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BANKING AND FINANCIAL INSTITUTIONS
TERM 1
Lecture 1 - AN INTRODUCTION TO MONEY AND FINANCIAL MARKETS
THE 6 PARTS OF THE FINANCIAL SYSTEM (F.S.):
1) MONEY - to pay for purchases and store wealth 2) FINANCIAL INSTRUMENTS (stocks, mortgages, insurance policies) - to transfer resources from savers to investors & to transfer risk to those best equipped to bear it 3) FINANCIAL MARKETS (The New York Stock Exchange) - to buy and sell financial instruments 4) FINANCIAL INSTITUTIONS (banks, insurance companies, pension funds, brokerage firms,
investment companies) - pool funds from people who save and lend them to people who need to borrow, providing an access to financial markets; and collect information 5) REGULATORY AGENCIES (government) - to make sure the 6 parts of the F.S. operate in a safe and reliable manner, by examining the systems a bank uses to manage its risk 6) CENTRAL BANKS (The Federal Reserve) - control the availability of money and credit to ensure low inflation, high growth and the stability of the financial system

THE 5 CORE PRINCIPLES OF MONEY & BANKING:
1) TIME has value - the borrower pays the interest rate to compensate the lender for the time during which the borrower has used the funds because the money that the borrower borrowed has an opportunity cost to the lender, so the borrower has to pay for it 2) RISK requires compensation - no one takes other people's risks for free therefore risk requires compensation and this compensation is made in a form of payment 3) INFORMATION is the basis for decisions - before a bank makes a loan, it will investigate the financial condition of the borrower and provide loans only to the highest-quality borrowers because if lenders fail to assess the creditworthiness of borrowers, they will end up with more low-quality borrowers. Financial intermediaries eliminate the information costs 4) MARKETS determine price & allocation of resource - financial markets gather information from a large number of individuals and combine it into a set of prices that signals what is valuable and what is not, thus by attaching prices to different stock/bonds they provide a basis for allocation of capital. Financial markets are essential to the economy, allocating the resources, minimizing the cost of gathering information and making transactions 5) STABILITY (is a desirable quality) improves welfare - the central bank controlling and eliminating the risks that individuals cannot eliminate on their own such as an inflation and business cycle insures economic stability and this improves welfare

1 Lecture 2 - MONEY AND THE PAYMENT SYSTEM
MONEY - is an asset that is generally accepted as payment for goods and services or repayment of debt
INCOME - is a flow of earnings over time
WEALTH = the value of assets minus liabilities

THE 3 FUNCTIONS OF MONEY:
1) IT IS A MEANS OF PAYMENT - people require payments made with money at the time the good/service is supplied because the alternative payment methods don't work really well. The role of money reduces the likelihood that a seller needs to have an information about buyer.
Money is easier & finalizes payments 2) IT IS A UNIT OF ACCOUNT - we use money to quote prices and debts. Consumers and producers use prices' information to ensure that resources are allocated to their best uses. Using money
(quoting prices in dollars) to compare different products is easier.
3) IT IS A STORE OF VALUE - money stores its value in paper currency and in many other forms such as stocks, bonds, houses and cars. But we all hold money because it is liquid
LIQUIDITY - is a measure of the ease with which an asset can be turned into a means of payment,
quickly at a low cost. The more costly it is to convert an asset into money, the less liquid it is.
MARKET LIQUIDITY - selling assets for money (liquidating assets)
FUNDING LIQUIDITY - borrowing money (make loans) to buy securities

PAYMENT SYSTEM (төлбөрийн систем) - is a web of arrangements that allow for the exchange of goods/services/assets. Money is at the heart of the payment system because almost every transaction we engage in involves the use of money at some point

THE 3 METHODS OF PAYMENT:
1) COMMODITY & FIAT MONIES - paper money. People use them as a means of payment because we will be able to use them in the future over a long time; and law says people must accept them (government action). In 20th century gold has been the most common commodity money.
2) CHECKS - instruction to the bank to take funds from your account and transfer them to another account; and it is not a final payment 3) ELECTRONIC PAYMENT: credit & debit cards, electronic funds transfers, stored-value card, emoney

CHANGES IN THE AMOUNT OF MONEY IS RELATED WITH:
1) INTEREST RATES
2) ECONOMIC GROWTH
3) INFLATION - is when prices are increasing over time. Inflation makes money less valuable and the primary cause of inflation is the issuance of too much money but we must be able to 2 measure how much money is circulating. So, we sort different financial assets by their degree of liquidity (from most to least). For this, the Central banks have developed several measures of money, called monetary aggregate (M1 & M2)
 M1 = the most liquid assets in the financial system (ex: currency, checks and deposits)
 M2 = M1 + the least liquid assets (ex: small-denomination time deposits, retail money market mutual shares)
M2 is the most commonly used monetary aggregate since its movements are most closely related to interest rates and economic growth. Comparing the size of the monetary aggregates to the size of the economy and the nominal GDP gives much larger number than M1 & M2.
Then which M should we use to understand the inflation?
Until 1980 economists looked at M1, however the introduction of some accounts/assets made
M1 less useful. If you total some accounts in M1 it represents only small fraction of GDP, but if you total accounts in M2 the total number represents almost one-half of the GDP. So, M1 is no longer a useful measure of money.
Between 1960-1980 the growth rates of M1 & M2 moved together. But after 1980, they are started to move into completely opposite directions. The reasoning behind this is that, in the 1970-1980, inflation rose more than 10%. People who had 0-ineterest accounts suffered from this because their money lost its value, however, soon financial firms offered the "money market" account that compensated people during inflation times. This account is part of M2 and made M2 more liquid. This movement of funds into M2 meant that the 2 measurements are no longer move together and analysts started to look at M2, and not M1.
Controlling inflation means controlling the money supply. However does money growth help to forecast the inflation?
M2 stopped being a useful tool in forecasting the inflation and same for other aggregates. M2 works only when there is a high inflation or over a longer period of time.

CPI - is the change in the price of a given basket of goods/services relative to benchmark. It tells us how much more would it cost for people to purchase today the same basket of goods and services that they actually bought at some fixed time in the past.
COST OF THE BASKET - people's expenditure on goods/services + the prices of these goods/services
GDP - is the market value of final goods and services produced in a country during a year
 MARKET VALUE - all the goods and services produced times their market price
 FINAL GOODS AND SERVICES - only look at the final market of destination
 DURING A YEAR - during a calendar year, although GDP measures are released quarterly

3 Lecture 3 - FINANCIAL INSTRUMENTS, FINANCIAL MARKETS AND FINANCIAL INSTITUTIONS
INDIRECT FINANCE - is when an institution stands between the lender & borrower (The car becomes borrower's asset, and the loan becomes borrower's liability)
DIRECT FINANCE - is when borrowers sell securities directly to lenders in the financial markets (The security becomes lender's asset, and the loan becomes borrower's liability)
THE 3 COMPONENTS OF A FINANCIAL SYSTEM:
A. FINANCIAL INSTRUMENTS/SECURITIES - stocks, bonds, loans & insurance
B. FINANCIAL MARKETS - New York Stock Exchange, Nasdaq
C. FINANCIAL INSTITUTIONS

A. FINANCIAL INSTRUMENTS - a legal obligation of one party to transfer something of value,
usually money, to another party at some future date under certain conditions
THE 3 MAIN FUNCTIONS OF FINANCIAL INSTRUMENTS:
1) MEANS OF PAYMENT - purchase of goods/services (ex: employee stock option)
2) STORES OF VALUE - transfer purchasing power into the future. Over time, they generate increases in wealth that are bigger than those we can obtain from holding money 3) TRANSFER OF RISK - transfer of risk from one person to another (ex: futures, insurance)
LEVERAGE - use of borrowing to finance a part of an investment
DELEVERAGE - selling assets and issuing financial instruments to raise their net worth
THE 2 FUNDAMENTAL CLASSES OF FINANCIAL INSTRUMENTS:
1) UNDERLYING - used by lenders to transfer resources directly to borrowers (ex: stocks & bonds that offer payments based on the issuer's status). These instruments are used to efficiently allocate the resources 2) DERIVATIVE - their payoffs are derived from the behavior of the underlying instrument (ex:
futures, options & insurance). Its value is based on the price of some other asset. Derivatives specify a payment to be made at some future date between the borrower and lender. The amount to be made depends on various factors associated with the price of the underlying asset. These instruments are used to shift risk among investors
THE 4 CHARACTERISTICS INFLUENCING THE VALUE OF FINANCIAL INSTRUMENTS:
1) SIZE OF THE PAYMENT - the bigger the promised payment, the more valuable the financial instrument 2) WHEN THE PAYMENT IS TO BE MADE - the sooner the payment is made, the more valuable the financial instrument 3) LIKELIHOOD THE PAYMENT IS TO BE MADE - this involves risk therefore it needs to be compensated, so the more likely the payment will be made, the more valuable the financial instrument 4 4) CIRCUMSTANCES UNDER WHICH PAYMENTS IS MADE - payments that are paid when we need them the most are more valuable (ex: insurance)
THE 2 TYPES OF FINANCIAL INSTRUMENTS:
 FINANCIAL INSTRUMENTS USED TO STORE VALUE INTO THE FUTURE: bank loans, bonds, stocks,
home mortgages, asset-backed securities (is a security whose income payments come from a group of small & illiquid assets which cannot be traded individually (ex: car loan, student loan, credit card debt & the most famous one); mortgage-backed security (is a large number of mortgages pooled together in which shares are then sold). The owners (buyers) of these securities receive a share of payments made by the homeowners (borrowers) who borrowed the funds
 FINANCIAL INSTRUMENTS USED AS TRANSFER OF RISK: insurance, futures, options

OPTIONS - gives the holder the right to buy/sell a fixed quantity of asset at a pre-determined price &
specific date
FUTURES - contracts for assets bought at agreed prices but delivered & paid letter (ex: farmer - wheat crop)

B. THE FINANCIAL MARKET
THE 3 ROLES OF FINANCIAL MARKET:
1) LIQUIDITY - ensures people can buy/sell financial instruments cheaply & quickly. It keeps the cost of buying & selling low 2) INFORMATION - pools & communicates information about issuers of financial instruments,
summarizing it in the form of price 3) TRANSFERRING RISK - allows us to buy/sell risks, holding the ones we want and getting rid of the ones we don't
THE STRUCTURE OF FINANCIAL MARKET:

1.1 Primary Market - where only newly issued securities are sold

1.2 Secondary Market - where only existing securities are traded

2.1 Centralized Exchange - secondary market, where buyers & sellers meet in a central,
physical location (NYSE, LSE) (broker)

2.2 Over-the-counter market (OTS) - decentralized secondary market, where dealers trade with one another electronically (Nasdaq) (dealer)

2.3 Electronic communication networks (ECN) - secondary market with electronic system bringing buyers & sellers together without the use of a broker/dealer (Arca, Instinet) (DMM)

3.1 Debt market - is for loans, mortgages & bonds

3.1.1 Money Market - instruments with maturity of 1 year (T-bills)
5 3.1.2 Bond market - instruments with a maturity of more than 1 year (T-bonds)

3.2 Equity market - only for stocks, designed to give investors a store of value for their wealth,
where claims are bought & sold for immediate cash payment

3.3 Derivative market - for futures & options, designed to transfer risk, where investors make agreement that are settled later

C. FINANCIAL INSTITUTIONS/INTERMEDIARIES - gives access to financial markets both for lenders
& borrowers (ex: banks, insurance companies, securities firms, pension & mutual funds)
THE STRUCTURE OF FINANCIAL INSTITUTIONS:
1) DEPOSITORY - take deposits & make loans (all types of banks)
2) NON-DEPOSITORY - screen & monitor borrowers; reduce & transfer risk (insurance companies,
securities firms, pension & mutual funds)

6 Lecture 4 - FUTURE VALUE, PRESENT VALUE AND INTEREST RATES
FV = PV * (1+i)n
FV IS HIGHER IF:
1) the PV is higher 2) the interest rate is higher

PV = FV / (1+i)n
PV IS HIGHER IF:
1) the FV is higher 2) the time period is shorter 3) the interest rate is lower

IRR - is the interest rate that equates the present value of an investment with its cost. An investment will be profitable if its internal rate of return exceeds the cost of borrowing
BOND - is a promise to make a series of payment on specific future dates. The price of the bond is the present value of its payments!

Coupon payment = coupon rate * amount borrowed

Real interest rate - inflation adjusted interest rate
Fisher equation:

i nominal = rreal + πe (inflation)

OR

(1 + i nominal) = (1 + rreal)*(1 + inflation)

The higher the expected inflation, the higher is the nominal interest rate

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