Chapter 2: The Financial System Objective Understanding the workings of the financial system Determining rates of return Chapter Contents • What is a Financial System • Financial Intermediaries • The Flow of Funds • Financial Infrastructure and Regulation • The Functional Perspective • Governmental & QuasiGovernmental Organizations • Financial Innovation & the “Invisible Hand” • Financial Markets • Financial Market Rates The Flow of Funds Diagram Markets Surplus Units Deficit Units Intermediaries Fund Flows via Market Markets Surplus Units Deficit Units Intermediaries Fund Flows via Intermediary Markets Surplus Units Deficit Units Intermediaries Fund Flows via Intermediary and Market Markets Surplus Units Deficit Units Intermediaries Funds Flow via Markets and Intermediaries Markets Surplus Units Deficit Units Intermediaries Funds Flow: Disintermediation Markets Surplus Units Deficit Units Intermediaries Funds Flow: Secured Credit Markets Poor Credit Risk Surplus Units Deficit Units Intermediaries Six Key Financial Functions: – Transferring Resources Across Time & Space – Managing Risk – Clearing and Settling Payments – Pooling Resources and Subdividing Shares – Providing Information – Dealing with Incentive Problems 10 Exchange Rate Example Time Japan 15000 Ơ U.K ã150 ¥/£ 3% ¥/¥ (direct) 1.73% ¥/£/£/¥ 15260 ¥ 15450 ¥ £100 9%£/£ 140 ¥/£ 11 £109 Exchange Rate Example Time Japan 15000 ¥ U.K 150 ¥/£ 3% ¥/¥ (direct) 8.27% ¥/£/£/¥ 16241 ¥ 15450 ¥ £100 9%£/£ 149 ¥/£ 12 £109 Exchange Rate Example Time Japan 15000 ¥ (borrowed) U.K 150 ¥/£ 3% ¥/¥ (direct) 3% ¥/£/£/¥ 15450 ¥ 15450 ¥ Repaid £100 Invested 9%£/£ Forward ¥/£ 13 £109 Matures US Treasury Yiled Curve, Jan 97 7.50 Annualized Yield (%) 7.00 6.50 6.00 5.50 5.00 4.50 10 15 20 Years to Maturity 14 25 30 Yield Comparisons April '95 - 10 Years 10 ++ Years US Corporate Corporate Treasury High Quality Med Quality 6.92% 7.57% 7.86% 7.65% 8.15% 8.55% 15 Computation of Return ( EndPrice − StartPrice) + CashDividend Return = StartPrice ($105 − $100) + $5 Return = = 0.10 = 10% $100 16 Security Returns 60.00 40.00 % Return 20.00 0.00 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 -20.00 -40.00 Bills Bonds Stocks Inflation -60.00 Year 17 1975 1980 1985 1990 1995 Consolidated Indicies 1000.0000 Index (Log Scale) Bills_Index Bonds_Index Stocks_Index Inflation_Index 100.0000 10.0000 1.0000 1925 1930 1935 1940 1945 1950 1955 1960 Year 1965 181970 1975 1980 1985 1990 1995 Frequency of Returns 70 60 Freq_Bills Freq_Bonds Freq_Stock Freq_Inflation Probability 50 40 30 20 10 -50 -40 -30 -20 -10 Percent 10 20 19 30 40 50 Nominal to Real (1 + NominalRate) = (1 + RealRate) * (1 + InflationRate) ⇒ NominalRate − InflationRate RealRate = + InflationRate 20