The Economics of Money

Dr. Nahla Azzam

Lecturer of economics
Faculty of Economic Studies
and Political Science (ESPS)
Alexandria University

Email:
[email protected]

Lecture (3)
15/10/2024
2024/2025
 Chapter 2
An Overview of the Financial System
(cont.)
Lecture Outline
In this lecture, we will understand:

4. Financial Market Instruments.

5. Function of Financial Intermediaries: Indirect Finance.
4- Financial Market Instruments
• To complete our understanding of how financial markets perform the
important role of channeling funds from lender-savers to borrower-investors,
we need to examine the securities (instruments) traded in financial markets.

Financial Market Instruments

Money Market Capital Market

Instruments Instruments
I. Money Market Instruments

• Short term debt instruments traded in the money market are characterized by
having the least price fluctuations, thus they are the least risky, more liquid,
and more likely traded investments. The most important types of money
market securities are:

1. Treasury bills.
2. Negotiable Bank certificates of Deposits.
3. Commercial Papers.
4. Banker’s Letters of Acceptance.
5. Repurchase Agreements.
6. Federal Funds.
 1. Treasury bills (TBs):
• These are the most important debt instruments issued by governments in
different countries.
• Governments issue treasury bills via the central bank, with one-, three-, and
six-month maturities to finance the government budget deficit.
• They pay a certain amount at maturity, and have no interest payments, but
they pay interest by initially selling at a discounted price (purchase price) —
that is, at a price lower than the amount paid at maturity (nominal price). For
instance, in May 2016, you might buy a six-month TB for $9,000 that can be
redeemed in November 2016 for $10,000.
• The discounted selling price of treasury bills can be calculated as follows:

number of days to maturity

The discount rate on the treasury bill= 360
x annual discount rate
• The amount of discount from the nominal price =
The discount rate x the nominal price

• The discounted price = nominal price - the amount of discount

Example 1:
• If someone bought a six month treasury bill, with a nominal price 1000$, at
an annual discount rate 10%. Find:
a) The discount rate on this TB.
b) The purchase price of this TB.
Answer:
180
a) The discount rate on this TB= x 10% = 5%
360
b) The purchase price of this TB = nominal price - the amount of discount
= 1000 – (1000 x 5%) = 1000-50 = 950$
Example 2:
• If you know that a TB’s nominal price is 1000$; it was sold in May 2023 for
950$ , to be redeemed after 180 days. Calculate the annual discount rate for
this TB.
Answer:
• The annual discount rate =

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 −𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 360

𝑥
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦

1000−950 360
= 𝑥 = 0.10 = 10%
1000 180
• TBs are the safest money market instrument
because there is a low probability of default, a
situation in which the party issuing the debt
instrument (the government) is unable to make
interest payments or pay off the amount owed
when the instrument matures. The government
can always meet its debt obligations because it
can raise taxes or issue currency (paper money
or coins) to pay off its debts.

• TBs are held mainly by banks, although small

amounts are held by households, corporations,
and other financial intermediaries.
2. Negotiable Bank Certificates of Deposit (CDs)
• A certificate of deposit (CD) is a debt instrument sold by a bank to depositors,
it pays annual interest of a given amount, and at maturity pays back the
original purchase price.
• Negotiable CDs are sold in secondary markets, they are an extremely
important source of funds for commercial banks.

3. Commercial Paper
• Commercial paper is a short-term debt instrument issued by large banks and
well-known corporations, such as Microsoft and General Motors.
• Before the 60s, large firms used to borrow from banks, but since the 60s these
firms started to issue and sell commercial papers to financial intermediaries in
financial markets. This allowed them to have access to needed financial
resources in a direct manner instead of depending on banks.
4. Banker’s Letters of Acceptance
• It is one of the most important short run debt instruments used to finance
domestic and international trade.

• A banker’s acceptance is a promise of payment - similar to a check- issued

by a firm to a bank requesting to pay him or a third party a specific
amount of money at a specific future date. the bank seal this banker’s
acceptance with the word “accepted” and receives a predetermined
commission in return.
• Banker’s acceptance have a relatively small
risk factor, since the firm issuing it must have
deposits in these banks. Hence, the bank
guarantee the firm even if the firm’s deposits
doesn’t cover the value of the acceptance.
5. Repurchase Agreements (Repos)
• Repurchase agreements (repos) are very short-term loans (usually with a
maturity term of less than two weeks) for which TBs serve as collateral (an
asset that the lender receives if the borrower does not pay back the loan).
• For example; A large corporation, such as Microsoft, may have some idle
funds in its bank account, say $1 million, which it would like to lend for a
week. Microsoft uses this excess $1 million to buy Treasury bills from a
bank, which agrees to repurchase them the next week at a price slightly above
Microsoft’s purchase price. The net effect of this agreement is that Microsoft
makes a loan of $1 million to the bank and holds $1 million of the bank’s
Treasury bills until the bank repurchases the bills to pay off the loan.
Repurchase agreements are now an important source of bank funds. The most
important lenders in this market are large corporations.
• Repos allow large firms to invest its idle funds in its current accounts in
banks over very short time periods for a return. At the same time, repos allow
banks to have financial liquidity in the short run, to settle different operations
at a relatively low cost.

6. Federal Funds
• These instruments are overnight loans between banks from their deposits at
the Central Bank. The word federal funds does not mean that these loans are
made by the federal government or by the Central Bank, but rather by banks
to other banks.
• Why a bank might borrow in the federal funds market ?
Banks might find it does not have enough funds in its deposit accounts at the
Central Bank to meet the amount required by regulators. It can then borrow
these funds from another bank, which transfers them to the borrowing bank
using their central bank accounts.
 • The interest rate on these loans, called the federal funds rate, is an indicator
of the tightness of credit market conditions in the banking system and the
state of monetary policy. When the federal funds rate is high, then banks
need more funds; when low, it indicates that banks’ credit needs are low.
II. Capital Market Instruments
• Capital market instruments are debt and equity instruments with maturities of
greater than one year. They have far wider price fluctuations than money
market instruments and are considered to be fairly risky investments. The
most important types of capital market securities are:
1. Stocks.
2. Mortgages.
3. Corporate bonds.
4. Government Securities.
5. State and Local Government bonds.
 1. Stocks
• Stocks are equity claims on the net income and assets of a corporation.
Stockholders share the net income and capital of the corporations that
issued these stocks. They share both profits and losses based on the
financial position of the firm.
• Individuals hold around half of the value of stocks; the rest is held by
pension funds, mutual funds, and insurance companies.

2. Mortgages
• Mortgages are loans to households or firms to purchase land, housing, or other
real structures, in which the structure or land itself serves as collateral for the
loans. The mortgage market is the largest debt market in the United States.
Mortgages are provided by financial institutions such as savings and loan
associations, mutual savings banks, commercial banks, and insurance
companies (main lenders).
 3. Corporate bonds
• These long-term bonds are issued by corporations with
very strong credit ratings. The typical corporate bond
sends the holder an interest payment twice a year and
pays off the face value when the bond matures. These
bonds help corporations obtain needed financial
resources from the capital market.
• Some corporate bonds, called 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. This feature makes these convertible bonds more
desirable, and allows the corporation to reduce its interest payments due to converting
some bonds into shares.
• As the traded amount of both convertible and nonconvertible bonds for business
corporations in the secondary market is relatively small, corporate bonds are not as
liquid as government bonds, a investors have more trust in government bonds.
4. Government Securities
• These long-term debt instruments are issued by the government via the
Central bank, to finance budget deficits. They are the most liquid security
traded in the capital market. They are held by the banks, households, and
foreigners.

5. State and Local Government bonds

• State and local bonds, also called municipal bonds, are long-term debt
instruments issued by state and local governments to finance expenditures
on schools, roads, and other large programs.
• An important feature of these bonds is that their interest payments are
exempt from income taxes in the issuing state.
5. Function of Financial Intermediaries:
Indirect Finance
• Funds can move from lenders to borrowers by a second route, called indirect
finance because it involves a financial intermediary that stands between the
lenders and borrowers, and helps transfer funds from one to the other.
• A financial intermediary does this by borrowing funds from lenders and
savers and then using these funds to make loans to borrowers. For example, a
bank might acquire funds by issuing a liability to the public in the form of
savings deposits (an asset for the public). It might then use the funds to
acquire an asset by making a loan to General Motors or by buying a U.S.
Treasury bond in the financial market. The ultimate result is that funds have
been transferred from the public (the lender-savers) to General Motors or the
U.S. Treasury (the borrower-spender) with the help of the financial
intermediary (the bank).
➢ Why are financial intermediaries and indirect finance so important in
financial markets?
To answer this question, we need to understand the roles of the following points
in financial markets:
1. Transaction costs,
2. Risk sharing.
3. Asymmetric Information: Adverse Selection and moral hazard

1. Transaction Costs
• Transaction costs represent the time and money spent in carrying out
financial transactions, and it is a major problem for people who have excess
funds to lend, especially small savers and potential borrowers.
• For example, if a Carpenter (Carl) needs $1,000 to get a new tool, and you
know that it is an excellent investment opportunity. You have the cash and
would like to lend him the money, but to protect your investment, you have to
hire a lawyer to write up the contract that specifies how much interest Carl
will pay you, when he will make these interest payments, and when he will
repay you the $1,000. Obtaining the contract will cost you $500 !!! This will
make you reluctant to make this investment.
• Financial intermediaries can substantially reduce transaction costs because
they have developed expertise in lowering them and because their large size
allows them to take advantage of economies of scale, the reduction in
transaction costs per dollar of transactions as the size (scale) of transactions
increases.
• For example, a bank knows how to find a good lawyer to produce a loan
contract, and this contract can be used over and over again in its loan
transactions, thus lowering the legal cost per transaction.
• Because financial intermediaries are able to reduce transaction costs
substantially, they make it possible for you to provide funds indirectly to
people with productive investment opportunities.
• In addition, a financial intermediary’s low transaction costs mean that it can
provide its customers with liquidity services, services that make it easier for
customers to conduct transactions. For example, banks provide depositors
with checking accounts that enable them to pay their bills easily.
2. Risk Sharing:
• Another benefit made possible by the low transaction costs of financial institutions
is that these institutions can help reduce the exposure of investors to risk—that is,
uncertainty about the returns investors will earn on assets.
• Financial intermediaries do this through the process known as risk sharing: They
create and sell assets with low risk, and then use the funds they acquire to
purchase other riskier assets.
• Low transaction costs allow financial intermediaries to share risk at low
cost, enabling them to earn a profit on the difference between the returns
they earn on risky assets and the payments they make on the assets they
have sold to people. This process of risk sharing is also referred to as asset
transformation, because in a sense, risky assets are turned into safer assets
for investors.
• Financial intermediaries also promote risk sharing
by helping individuals to diversify and thereby
lower the amount of risk to which they are exposed.
Diversification entails investing in a collection
(portfolio) of assets whose returns do not always
move together, with the result that overall risk is
lower than for individual assets. This goes with the
advice saying “You shouldn’t put all your eggs in one
basket.”
3. Asymmetric Information: Adverse Selection and moral hazard:
• In financial markets, one party often does not know enough information about the
other party to make accurate decisions. This inequality is called asymmetric
information. For example, a borrower who takes out a loan usually has better
information about the potential returns and risks associated with the investment
projects for which the funds are borrowed for than the lender does.
• Lack of information creates problems in the financial system both before the
transaction is entered into, and afterward too.
• Adverse selection is the problem created by asymmetric information before the
transaction occurs. In financial markets it occurs when the potential borrowers who
are the most likely to produce an undesirable (adverse) outcome—the bad credit
risks—are the ones who most actively seek out a loan and are thus most likely to be
selected. Because adverse selection makes it more likely that loans might be made to
bad credit risks, lenders may decide not to make any loans, even though good credit
risks (a good investment) exist in the marketplace.
• Moral hazard is the problem created by asymmetric information after the
transaction occurs. Moral hazard in financial markets is the risk (hazard) that
the borrower might engage in activities that are undesirable (immoral) from the
lender’s point of view, and make it less likely that the loan will be paid back.
Because moral hazard lowers the probability that the loan will be repaid,
lenders may decide that they would rather not make a loan.
• The problems created by adverse selection and moral hazard are a major
constraint to the well-functioning of financial markets. How can financial
intermediaries alleviate these problems?
➢ Financial intermediaries allow small savers to provide their funds to the
financial markets by lending these funds to a trustworthy intermediary which in
turn lends the funds out either by making loans or by buying securities such as
stocks or bonds, thus realizing higher earnings on their investments than do
small savers, where successful financial intermediaries :
1. are better equipped than individuals to screen out bad credit risks from good
ones, thereby reducing losses due to adverse selection.
2. develop expertise in monitoring the parties they lend to, thus reducing losses
due to moral hazard.
✓ The result is that financial intermediaries can afford to pay lender-savers
interest and still earn a profit.

• Therefore, financial intermediaries provide liquidity services, promote risk

sharing, and solve information problems, thereby allowing small savers and
borrowers to benefit from the existence of financial markets. Thus, they play
a key role in improving economic efficiency through helping financial
markets channel funds from lender-savers to people with productive
investment opportunities.
• Without a well-functioning set of financial intermediaries, it is very hard for
an economy to reach its full potential.