Chapter 2: The Financial System

Chapter 2: The Financial System

John Bogle and Vanguard

  • John Bogle (1929-2019)

    • American investor, business tycoon, and philanthropist.

    • Founded Vanguard, recognized as a top investment firm.

  • Background

    • Born in Montclair, New Jersey, from a modest-income family, losing wealth in the 1929 stock market crash.

    • Studied economics and investments at Princeton University.

    • Worked at Wellington Management Company before starting Vanguard in 1975.

  • Contributions to Investing

    • Known as the "father of passive investing."

    • Pioneered index investing allowing investors to buy mutual funds tracking major market indices (e.g., S&P 500).

    • Philosophy: Average investors struggle to beat the market; advocating low-cost, long-term investments.

    • Advocated against speculation and excessive brokerage fees.

  • Vanguard’s Growth

    • Initial funding for the Vanguard 500 fund in 1976 was $11 million; by 2022, managed over $700 billion.

2.1 Financial Market Functions

  • Financial Markets: Facilitate the flow of funds between savers and borrowers.

Key Concepts

  • Direct Finance: Borrowers obtain funds directly from lenders; no intermediaries (e.g., corporations selling bonds directly to households).

  • Indirect Finance: Borrowers obtain funds through financial intermediaries (e.g., banks lending deposits).

  • Economic Participants: Domestic and foreign households, businesses, and governments.

    • Savers: Individuals or entities that spend less than their income.

    • Borrowers: Entities that spend more than their income.

2.2 Financial Market Components

Learning Objectives

  1. Distinguish between equity market and debt market.

  2. Discuss primary and secondary markets and the role of investment banks.

  3. Review centralized securities exchanges and the over-the-counter market.

  4. Differentiate between the money market and the capital market.

Financial Markets Overview

  • Equity Market:

    • Market for shares of corporations.

    • Provides capital for business expansion, potential returns via dividends to investors.

    • Examples: New York Stock Exchange, Nasdaq, Tokyo Stock Exchange.

    • Considered long-term investments.

  • Debt Market:

    • Market for buying and selling debt contracts (e.g., bonds).

    • Investors lend money for specified periods with interest.

    • Includes U.S. Treasury bonds and corporate bonds.

    • Bonds can be short-term (maturity < 1 year) or long-term (maturity > 1 year).

Key Definitions

  • Primary Market: Newly issued securities are sold for the first time (e.g., Initial Public Offerings (IPOs)).

  • Secondary Market: Previously issued securities are traded among investors.

  • Investment Banks: Financial intermediaries that facilitate primary market transactions, assist in underwriting, and offer advisory services for mergers.

Centralized vs. Over-the-Counter Markets

  • Centralized Exchanges: Physical marketplaces for securities trading (e.g., NYSE).

  • Over-the-Counter (OTC) Market: Decentralized, electronic trading of securities without a central exchange.

Money Market vs. Capital Market

  • Money Market: Short-term debt instruments traded (< 1 year).

  • Capital Market: Medium (1-5 years) and long-term (> 1 year) securities.

2.3 Instruments of the Money Market

Learning Objectives

  1. Identify components of the money market.

  2. Describe U.S. Treasury bills (T-Bills).

  3. Explain risks associated with negotiable certificates of deposit (NCDs).

  4. Distinguish among federal funds, commercial paper, and repurchase agreements.

  5. Discuss banker’s acceptances in trade.

Money Market Instruments

  • U.S. Treasury Bills (T-Bills):

    • Short-term securities backed by the Treasury Department, sold at discount, e.g., denominations of $1,000.

    • Maturities options: 1 month, 3 months, 6 months, 1 year.

    • Yield calculated as the difference between purchase price and face value at maturity.

  • Negotiable Certificates of Deposit (NCD):

    • Fixed interest time deposits, minimum denomination usually at $100,000.

    • More liquid than regular CDs due to secondary market.

    • Higher risk than T-Bills due to default potential.

  • Federal Funds:

    • Excess reserves held by banks at Federal Reserve for overnight lending, influencing federal funds rate.

  • Commercial Paper:

    • Short-term unsecured promissory notes issued by corporations to meet liabilities.

    • Typically less than 270 days maturity.

  • Repurchase Agreements (Repos):

    • Short-term loans secured by government securities, usually with maturity of less than 2 weeks.

  • Banker’s Acceptances:

    • Financial assurance by banks for payments in international trade, typically short-term (20-180 days).

2.4 Instruments of the Capital Market

Learning Objectives

  1. Identify major financial instruments of the capital market.

  2. Define differences between U.S. Treasury bonds and agency bonds.

  3. Discuss why corporate bonds usually yield higher interest rates than government bonds.

  4. Identify tax benefits associated with municipal bonds.

Capital Market Instruments

  • Stock: Represents ownership in a corporation.

  • U.S. Government Bonds: Issued by the U.S. Treasury; includes notes and bonds with varying maturities.

  • Government Agency Bonds: Issued by enterprises like FNMA (Fannie Mae) and others but not backed by full U.S. government credit.

  • Corporate Bonds: Debt securities issued by firms to finance activities; higher interest due to increased risk of default.

  • Municipal Bonds: Debt securities issued by local governments with typically tax-exempt interest.

    • Mortgages: Long-term loans for real estate backed by property collateral.

2.5 Financial Intermediary Services

Learning Objectives

  1. Identify services of financial intermediaries.

  2. Discuss liquidity significance to the financial system.

  3. Explain risk exposure management by intermediaries.

  4. Discuss concepts of asymmetric information (e.g., adverse selection, moral hazard).

  5. Explain economies of scale and scope for banks.

Services of Financial Intermediaries

  • Liquidity: Ability to convert assets to cash quickly without significant loss of value. E.g., cash is highly liquid; real estate is less liquid.

  • Risk Sharing: Helps manage investment risks through diversification of portfolios.

  • Information Services: Provides bridging information to ensure credible lending between parties.

  • Transaction Costs: Financial intermediaries reduce costs associated with trading and obtaining capital, benefiting from economies of scale and scope.

Key Definitions

  • Asymmetric Information: Different levels of information among market participants, leading to adverse selection and moral hazard dilemmas.

    • Adverse Selection: Occurs before a transaction; untrustworthy borrowers attract loans due to lack of information.

    • Moral Hazard: Arises after a transaction; irresponsible behavior by borrowers due to reduced stakes in the outcome.

  • Economies of Scale: Cost reductions per unit when production increases; relevant for banks that can spread costs over large volumes of transactions.

  • Economies of Scope: Cost advantages gained when a firm produces a variety of goods or services simultaneously.

2.6 Financial Intermediary Categories

Learning Objectives

  1. Identify categories of financial intermediaries.

  2. Discuss four types of depository institutions.

  3. Identify contractual savings institutions (e.g., pension funds, insurance companies).

  4. Discuss investment intermediaries, including mutual funds, hedge funds, and finance companies.

Categories of Financial Intermediaries

  • Depository Institutions: Include banks accepting deposits and making loans. E.g., commercial banks, S&Ls, mutual savings banks, and credit unions.

  • Contractual Saving Institutions: Accept funds based on contracts offering insurance or pension services, investing capital to meet obligations.

  • Investment Intermediaries: Include mutual funds, hedge funds, and finance companies generating funds for investments.

Key Institutions and Definitions

  • Commercial Banks: Accept deposits, offer loans, profit through interest spread; regulated and taxed.

  • Savings and Loan Associations (S&Ls): Focus on offering mortgage loans, traditionally supporting homeownership.

  • Mutual Savings Banks: Owned by depositors, provide dividend benefits on profits instead of shareholder dividends.

  • Credit Unions: Not-for-profit institutions focusing on low costs and member benefits, offering similar services to banks.

  • Pension Funds: Institutions providing retirement income through pooled contributions.

  • Life Insurance Companies: Issue life insurance policies using premiums to fund long-term investments.

  • Hedge Funds: Invest pooled money from accredited investors, often using complex strategies and leverage.

  • Finance Companies: Offer loans, typically with higher rates to borrowers unable to secure bank loans.

2.7 Investing in the Stock Market

Learning Objectives

  1. Describe characteristics of the stock market.

  2. Identify strategies for investors.

  3. Discuss the nature of the efficient market hypothesis.

  4. Explain the relevance of behavioral finance for investors.

Stock Market Overview

  • Definition of Stock: Ownership stake in a company (e.g., Apple). Share prices determined by supply and demand dynamics; influenced by corporate growth expectations.

  • Market Infrastructure: Stocks traded on exchanges (e.g., NYSE) subject to regulations ensuring fair treatment and information availability.

Investment Strategies

  • Active Investing: Investors aim to outperform the market through selective investments. Often requires thorough market analysis and frequent trading.

  • Passive Investing: Investors focus on long-term holdings and match market performance; typically achieved through index funds.

  • Market Timing: Attempting to predict market movements for buying/selling, which is highly unpredictable.

  • Dollar-Cost Averaging: Regular investment of a fixed amount of money, reducing risk associated with price fluctuations.

Efficient Market Hypothesis

  • Efficient Market Hypothesis (EMH): Proposes security prices reflect all available information, making it impossible for investors to consistently outperform the market.

  • EMH suggests that the best approach for most investors is a diversified low-cost portfolio (index funds).

Behavioral Finance

  • Field of Study: Examines psychological influences on financial behavior and market outcomes.

  • Key Concepts: Loss aversion, herd behavior, emotional gaps in decision-making, overconfidence, and heuristics that affect rationality in investments.

2.8 Chapter Summary and Study Questions

Summary Points

  1. Financial markets allow the smooth flow of funds from savers to borrowers.

  2. Both direct and indirect finance mechanisms play critical roles.

  3. Distinction between equity and debt markets is established; along with primary and secondary market operations.

  4. Money market instruments identified, including Treasury bills and commercial paper.

  5. Capital market includes long-term securities like stocks and bonds.

  6. Importance of financial intermediaries highlighted including liquidity, risk-sharing, and reduced transaction costs.

  7. Overview of types of depository institutions and their functions.

  8. Descriptions of contractual saving institutions and distinct categories of investment intermediaries.

  9. Stock market dynamics and investment strategy considerations.

  10. Review of efficient market hypothesis and area of behavioral finance showing psychological impacts on decision-making.