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Chapter 1
Functions and Roles of Financial Institutions and Markets
in the Global Economy
Learning Objectives in This Chapter
- You will understand the functions performed and the roles played by the system of financial institutions and markets in the global economy and in our daily lives.
- You will discover how important financial institutions and markets, including the whole financial system, are to increasing our standard of living, generating new jobs, and building our savings to meet tomorrow’s financial needs.
What’s in This Chapter? Key Topics Outline
- How the System of Financial Institutions and Markets Interfaces with the Economy
- The Importance of Savings and Investment
- The Nature of Financial Claims in the Financial Markets
- Functions of Financial Institutions and Markets: Savings, Wealth, Liquidity, Credit, Payments, Risk Protection, and Pursuing Public Policy
- Types of Financial Markets within the Global Financial System
- Factors Tying All Financial Markets Together
- The Dynamic Financial System: Key Emerging Trends
Chapter Outline
- Introduction to the System of Financial Institutions and Markets
- The Global Economy and the System of Financial Institutions and Markets
- Flows within the Global Economic System
- The Role of Markets in the Global Economic System
- Types of Markets
- The Financial Markets and the Financial System: Channel for Savings and Investment
- Nature of Savings
- Nature of Investment
- Economic Functions Performed by the Global System of Financial Institutions and Markets
- Savings Function
- Wealth Function
- Liquidity Function
- Credit Function
- Payments Function
- Risk Protection Function
- Policy Function
- Types of Financial Markets within the Global Financial System
- The Money Market versus the Capital Market
- Divisions of the Money and Capital Markets
- Open versus Negotiated Markets
- Primary versus Secondary Markets
- Spot versus Futures, Forward, and Option Markets
- Factors Tying All Financial Markets Together
- Credit, the Common Commodity
- Speculation and Arbitrage
- The Dynamic Financial System
- The Plan of This Book
Key Terms Appearing in This Chapter
financial system, 3
market, 4
financial market, 6
savings, 6
investment, 6
wealth, 8
net worth, 8
financial wealth, 8
net financial wealth, 8
liquidity, 9
credit, 9
money market, 12
capital market, 12
open markets, 14
negotiated markets, 14
primary markets, 14
secondary markets, 14
speculators, 16
arbitrage, 16
Questions to Help You Study
- Why is it important for us to understand how the global system of financial institutions and markets works?
Answer: The global financial system of institutions and markets is an integral part of the global economic system. It is the collection of markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other securities are traded, interest rates are determined, and financial services are produced and delivered around the world.
- What are the principal links between the financial system and the economy? Why is each important to the other?
Answer: The principal link between the financial system and the economy is the Financial Markets. The financial markets channel savings to those individuals and institutions needing more funds for spending than are provided by their current incomes. The financial markets are the heart of global financial system, attracting and allocating saving and setting interest rates and prices of financial assets (stocks, bonds, etc.).
- What are the principal functions or roles of the global financial system? How do financial institutions and markets fulfill those roles or functions?
Answer: The principal function or role of the global financial system is to move scarce loanable funds from those who save to those who borrow to buy goods and services and to make investments in new equipment and facilities so that the global economy can grow and increase the standard of living enjoyed by its citizens. Those who supply funds to the financial market receive promises packaged in the form of financial claims (future dividends, interest, etc.) and financial services (stocks, bonds, deposits, and insurance policies) in return for the loan of their money.
- What exactly is saving? Investment? Are these terms often misused by people on the street? Why do you think this happens?
Answer: Saving: For households, savings are what is left from current income after current consumption expenditures and tax payments are made. For the business sector, savings include current earnings retained inside business firms after payment of taxes, stockholder dividends , and other cash expenses. For government, savings arise when there is a surplus of current revenues over current expenditures in a government’s budget.
Investment: Investment generally refers to the acquisition of capital goods, such as buildings and equipment, and the purchase of inventories of raw materials and goods to sell. For households, investment is the purchase of a home. For business firms, investment is the expenditures on capital goods (buildings, equipment and other fixed assets) and inventories (raw materials and goods for sale). For government, investment is the expenditures to build and maintain public facilities (buildings, monuments, highways, etc.).
The terms may be misused since their definitions depend on the type of unit in the economy that is doing the saving or investment.
- How and why are savings and investment important determinants of economic growth? Do they impact our standard of living? How?
Answer: The role of the financial system in channeling savings into investment is absolutely essential to the growth of the economy. For example, if households set aside savings and those funds are not returned to the spending stream through investment by businesses and governments, future income payments will decline, leading, in turn to reduced consumption spending. Then, the public’s standard of living will fall. On the other hand, if the households save and these savings are channeled into investment, the economy’s productive capacity will increase. In turn future income payments will rise, making possible increased consumption spending and a higher standard of living.
- What seven vital functions does the financial system of money and capital markets perform?
Answer: Savings Function: Bonds, stocks, and other financial claims produced and sold in financial markets by financial institutions provide a profitable, relatively low-risk outlet for the public’s saving which flow through the financial markets into investment. Wealth Function: A stock of assets (the financial instruments) sold by financial institutions in financial markets provide an excellent way to store of wealth. Liquidity Function: Financial markets provide liquidity (immediately spendable cash) for savers who hold financial instruments but are in need of money. Credit Function: Global financial markets furnish credit to finance consumption and investment spending. Payments Function: The global system of financial institutions and markets provides a mechanism for making payments for goods and services. Risk Protection Function: The financial institutions and markets around the world offer businesses, consumers, and government protection against life, health, property, and income risks. Policy Function: The financial markets are a channel through which governments may attempt to stabilize the economy and avoid inflation.
- Why is each function of the financial system important to households, businesses, and governments? What kinds of lives would we be living today if there were no financial system or no financial markets?
Answer: Each function of financial system will create a need for the money and capital markets through the flow of funds and the flow of financial services, income, and financial claims. Without savings, wealth and liquidity, our future consumption may be limited. It will also be disastrous if our source of income is disrupted. Without credit, our consumption and investment spending will be limited. Without the payments function, we will not be able to buy goods and services. Without risk protection, we will be exposed to life, health, property, and income risks. Without the policy function, the economy may fluctuate freely beyond control.
- What exactly do we mean by the term wealth? How does it differ from net worth? Why is it important?
Answer: Wealth is the sum of the values of all assets we hold at any point in time. The increase (or decrease) in the total wealth we own in the current time period equals to our current savings plus the value of all previously accumulated wealth multiplied by average rate of return on all previously accumulated wealth. While the measure of an individual’s wealth is important measure of their financial position, a more accurate measure is that of net worth. Net worth is the difference between an individual’s assets and their liabilities. It is important because wealth holdings represent stored purchasing power that will be used as income in future periods to finance purchases of goods and services and to increase the society’s standard of living.
- What is net financial wealth? What does it reveal about each of us?
Answer: Net financial wealth equals to financial assets – total debt. Net financial wealth indicates our net value, i.e., the residual value of all our assets after fulfilling all our financial obligations.
- Can you explain what factors determine the current volume of financial wealth and net financial wealth each of us has?
Answer: The volume of financial wealth is thus dependent on current savings (which is in turn dependent on current income – current expenditures) and the size of previously accumulated wealth. The volume of net financial wealth is thus dependent on the current volume of financial wealth and the total debt. The average rate of return is one of the factors in the volume of financial wealth. Furthermore, different units in the economy have different wealth and net wealth due to their different inheritances of wealth, capabilities of creating and retaining wealth, luck, foresight, debt preferences, opportunities, etc.
- Can you distinguish between the following institutions?
Money market versus capital market
Open market versus negotiated market
Primary market versus secondary market
Spot market versus forward or futures market
Answer: The money market is for short-term (one year or less) loans, while the capital market finances long-term investments by businesses, governments, and households. In an open market, financial instruments are sold to the highest bidder, and they can be traded as often as is desirable before they mature. In a negotiated market, the instruments are sold to one or a few buyers under private contract. The primary market is for the trading of new securities (often used for new investment in buildings, equipment, and inventories), while the secondary market deals in securities previously issued (provide liquidity to security investors). In the spot market, assets or financial services are traded for immediate delivery (usually within two business days). Contracts calling for the future delivery of financial instruments are traded in the futures or forward market.
- If we follow financial institutions and markets around the world each day, it soon becomes apparent that the interest rates and asset prices in different markets tend to move together, albeit with small leads and lags. Why do you think this is so?
Answer: For the common commodity and credit, borrowers can switch from one credit market to another, seeking the most favorable credit terms wherever they can be found. The shifting of borrowers among markets helps to weld the parts of the global financial system together and to bring the credit costs in the different markets into balance with one another. Also, speculators work to equilibrate asset prices by purchasing assets that they believe are under priced and by selling those that they believe are overpriced. Similarly, arbitrageurs purchase underpriced assets in one market in order to sell them in a market which overvalues them.
- What are some of the forces that appear to tie all financial institutions and markets together and often result in common movements in prices and interest rates across the whole financial system?
Answer: Credit, the common commodity, can help the borrowers shift between markets and weld the parts of the financial system together, thus bringing the credit costs in the different markets into balance with one another. The speculators are continually on the lookout for opportunities to profit from their forecasts of future market development. The arbitrageurs help to maintain consistent prices betweens markets aiding other buyers in finding the best prices with minimal effort.
- What is meant by the dynamic financial system? What trends appear to be reshaping the financial system of financial institutions and markets?
Answer: The global financial system is rapidly changing into a new financial system, powered by innovation as new financial services and instruments continually appear o attract customers. Major trends are under way to convert smaller national financial systems into an integrated global system, at work 24 hours a day to attract savings, extend credit, and fulfill other vital roles. Many countries have begun to harmonize their regulations so that financial service firms operate under similar rules no matter where they are located.
Problems and Issues
- Identify which of the following statements is correct and which is false. If the statement is false, identify the error and correct the statement.
- The change in a household’s wealth over a quarter is its income minus its expenses plus interest earned on its wealth held at the beginning of the period.
ANSWER: False – household’s wealth must also take into account the value of the individuals asset holdings as well as their liabilities.
- The market value of a household’s home is equal to the equity that the household has in the home and is therefore part of the household’s net worth.
ANSWER: False – Market value of a home is not equal to the equity that the household has in the home. Market value of the home is the going price for such a home in current time, while equity is the new sales price minus the debt outstanding on the home.
- The saving and wealth functions performed by the financial markets enable households to increase current consumption at the expense of future consumption.
ANSWER: True
- Which of the following economic functions that financial markets perform would be best represented by the following properties of S. Treasury bills: (i) the fact that they retain their value over time and (ii) their ability to be sold on short notice at their true market value?
- Liquidity and risk protection
- Wealth and liquidity
- Policy and wealth
- Risk protection and policy
Answer: b
- John Jacobs looks over his balance sheet from the beginning of the month. He observes that his assets include: (i) a market value of $120,000 for his home; (ii) $25,000 in corporate stock; (iii) a Treasury bill with a face value of $1,000 to be received at the end of the month, for which the current market value was $983; (iv) a bank deposit account of $6,000; and (vi) some miscellaneous items that he values at $35,000. His only outstanding liability is the mortgage on his house, which has a balance totaling $40,000. It is now the end of the month and he just received his $6,000 salary, along with the income from the maturing T-bill and interest on his bank deposits, which were paying an annualized interest rate of 2 percent (2/12 percent per month). His mortgage payment was $1,500, of which $500 would go toward the principal. His other expenses for the month came to $4,000. He had planned to make an additional house payment for the month, all of which would go to paying down the principal on the loan. However, his daughter is in college and wants to go to the Bahamas for spring break. The expense of her trip would be an additional $1,800.
- Would he be able to make the additional house payment and fund his daughter’s trip without reducing his account balance in the bank deposit account?
ANSWER: His total monthly income, including the bond and interest payments equal $1,000 + $6,000 + $10 = $7,010.
His total expenses this month if he chooses to fund his daughter’s trip and make the additional payment on the house is $1,500 + $4,000 +$1,500 + $1,800 = $8,800.
Therefore he would have to draw down his savings account by $7,010-$8,800 = $1,790.
- What would his net worth be if he funded his daughter’s trip and made the additional mortgage payment?
ANSWER: His total assets would consist of a home valued at $120,000, $25,000 in corporate stock, a bank account of $4,210, and miscellaneous items totaling $35,000. This brings his total assets to $184,210.
His only liability is the outstanding balance on his mortgage. His made two payments of $1,500 on his mortgage this month. One of the payments included a $500 payment on the principal of the loan. The other payment was a principal only payment. Thus the new outstanding balance of his mortgage is $40,000 – $500 – $1,500 = $38,000.
So his net worth is given by his total assets less his total liabilities, or $184,210 – $38,000 = $146,210.
- What would his net worth be if he did not fund his daughter’s trip and made the additional mortgage payment?
ANSWER: If he did not fund his daughter’s trip, but he did make the extra payment, then his monthly expenses would be $1,500 + $4,000 +$1,500 = $7,000. His monthly income, including the maturing bond and interest payments, would still be $7,010. This means that he would be able to increase his deposit account by $7,010 – $7,000 = $10 this month.
Given this, his assets would be a home valued at $120,000, $25,000 in corporate stock, a bank account of $6,010, and miscellaneous items totaling $35,000. This brings his total assets to $186,010.
Since he still made the extra payment, his total liabilities remain the same as in part b. So his net worth would be $186,010 – $38,000 = $148,010
- Would his net worth change if he decided to fund the trip, but did not make the additional mortgage payment? Explain.
ANSWER: If he funded his daughter’s trip, but did not make the extra payment, his monthly expenses would be $1,500 + $4,000 + $1,800 = $7,300. His income would still be $7,010. This means that he would need to draw on his savings by $7,010 – $7,300 = $290.
Given this, his total assets would be $120,000 + $25,000 + $5,710 + $35,000 = $185,710. Since he did not make the extra mortgage payment, his liability is only reduced by the $500 principal payment of the original mortgage payment. So his total liabilities are given by $39,500.
This means that his net worth is $185,710 – $39,500 = $146,210.
Coming into the month his net worth was given by
$120,000 + $25,000 + $6,000 + $1,000 + $35,000 – $40,000 = $147,000
So his net worth fell by $147,000 – $146,210 = $790.
This happened because the $1,000 matured and was spent, reducing his assets, while at the same time his liabilities was reduced by $500 from the principal payment on his mortgage. Together this results in a $500 reduction in net worth. The other $290 in net worth reduction comes from the drawing down of his bank account to cover current expenses.
So in summary, the principal payment boosted his net worth by reducing his liabilities by $500, but the spending of the bond and the drawing down of his
deposit account for current consumption reduced his assets by $1,290. Together, the net effect is a reduction of $790 in his net worth.
- George Wintle purchased a new home valued at $200,000. He paid a 20 percent initial down payment. He looked at his balance sheet to determine what his cash flow would be for the month. His new mortgage payment was $1,200, of which only $100 would go toward the principal in the first month. He had a bank deposit account of $3,500, which he had set aside for a shot vacation. He also owned $3,000 in corporate stock. His income for the month was $5,000, but he anticipates receiving a sales bonus of $1,500. He estimated his usual monthly expenses, other than his mortgage, to be $3,500.
- If his estimates are all accurate, would he have any additional income left over at the end of the month that he could add to the money he had set aside for his upcoming vacation?
ANSWER: If his estimates are correct, he will receive $5,000+$1,500 = $6,500 in income this month and will have $1,200+$3,500=$4,700. This means he will have $6,500-$4,700=$1,800 left over that he could add to his vacation account
- If he failed to receive the sales bonus, would he have to sell stock to keep from drawing down his bank deposit account and having to curtail his vacation?
ANSWER: If he fails to receive his sales bonus, he will still earn $5,000. In this case he will have $5,000-$4,700 = $300 left over to put toward his vacation
- Megan Morgan recently graduated from college and was just hired at a large retail firm for $36,000 per year. She estimates her personal belongings to be worth $7,800. She has school loans of $10,000 that will require her to make monthly payments of $125 for the next 10 years. She rents an apartment for $550 per month and estimates that she will have monthly expenses for utilities, phone, cable, and so forth of $150. She needs a car and has a small noninterest-bearing bank account of $2,000. She could either buy a used car for $1,600 or take out a loan for $10,000 for a new compact. The new loan would require a down payment of $2,000 and five years of monthly payments of $350. Her parents are willing to give her $1,000 for graduation, which she could apply to the purchase of a car. Megan estimates that $1,600 per month in discretionary income would be comfortable for her to live on.
- What was her net worth when she graduated?
ANSWER: Her total assets were given by here total belongings valued at $7,800 plus her noninterest-bearing account of $2,000 and plus the $1,000 graduation gift from her parents (assuming that they gave this to her prior to our accounting). This means her assets total to $10,800.
Here only liability is her $10,000 in student loans, so her net worth is $800.
- How much discretionary income would she have each month if she bought the new car? Would it be feasible for her to save $250 per month and make all her payments?
ANSWER: Assuming she lives in a world without income tax, her monthly salary would be $3,000. If she bought the new car, she could use $1,000 of her bank account balance along with the $1,000 her parents gave her to cover the down payment.
Her monthly expenses would equal $120 + $550 + $150 + $350 + $1600 = $2,770. Again, her monthly income, assuming no income tax, is $3,000. This means she would have $3,000 – $2,770 = $230 left over every month. So she would not be able to save $250 a month.
- What would her discretionary income be after the first month if she bought the used car? Could she now save that $250 per month?
ANSWER: If she bought the used car, here expenses would fall by the amount of the new car payment to $2,420. Her leftover monthly income would now be $3,000 – $2,420 = $580.
- Classify the market in which each of the following financial transactions takes place as: (i) money versus capital, (ii) primary versus secondary, (iii) open versus negotiated, or (iv) spot versus futures or forward.
- A contract to receive wheat three months from today
ANSWER: (iv) spot versus futures or forward
- The purchase of a share of IBM on the New York Stock Exchange
ANSWER: (iii) open versus negotiated
- A six-month CD purchased from your bank
ANSWER: (i) money versus capital
- A newly issued three-month Treasury bill purchased at the government’s weekly auction
ANSWER (ii) primary versus secondary
- You open a bank savings account
ANSWER (iii) open versus negotiated
- You write a check to purchase for cash
ANSWER (i) money versus capital
- At the end of the calendar year, a firm has total financial assets amounting to $4.32 billion, while its total liabilities are $3.58 billion. What is the firm’s net financial wealth? If the firm saved $50 million over the previous year, representing the amount by which its financial assets rose relative to its liabilities, and it had begun the year with 3.72 billion in total financial assets, how much did it earn on its previously accumulated assets?
ANSWER: The firm’s net financial wealth is given by $4.32 billion – $3.58 billion =$ 0.74 billion
- One definition of pure arbitrage is to combine a series of investments with a series of debts such that the net dollar investment is zero, no risk is taken, and a profit is made. How does this differ from pure speculation in the financial markets? Do you think that arbitrage opportunities can really exist? If so, do you think the opportunities for pure arbitrage would be long-lived? Please explain.
ANSWER: Pure speculation in the financial market gambles that security prices or interest rates will move in a direction that will result in quick gains due to the speculator’s ability to outguess the market’s collective judgment. Thus, speculation carries risk, and is in contrast with the notion of pure arbitrage presented above. Yes, arbitrage opportunities can really exist, but they would not be long-lived. Arbitrageurs will drive down the price of the asset in the market where it is relatively high, and up in the market where the price is relatively low, until the security price is the same in both markets. In the future, the new financial services and instruments will covert smaller national financial system into an integrated global system. It is difficult for arbitrageurs move from one market to another, because the financial market will have just only one global financial market.
Web-Based Problems – DATA SERIES MAY BE DIFFERENT
- Your text defines the wealth of a business firm as the sum of all its assets. To determine its net wealth (or total equity) you have to subtract the firm’s liabilities from its assets. Net wealth is the value of the firm and should be reflected in its market capitalization (or stock price times the number of shares outstanding). Firms in different industries will require different amounts of wealth to create the same market value (or market capitalization). In this problem you are asked to compare the wealth (total assets), net wealth (assets less liabilities), and market capitalization of a large firm in each of the following industries: Financial Services (Citigroup, ticker symbol C); Manufacturing (Caterpillar, CAT); and High Tech (Microsoft, MSFT). Using the financial resources of worldwide web key in each firm’s ticker symbol and find its most recent balance sheet and its market capitalization under. Are you surprised by how different these firms are in
terms of the dollar value of assets required to create one dollar of market value?
Answer: You can use the website http://finance.yahoo.com. These are the financial data on December 2006:
For Citigroup, C: The Total Asset 1,884,318 million dollars
The Total Liabilities 1,764,535 million dollars
Net Wealth 119,783 million dollars
The Market Capitalization 265,430 million dollars
$1 of market value equal $7.1 of value of assets
For Caterpillar, CAT: The Total Asset 50,879 million dollars
The Total Liabilities 44,020 million dollars
Net Wealth 6,859 million dollars
The Market Capitalization 52,170 million dollars
$1 of market value equal $0.98 of value of assets
For Microsoft, MSFT: The Total Asset 69,597 million dollars
The Total Liabilities 29,493 million dollars
Net Wealth 40,104 million dollars
The Market Capitalization 289,110 million dollars
$1 of market value equal $0.24 of value of assets
- A large share of household wealth is held in the form of corporate stock. How much wealth does the entire stock market represent? To find an approximate answer, go to the web site for Wilshire Associates at www.wilshire.com and click Indexes from the menu. Locate the information that explains how the Wilshire 5000 index is constructed. This index is weighted by the market capitalization of the firms included in it, such that if you add the right amount of zeros to the index, you obtain the total value of all the firms represented in the index. Why is this number a good approximation to the entire U.S. stock market? Now obtain a chart for the index. How much stock market wealth has been created or destroyed over the past 12 months? Determine how much stock market wealth was created or lost per person in the United States over this period. (Hint: You can find the U.S. population at http://www.census.gov/main/www/popclock.html). Compare this with the average after-tax annual income per person in the U.S. Use the disposable personal income figure that can be found under “Selected NIPA Tables: Table 2.1” at www.bea/gov.doc/bea/dn/nipaweb/index.asp to make the comparison.
Answer: As of June 6, 2007, the total wealth that the entire stock market represents is 15,291.15 billion (from http://www.wilshire.com/quote.html?symbol=dwc). The Dow Jones Wilshire 5000 base is its December 31, 1980 capitalization of $1,404.596 billion. The index is an excellent approximation of total value of the U.S. equity market because it measures the performance of all U.S. headquartered equity securities with readily available price data.
The following is a chart of the index over a year (from 6/22/06 to 6/21/07):
.
Since the difference in the index is approximately 2,800 (=15,300-12,500), we found the stock market wealth creation to be $2,800 billions for the period between June 22, 2006 and June 21, 2007.
During this period of time, the U.S. population is approximately 302,152,705 (from http://www.census.gov/main/www/popclock.html). Therefore, $5,060.74 worth of stock market wealth was created per person in the United States over this period.
During the first quarter of 2007, the disposable personal income is roughly at $9,898.0 billion, or $32,758.2 per person
(from http://www.bea.gov/bea/dn/nipaweb/TableView.asp#Mid).
- One of the world’s most important financial markets that we will study throughout this book is the market for U.S. Treasury securities. It is important because it is one of the few default-free, highly liquid debt instruments available anywhere in the financial marketplace. To determine the size of this market go to the Treasury Department’s website at www.treasurydirect.gov and find the Monthly Statement of the Public Debt (MSPD). How much debt does the U.S. government owe per person in the United States? (See the previous problem on how to find the U.S. population figure.) How much of this debt is held by the public and how much by government agencies? Only a portion of this debt – termed “marketable” – is traded daily in the system of financial markets and institutions. The remainder is held by the buyer until it matures. How much of this public debt is “marketable”?
Answer: http://www.treasurydirect.gov/govt/reports/pd/account/2007/2007_may.pdf As of May 31, 2007, the amount of debt outstanding held by the public (Non-governmental) is $4,977,832 millions. When we divide the amount of debt outstanding by the size of the U.S. population, we obtain the debt that the U.S. government owes per person in the United States – $16,475. The amount of debt held by the public (Intra & Non-governmental) is $9,142,527 million, while the amount of debt held by government agencies is $4,164,695 millions. Of the total amount of $9,142,527 millions of public debt outstanding, $4,977,832 millions, or approximately 54.45 %, of it is marketable.
