2. The Role of Financial AssetsThe Role of Financial Assets
The financial system is the mechanismThe financial system is the mechanism
through which loanable funds reachthrough which loanable funds reach
borrowersborrowers
Operation of the financial marketOperation of the financial market
Money exchanged for financial claimsMoney exchanged for financial claims
StocksStocks
BondsBonds
Other securitiesOther securities
Transforms savings into investmentTransforms savings into investment
Permits the economy to growPermits the economy to grow
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3. The Nature and Characteristics ofThe Nature and Characteristics of
Financial AssetsFinancial Assets
A financial assetA financial asset
AA claimclaim against the income or wealth of aagainst the income or wealth of a
business firm, household, or unit ofbusiness firm, household, or unit of
governmentgovernment
Represented usually by a certificateRepresented usually by a certificate
receipt, computer record file, or other legalreceipt, computer record file, or other legal
documentdocument
Usually related to the lending of moneyUsually related to the lending of money
Examples include stocks, bonds,Examples include stocks, bonds,
deposits, and othersdeposits, and others
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4. Characteristics of Financial AssetsCharacteristics of Financial Assets
Financial assets are sought afterFinancial assets are sought after
because they promisebecause they promise futurefuture returns toreturns to
their owners and serve as atheir owners and serve as a store ofstore of
valuevalue (purchasing power).(purchasing power).
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5. Characteristics of Financial AssetsCharacteristics of Financial Assets
Financial asset value based on faith thatFinancial asset value based on faith that
issuer honors contractual promise to payissuer honors contractual promise to pay
Financial assets characteristicsFinancial assets characteristics
Do notDo not depreciatedepreciate like physical goodslike physical goods
Physical condition or form usually notPhysical condition or form usually not
relevant in determining market valuerelevant in determining market value
Have little or no value as a commodityHave little or no value as a commodity
Cost of transportation and storage is lowCost of transportation and storage is low
Financial assets areFinancial assets are fungiblefungible – can easily be– can easily be
changed in form and substituted for otherchanged in form and substituted for other
assetsassets 2-5
6. Types of Financial AssetsTypes of Financial Assets
MoneyMoney
Financial asset accepted in payment forFinancial asset accepted in payment for
purchases of goods and servicespurchases of goods and services
Examples are currency and checkingExamples are currency and checking
EquitiesEquities
Ownership shares in a business firmOwnership shares in a business firm
Claims against the firm’s profitsClaims against the firm’s profits
Claims against proceeds from the sale of itsClaims against proceeds from the sale of its
assetsassets
Examples are common stock and preferredExamples are common stock and preferred
stockstock
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7. Types of Financial AssetsTypes of Financial Assets
Debt SecuritiesDebt Securities
Priority claim over the holders of equities to thePriority claim over the holders of equities to the
assets and income of an economic unitassets and income of an economic unit
Can be negotiable or nonnegotiableCan be negotiable or nonnegotiable
Examples include bonds, notes, accounts payable,Examples include bonds, notes, accounts payable,
and savings depositsand savings deposits
DerivativesDerivatives
Market value tied to or influenced by the value orMarket value tied to or influenced by the value or
return on a financial assetreturn on a financial asset
Examples include futures contracts, options, andExamples include futures contracts, options, and
swapsswaps
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8. How Financial Assets Are CreatedHow Financial Assets Are Created
Internal financing to acquire assetsInternal financing to acquire assets
Use current incomeUse current income
Use accumulated savingsUse accumulated savings
External financing to acquire assetsExternal financing to acquire assets
Raise funds by issuing financial liabilitiesRaise funds by issuing financial liabilities
(debt)(debt)
Raise funds by issuing stock (equities)Raise funds by issuing stock (equities)
2-8
9. Balance Sheets of Units in aBalance Sheets of Units in a
Simple Financial SystemSimple Financial System
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10. Unit Balance Sheets Following theUnit Balance Sheets Following the
Equipment Purchase and Debt IssuanceEquipment Purchase and Debt Issuance
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11. Unit Balance Sheets Following EquipmentUnit Balance Sheets Following Equipment
Purchase and Stock IssuancePurchase and Stock Issuance
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12. Financial Assets and the Financial SystemFinancial Assets and the Financial System
The act of borrowing or of issuing newThe act of borrowing or of issuing new
stock simultaneously gives rise to thestock simultaneously gives rise to the
creation of an equal volume of financialcreation of an equal volume of financial
assets.assets.
All financial assets are recorded as aAll financial assets are recorded as a
liability or claim on some otherliability or claim on some other
economic unit’s balance sheet.economic unit’s balance sheet.
Volume of financial assets for lendersVolume of financial assets for lenders
= Volume of liabilities issued by borrowers= Volume of liabilities issued by borrowers
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13. Financial Assets and the Financial SystemFinancial Assets and the Financial System
For the balance sheet ofFor the balance sheet of any economicany economic
unitunit,,
Total assets = Total liabilities + Net WorthTotal assets = Total liabilities + Net Worth
WhereWhere
Assets = Real assets + Financial assetsAssets = Real assets + Financial assets
For theFor the wholewhole economy and financialeconomy and financial
system,system,
Total financial assets = Total liabilitiesTotal financial assets = Total liabilities
So, for the economy as a whole,So, for the economy as a whole,
TTotalotal real assets = Total net worthreal assets = Total net worth
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14. Financial Assets and the Financial SystemFinancial Assets and the Financial System
Society can increase its wealthSociety can increase its wealth
Saving and increasing the quantity of itsSaving and increasing the quantity of its
real assetsreal assets
Real assets enable the economy toReal assets enable the economy to
produce more goods and servicesproduce more goods and services
The financial system provides theThe financial system provides the
essential channelessential channel
Necessary for the creation and exchangeNecessary for the creation and exchange
of financial assetsof financial assets
Exchange is between savers andExchange is between savers and
borrowers so that real assets can beborrowers so that real assets can be
acquiredacquired
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15. Financial System MattersFinancial System Matters
Strong financial system helps societyStrong financial system helps society
Reducing barriers to external financingReducing barriers to external financing
Lowering cost of capitalLowering cost of capital
Accelerating economic growthAccelerating economic growth
Nations with more fully developedNations with more fully developed
financial systemsfinancial systems
Tends to grow fasterTends to grow faster
Tends to enjoy a higher standard of livingTends to enjoy a higher standard of living
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16. Lending and Borrowing in theLending and Borrowing in the
Financial SystemFinancial System
Economists John Gurley and Edward ShawEconomists John Gurley and Edward Shaw
pointed out that each business firm,pointed out that each business firm,
household, or unit of government active inhousehold, or unit of government active in
the financial system must conform to:the financial system must conform to:
R - E =R - E = ∆∆FA -FA - ∆∆DD
wherewhere
R =R = Current income receiptsCurrent income receipts
E =E = Expenditures out of current incomeExpenditures out of current income
∆∆FA =FA = Change in holdings of financial assetsChange in holdings of financial assets
∆∆D =D = Change in debt and equity outstandingChange in debt and equity outstanding
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17. Lending and Borrowing in theLending and Borrowing in the
Financial SystemFinancial System
So, for any given time period, eachSo, for any given time period, each
economic unit must fall into one ofeconomic unit must fall into one of
three groups:three groups:
Deficit-budget unit (DBU):Deficit-budget unit (DBU):
E > R, soE > R, so ∆∆D >D > ∆∆FA (net borrower ofFA (net borrower of
funds)funds)
Surplus-budget unit (SBU):Surplus-budget unit (SBU):
R > E, soR > E, so ∆∆FA >FA > ∆∆D (net lender of funds)D (net lender of funds)
Balanced-budget unit (BBU):Balanced-budget unit (BBU):
RR == E, soE, so ∆∆DD == ∆∆FA (neither net lender norFA (neither net lender nor
borrower)borrower)
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18. Lending and Borrowing in theLending and Borrowing in the
Financial SystemFinancial System
The global financial system permitsThe global financial system permits
businesses, households, andbusinesses, households, and
governments to adjust their financialgovernments to adjust their financial
position from that of net borrowerposition from that of net borrower
(DBU) to net lender (SBU) and back(DBU) to net lender (SBU) and back
again, smoothly and efficiently.again, smoothly and efficiently.
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19. What is Money?What is Money?
All financial assets are valued in termsAll financial assets are valued in terms
of money, and flows of funds betweenof money, and flows of funds between
lenders and borrowers occur throughlenders and borrowers occur through
the medium of money.the medium of money.
Money itself is a financial asset,Money itself is a financial asset,
because all forms of money in usebecause all forms of money in use
today are claims against some publictoday are claims against some public
or private institution.or private institution.
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20. The Functions of MoneyThe Functions of Money
Money serves as aMoney serves as a standard of valuestandard of value
(or(or unit of accountunit of account))
Money serves as aMoney serves as a store of valuestore of value
Reserve of future purchasing powerReserve of future purchasing power
Value of money can fluctuate withValue of money can fluctuate with
inflationinflation
Money serves as aMoney serves as a medium ofmedium of
exchangeexchange
Buyers and sellers no longer need toBuyers and sellers no longer need to
have an exact coincidence of wantshave an exact coincidence of wants
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21. The Value of Money and Other FinancialThe Value of Money and Other Financial
Assets and InflationAssets and Inflation
InflationInflation
Rise in the average price level of all goodsRise in the average price level of all goods
and servicesand services
Lowers purchasing power of moneyLowers purchasing power of money
Can damage value of financial contractsCan damage value of financial contracts
DeflationDeflation
The opposite of inflationThe opposite of inflation
Fall in the average price level of all goodsFall in the average price level of all goods
and servicesand services
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22. The Value of Money and Other FinancialThe Value of Money and Other Financial
Assets and InflationAssets and Inflation
Inflation is commonly measuredInflation is commonly measured
usingusing price indicesprice indices, such as:, such as:
the Consumer Price Index (CPI),the Consumer Price Index (CPI),
the Producer Price Index (PPI), orthe Producer Price Index (PPI), or
the Gross Domestic Product (GDP)the Gross Domestic Product (GDP)
deflator Index.deflator Index.
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23. Impact on Purchasing PowerImpact on Purchasing Power
Changes in purchasing power can beChanges in purchasing power can be
dramaticdramatic
Due to inflationDue to inflation
Even in the United StatesEven in the United States
Provides a warning about measuring valueProvides a warning about measuring value
Need to think in terms of real valuesNeed to think in terms of real values
Purchasing power adjustedPurchasing power adjusted
Nominal values can be misleadingNominal values can be misleading
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24. The Evolution of FinancialThe Evolution of Financial
TransactionsTransactions
Financial systems change constantlyFinancial systems change constantly
Shifting demands from the publicShifting demands from the public
Development of new technologyDevelopment of new technology
Changes in laws and regulationsChanges in laws and regulations
The ways of carrying out financialThe ways of carrying out financial
transactions have evolvedtransactions have evolved
In particular, the transfer of fundsIn particular, the transfer of funds
from savers to borrowers can befrom savers to borrowers can be
accomplished in at least threeaccomplished in at least three
different waysdifferent ways
2-24
25. The Evolution of FinancialThe Evolution of Financial
TransactionsTransactions
Direct FinanceDirect Finance – Direct lending gives rise– Direct lending gives rise
to direct claims against borrowersto direct claims against borrowers
Borrowers
(DBUs)
Lenders
(SBUs)
Flow of funds and other financial services
(loans of spending power for an
agreed-upon period of time)
Primary Securities
(stocks, bonds, notes, etc., evidencing
direct claims against borrowers)
SimpleSimple Difficult to match & riskyDifficult to match & risky
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26. The Evolution of FinancialThe Evolution of Financial
TransactionsTransactions
Semidirect FinanceSemidirect Finance – Direct lending with the– Direct lending with the
aid of market makers who assist in the saleaid of market makers who assist in the sale
of direct claims against borrowersof direct claims against borrowers
Lower search (information) costsLower search (information) costs
Risky & matching is still requiredRisky & matching is still required
Borrowers
(DBUs)
Lenders
(SBUs)
Flow of funds
and other
financial services
(loans of spending
power)
Security
brokers,
dealers, &
investment
bankers
Primary Securities
(direct claims
against
borrowers)
Primary Securities
(direct claims
against
borrowers)
Proceeds of
security sales and other
financial services
(less fees and commissions)
2-26
27. The Evolution of FinancialThe Evolution of Financial
TransactionsTransactions
Indirect FinanceIndirect Finance – Financial intermediation of– Financial intermediation of
fundsfunds
Low risk & affordableLow risk & affordable
Ultimate
borrowers
(DBUs)
Ultimate
lenders
(SBUs)
Flow of funds and other
financial services
(loans of spending power)
Financial intermediaries
(banks, savings and loan associations,
insurance companies, credit unions,
mutual funds, finance companies,
pension funds)
Secondary Securities
(indirect claims against ultimate
borrowers issued by financial
intermediaries in the form of
deposits, insurance policies,
retirement savings accounts, etc.)
Primary Securities
(direct claims against ultimate
borrowers in the form of loan
contracts, stocks, bonds, notes,
etc.)
Flow of funds and other
financial services
(loans of spending power)
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28. Classifying Financial InstitutionsClassifying Financial Institutions
Depository institutionsDepository institutions
Bulk of their loanable funds from depositBulk of their loanable funds from deposit
accounts sold to the publicaccounts sold to the public
Commercial banks, savings and loanCommercial banks, savings and loan
associations, savings banks, credit unionsassociations, savings banks, credit unions
Contractual institutionsContractual institutions
Funds from offering legal contracts toFunds from offering legal contracts to
protect the saver against riskprotect the saver against risk
Insurance companies, pension fundsInsurance companies, pension funds
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29. Classifying Financial InstitutionsClassifying Financial Institutions
Investment institutionsInvestment institutions
Sell shares to the publicSell shares to the public
Invest the proceeds in stocks, bonds, andInvest the proceeds in stocks, bonds, and
other assetsother assets
Mutual funds, money market funds, realMutual funds, money market funds, real
estate investment trustsestate investment trusts
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30. Portfolio (Financial-Asset)Portfolio (Financial-Asset)
Decisions by Financial InstitutionsDecisions by Financial Institutions
Deciding what financial assets to buyDeciding what financial assets to buy
or sellor sell
Depends on various asset factorsDepends on various asset factors
Different financial assetsDifferent financial assets relative rate ofrelative rate of
returnreturn
Different financial assetsDifferent financial assets riskrisk
CostCost of incoming fundsof incoming funds
VolatilityVolatility of incoming fundsof incoming funds
MaturityMaturity of incoming fundsof incoming funds
2-30
31. Portfolio (Financial-Asset)Portfolio (Financial-Asset)
Decisions by Financial InstitutionsDecisions by Financial Institutions
Also depends on financial institutionAlso depends on financial institution
sizesize
Larger financial institutions tend to haveLarger financial institutions tend to have
more diversified sources and usesmore diversified sources and uses
Larger financial institutions also enjoyLarger financial institutions also enjoy
economies of scale.economies of scale.
Regulations and competitionRegulations and competition
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32. The Disintermediation of FundsThe Disintermediation of Funds
Disintemediation processDisintemediation process
Withdrawal of funds from a financialWithdrawal of funds from a financial
intermediary by the ultimate lendersintermediary by the ultimate lenders
(SBUs)(SBUs)
Lending of those funds to ultimateLending of those funds to ultimate
borrowers (DBUs)borrowers (DBUs)
Disintermediation shifts fundsDisintermediation shifts funds
Away from indirect financeAway from indirect finance
To direct financeTo direct finance
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33. The Disintermediation of FundsThe Disintermediation of Funds
Primary Securities
Ultimate
borrowers
(DBUs)
Ultimate
lenders
(SBUs)
Financial
intermediaries
Loanable funds
Financial Disintermediation
2-33
34. The Disintermediation of FundsThe Disintermediation of Funds
Disintermediation is not a foregoneDisintermediation is not a foregone
conclusionconclusion
ReintermediationReintermediation
Reversal of flow of fundsReversal of flow of funds
Back to a “safe haven” of financialBack to a “safe haven” of financial
intermediariesintermediaries
Interest rates are low or decliningInterest rates are low or declining
Or riskiness of financial instruments appearOr riskiness of financial instruments appear
to be risingto be rising
2-34
35. New Forms of DisintermediationNew Forms of Disintermediation
Initiation by financial intermediariesInitiation by financial intermediaries
Banks sell off loansBanks sell off loans
Difficulty in raising capitalDifficulty in raising capital
Initiation by borrowing customersInitiation by borrowing customers
Customer learn alternate financingCustomer learn alternate financing
conduitsconduits
Nonfinancial retail and industrial firmsNonfinancial retail and industrial firms
attempting to draw financial servicesattempting to draw financial services
customerscustomers
Raise funds in the open marketRaise funds in the open market
2-35
36. Bank-Dominated Versus Security-Bank-Dominated Versus Security-
Dominated Financial SystemsDominated Financial Systems
Bank-dominated financial systemsBank-dominated financial systems
Banks and other similar institutionsBanks and other similar institutions
dominatedominate
Supply of creditSupply of credit
Attracting savingsAttracting savings
Common in economies with lessCommon in economies with less
protection of investor rights or less well-protection of investor rights or less well-
defined rulesdefined rules
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37. Bank-Dominated Versus Security-Bank-Dominated Versus Security-
Dominated Financial SystemsDominated Financial Systems
Security-dominated financial systemsSecurity-dominated financial systems
Traditional intermediaries are lessTraditional intermediaries are less
importantimportant
More borrowers sell securities to the publicMore borrowers sell securities to the public
Many economies are gradually movingMany economies are gradually moving
toward a more security-dominated financialtoward a more security-dominated financial
systemsystem
2-37
