CHAPTER 1

AN OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS

CHAPTER OVERVIEW AND LEARNING OBJECTIVES

This chapter introduces the concept of the financial system and explains its economic role—to channel savings into productive investment by bringing savers and borrowers together. A reliable system of financial institutions and markets helps sustain economic prosperity.

This chapter identifies the participants in financial activity, classifies their relationships, and defines basic terms for use throughout the course.

This study guide helps you organize your thinking about these new concepts and terms. Try to link each topic to your own life, the news of the day, and the “big picture”. Are you a depositor at a bank or credit union? Do you have insurance or student loans? Have you noticed headlines about interest rates or the stock market? The financial system affects almost everyone, almost all the time.

Answer the questions or problems, compare your answers with the solutions, then re-read and reinforce the material. Make full use of each opportunity to use the Wall Street Journal and the various online resources to which you will be directed.

CAREER PLANNING NOTE

Finance traditionally comprises 3 main career areas. Managerial finance involves financial roles within a business or government. Examples of entry-level jobs in this area include “financial analyst” or “budget analyst”. The Investment area involves products and services for the investing public, with opportunities for analysts, brokers, and traders. Financial institutions offer a large array of entry-level finance jobs. Banks, insurance companies, and regulators all recruit college graduates for well-defined career paths.

Every topic in the book represents a potential career path. Find out more about opportunities—and working conditions—associated with various financial institutions and markets. Many of your professors have worked outside the “ivory tower”; ask about their experiences. Your academic advisor can point you toward resources—on and off campus—to help you learn more. And the worldwide web, of course, is not far from your fingertips. For the 21st-century college student, it’s never too early to start looking!

READING THE WALL STREET JOURNAL….

…is one of the best professional habits you can cultivate. As a student, you may qualify for a discounted subscription. Ask your instructor, or contact the Journal directly:

1.800.568.7625 http://info.wsj.com/college/jumppage/

Chapter by chapter, this Study Guide will help you get the most from Journal, as both a companion to your studies and a tool in your professional life.

TOPIC OUTLINE AND KEY TERMS

I. The financial system facilitates the flow and allocation of funds throughout the economy.

A. Basic components of the financial system: markets and institutions.

1. Financial markets are markets for financial instruments, also called financial claims or securities.

2. Financial institutions (also called financial intermediaries) facilitate flows of funds from savers to borrowers.

B. Economic units with financial needs: Households, businesses, and governments.

1. Households supply labor, demand products, and save for the future.2. Businesses demand labor, supply products, and invest in productive assets.3. Governments collect taxes and provide “public goods” (e.g. education, defense).

C. Budget positions creating financial needs for a given period: Surplus or deficit.

1. Surplus spending units ( SSUs) are economic units in a surplus budget position.a. Income for the period exceeds planned expenditures, resulting in savings.b. Ultimately, most SSUs are households, who need to invest savings as

beneficially as possible.c. Other words for “SSU” include “saver”, “lender”, or “investor”.

2. Deficit spending units (DSUs) are economic units in a deficit budget position.a. Planned expenditures for the period exceed income, resulting in funding

requirements.b. Ultimately, most DSUs are businesses or governments, who need to

finance planned expenditures as cost-effectively as possible.c. Another word for “DSU” is “borrower”.

II. Financial claims (or “financial instruments” or “securities”) arise as SSUs lend to DSUs.

A. DSUs borrow from SSUs and issue SSUs written promises to pay back the loans.

1. Written promises of payment, sometimes called “IOU”s, typically provide for— a. a specific sum of money (the “principal”), b. plus a fee (the “interest rate”), c. for a certain period of time (the “maturity”).

2. The resulting claim against the DSU by the SSU, is simultaneously—a. a liability to the DSU, who pays interest as a penalty for accelerating

consumption, andb. an asset to the SSU, who earns interest as the reward for postponing

consumption.

3. A liability is someone else’s asset (one’s “payable” is another’s “receivable”) a. Assets arising in this way are called “financial assets”.

b. The system “balances”--total financial assets equal total liabilities

B. Marketability is the ease with which a financial asset may be sold to another SSU.

1. Many SSUs may buy and resell the claim, but the DSU still has use of the funds. 2. The ability to resell financial claims is important because it gives SSUs choices: a. Match the maturity of the claim to the planned investment period; b. Buy a claim with a longer maturity, but sell at the end of the period; or c. Buy a claim with a shorter maturity, then reinvest.

III. Direct financing to DSUs from SSUs the simplest way for funds to flow.

A. “Direct credit” markets can increase efficiency.

1. DSUs and SSUs divide benefits of economic opportunities as they arise a. DSUs fund promising opportunities immediately. b. SSUs earn timely returns on savings.

2. Direct markets are “wholesale” markets. a. Transactions are large—typically $1 million or more. b. Institutional arrangements are therefore common.

B. Institutional arrangements common in direct finance: Private placements, investment bankers, brokers and dealers.

1. Private placements are the simplest form of “direct finance”.

a. A DSU sells a whole security issue to one investor or investor group. b. Advantages include speed and low transactions costs.

2. Investment bankers often “underwrite” new issues of securities; they—a. buy entire issues from DSUs, thenb. find SSUs to buy the securities at a higher price, in order to

c. profit from the difference--the “underwriting spread.”

3. Brokers and dealers help bring buyers and sellers of financial claims together.a. Brokers buy or sell at the best possible price for their clients.

b. Dealers “make markets” by carrying inventories of securities. (1) Dealers buy securities at “bid price” and sell them at “ask price”. (2) The resulting “bid-ask spread” represents a dealer’s gross profit.

C. Problem with direct financing: DSUs and SSUs cannot always match preferences.

1. Not every SSU can afford “wholesale” denominations of $1 million or more. 2. DSUs and SSUs often prefer different terms to maturity.

IV. Indirect financing (financial intermediation) involves a financial intermediary.

A. Financial intermediaries “transform” claims to mediate unmatched preferences.

1. Intermediaries issue claims against themselves to SSUs in exchange for funds. 2. Intermediaries use these funds to purchase claims issued by DSUs. 3. The two sets of claims can have materially different characteristics, because— a. SSUs have claims against intermediaries, not DSUs, and b. DSUs are liable to the intermediaries, not SSUs.

B. Daily life involves 2 common financial intermediaries (but there are many more).

1. Commercial banks (or other “depository” institutions) take deposits and make loans—the depositors are SSUs and the borrowers are DSUs.

2. Insurance companies issue policies, collect premiums, and invest in stocks and bonds—the policyholders are SSUs; the DSUs are businesses or governments whose securities the insurance company holds.

C. Disintermediation is the reverse of intermediation--SSUs “disintermediate” when they perceive it will be more beneficial take funds out of intermediaries and invest directly.

D. Indirect markets tend to be “retail” markets—the end-users rarely interact directly.

V. The benefits of financial intermediation are a primary rationale for the financial system.

A. Financial intermediaries lower the cost of financial services as they pursue profit.

1. Intermediaries pay SSUs less than they earn from DSUs. a. Operating costs of the intermediary absorb part of this margin. b. Risks taken by the intermediary are rewarded by any remaining profit.

2. Profitability of intermediaries is based on 3 sources of comparative advantage: a. Economies of scale —large volumes of similar transactions.

b. Transaction cost control—find and negotiate direct investments less expensively.

c. Risk management expertise—bridge “information gap” about DSU’s creditworthiness.

3. Competition among intermediaries tends to force interest rates downward, so— a. Financing is less costly. b. Projects have higher net present values. c. Increased investment in real assets promotes economic growth.

B. Financial intermediaries perform 5 basic services as they transform claims.

1. Denomination Divisibility.a. DSUs prefer to borrow the full funding need all at once. b. SSUs tend to save small amounts, month by month or year by year.c. Intermediaries pool savings of many small SSUs into large investments.

2. Currency Transformation.a. Few ordinary SSUs will hold claims denominated in foreign currency.

b. Success in foreign trade is critical in modern economies.c. Intermediaries can buy claims denominated in one currency while

issuing claims denominated in another.

3. Maturity Flexibility. a. DSUs generally prefer longer-term financing. b. SSUs generally prefer shorter-term investments. c. Intermediaries can offer different ranges of maturities to both.

4. Credit Risk Diversification.a. Intermediaries can afford to spread risk by holding many different

securities.b. The less correlated the securities are with each other, the more stable the

portfolio’s value. c. SSUs, on their own, would have to leave “more eggs in one basket.”

5. Liquidity.a. Most economic units prefer that some of their assets be readily

convertible to money. b. Many claims issued by intermediaries are highly liquid.

c. Claims issued by DSUs are marketable, but subject to price fluctuation and transactions costs.

C. Financial intermediaries give other economic units choices about financial strategy.

1. SSUs can choose between direct or indirect investment.2. DSUs can decide whether a direct market or an intermediary is the cheapest

source of funds.

VI. Four major types of financial intermediaries transform claims to meet various needs.

A. Deposit-Type or “Depository” Institutions take deposits and make loans.

1. Depository institutions are the most familiar intermediaries in daily life.

a. Common deposit arrangements include— (1) checking accounts or “demand deposits”, (2) savings accounts, and (3) “ time deposits” (such as certificates of deposit or “CDs”).

b. Common loan purposes include— (1) business loans for inventory or equipment

(2) consumer loans for education, vehicles, or other “big ticket” household items, and

(3) real estate loans or “mortgages”.

c. In developed countries, deposits are safe and liquid.(1) Government-mandated insurance protects most depositors. (2) Most deposits may be withdrawn on demand, or on very short

notice at minimal cost.

2. Three main forms of depository institutions resemble each other, but differ in some ways.

a. Commercial Banks, the largest, most diversified, and most regulated intermediaries—

(1) issue a wide variety of deposit products;(2) carry widely diversified portfolios of loans, leases and

government securities; and (3) may offer trust or underwriting services.

b. Thrift Institutions resemble commercial banks in many respects but—(1) concentrate more on real estate loans, especially residential

mortgage loans; and (2) are called “savings and loan associations” or “savings banks”.

c. Credit unions resemble banks or thrifts in basic function but have 4 unique characteristics:(1) Mutual ownership—“owned” by depositors or “members”.(2) “Common bond”—members must share some meaningful

common association.(3) Not-for-profit and tax-exempt—any surplus must be used to

benefit members. (4) Restricted mostly to small consumer loans.

B. Contractual Savings Institutions bring long-term savers and borrowers together.

1. Common contractual arrangements include—a. insurance, covering policyholders against some specified loss; and

b. pension plans, under which workers save for retirement.

2. Three main forms of contractual institutions focus on long-term financial needs.

a. Life Insurance Companies insure against lost income at death. (1) Policyholders pay premiums, which are pooled and invested in

stocks, bonds, and mortgages.(2) Investment earnings cover the costs and reward the risks of the

insurance company. (3) Investments are liquidated to pay benefits.

b. Casualty Insurance Companies cover property against loss or damage. (1) Sources and uses of funds resemble those of life insurers, but

(2) Casualty claims are not as predictable as death claims; so(3) More assets are in short-term, easily marketable investments.

c. Pension Funds help workers plan for retirement.(1) Workers and/or employers make contributions, which are pooled

and invested in stocks, bonds, and mortgages.(2) Net of administrative costs, investment earnings are reinvested

and compounded.(3) Retirement benefits replace paychecks (at least partly).

C. Investment Funds help small investors share the benefits of large investments. 1. Benefits to investors include denomination divisibility and diversification. 2. Two kinds of investment funds are especially popular among ordinary investors.

a. Mutual Funds provide intermediated access to various capital markets.(1) Shareholders’ money is pooled and invested toward an objective.

(2) Common fund classifications or investment objectives include— i. “Index” funds, which follow some major index

(e.g. Dow Jones Industrial Average or S&P 500); andii. “Sector” funds, which focus on particular investments

(e.g. bond funds, utility funds).

b. Money Market Mutual Funds (“MMMFs”) are close but uninsured substitutes for deposit accounts.(1) MMMFs buy “money market” instruments “wholesale” (2) Investors receive interest and limited check-writing privileges.

D. Other types of intermediaries include Finance Companies and Federal Agencies.

1. Finance Companies make loans but do not take deposits. a. Consumer finance companies make personal installment loans. b. Business finance companies make loans and leases to businesses.

c. Sales finance companies finance retail purchases of products.d. Sources of loanable funds to finance companies include—

(1) Shareholders, and (2) “Commercial Paper”, a short-term IOU described in Chapter 7.

2. Federal Agencies can function as financial intermediaries.a. Certain agencies channel low-cost credit to targeted economic sectors by

(1) issuing “agency securities” backed by the government and(2) lending at sub-market rates to selected households or businesses.

b. Various agencies promote various socioeconomic interests (e.g. home ownership, small business, agriculture, exports). VII. Financial intermediaries buy and sell claims in financial markets classified in several ways.

A. Primary and Secondary Markets represent the stages of a financial claim’s “life”. 1. Primary markets are where financial claims are “born”—originally issued. a. DSUs receive funds (e.g., IBM raises capital by selling bonds). b. Claims are issued (e.g., an investment banker buys the bonds).

2. Secondary markets are where financial claims “live”—are resold and repriced. a. All subsequent purchases or sales of a claim are in a secondary market.

b. Secondary markets offer liquidity: SSUs set their own holding periods. c. Secondary markets determine prices and yields of widely held securities.

B. Organized and Over-the-Counter Markets differ as secondary market schemes.

1. Organized Exchanges are physical and relatively exclusive. a. A physical trading floor and facilities are exclusively available— (1) to members of the exchange, (2) for securities listed on the exchange. b. Famous examples of organized exchanges include the— (1) New York Stock Exchange, founded in 1792, and (2) Chicago Board of Trade (for futures contracts), founded in 1848.

2. Over-the-Counter (“OTC”) Markets are virtual and relatively inclusive. a. A decentralized information and trading network is available— (1) To any licensed dealer willing to buy access and obey the rules, (2) For a wide range of securities registered for public issue. b. The NASDAQ, founded in 1971, is a famous “OTC” market.

c. The National Association of Securities Dealers licenses dealers and polices their behavior.

C. Spot and Futures Markets involve different timing of pricing and delivery.

1. Spot Markets involve immediate pricing for immediate delivery. 2. Futures Markets involve immediate pricing for a promise of future delivery.

a. While in effect, the right to delivery is itself transferable and valuable.b. Practical finance vocabulary distinguishes between “futures” and

“forward” contracts.(1) “Futures” contracts are standardized in terms of amounts,

instruments, and dates. i. Futures contracts trade on organized exchanges

(such as the Chicago Board of Trade).ii. The futures exchange guarantees contracts negotiated

through its auspices.(2) “Forward” contracts are individualized between parties with

particular needs.i. Forward contracts typically do not trade on organized

exchanges.ii. Forward contracts typically serve purposes more

operational then financial (e.g., an electrical utility may purchase fuel on forward contracts to stabilize costs).

D. Option Markets involve different rights in underlying securities or commodities.

1. An “option writer” and “option buyer” or “owner” make an “option contract” concerning some underlying security, commodity, or property.a. The writer grants the owner some exclusive right for a certain time.b. While in effect, the option itself is transferable and valuable. c. Options on listed securities or widely traded commodities trade on

organized exchanges.

2. The main types of options are Puts (options to sell) and Calls (options to buy).

E. Foreign Exchange Markets are where different nations’ currencies are exchanged.

1. Foreign exchange (“Forex”) involves spot, future, forward, and option markets.2. Any currency is convertible to any other at some exchange rate.

a. Markets set exchange rates among widely held currencies (e.g. US dollar, euro, British pound, Japanese yen, Swiss franc).

b. Exchange rates among lesser-held currencies may be set contractually for a particular transaction, or by central bank action.

F. International and Domestic Markets are represent global financial choices.

1. International markets help participants diversify both sources and uses of funds.2. Eurodollar and Eurobond markets are examples of major international markets.

a. “Eurodollars” are U.S. dollars deposited outside the U.S.b. “Eurobonds” are issued outside the U.S. but denominated in US dollars.

G. Money and Capital Markets represent different intentions and time horizons.

1. Money markets are wholesale markets for debt claims closely resembling money itself.

a. Money markets help participants adjust liquidity. (1) DSUs borrow-short-term to finance current operations. (2) SSUs lend short-term to avoid holding idle cash.

b. Money market instruments typically share 3 common characteristics— (1) Short maturities (usually 90 days or less). (2) High liquidity (active secondary markets). (3) Low risk (and consequently low yield).

c. Money markets 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.

d. Major money market instruments described later in Chapter 7 include—(1) Treasury Bills—IOUs auctioned weekly by the U.S. 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 (“Fed Funds”)—excess reserves of depository

institutions in the Federal Reserve System.

2. Capital markets are where “capital goods” are permanently financed.

a. “Capital goods” are real assets held long-term to produce wealth (e.g. land, buildings, equipment, or proprietary rights or technology).

b. Capital markets help participants build wealth. (1) DSUs seek long-term financing for “capital projects” (systems of

capital goods).(2) SSUs seek to invest at the highest possible return for a given

level of risk.

c. Capital market instruments differ from money market instruments— (1) Long maturities (usually 5 to 30 years). (2) Less liquidity (secondary markets are active but more volatile). (3) Higher risk in most cases (and therefore higher potential yield).

(4) Widely traded “wholesale” and “retail” on organized exchanges and in OTC markets.

d. Major capital market instruments described later in Part III of the Text include—(1) Common stock—shares of ownership in a business corporation

and its profits.(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).

VIII. Efficiency is an important aspect of a financial market’s contribution to the economy. A. Allocational Efficiency is the extent to which funds find their highest and best use.

1. Businesses try to fund projects offering the highest ratio of benefit to cost.2. Households try to invest for the best possible return for a given maturity and risk.

B. Informational Efficiency is the extent to which prices reflect relevant information. 1. Informationally efficient markets reprice quickly in response to new information;2. Informationally inefficient markets offer opportunities to profit from buying

“underpriced” assets or selling “overpriced” assets.

C. Operational Efficiency is the extent to which transactions costs are minimized.

IX. Financial institutions manage and balance 5 basic risks. A. Credit Risk (or default risk) is the possibility that a borrower may not pay as agreed.

1. Any DSU except the U.S. Government is assumed to offer credit risk. 2. Financial institutions manage credit risk in 3 concurrent ways: a. Diversification among different borrowers representing different risks. b. Credit analysis of each borrower to assess ability and willingness to pay. c. Regular monitoring of each borrower while debt is outstanding.

B. Interest Rate Risk is the likelihood that interest rate fluctuations will change a security’s price and reinvestment income.

1. Any fixed-rate financial instrument carries interest rate risk (see Chapter 5).2. Any portfolio including such instruments is subject to interest rate risk.3. Financial institutions must manage interest rate risk; they both lend and borrow.

C. Liquidity Risk is the possibility that a financial institution may be unable to pay required cash outflows.

1. SSUs expect to be able to redeem their claims on relatively short notice. 2. DSUs expect timely decisions about financing proposals. 3. Illiquid institutions can fail, even if they are profitable in the long run.

4. Illiquidity is a common historical cause of bank failures (see Chapter 16).

D. Foreign Exchange Risk is the possibility of loss on fluctuations in exchange rates. 1. Large financial institutions both lend and borrow in multiple currencies. 2. Widely held currencies float against each other (do not exchange at a fixed rate).

E. Political Risk is the possibility that government action will harm an institution’s interests.1. Domestically, U.S. financial institutions are both heavily regulated by

government and heavily invested in government securities. 2. Internationally, large U.S. institutions operate in many foreign countries.3. As regulators, governments vary in integrity and competence.

a. In some cases “the rule of law” is well-established and well-respected.b. In other cases government interferes with contracts or property without

“due process of law”, or for corrupt purposes.c. Government often prefers political expediency to economic efficiency.

4. As borrowers, governments vary in credit risk.a. A government can unilaterally repudiate or reschedule its debts.

b. A private firm has limited recourse against a government.

COMPLETION QUESTIONS

1. Ultimately, most SSUs are ___________________ .

2. _______________ is the ease with which a financial asset may be sold before maturity to another SSU.

3. The process by which investment bankers help DSUs issue new securities is called

_______________ .

4. Financial intermediaries ________________ claims.

5. ____________________________ is the reverse of intermediation.

6. ____________________________ are the largest, most diversified, and most regulated intermediaries.

7. ____________________________ make loans but do not take deposits.

8. ____________________________ are where financial claims are resold and repriced.

9. Synonyms for “financial claims” include ____________________________ or __________________ .

10. ___________________________ is the possibility that a borrower may fail to pay as agreed.

TRUE-FALSE QUESTIONS

T F 1. Businesses are never DSUs.

T F 2. An SSU must hold a claim until its scheduled maturity.

T F 3. Private placements are the simplest form of direct finance.

T F 4. Competition among financial intermediaries tends to force interest rates downward.

T F 5. Every asset is someone else’s liability, but not every liability is someone else’s asset.

T F 6. “Agency securities” carry relatively low risk.

T F 7. Organized exchanges are less “exclusive” than over-the-counter markets.

T F 8. Foreign exchange may involve spot, future, forward, or option transactions.

T F 9. Money markets depend on organized exchanges.

T F 10. Operational efficiency has to do with the speed at which transactions are executed.

MULTIPLE-CHOICE QUESTIONS

1. Bob and Nancy Gutierrez have been married for 10 years and are both executives at Fortune 500 corporations. They have a son, 8 and a daughter, 5. The Gutierrez family is most likely a a. business b. financial institution c. household d. deficit unit

2. During 2009, Bob and Nancy expect total income of about $225,000 and are budgeting total expenditures of about $180,000. For this budget period, the Gutierrez family is most specifically a(n)a. DSU b. business c. SSU d. household

3. During 2009, Bob and Nancy deposit $3,750 per month into a savings account at Bank of America. Every 3 months, they take $10,000 from savings and buy a 1-year CD from B of A. These uses of funds may be most precisely characterized asa. financial intermediationb. direct financec. indirect financed. disintermediatione. a or c

4. During May of 2009, Bank of America makes a 3-year $375,000 equipment loan to CP Construction Company, in which the 2 shareholders are Andrea Chang and Marjorie Patel. What benefit(s) to both the Gutierrez family and CP Construction are clearly evident?a. denomination divisibilityb. maturity flexibilityc. credit risk diversificationd. liquiditye. all of the above f. a & b

5. During July of 2009, Andrea and Marjorie each withdraw $150,000 from personal savings accounts at Bank of America, and invest the money in CP Construction by purchasing new shares of common stock in the company. This transaction is a. a primary market transactionb. an equity transactionc. an example of “disintermediation”d. all of the above

6. The difference between brokers and dealers is thata. brokers carry an inventory of securities; dealers don’t.b. dealers carry an inventory of securities; brokers don’t.c. dealers care what the “ask price” is; brokers don’t.d. brokers care what the “ask price” is; dealers don’t.

7. Profitability of financial intermediaries derives from all of the following excepta. government regulation of interest ratesb. economies of scalec. ability to manage credit riskd. control of transactions costs

8. Currency transformation is an important service becausea. most SSUs want to invest in more than one currencyb. all financial institutions operate internationallyc. few ordinary investors care to hold claims denominated in foreign currencyd. DSUs can’t export unless they can borrow in the currency of the importing country

9. The only “deposit-type” institutions that do not operate for profit area. thrift institutions b. credit unions c. pension funds d. commercial banks

10. Money market instruments and capital market instruments differ appreciably in a. maturityb. liquidityc. availability to ordinary individual investorsd. all of the above

SUPPLEMENTARY MATERIAL: WORDS AND MEANINGS

Financial vocabulary is often a matter of context. Familiar words take on new meanings, different words take on the same meaning, or the same word can have different meanings. Here are some examples:

“Deficit” and “surplus”, as used here, have little to do with financial health. They merely relate cash inflows and outflows. Businesses, no matter how profitable, usually invest more in productive assets than they collect in operating cash flow. The key is financing those assets wisely. The U.S. Government has both the largest deficit and the best credit rating in the world. Can you find out why?

“Borrowing”, “lending”, “debt”, and “equity”. Some financing is “debt”: a DSU borrows; an SSU lends; interest and principal are paid on schedule. An intermediary may play a role. Some financing is “equity”: An SSU buys part ownership in a DSU and shares profits or losses indefinitely. Chapter 1 speaks generally of “borrowing”, “lending”, and “IOUs” because those terms are familiar, and most financing does in fact take this general form. Money market instruments (Chapter 7), bonds (Chapter 8) and mortgages (Chapter 9) are all “debt” to their issuers. Equity securities (Chapter 10), however, are also financial claims against DSUs (the corporations issuing the shares) by SSUs (the shareholders).

“Financial claim”, “financial instrument”, and “security”. These terms are interchangeable for all practical purposes. Sometimes, though, “securities” connotes instruments issued to many investors at once in a standard legal form and evidenced by a standard certificate, such as bonds or shares of stock.

“Financial asset”. A claim, instrument, or security is an asset to the SSU. It’s some kind of obligation of the DSU. “Real assets”, unlike financial assets, arise from production or purchase, not claims. They include “tangibles” such as inventory, land, buildings, and equipment, and “intangibles” such as goodwill, patents, trademarks, or copyrights. We don’t make a parallel distinction for liabilities: Any liability is by definition “financial”—an “IOU” to someone else.

“Investment” commonly suggests the notion of buying securities such as stocks or bonds. However, these forms of financial investment are available only because they are useful ways of financing real investment. Real investment is the commitment of funds to “real” assets (distinguished from financial assets above). This crucial distinction is a sobering reminder that wealth is created by production in the real sector, not by any activity in the financial sector. The financial sector ultimately exists to channel savings into real investment. Financial investment is merely a useful way of doing so.

“Financial Institution” and “Financial Intermediary”. Older books often differentiated these terms; newer ones tend not to. Traditionally, a “financial institution” was any firm devoted chiefly to providing any financial service; a “financial intermediary” was a financial institution that completely transformed claims. An investment banker was an institution but not an intermediary (investment bankers don’t transform claims, they just help issue them) and a commercial bank was both. Today we usually interchange these terms because financial services are more integrated. On Citigroup’s organizational chart are examples of practically every institution and service mentioned in Chapter 1 (except credit unions and federal agencies). During much of the 20th century, however, institutions and services were segregated by regulators. For example, commercial banks could not underwrite securities, thrifts could not make commercial loans or offer checking accounts, and insurance companies could not offer products resembling deposits. “Institutional investor” sounds interchangeable with “financial institution”, but actually refers to a relative handful of institutions: mutual funds, pension funds, and insurance companies.

“Underwriting” chiefly connotes the process by which investment bankers help issue new securities to the investing public. Other financial workplaces, however, use this word. When a lending officer at a depository institution “underwrites” a loan, she justifies the credit decision and documents its conformity to the institution’s standards. When an insurance company “underwrites” a risk, it agrees to cover that risk for the policyholder under specified terms and conditions.

“Bank” and “banking” refer in everyday life to the business of taking deposits and making loans. Strictly speaking, though, this is “commercial banking”. All depository institutions exemplify it. They have different names (banks, S&Ls, credit unions) because they have different charters and focus on different types of loans. “Mortgage bankers” don’t take deposits; they sell their mortgages in secondary markets. Investment bankers say they are in “banking” and rarely say “investment banking” themselves. In other countries “banking” has almost always meant commercial and investment banking together. “Swiss banks” are examples, as are the great banking houses of Britain, Germany, and Japan. “Central banking” is a unique topic, to which we turn in Chapters 2 and 3.

SUPPLEMENTARY ASSIGNMENT: THE FLOW OF FUNDS

The “flow of funds” is more than theory. The Federal Reserve System (or “Fed”) tracks actual flows of funds among the sectors of the economy and publishes the Flow of Funds Accounts quarterly. Read The U.S. Flow of Funds Accounts and Their Uses by Albert M. Teplin at

http://www.federalreserve.gov/pubs/bulletin/2001/0701lead.pdf ;

then attempt an examination of the last 2 or 3 quarters of Statistical Release Z.1-- Flow of Funds Accounts of the United States at http://www.federalreserve.gov/releases/Z1/ . While you’re at the Fed’s web site, order or download a free copy of The Federal Reserve System: Purposes and Functions:

http://www.federalreserve.gov/pf/pf.htm

This free, short, and highly informative book will be a big help to you as you take up Chapters 2 and 3.

SOLUTIONS TO COMPLETION QUESTIONS

1. households

2. Marketability

3. underwriting

4. transform

5. Disintermediation

6. Commercial banks

7. Finance companies

8. Secondary markets

9. financial instruments; securities

10. Credit risk (or default risk)

SOLUTIONS TO TRUE-FALSE QUESTIONS

1. F Businesses are usually DSUs—they usually want to invest more in productive assets than they collect in operating cash flow.

2. F Most financial claims are marketable to some extent—they may be resold to other SSUs.

3. T Private placements are the simplest form of direct finance.

4. T Competition among intermediaries tends to force interest rates downward.

5. F Actually, the reverse is true: Every liability is someone else’s asset, but many assets are “real assets”, not “financial assets”.

6. T “Agency securities” carry relatively low risk because they are backed by the U.S. Government.

7. F Organized exchanges are more exclusive than OTC markets; participants must be members and securities must be listed.

8. T “Forex” may involve spot, future, forward, or option transactions.

9. F There are no organized exchanges in the money markets; brokers and dealers specialize in various money market instruments and trade them in “wholesale” transactions.

10. F Operational efficiency has to do with minimizing transactions costs.

SOLUTIONS TO MULTIPLE CHOICE QUESTIONS

1. c Household, although not every household is such a traditional family. Adults living alone, single- parent families, and “domestic partnerships” are other possible examples of “households”.

2. c. SSU, to the extent of some $45,000 by which expected income exceeds planned spending.

3. a. Financial intermediation. The deposit accounts are claims by Bob and Nancy against a depository institution.

4. f. a & b—denomination divisibility and maturity flexibility are the benefits clearly evident to both the SSU (the Gutierrez family) and the DSU (CP Construction). The bank has pooled the funds of the Gutierrez family and other depositors to provide CP Construction with one large loan, for a maturity that exceeds that of the Gutierrez family’s deposits. Credit risk diversification and liquidity are additional benefits to an SSU, but are irrelevant to a DSU.

5. d. All of the above—the investment of funds directly in a business is a primary market transaction; the acquisition of common stock is an equity transaction, and the withdrawal of funds from a deposit- type institution for the purpose of financing a direct investment is an act of disintermediation.

6. b. Dealers carry an inventory of securities, brokers don’t. Brokers simply execute their clients’ buy or sell orders at the best possible price. Accordingly, brokers care at least as much as dealers about the “ask” price, which is the price at which dealers sell securities….to brokers, among other buyers.

7. a. The U.S. government hasn’t regulated interest rates since the early 1980s.

8. c. Few ordinary investors care to hold claims denominated in foreign currency—the reverse of “a”. Not all financial institutions operate internationally. Not all DSUs export.

9. b. Credit unions are the only deposit-type institutions that are not-for-profit. Pension funds are not deposit-type institutions.

10. d. All of the above. Capital market securities typically have longer maturities and relatively less liquidity, and are traded both “wholesale”and “retail” on organized exchanges and in OTC markets.