Lecture 1 Flashcards
Financial system
Consists of markets and institutions/intermediaries
Model of a simple economy
Households and firms = savings, income, input of land/labour/capital, consumption of outputs, payments for outputs, issuance of financial claims
How the system works
Funds from surplus to deficit
Surplus
Risk-averse with short-term horizons
Deficit
Risk taker with medium or long-term time horizons
Financial security
A legal claim to a future cash flow = financial instruments, assets or claims
Examples of securities
Treasury bills, bills of exchange bonds, convertibles, debentures, preference shares
Characteristics of financial claims
-Risk is referred to the fact that some future outcome affecting that instrument is not know with certainty
Examples: changes in the price of the security or default with respect to repayment of capital or income stream
-Liquidity = refers to how fast it can be turned to cash
-Real value certainty = refers to the susceptibility of financial securities to loss due to a rise in the general level of prices (inflation)
-Expected return = for capital uncertain instruments which are subject to a change in price, the expected rerun is used to determine whether to purchase or hold on to the security.
-Term to maturity = an issuance policy, refers to the remaining life of a debt instrument.
E.g. Zero term to maturity - sight deposits at bank - maturity (years)
-Currency denomination = adds a further component to the return on non-domestic instruments.
Debt claims
Deposits, loans, bills and bonds
- debt claim holder has predetermined cash claims via the rate of interest charged, which may be fixed or variable
Equity claims
An equity debt holder is entitled to dividends once holders of debt claims have been paid
Debt financing
Means borrowing in order to acquire an asset.
Also known as financial leverage.
Using debt financing allows the existing stockholders to maintain their percentage of ownership, since now new stock is being issued.
Problems with debt financing
- The claims issued by borrowers are likely to be long term and high risk, whereas lenders are likely to prefer to hold claims, which are more certain and short term
- The need of particular lenders and borrowers may not match
- The process of finding a transaction that suits both borrower and lender is likely to be costly
- Asymmetric information
- Adverse selection
- Moral hazard
Costs of Direct Financing
Search costs - for obtaining information about potential transactions; and negotiating contracts
Verification costs - incurred to evaluate borrowing proposals
Monitoring costs - incurred after the loan is made to monitor the actions of borrowers to ensure that the terms of the contract are met
Enforcement costs - costs associated in the case if borrower is unable to meet the commitments as promised and a solution must be worked out between borrower and lender and other aspects of contract enforced.
Organised capital markets
Can solve some of the problems of direct financing
Lenders benefit from wing able to sell on their claims in the capital market, thereby enhancing liquidity of those claims and so encouraging more lending to take place.
Financial intermediaries can reduce the costs of financing associated with contracting, search and information due to economies of scale.
Financial intermediaries
Alleviate the problems arising out of asymmetric information:
Banks can develop expertise in assessing lenders helping to solve the adverse selection problem
Banks can also afford to devote resources to monitor borrowers thus reduce the moral hazard problem
