • HK: Exchange Fund Bills • Commercial Paper: Short-run private sector debt. • Banker’s Acceptances: International Trade Credit • Repurchase Agreements: Short-term Collateralized Loans. • Inter-bank Lending • US: Fed Funds • HK: HIBOR (Hong Kong Interbank Offered Rate) • International: LIBOR • Negotiable Certificates of Deposit (Fixed Maturity Deposit Instrument)

13. Capital Market Instruments • Government Debt • US: Treasury Notes & Bonds • HK: Exchange Fund Notes, Treasury Bonds • Corporate Debt • Stocks • Securitized Mortgages • US: FNMA, GNMA, FHLMC • HK: HKMC

14. Hong Kong Debt Markets Dominated by Banks

15. HK Dollar Bond Market by Borrower

16. Foreign Currency Instruments play a significant part in HK Financial markets.

17. Market Capitalization by Sector: HK 2004

18. Trading Places: Auction vs. OTC • Auction Markets – Large number of traders engage in competitive bidding at centralized location. • HK Clearing Exchanges Ltd runs all auction markets in HK (HKSE & HKFE). • Over the Counter – Markets for broker-dealers connected electronically without centralized trading place. • OTC markets main site for trading debt and foreign exchange. • In US, some stocks (for small or new firms) are traded on the OTC market, not in HK.

19. Settlement: Cash and Derivative Markets • Cash Markets – Claims are traded with immediate (within several days) settlement. • Hong Kong Stock Exchange is a cash market. • Derivative Markets – Claims are traded with settlement promised at some future date. • Futures and options are traded on Hong Kong Futures Exchange • Futures and Forwards require settlement at a fixed future date • Options confer one party an option to engage in transaction at a future date.

20. Asset Holding/Portfolio Choice • To think about the social contribution of secondary markets it is useful to think about the various determinants of portfolio allocation or why agents choose the assets that they do. • One key determinant of the attractiveness of an asset is its expected return (i.e. the expected income generated by an asset relative to its initial price). • But other factors also determine the demand for an asset.

21. Risk Sensitivity • Generally, we assume savers are risk averse. Given a choice between two assets with the same average return, savers will prefer the one with the lowest level of unpredictable volatility. • Savers would prefer an asset that always pays $1.10 for each $1invested to one which pays nothing, 50% of the time and $2.20, 50% of the time. • In equilibrium, risky assets must pay higher returns.

22. Diversification • By spreading their wealth into assets whose returns are uncorrelated with each other, the overall risk of a portfolio can be minimized. • Consider two portfolios that cost $1 Million. • Portfolio A is a million shares (each costing $1) which will pay $2.2 million if a coin is flipped and comes up heads and 0 if tails. • Portfolio B is a million shares in a million different companies that will each flip a coin and pay $2.2 if heads and 0 if tails. • Both portfolios have equal expected returns and consist of assets with identical statistical properties but A is risky and B has no risk.

23. Diversification • In real world, portfolios cannot be perfectly diversified because borrowers do not earn money and pay returns by flipping coins. • Borrowers typically pay returns by earning money producing and selling goods, but since economies move up and down jointly through business cycles, returns have a common component called systemic risk. • Savers can use diversification to eliminate idiosyncratic risk. • In equilibrium, assets with more systemic risk must pay higher returns.

24. Liquidity • Liquidity is the cost, in terms of time and money of converting an asset into cash at any time. • Since no one is ever certain about their future cash needs for transactions, people prefer liquid assets. • Liquid assets are thought to be assets for which there are thick markets – I.e assets with many buyers or sellers. • Liquidity may be of different value to different investors. In particular, wealthy people are less likely to value liquidity.

25. Information • To correctly select their portfolio, savers must have information about the assets they buy as well as the overall financial markets. • Investors will prefer assets with low information costs.

26. Secondary Markets: Services of the Financial System • Risk Sharing – Savers can reduce the risk in their assets by diversifying their portfolio [exchange some assets for others]. • Liquidity – Agents may face unexpected cash needs. Secondary markets allow investors to raise this cash with little cost. • Information – Savers and borrowers can get information about the value of assets, the cost of capital or expected returns cheaply by observing financial markets.

27. Financial Intermediaries • Financial intermediaries also provide important services to matching savers and borrowers. Types of Financial intermediaries include: • Securities Market Institutions • Investment Institutions • Contractual Savings • Depositary Institutions • Government Institutions

28. Securities Market Institutions • Investment Banks (Merchant Banks) perform underwriting services which help borrowers with the tasks and risks of bringing securities to primary markets. • Brokers match buyers and sellers in secondary markets and dealers provide liquidity to secondary markets by trading on their own account.

29. Investment Institutions • Mutual Funds (Unit Trusts) provide liquidity, diversification and information services by allowing investors to buy a small share of a larger portfolio. Some are index funds which buy a portfolio which matches the broad markets. • Hedge Funds are similar but limited to wealthy investors and may engage in exotic investment strategies. • Finance companies raise money in capital markets and make small individual loans to borrowers.

30. Contractual Savings • Insurance companies diversify idionsyncratic non-financial risk. • Property and Casualty • Life Insurance • Pension Funds take a certain contribution from peoples wages and invest them like mutual funds for retirement. • In HK, workers without retirement plans must participate in Mandatory Provident Fund (a forced saving plan).

31. Insurance in HK

32. Mandatory Provident Funds • Since December 2000, employees without a retirement plan must enroll in an investment fund. • Both the employer and employee are required to put 5% of wages into the fund. • Funds are invested in a set of essentially mutual funds chosen by the employer and employee. Savings can be shifted across funds at some costs.

33. MPF Coverage

34. Depository Institutions • Banks. More later.

35. Government Financial Institutions • Governments throughout the world set up financial institutions which fill “gaps” in financial system. • In USA and HK, institutions exist which securitize mortgages which means that they issue bonds and use proceeds to buy bundles of mortgages from banks, using the payments of homeowners to pay-off bonds. • In Japan, Post Office provides risk-free bank deposits (which is used to by government bonds). • In Singapore, government collects proceeds of mandatory savings funds and puts them into government controlled investment fund, Temansek.

36. Regulation • Governments indirectly intervene in financial markets for a number of reasons. • An efficient financial market requires that all participants have equal and comprehensive access to information. • Various imperfections may cause financial markets to undergo periods of extreme instability. Government regulation seeks to prevent this. • Government may manipulate financial markets to address other societal problems.

37. Financial Regulation • Provision of Information – Government requires that financial market participants make some information public. • HKCE Ltd {technically a private sector company} regulates listings on stock market. • Securities & Finance Commission regulates markets and enforces laws. • Maintenance of Financial Stability – Government enforces a certain level of financial soundness among financial intermediaries • HKMA regulates banking system (more later)