FIN 221 Chapter 1 1 Dr Hisham Abdelbaki

FIN 221 Chapter 1 1 Dr. Hisham Abdelbaki - FIN 221

The Role of Financial System • The financial system consists of: 1. Financial Market: two sides (D & S ): buying and selling financial instruments also called financial claims or securities (stocks, bonds, future contracts, mortgage – backed securities. 2. Financial Institutions (financial intermediaries): facilitate the flow of funds from savers to borrowers. Such as Commercial banks, credit unions, life insurance companies and finance companies. 2 Dr. Hisham Abdelbaki - FIN 221

• Economic Units: 1. Households: Budget constraint (income , consumption , real investment expenditures) 2. Business firms: Budget constraint 3. Governments (local , state and federal): Budget constraint 3 Dr. Hisham Abdelbaki - FIN 221

• Budget Position: 1. A balanced Budget Position (receipts = expenditures) 2. A surplus Position (receipts > expenditures) 3. A deficit Position (expenditures > receipts) • Surplus Spending Units (SSUs) Vs Deficit Spending Units (DSUs) • SSUs have income for the period that exceeds spending, resulting in savings. Other words for “SSU” are saver, lender, or investor. Most SSUs are households. • DSUs have spending for the period that exceeds income. Another word for “DSU” is “borrower”. Most DSUs are businesses or governments. 4 Dr. Hisham Abdelbaki - FIN 221

• Components of a Financial Claim (loan): 1. The principal 2. The Price (Fee or the interest rate) 3. Maturity of the loan How financial system transfer the SSUs excess purchasing power to the DSUs? The transfer can be done by SSU lending money to and accepting IOU from a DSU. 5 Dr. Hisham Abdelbaki - FIN 221

• IOU (financial Claims): is a written promise to pay a specific amount of money (the principal) plus a fee (an interest rate) for the privilege of borrowing the money over a period of time (maturity of the loan). • IOU for DSU is a liability and the interest payments are the penalty for consuming before income is earned. • IOU for SSU is an asset and the interest earned is a reward for postponing consumption. 6 Dr. Hisham Abdelbaki - FIN 221

• SSU’s claim against DSU is liability to DSU and asset to SSU. • One’s liability is another’s asset: What is payable by one is receivable by another. • Assets arising this way are “financial assets” The financial system “balances”-total financial assets equal total liabilities. • Total financial liabilities MUST EQUAL to total financial assets. • The ease with which a financial claim can be resold is called MARKETABILITY. 7 Dr. Hisham Abdelbaki - FIN 221

Types of Finance • There are TWO types of finance (financing intermediation): 1. Direct Financing SSUs and DSUs exchange money and financial claims directly using direct claims. (Magdy family as SSU and Al -amal firm as DSU) • Transaction: 8 Dr. Hisham Abdelbaki - FIN 221

Direct Financing Methods • Private placements. • Brokers: act as “matchmakers” bringing SSUs & DSUs together. Compensated for their services with a commission fee. • Dealers: They are “market makers” for securities. Make profits by selling from their inventory of securities. Their gross profit comes from the “bid-ask spread”. • Investment Bankers: Help DSUs market IOUs. Purchases an entire issue of stocks/ bonds at a guaranteed price and resells the securities to investors at a higher price, a process known as “underwriting". They are compensated for their services through “underwriting spread” 9 Dr. Hisham Abdelbaki - FIN 221

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Problems of Direct Financing 1. The denomination of the securities sold in direct credit markets are very large. 2. Because of the first problem, few consumers can transact in these markets. 3. Double coincidence of wants (desires) of both SSU and DSU. To solve (overcome) these problems, financial intermediaries intervene between SSU and DSU. 11 Dr. Hisham Abdelbaki - FIN 221

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Comparative Advantages Financial intermediaries (institutions) enjoy 3 sources of comparative Advantages: 1 - Economies of scale 2 - Low costs 3 - information (reliable) 13 Dr. Hisham Abdelbaki - FIN 221

Intermediaries Services 5 services : 1 - Denomination Divisibility (different size of securities): intermediaries offer a wide range of denomination – from $ 1 to many millions. 2 - Currency Transformation: exchange financial claims denominated in various currencies. 3 - Maturity Flexibility: offer different maturities to both SSUs and DSUs. 14 Dr. Hisham Abdelbaki - FIN 221

Intermediaries Services contin. 4 - Credit Risk Diversification: Spread risks over many different types of SSUs / DSUs 5 - Liquidity: Liquidity means easy to convert into money at low costs. Many of financial commodities produced by intermediaries are highly liquid. Note: Intermediaries engage in one or more of the above intermediation (denomination, currency, risk, maturity or liquidity). 15 Dr. Hisham Abdelbaki - FIN 221

Types of Financial Intermediaries Deposit – type Institutions Investment Funds 16 Contractual Saving Institutions Others Dr. Hisham Abdelbaki - FIN 221

Types of Financial Intermediaries First: Deposit – Type Institutions: • The most commonly recognized intermediaries because most people use their services daily. • Interest rate on deposits is usually insured (so, deposits are devoid of any risk of loss of principal. • Deposits are highly liquid because they can be withdrawn on very short notice, usually in demand. 17 Dr. Hisham Abdelbaki - FIN 221

Deposit – Type Institutions 1 - Commercial Banks 2 - Thrift Institutions 3 - Credit Unions We can add Islamic Banks 18 Dr. Hisham Abdelbaki - FIN 221

1 - Commercial Banks: • According to the assets and liabilities, they are the largest and most diversified intermediaries. • Many of them have trust department and leasing operations & may underwrite certain classes of securities. • They are the most highly regulated of all financial institutions. 19 Dr. Hisham Abdelbaki - FIN 221

2 - Thrift Institutions (called saving and loan associations, or saving banks): • Savings and loans associations and mutual savings banks are commonly called thrift institutions. • They issue checking accounts, savings accounts and a variety of consumer time deposits. • They use these funds to purchase real estate loans (long term mortgages) (different from commercial banks) • They are the largest providers of residential mortgages loans to consumers. • They are also allowed to make limited number of consumer and business Hisham Abdelbaki - FIN 221 loans. 20 Dr.

• They specialize in maturity and denomination intermediation …. . Why? Because BORROW small amounts of money short term with checking and saving accounts and LEND long term on real estate collateral. • The FDIC insures deposits in thrifts in amounts up to $ 100, 000 21 Dr. Hisham Abdelbaki - FIN 221

3 - Credit Unions: • Credit unions are small, nonprofit, cooperative, consumer – organized institutions. • They are owned by their member- customers. • Their primary liabilities are checking accounts (called share drafts) and saving accounts (called share accounts). • Their investment are devoted to short term installment consumer loans. • They are organized by consumers having a common bonds. 22 Dr. Hisham Abdelbaki - FIN 221

• The FDIC insures deposits in credit union in amounts up to $ 100, 000 • To use any service of a credit union, you must be a member. Q: what are the major regulatory differences between credit unions and other depository institutions? 1 - common bond requirement 2 - the restriction that most loans are to consumers. 3 - their exemption from federal income tax because of their cooperative nature. 23 Dr. Hisham Abdelbaki - FIN 221

Second: Contractual Savings Institutions • They OBTAIN funds under long term contractual arrangements and INVEST the funds in capital market. • Their funds are relatively steady. • Liquidity is NOT a problem in the management of these institutions. 24 Dr. Hisham Abdelbaki - FIN 221

Second: Contractual Savings Institutions 1 - Life Insurance Companies 2 - Casualty Insurance Companies 3 - Pension Funds 25 Dr. Hisham Abdelbaki - FIN 221

1 - Life Insurance Companies: • They obtain funds by selling insurance policies that protect against loss of income from premature death or retirement. • Because their inflow and outflow of funds are predictable, they able to invest in higher yielding and long term assets. • Regulation on their operations by state is less strict than in case of deposit - type institutions. 26 Dr. Hisham Abdelbaki - FIN 221

2 - Casualty Insurance Companies • They sell protection against loss of property from fire, theft, accident, negligence, and other causes that can be predicted. • Their major sources of funds is premium charged on insurance policies. • Their insurance policies are pure risk – protection policies. • They provide NO liquidity to the policyholders. • Because their outflow of funds are NOT predictable, they invest in short - term assets. 27 Dr. Hisham Abdelbaki - FIN 221

• To solve the lower returns generated by investment in short term assets, they hold equity securities. AND they also hold municipal bond to reduce their taxes. 3 - Pension Funds • Obtain their funds from employers and employees during the employees’ working years. • Provide monthly payment upon retirement. • Their purpose is to help workers plan for their retirement years. • Because their inflow is long term and outflow is highly predictable, they are able to invest in highly yielding and long term securities (cooperate bonds and equity 28 Dr. Hisham Abdelbaki - FIN 221 obligations)

Third: Investment Funds: • Sell shares to investors and use funds to purchase direct financial claims. • They offer benefits of both denomination flexibility and default – risk intermediation. 29 Dr. Hisham Abdelbaki - FIN 221

Third: Investment Funds: 1 - Mutual Funds 2 - Money Market Mutual Funds 30 Dr. Hisham Abdelbaki - FIN 221

1 - Mutual Funds: • Sell equity shares to investors and use these funds to purchase stocks and bonds. • Provide small investors access to reduced investment risk that results from diversification, economies of scale in transaction costs, and professional financial managers. • The share’s value changes as the price of the stocks held by the mutual fund change. 31 Dr. Hisham Abdelbaki - FIN 221

2 - Money Market Mutual Funds (MMMF): • They invest in money market securities. • Money market securities are: A - short term securities B- low default risk. C- sell in denomination of $ 1 million or more D- most of them offer check – writing privileges Disadvantages: A- most of them restrict the amount of withdrawals B- the federal government doe NOT insure the funds. 32 Dr. Hisham Abdelbaki - FIN 221

Fourth: Other Types of Financial Institutions 1 - Finance Companies 2 - Federal Agencies 33 Dr. Hisham Abdelbaki - FIN 221

1 - Finance Companies: • They make loans to consumers and small businesses. • They obtain the majority of their funds by selling short term IOUs, called Commercial Papers, to investors. • The balance of their funds comes from the sale of equity capital and long – term debt obligations. • They are regulated by the states and are subject to many federal regulations. 34 Dr. Hisham Abdelbaki - FIN 221

• There are 3 types of finance companies: 1 - Consumer finance com. Specializing in installment loans to HH. 2 - Business finance com. Specializing in loans and leases to businesses. 3 - Sales finance com. That finance the products sold by retail dealers. 35 Dr. Hisham Abdelbaki - FIN 221

2 - Federal Agencies: • The US government acts as a major financial intermediary through borrowing and lending activities of its agencies. • The main purposes of federal agencies are: 1 - to reduce the cost of funds 2 - to increase the availability of funds to targeted sectors. • They sell debt instrument called agency securities in the direct credit market at or near government borrowing rate. • Most of these funds are to support agriculture and Housing sectors. 36 Dr. Hisham Abdelbaki - FIN 221

Types of Financial Markets 1 - Primary & Secondary Markets • Primary: sell / issue of financial claims for the first time • Secondary: exchange of used / issued financial claims. 37 Dr. Hisham Abdelbaki - FIN 221

2 - Organized & Over –the – counter • Organized: physical meeting place and communication facilities to exchange securities under a specific set of rules and regulations on the floor or through the computer system. • unorganized or over – the – counter market 3 - Spot and Future Market • Spot Market: market for current exchange • The future contract date: the future time when the contract is scheduled to be settled by exchange of cash for contracted goods. Dr. Hisham Abdelbaki - FIN 221 38

4 - Option market • Trade option contracts that call for conditional future delivery of a security, a commodity, or a futures contract. • Option writer and option buyer or owner make an option contract. • Option contract gives the buyer / seller the right to either buy or sell a security depending upon whether the option is a “call” or “put” option. 1. Call options: give the security issuer the right to buy a predetermined (given) amount of a security at a given/ agreed price on, or possibly before, the expiry date of the options. 2. Put options: give the buyer the right to sell a predetermined (an agreed) amount of a security at the agreed price prior to the option’s expiry date. 3. Convert option: give the buyer the right to convert the security to another one. • Options contract are traded on organized exchanges. 39 Dr. Hisham Abdelbaki - FIN 221

5 - Foreign Exchange Market Involves Spot, future forward and option markets 6 - International & Domestic Markets • According to where they are located. • Eurodollar and Eurobond markets are examples of major international markets. • Eurodollars are US dollars deposited outside the US. • Eurobonds are issued outside the US but denominated in US dollars. 40 Dr. Hisham Abdelbaki - FIN 221

The Money Market • Borrow, lend, invest for short term period • Money market instruments characteristics: 1 - high liquidity 2 - Low risk (and consequently low yield) 3 - short maturity (often 90 days or less) • Money market are wholesale and over –the – counter in character. 1. Minimum primary market transaction is usually $ 1 million. 2. There is NO organized exchange; brokers and dealers specialize in various instruments. 41 Dr. Hisham Abdelbaki - FIN 221

• Money Market instruments include: 1. Treasury Bills IOUs auctioned weekly by the US Treasury. 2. Negotiable Certificates of Deposit Large, marketable CDs sold by a few large banks. 3. Commercial Paper Unsecured IOUs issued by large, creditworthy businesses. 4. Federal Funds Excess reserves of depository institutions in the Federal Reserve System. 42 Dr. Hisham Abdelbaki - FIN 221

The Capital Market • To finance Capital Goods. • Its instruments are: 1. 2. 3. 4. long maturities (usually 5 to 30 years) Less liquidity Higher risk in most assets (so higher yields) Traded in organized market and in over –the – counter markets 43 Dr. Hisham Abdelbaki - FIN 221

• Major capital market instruments are: 1. Common Stock: shares of ownership in an incorporated business and its net profit. 2. Corporate Bonds: long – term debt securities issued by large corporations. 3. Municipal Bonds : long – term debt securities issued by state and local governments. 4. Mortgages: long term loans secured by real estate (land or buildings) 44 Dr. Hisham Abdelbaki - FIN 221

Financial Market Efficiency 1. Allocational Efficiency: Funds find their highest and best use. 2. Informational Efficiency Prices reflect relevant information. 3. Operational Efficiency Transactions costs are minimized. 45 Dr. Hisham Abdelbaki - FIN 221

Risks Faced By Financial Institutions First: Credit Risk (or default risk) • Borrower may not pay as agreed. • Financial institutions manage to credit risk in 3 concurrent ways: 1 - diversify their portfolios. 2 - conduct a credit analysis of the borrower to measure ability and willingness to pay. 3 - monitor the borrower over the life of the loan or investment to detect any critical changes in financial health. Dr. Hisham Abdelbaki - FIN 221 46

Second: Interest Rate Risk Change in interest rates causes fluctuations in a security’s price and reinvestment income. Third: Liquidity Risk It is possibility that a financial institution may be unable to pay required cash outflow. Fourth: Foreign Exchange Risk Fluctuation of exchange rate causes fluctuation in the earning or value of a financial institution Fifth: Political Risk It is possibility that government action will harm an 47 institution’s interests. Dr. Hisham Abdelbaki - FIN 221