Financial markets & institutions

Finance & Money, Wealth & Saving

To understand financial markets and financial institutions, we first need to understand the difference between the following,

1. Finance & Money
2. Wealth & Saving
3. Physical & Financial Capital

Finance: the act of finding and providing funds which help pay for expenditures on capital.

When we study finance, want to see how households and firms obtain these funds, and how they deal with risks when they are financing.

Money: is any commodity or token that is acceptable as payment for goods and services. It is what we use to make financial transactions.

Finance and money are closely related, but they are not the same. Money is what you use to finance a project.

Note: In this chapter, we will mostly be focusing on finance.

Wealth: is the value of all items and money that a person owns. This is different from income, since that’s the money you earn during a time period.

Saving: the income that is not used on consumptions goods and services and tax.

Note: The more you save, the higher your wealth is.

Financial Capital Markets

We use savings as a source of the funds to finance investments. These funds are then supplied and demanded to three markets:

1. Bond Markets
2. Loan Markets
3. Stock Markets

Bond Markets: When firms expand its business and open new stores, it is going to need money to do so. They get the money by selling bonds.

A bond is a fixed income investment that represents a loan made by an investor to a borrower. The investor gives a loan to a borrower, and the borrower pays a specific amount at a specific time period until the final payment is done.

Example: Person A loans firm $100. Firm pays person A $5 every year until 2050, where the firm pays the last $5 and also the loan amount ($100).

Firms use to this to get their money first, and then pay back later including interest.

Loan Market: Firms get money to expand their business by loaning from a bank.

For example, bank loans the firm $100 with an interest rate of 5%. The firm must pay back $100 including an additional $5 next year (total $105).

Households can also get financing for new homes by getting a mortgage from banks.

Stock Market: Firms can get money to expand their business by issuing stocks. A stock is a legal ownership which allows you to claim a certain percentage of the firm’s profits.

Example: If a firm has 100 stocks and you own 1 of them, then you are entitled to get 1% of the firm’s profits.

Financial Institutions

A financial institution is firm that conducts financial transactions like investments, loans and deposits. They operate on both sides of the market. In other words, they can be a borrower in one market, and a lender in another.

The 4 following financial institutions are:

1. Insurance Companies: these companies allow households to deal with risks like theft, fire, death, and accidents. They receive premiums from clients and pay claims. They use statistical analysis to find out their actual losses for a given class, and by that they can calculate what the premiums should cost. This gives them a steady flow of funds.


2. Commercial Banks: they accept deposits, give payment services to other institutions, and make loans to households and firms. You will learn more about how they manage their money later.


3. Pension funds: uses pension contributions from workers and firms to buy bonds and stocks. There are pension funds that are extremely high, so they have a lot of power to what stock they want to hold.


4. Government-sponsored mortgage lenders: In simple terms, they are large financial institutions that buy mortgages from banks, make them into mortgage-backed securities, and sell them.

Financial Assets & Interest Rates

Loans, bonds, and stocks are all known as financial assets.

The interest rate of a financial asset is the interest received from the percentage of the price of the asset.

Essentially:

1. If price of asset $\, \uparrow \,$, then interest rate $\, \downarrow \,$.
2. If price of asset $\, \downarrow \,$, then interest rate $\, \uparrow \,$.

Suppose the price of the asset (bond) is $100, and the interest received is $5 per year. So,

Interest Rate = $\frac{5} {100} \, \times 100$ = 5%

1. If the price of asset is now $110, then
   
   Interest Rate = $\frac{5} {110} \, \times 100 = 4.\overline{54}$%
2. If the price of asset is now $90, then
   
   Interest Rate = $\frac{5} {90} \, \times 100 = 5.\overline{55}$%

Note: If interest rate increases, then price of asset decreases, which makes it hard for firms to pay their debts.