Introduction. Master Programmes INTERNATIONAL FINANCE. Szabolcs Sebestyén

Transcription

1 Introduction Szabolcs Sebestyén Master Programmes INTERNATIONAL FINANCE Sebestyén (ISCTE-IUL) Introduction International Finance 1 / 43

2 Outline 1 Why Study Money, Banking, and Financial Markets? 2 Appendix: Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 3 An Overview of the Financial System 4 Appendix: Financial Market Instruments Sebestyén (ISCTE-IUL) Introduction International Finance 2 / 43

3 Why Study Money, Banking, and Financial Markets? Outline 1 Why Study Money, Banking, and Financial Markets? 2 Appendix: Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 3 An Overview of the Financial System 4 Appendix: Financial Market Instruments Sebestyén (ISCTE-IUL) Introduction International Finance 3 / 43

4 Why Study Money, Banking, and Financial Markets? Why Study Money, Banking, and Financial Markets? To examine how financial markets such as bond, stock and foreign exchange markets work To examine how financial institutions such as banks and insurance companies work To examine the role of money in the economy Sebestyén (ISCTE-IUL) Introduction International Finance 4 / 43

5 Why Study Money, Banking, and Financial Markets? Financial Markets Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage of funds Well-functioning financial markets are a key factor in producing high economic growth, and poorly performing financial markets are one reason that many countries remain poor A security (financial instrument) is a claim on the issuer s future income or assets An asset is a financial claim or piece of property that is subject to ownership The bond market and interest rates: A bond is a debt security that promises to make payments periodically for a specified period of time An interest rate is the cost of borrowing or the price paid for the rental of funds Sebestyén (ISCTE-IUL) Introduction International Finance 5 / 43

6 Why Study Money, Banking, and Financial Markets? Interest Rates on Selected Bonds, Source: Mishkin (2010), Figure 1.1; the data source is Federal Reserve Bulletin. Sebestyén (ISCTE-IUL) Introduction International Finance 6 / 43

7 Why Study Money, Banking, and Financial Markets? The Foreign Exchange Market The foreign exchange market is where funds are converted from one currency into another The foreign exchange rate is the price of one currency in terms of another currency The foreign exchange market determines the foreign exchange rate Sebestyén (ISCTE-IUL) Introduction International Finance 7 / 43

8 Why Study Money, Banking, and Financial Markets? Exchange Rate of the US Dollar, Source: Mishkin (2010), Figure 1.8; the data source is Federal Reserve. Sebestyén (ISCTE-IUL) Introduction International Finance 8 / 43

9 Why Study Money, Banking, and Financial Markets? Financial Institutions and Banking Financial intermediaries: institutions that borrow funds from people who have saved and make loans to other people: Banks: accept deposits and make loans Other financial institutions: insurance companies, finance companies, pension funds, mutual funds and investment banks Financial intermediaries are the most heavily regulated businesses in the economy Financial innovation: in particular, the advent of the information age and e-finance Financial crises are major disruptions in financial markets that are characterised by sharp declines in asset prices and the failures of many financial and non-financial firms Sebestyén (ISCTE-IUL) Introduction International Finance 9 / 43

10 Why Study Money, Banking, and Financial Markets? Money and Business Cycles Money is anything that is generally accepted in payment for goods or services or in the repayment of debts Evidence suggests that money plays an important role in generating business cycles Recessions (unemployment) and expansions affect all of us Monetary theory ties changes in the money supply to changes in aggregate economic activity and the price level Sebestyén (ISCTE-IUL) Introduction International Finance 10 / 43

11 Why Study Money, Banking, and Financial Markets? Money Growth (M2 Annual Rate) and the Business Cycle in the US, Note: Shaded areas represent recessions. Source: Mishkin (2010), Figure 1.3; the data source is Federal Reserve Bulletin, p. A4, Table Sebestyén (ISCTE-IUL) Introduction International Finance 11 / 43

12 Why Study Money, Banking, and Financial Markets? Money and Inflation The aggregate price level is the average price of goods and services in an economy A continual rise in the price level (inflation) affects all economic players Data shows a connection between the money supply and the price level Sebestyén (ISCTE-IUL) Introduction International Finance 12 / 43

13 Why Study Money, Banking, and Financial Markets? Aggregate Price Level and the Money Supply in the US, Source: Mishkin (2010), Figure 1.4; the data source is St. Louis Fed and Federal Reserve. Sebestyén (ISCTE-IUL) Introduction International Finance 13 / 43

14 Why Study Money, Banking, and Financial Markets? Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, Source: Mishkin (2010), Figure 1.5; the data source is International Financial Statistics. Sebestyén (ISCTE-IUL) Introduction International Finance 14 / 43

15 Why Study Money, Banking, and Financial Markets? Money and Interest Rates Interest rates are the price of money Prior to 1980, the rate of money growth and the interest rate on long-term Treasury bonds were closely tied Since then, the relationship is less clear but the rate of money growth is still an important determinant of interest rates Sebestyén (ISCTE-IUL) Introduction International Finance 15 / 43

16 Why Study Money, Banking, and Financial Markets? Money Growth (M2 Annual Rate) and Interest Rates (Long-Term US Treasury Bonds), Source: Mishkin (2010), Figure 1.6; the data source is Federal Reserve Bulletin, p. A4, Table Sebestyén (ISCTE-IUL) Introduction International Finance 16 / 43

17 Why Study Money, Banking, and Financial Markets? Monetary and Fiscal Policy Monetary policy is the management of the money supply and interest rates Conducted in the US by the Federal Reserve System (Fed) and in the euro area by the European Central Bank (ECB) Fiscal policy deals with government spending and taxation Budget deficit is the excess of expenditures over revenues for a particular year Budget surplus is the excess of revenues over expenditures for a particular year Any deficit must be financed by borrowing Sebestyén (ISCTE-IUL) Introduction International Finance 17 / 43

18 Why Study Money, Banking, and Financial Markets? Government Budget Balance as % of GDP, Source: Mishkin (2010), Figure 1.7; the data source is US Government Printing Office. Sebestyén (ISCTE-IUL) Introduction International Finance 18 / 43

19 Why Study Money, Banking, and Financial Markets? International Finance Financial markets have become increasingly integrated throughout the world The international financial system has tremendous impact on domestic economies: How a country s choice of exchange rate policy affect its monetary policy? How capital controls impact domestic financial systems and therefore the performance of the economy? Which should be the role of international financial institutions like the IMF? Sebestyén (ISCTE-IUL) Introduction International Finance 19 / 43

20 Defining Aggregate Output, Income, the Price Level, and Inflation Outline 1 Why Study Money, Banking, and Financial Markets? 2 Appendix: Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 3 An Overview of the Financial System 4 Appendix: Financial Market Instruments Sebestyén (ISCTE-IUL) Introduction International Finance 20 / 43

21 Defining Aggregate Output, Income, the Price Level, and Inflation Aggregate Output and Aggregate Income Aggregate output Gross Domestic Product (GDP) = market value of all final goods and services produced in the domestic economy during a particular year Aggregate income Total income of the factors of production (land, capital, labor) during a particular year Income payments must equal payments for final goods and services Distinction between nominal and real: Nominal = values measured using current prices Real = quantities measured with constant prices Nominal values can be misleading Sebestyén (ISCTE-IUL) Introduction International Finance 21 / 43

22 Defining Aggregate Output, Income, the Price Level, and Inflation Aggregate Price Level Aggregate price level is a measure of average prices in the economy Three measures: GDP deflator: nominal GDP divided by real GDP PCE deflator: nominal personal consumption expenditure (PCE) divided by real PCE Consumer price index (CPI): is a measure of the average change over time in the prices paid by urban consumers for a market basket of goods and services These three measures can be used to convert a nominal magnitude into a real magnitude Sebestyén (ISCTE-IUL) Introduction International Finance 22 / 43

23 Defining Aggregate Output, Income, the Price Level, and Inflation Growth Rates and the Inflation Rate A growth rate is a percentage change in a variable: growth rate = x t x t 1 x t For example, if real GDP grew from $9 trillion in 2010 to $9.5 trillion in 2011, then the GDP growth rate for 2011 would be $9.5 trillion $9 trillion GDP growth rate = 100 = 5.6% $9 trillion The inflation rate is the growth rate of the aggregate price level For example, if the GDP deflator rose from 111 in 2010 to 113 in 2011, the inflation rate would be inflation rate = 100 = 1.8% 111 If the growth rate is for a period less than one year, it is usually reported on an annualised basis Sebestyén (ISCTE-IUL) Introduction International Finance 23 / 43

24 An Overview of the Financial System Outline 1 Why Study Money, Banking, and Financial Markets? 2 Appendix: Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 3 An Overview of the Financial System 4 Appendix: Financial Market Instruments Sebestyén (ISCTE-IUL) Introduction International Finance 24 / 43

25 An Overview of the Financial System Function of Financial Markets Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities Securities are assets for those who buy them but liabilities (IOUs or debts) for those who sell (issue) them Promotes economic efficiency by producing an efficient allocation of capital, which increases production Directly improves the well-being of consumers by allowing them to time purchases better Sebestyén (ISCTE-IUL) Introduction International Finance 25 / 43

26 An Overview of the Financial System Flows of Funds Through the Financial System Source: Mishkin (2010), Figure 2.1 Sebestyén (ISCTE-IUL) Introduction International Finance 26 / 43

27 An Overview of the Financial System Structure of Financial Markets (1) Debt and Equity Markets Debt instruments (maturity) Equities (dividends) Primary and secondary markets Investment banks underwrite securities in primary markets Brokers and dealers work in secondary markets Secondary markets make assets more liquid They determine the price of the security that the issuing firm sells in the primary market Sebestyén (ISCTE-IUL) Introduction International Finance 27 / 43

28 An Overview of the Financial System Structure of Financial Markets (2) Exchanges and Over-the-Counter (OTC) markets Exchanges: NYSE, Chicago Board of Trade OTC Markets: Foreign exchange, Federal funds, swaps Money and capital markets Money markets deal in short-term debt instruments Capital markets deal in longer-term debt and equity instruments Sebestyén (ISCTE-IUL) Introduction International Finance 28 / 43

29 An Overview of the Financial System Internationalisation of Financial Markets Foreign bonds: sold in a foreign country and denominated in that country s currency Eurobond: bond denominated in a currency other than that of the country in which it is sold Eurocurrencies: foreign currencies deposited in banks outside the home country Eurodollars: US dollars deposited in foreign banks outside the US or in foreign branches of US banks Sebestyén (ISCTE-IUL) Introduction International Finance 29 / 43

30 An Overview of the Financial System Function of Financial Intermediaries: Indirect Finance Indirect finance: involves a financial intermediary that stands between the lender-savers and the borrower-spenders Lower transaction costs (time and money spent in carrying out financial transactions) Economies of scale Liquidity services Reduce the exposure of investors to risk Risk sharing (asset transformation) Diversification Deal with asymmetric information problems (before the transaction) Adverse selection: try to avoid selecting the risky borrower Gather information about potential borrower (after the transaction) Moral hazard: ensure borrower will not engage in activities that will prevent him/her to repay the loan Sign a contract with restrictive covenants Sebestyén (ISCTE-IUL) Introduction International Finance 30 / 43

31 An Overview of the Financial System Primary Assets and Liabilities of Financial Intermediaries Source: Mishkin (2010), Table 2.3 Sebestyén (ISCTE-IUL) Introduction International Finance 31 / 43

32 An Overview of the Financial System Principal Financial Intermediaries and Value of Their Assets Source: Mishkin (2010), Table 2.4 Sebestyén (ISCTE-IUL) Introduction International Finance 32 / 43

33 An Overview of the Financial System Regulation of the Financial System To increase the information available to investors: Reduce adverse selection and moral hazard problems Reduce insider trading (SEC) To ensure the soundness of financial intermediaries: Restrictions on entry (chartering process) Disclosure of information Restrictions on assets and activities (control holding of risky assets) Deposit insurance (avoid bank runs) Limits on competition (mostly in the past) Branching Restrictions on interest Rates Sebestyén (ISCTE-IUL) Introduction International Finance 33 / 43

34 Appendix: Financial Market Instruments Outline 1 Why Study Money, Banking, and Financial Markets? 2 Appendix: Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 3 An Overview of the Financial System 4 Appendix: Financial Market Instruments Sebestyén (ISCTE-IUL) Introduction International Finance 34 / 43

35 Appendix: Financial Market Instruments Money Market Instruments (1) US Treasury Bills: short-term instruments of the US government, issued in 3-, 6-, and 12-month maturities to finance the federal government No interest payment, sold initially at a discount The most liquid and safest money market instrument Certificates of deposit (CD): debt instrument, sold by a bank to its depositors, that pays annual interest and at maturity pays back the original purchase price Since 1961 they are negotiable Sebestyén (ISCTE-IUL) Introduction International Finance 35 / 43

36 Appendix: Financial Market Instruments Money Market Instruments (2) Commercial paper: short-term debt instrument issued by large banks and corporations Direct finance for companies instead of borrowing from banks Banker s acceptances: bank draft issued by a firm, payable at some future date, and guaranteed for a fee by the bank that stamps it accepted The firm issuing the instrument is required to deposit the required funds into its account to cover the draft They can be resold in the secondary market at a discount Sebestyén (ISCTE-IUL) Introduction International Finance 36 / 43

37 Appendix: Financial Market Instruments Money Market Instruments (3) Repurchase agreements (repos): short-term loans in which Treasury bills serve as collateral Important source of bank funds The most important lenders are big corporations Federal (Fed) funds: typically overnight loans between banks of their deposits at the Fed This market is very sensitive to the credit needs of banks, so the interest rate on these loans (federal funds rate) is a closely watched barometer of the tightness of credit market conditions in the banking system and the stance of monetary policy Sebestyén (ISCTE-IUL) Introduction International Finance 37 / 43

38 Appendix: Financial Market Instruments Principal Money Market Instruments Source: Mishkin (2010), Table 2.1 Sebestyén (ISCTE-IUL) Introduction International Finance 38 / 43

39 Appendix: Financial Market Instruments Capital Market Instruments (1) Stocks: equity claims on the net income and assets of a corporation Mortgages: loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans The largest debt market in the US The federal government plays an active role in the mortgage market via the three government agencies: Fannie Mae, Freddie Mac, Ginnie Mae Sebestyén (ISCTE-IUL) Introduction International Finance 39 / 43

40 Appendix: Financial Market Instruments Capital Market Instruments (2) Corporate bonds: long-term bonds issued by corporations with very strong credit ratings Sends the holder an interest payment twice a year and pays off the face value when the bond matures Some corporate bonds (convertible bonds) have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date The volume of new corporate bonds issued each year is substantially greater than the volume of new stock issues Sebestyén (ISCTE-IUL) Introduction International Finance 40 / 43

41 Appendix: Financial Market Instruments Capital Market Instruments (3) US government securities: long-term debt instruments issued by the US Treasury to finance the deficits of the federal government The most liquid security traded in the capital market US government agency securities: long-term bonds issued by various government agencies to finance such items as mortgages, farm loans, or power-generating equipment Many are guaranteed by the federal government Sebestyén (ISCTE-IUL) Introduction International Finance 41 / 43

42 Appendix: Financial Market Instruments Capital Market Instruments (4) Municipial bonds: long-term debt instruments issued by state and local governments to finance expenditures on schools, roads, and other large programs their interest payments are exempt from federal income tax and generally from state taxes in the issuing state Consumer and bank commercial loans: loans to consumers and businesses made principally by banks, but in the case of consumer loans also by finance companies The least liquid of the capital market instruments Sebestyén (ISCTE-IUL) Introduction International Finance 42 / 43

43 Appendix: Financial Market Instruments Principal Capital Market Instruments Source: Mishkin (2010), Table 2.2 Sebestyén (ISCTE-IUL) Introduction International Finance 43 / 43