Financial and Monetary Theory

Week 1

1
Administration (cont’)
Textbook:
 Frederic S. Mishkin, The Economics of
Money, Banking and Financial markets, 9th
ed., 2007 (Addison-Wesley)
 Students are required to read text book
before lectures.

2
Administration (cont’)
 Assessments:
 Attendance 10%
 Small test 10%
 Group project 10%
 Mid-term exam 20%
 Final exam 50%

3
FINANCIAL & MONETARY
THEORY

Week 1
OVERVIEW OF FINANCIAL SYSTEM
Chapter 1, 2

4
Objectives
 Introduce financial system:
 Functions
 Structure
 Financial markets
 Financial institutions
 Financial instruments
 Regulation

5
Financial markets
 What are financial markets?
 The place where funds (money) are
transferred from people who have an
excess of available funds to people who
have a shortage.
 Example: stock or bond markets…

6
Financial markets

7
 Function of financial markets
 A channel for moving funds from savers to
spenders in order to:
Increase production of a business


 Satisfy personal needs (buying a car…)

 Promote economic efficiency and economic

welfare of everyone in the society

8
Financial markets
1. Direct versus Intermediated financial
flow markets
2. Primary Markets versus Secondary
Markets
3. Wholesale versus Retail markets
4. Money Markets versus Capital Markets
5. Foreign Exchange Markets
6. Exchange vs. Over-the-counter (OTC)
9
Direct vs. indirect flow
markets

X A
10
 Primary vs. Secondary markets
 Primary market  Secondary market
The ISSUE of a NEW The BUYING / SELLING of
Financial Instrument EXISTING Fin
 Issuers can be: Instrument
 Businesses (issue  No direct impact on
shares, debentures)
original issuer
 Governments (issue T-
notes, T-bonds)
 Transfer of ownership
 Individuals (Mortgage) from one investor to
 To raise funds to buy another investor
goods, services or  Provides liquidity to
assets owners of Fin Instrument
11
 Importance of Secondary market
 Increase the marketability and liquidity of
new instruments issued in primary market
 Savers like liquidity and don’t like risk.

 well- developed secondary markets encourage

savings and investment
 improve economic growth

12
 Wholesale vs. Retail markets
 Wholesale markets  Retail markets
 Involves large  Involves smaller
transactions transactions
 Direct financial flow  Transactions mostly
transactions between conducted with financial
institutional investors intermediaries primarily
and borrowers by the household and
small to medium-sized
businesses

13
 Money vs. capital markets
 Money Markets  Capital Markets
 markets that trade  markets that trade debt
debt securities & equity instruments
with maturities ≤ 1 with maturities > 1 YEAR
YEAR
 e. g.: CD’s, Treasury  e. g.: shares, term loans,
bills, commercial paper mortgages
 More liquid
 Less fluctuations in
prices
14
Foreign Exchange Markets
 FX markets deal in trading one currency
for another (e. g. dollar for yen)

15
Exchanges vs. Over-the-counter
markets (OTC)
 Exchanges: standardized market where
buyers and sellers of securities meet in
one central location to conduct trades.
 Example:
 OTC market: dealers ready to buy and
sell securities to anyone who comes and
accepts their prices
 Example:

16
Types of Financial Institutions
 3 categories:
 Depository institutions (banks).
 Contractual savings institutions.

 Investment intermediaries.

17
 Types of Financial Institutions
(cont.)
 Depository Institutions (banks):Financial
intermediaries that accepts deposits from
individuals & institutions and make loans.
 Include:
 Commercial Banks.
 Saving & Loan Associations (S&Ls).
 Credit Unions.

18
Types of Financial Institutions
(cont.)
 Contractual Savings Institutions: Financial
intermediaries acquire funds at a periodic
intervals on a contractual basis and invest
primarily in long-term securities.
 Include:
 Life Insurance Companies.
 Fire & Casualty Insurance Companies (Non-life).
 Pension Funds & Government Retirement Funds.

19
Types of Financial Institutions
(cont.)
 Investment Intermediaries include:
 Finance Companies.
 Mutual Funds.
 Money Market Mutual Funds.
 Investment Banks. (is not a bank or a
financial intermediary in the ordinary sense)

20
Principal intermediaries and their assets

21
Financial Intermediaries and their
assets

22
Regulation of Financial
Institutions
 More information disclosure to investors
 Ensure soundness of financial intermediaries:
Example:
 Person to set up financial intermediaries

 Reporting requirements

 What to do, what assets to hold

 Insurance for deposits

 Expansion of branches

 Interest rates

23
Regulatory agencies of US
financial system
 Security and Exchange Commission
(SEC)
 Office of the Comptroller of the
Currency (OCC)
 Federal Reserve System (FED)
 Federal Deposit Insurance Corporation
(FDIC)

24
Vietnam financial regulatory
authorities

25
Source:tapchitaichinh.vn
26
Financial instruments
 Financial Assets: An asset that entitles the owner to
future cash flows or real assets (interest payments,
principal repayments and capital gains). Eg.: trade
receivable, shares, bonds
 Financial Instruments: any contract that give rise to
a financial assets of one entity and a financial liablility
or equity instrument of another entity
Eg.: shares, bonds, commercial loan,
 Financial Securities: Financial instrument that has an
organised SECONDARY market (eg.:Bond,stock; Bank
deposits/ normal Bank loans are not securities)

27
 Financial instruments
1. Equity: Shares
 Ownership of an asset (company) – No maturity
 Voting right
 Direct benefit from higher profitability and asset value
 Owners have RESIDUAL Claims:
 Claim on profits (dividend)

 Claim on assets (in liquidation case/ bankruptcy)

 Types:
 Ordinary Share

 Hybrid (or quasi-equity) security: such as Preference Shares &

Convertible Notes

28
Financial instruments
2. Debt
 Loans, Bonds, debentures, commercial bills, P notes,
overdrafts, leases …
 Contractual claim to
 Periodic interest payments

 Repayment of principal

 DEBT Claim ranks ahead of EQUITY Claim

 Can be secured or unsecured, short term or long term,
at floating rate or fixed rate, negotiable or non-
negotiable.

29
Financial instruments
 Bond: debt security that promises to make
payments periodically for a specified period of
time.
Example: 5 year Treasury Bond with face value
of VND10 million, coupon rate 8% paid semi-
annually
 Maturity:
 coupon payment:
 Price:

30
 Financial instruments
3. Derivatives
 Provide specific future rights in relation to a
 Physical market commodities

 Gold and oil

 Financial instruments

 Currencies, debt and equities instruments

 Purpose: + to manage price risk exposure

+ to speculate
 4 types: Futures, forwards, options & swaps
 In VN: 10/08/2017, launch Derivative market (VN30
futures, 5-year T-bond futures) 31
Financial instruments
 Short-term instruments: Money market
instruments (less than 1 year)
 Treasury bills

 Negotiable certificate of deposits

 Commercial paper

 Repurchase agreements (repos)

 Fed Funds

32
Financial instruments
 Long-term instruments: Capital
markets instruments
 Stocks
 Mortgage
 Bonds: corporate, government (central,
local, authority)
 Consumer and bank commercial loans

33
Financial system: summary
 Basic function is to facilitate efficient flows
of funds from savers to spenders
domestically and internationally.
 Increase production and efficiency of the
economy, wealth to consumers
 Financial markets can be classified by
different categories and by instruments,
which are traded in the markets

34
Financial system: summary
 Financial intermediaries: transaction costs
and information asymmetry.
 Financial markets are integrated for easier
access and mobilization of funds
 Financial systems are heavily regulated by
governments and international standards.

35