FINANCIAL MARKETS

& THE SPECIAL CASE OF MONEY

Prepared by: RSEL

THE MODERN FINANCIAL SYSTEM
 Finance – process by which economic
agents borrow from and lend to other
agents in order to consume or invest.
Example:
Students’ Loan

 Financial System – activities involved in

finance took place here.

THE ROLE OF THE FINANCIAL

SYSTEM
 Important parts of the financial system
include the money market, market for
fixed-interest assets (bonds, stock
markets), stock markets for the
ownership of firms, and foreign exchange
markets.

 Borrowing & lending take place in

financial markets & through financial
intermediaries.
Financial Markets

Like any other

market except that
their products &
services consists of
financial
instruments like
stocks and bonds.
Example:
Stock markets, bond markets
and foreign exchange markets
The foreign exchange market (forex, FX, or currency
market) is a global, worldwide decentralized financial market
for trading currencies
Financial Intermediaries
 Institutions that
provide financial
services and
products.
Example:
Commercial Banks (deposit
& lending), insurance
company, pension funds,
mutual funds and mortgage
resellers

Commercial banks – creates money

Insurance & pension funds – insurance policies
Pool & Subdivide Securities:
Mortgage Resellers – buy mortgages & repackage them
Mutual Funds – holds bonds & corporate stock in behalf of small
investor
Because the financial system is such a
critical part of a modern economy, let’s
consider its major functions:

Transfer resources
Manage Risks
Pools & Subdivides Funds
Clearing House Function

Functions of the Financial System

Transfers across time, sectors and regions.
Allows investment to be devoted in
productive uses rather than being bottled
up where they are least needed.
Example:
Japan has a high saving rate transfers
resources to China which has robust
investment opportunities.
 Loans / Direct foreign investment

Transfer Resources
 Risk Management is like resources
transfer;
 It move risks from those people that most
need to reduce their risks to others who
are able to weather them.
Example:
Fire Insurance of P200,000  spread out
to stockholders of the company.

Manage Risk
Example:
 Investor wants to invest P10,000 in a
diversified portfolio of common stocks.
 To buy efficiently a portfolio of 100
companies, it requires P10 million of
funds.
 Stock Mutual Fund: By having 1000
investor, it can buy the portfolio,
subdivide it and manage it for you.

Pools & Subdivides Funds

 Facilitates transaction between payers and
payees.
 This allows rapid transfer of funds around
the world.
 Example:
◦ You write a check on your checking account to
buy a new computer, a clearing house will debit
your bank and credit the bank of the company
selling the computer.

Clearing House Function

 Financial Assets – monetary claims by one
party against another part.
 Here are the major financial instruments or
assets.
◦ Money – a very special asset (to be discuss later).
◦ Savings Accounts – deposits with banks, usually
with interests.
◦ Government Securities – bills & bonds of the
government.
◦ Equities – ownership rights to companies (yields
dividends).
◦ Financial Derivatives –values are based on values of
other assets like stock options (determined
through the stocks which its is benchmarked)
◦ Pension Funds – ownership in the assets that are held by
companies or pension plans. (contribute
drawn down)

MENU OF FINANCIAL ASSETS

When you borrow money or invest…
 Return on Investment – rate of profit,
is the ratio of money gained or
lost on an investment relative to the
amount of money invested.
 Return on Fixed-interest Securities –
it is called interest rates.

◦ Interest Rates – price paid for borrowing

money.

INTEREST RATES & THE RETURN

ON FINANCIAL ASSETS
Nominal Interest Real Interest Rates
Rates  Corrected for
 Interest rate on inflation and is
money in terms of calculated as the
money per year nominal interest
(with out rates minus the rate
considering of inflation.
inflation)
Example:
NIR – Inflation = RIR
Nominal rate = 8 8-3 = 5  RIR
Inflation rate = 3

NOMINAL VS REAL INTEREST

RATES
THE SPECIAL CASE OF MONEY
 Money is anything that serves as a commonly accepted
medium of exchange

Evolution of Money
THE HISTORY OF MONEY
 Barter – exchange of goods for other goods.
◦ Problem: “want of coincidence”
 Commodity Money – commodities as
money (cattle, beer/wine, olive oil  18th
Century: silver & gold); they have intrinsic
value
◦ Problem: Division, Life, Extraction, Deposits
 Modern Money – paper money; it is wanted
because of what it can buy; protected from
counterfeiting; includes bank money
(checks), internet, e-money

HISTORY OF MONEY
Let us now look more carefully at the
different kinds of money. The major
monetary aggregates are the quantitative
measures of the supply of money.

They are known today as:

M1: Narrow (Transaction) Money
M2: Broad Money

COMPONENTS OF MONEY SUPPLY

 Consists of items that are actually used
for transactions.

 Components:
Coins Legal tender – must be
accepted by all

Paper Currency

Checking Accounts- checking deposits or bank

money

NARROW MONEY
 Near Money, M2 includes M1 as well as other
close substitutes for M1.
 Components:
◦ M1
◦ Savings account & Small time deposits
◦ Retail money market mutual funds

 They are safe and can be converted into M1.

 They are broad money because they cannot
be used as means of exchange for all
purchases.
BROAD MONEY
Money is not desired for its own sake, we cannot eat coins or hang
paper bills for aesthetic purposes. We demand money because it
serves us indirectly, as a lubricant to trade and exchange.

The Demand for Money

Let’s note money’s functions:
 Medium of Exchange – otherwise we
will be roving around looking for someone
to barter with.

 Unit of Account – money is the unit by

which we measure the value of things.

 Store of value – money is a riskless

store of value.

MONEY’S FUNCTION
 Individuals are willing to incur a cost to hold
currency or low-yielding checking accounts.
What is the opportunity cost of holding
money?
 It is the sacrifice of interest that you must
incur by holding money rather than another
asset.
◦ P1000 with 5% interest/year = end of the year
P1,050
◦ P1000 in currency = end of the year P1,000.

 The cost of holding money is the interest

foregone from not holding other assets.
COST OF HOLDING MONEY
Two Source of Money Demand
 People need money primarily because
their incomes & expenditures do not
come at the same time.
 Example:
◦ Pay day versus expenditure for the month

 The need to have money to pay purchases

or transactions, of goods, services and
other items constitutes the transaction
demand for money.

TRANSACTIONS DEMAND FOR

MONEY
 Demand for money responds to different
economic fluctuations.
 How does demand for money vary with
interest rates?
◦ As interest rates rise, other things equal, the
quantity of money demanded declines.
 Money is sometimes a store of value.
 The role of money as an investment is
addressed by financial economics, which
analyzes how investors should invest their
funds to attain their objectives in the best
possible manner.
 Its not advisable to hold M1 even though its
safe, because other assets are equally safe
but have higher yields.
 Example:
Savings with interest versus Currency

ASSET DEMAND
BANKING & THE SUPPLY OF
MONEY
 Of the financial intermediaries, the most
important are the commercial banks.
 Banks- they are fundamentally
businesses that are organized to earn
profits for their owners.
 It provides certain services for customers
and in return receives payments from
them.

Commercial Banks
 Assets Liabilities
Reserves 41 Checking deposits 614
Loans 4206 Savings & Time deposits 3964
Investment & Securities 1742
Other Assets 1082 Other liabilities & networth 2495
Total 7071 Total 7,071
The table above shows the consolidated balance sheet of all US
commercial banks.

A balance sheet is the statement of a firm’s financial position at a

point in time. It list assets (items that the firms own) & liabilities
(items the firms owes). The difference between assets & liabilities is
called net worth.

They have relatively the same balance sheet like other firms except
for the asset reserves. These are cash on hand or funds deposited
by the bank with the central bank
 Commercial banking began in England
with the goldsmiths, who developed the
practice of storing people’s gold and
valuable for safe-keeping.

 Deposit  receipts.

 No creation of money. No interests.

HOW BANKS DEVELOPED FROM

GOLDSMITH ESTABLISHMENTS
Banks turn reserves into bank money. There are two steps in
the process:

1. The Central bank determines the quantity of reserves of

the banking system

2. Using those reserves as an input, the banking system

transforms them into a much larger amount of bank
money. (The currency plus the bank money is the money
supply, M1). The process is called multiple expansion of
bank deposits.

MODERN FRACTIONAL-RESERVE
BANKING
THE PROCESS OF DEPOSIT CREATION
 Assume that the Federal Reserve buys
P1000 government bond from Mr. Bond,
and she deposits the P1000 in her
checking account at Bank 1.
 The change in the balance sheet as the
new demand deposit is concerned is
shown below:
Assets Liabilities
Reserves +P1000 Deposits +P1000
Total +P1000 Total +P1000

HOW DEPOSITS ARE CREATED:

FIRST GENERATION BANKS
 When Mr. Bond made the deposits, P1000 of
bank money were created.

 If the bank were to keep 100% of deposits in

reserves, as did the old goldsmiths, no extra
money would be created from the new
deposit of P1000.
 The depositors P1000 would just match the
P1000 reserves.
 But modern banks do not keep 100%
reserves for their deposits. Because banks
are assumed to keep a reserve requirement
of 10%, Bank 1 must set aside as reserves
P100 of the P1000.
 Assets Liabilities
Reserves +P100 Deposits +P1000
Loans and Investments +900
Total +P1000 Total +P1000

Bank 1 now has P900 more in reserve than it needs to meet the
requirements. Because reserves has no interests, the bank will
invest the P900 in check(i.e loan) .

The borrower will deposit the P900 to another bank, then Bank 1
will pay this P900.

Assets Liabilities
Reserves +P900 Deposits +900
Total +P900 Total +900

Bank 1 activity has created P900 of new money (P1,900)

As the other bank do the same thing a chain of expansion is created.

 The Money-Supply Multiplier – the
ration of new checking deposits to the
increase in reserves.
 The ratio of the new money created to the
change in reserves.

= 1__________
required reserve ratio

= 1__________ x deposit
required reserve ratio

MONEY-SUPPLY MULTIPLIER
 Leakage into Hand-to Hand
Effects of withdrawals:
If P1000 stays with the bank P10000 of new
deposits are created. If P100 will leak into
circulation outside the bank, it will only yield
P9000. The 10to1 amplification will only
occur if no reserves leaked from banks.

 Possible Excess Reserve

If banks decided to keep more of the
deposits than the required reserve, the whole
process of multiple deposit creation would
stop dead, with no expansion of deposits at
all.

TWO QUALIFICATIONS TO
DEPOSIT CREATION
THE STOCK MARKET
One of the most exciting part of capitalism system
 Stock Market – a place where the shares in
publicly owned companies, the titles to
business firms, are bought & sold.
 The stocks are listed and traded on stock
exchanges which are entities of a corporation
specialized in the business of bringing buyers
and sellers of the organizations to a listing of
stocks and securities together.
 Example:
◦ New York Stock Exchange, Philippine Stock
Exchange

THE STOCK MARKET

Before discussing issues in stock market
analysis, we need to introduce some
elementary concepts in Financial
Economics.

We noted earlier that assets have different

characteristics.

The two important characteristics are the

rate of return & risks.
 Rate of Return – total dollar gain from a
security.

 For saving accounts and short term

bonds, the return would be the interest
rate.

 For most assets the return combines an

income (dividends) with a capital gain or
loss, which is represents a decrease or
increase in the value of assets.

RISK & RETURN ON DIFFERENT

ASSETS
Example:
(For this example, ignore taxes & commissions)

 You bought a portfolio of P10,000 worth

of stock is US companies in Dec 2007.
 In 1998, your fund paid dividends of
P256, also, because it was a good year,
your fund rose in value to P13,500 at the
end of the year (capital gain of 35%).
 Your return was therefore (P256 +
3,500)/10,000= 37.6% in 1998.
 But although there are gains, at some point
investors also suffered from losses.

 Risk – refers to the variability of the returns

on an investment.

 Usually this is where in you invest in a broad

array of stocks.
Example:
 If I buy 1-year Treasury bond with a 6%
return, the bond is a riskless investment
because I am sure to get a return.

 But if u buy P10,000 of stocks, I am

uncertain about their year-end value.
 Individuals generally prefer higher return,
but they also prefer lower risk because
they are risk-averse.
returns  to induce investment to
higher risk.

 Usually safe investments like bonds have

lower average returns than risky
investment like stocks.
 Sound judgements get put aside as
markets engage in frenzies of
speculations.

 Investors are sometimes divided into

those who:
◦ Invest on firm foundation
◦ Try to outguess the market psychology

BUBBLES & CRASHES

 Firm-foundation Approach – holds that
assets should be valued on the basis of their
intrinsic value.
 For common stocks, the intrinsic value is the
expected present value of the dividends.
 Example:
 If a stock has a constant dividend of P2.00
and appropriate interest rate with which to
discount dividends of 5%/year, the intrinsic
value would be P2/0.05 =P40/share.

 This approach is a slow but safe way of

getting rich.
 Market Psychology – speculate on the
future value of assets rather than wait
patiently for stock to prove their intrinsic
value.

 When a psychological frenzy seizes the

market, it can result in speculative bubbles
and crashes.

 A speculative bubble occurs when prices

rise because people think they are going to
rise in the future. Their buying sends up the
price of stocks.
 One important hypothesis is that speculative
markets tend to be “efficient”.
 controversy

 What is the essence of the efficient-market

theory?
Finance Professor & Student Story ($100)

 Their lesson is not that you will not get rich

by following a rule or formula but that, on
average, such rules do not outperform a
diversified portfolio of stocks.

EFFICIENT MARKETS & THE

RANDOM WALK
 Efficient Financial Market – is one where
all new information is quickly understood by
market participants and becomes
immediately incorporated into market prices.
Example:
 New found source of Oil
 The theory also holds that market prices
contains all available information. It is not
possible to make profits by acting on an
old information or at patterns of past
price changes. Returns will be primarily
determined by their riskiness relative to
market.
 A Random Walk
Here are some reservations:

1. Anomalies in stock-price movements

2. Sharp movements in stock prices 
reflect new information?
3. Efficient-market view applies to
individual stocks but not necessarily to
the market as a whole.

Qualifications to the Efficient-

Market View
 Lesson 1: Know thy investment
 Lesson 2: Diversify, diversify – that is the
law of the prophets of finance.
 Lesson 3: Consider common stock index
funds
 Lesson 4: Minimize unnecessary expense
and taxes
 Lesson 5: Match your investment with
your risk preference

PERSONAL FINANCIAL
STRATEGIES
“If you are ready to give up
everything else– to study the whole
history & background of the market and
all the principal companies whose stocks
are on the board as carefully as a
medical student studies anatomy – if
you can do all that and in addition you
have the cool nerves of a great
gambler, the 6th sense of a kind
clairvoyant, and the courage of a lion,
you have a ghost of a chance.” – Bernard
Baruch
END.
Prepared by: RSEL