The Financial System-I

(The Rationale of Saving

Decision)
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Surplus and Deficit

Spending Units
Surplus
Surplus spending
spending unit
unit (SSU)
(SSU) aa spending
spending unit
unit who
who
prefers
prefers to
to spend
spend on
on current
current consumption
consumption and/or
and/or
investment
investment goods
goods less
less than
than his
his or
or her
hercurrent
current income
income
at
at current
current market
market rates
rates of
of interest.
interest.
Deficit
Deficit spending
spending unit
unit (DSU)
(DSU) aa spending
spending unit
unit who
who
prefers
prefers to
to spend
spend more
more on
on current
current consumption
consumption
and/or
and/or investment
investment goods
goods than
than his
his or
or her
her current
current
income
income at
at current
current market
market rates
rates of
of interest.
interest.
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FACTORS
FACTORSAFFECTING
AFFECTINGTHE
THEDIVISION
DIVISIONOF
OFSPENDING
SPENDING
UNITS
UNITSBETWEEN
BETWEENSURPLUS
SURPLUSAND
ANDDEFICIT
DEFICIT

current
current income
income

family
family status
status

expected
expected income
income

tastes
tastes

wealth
wealth

current
current interest
interest rates
rates

age
age
health
health
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education
education

The
The surplus
surplus spending
spending units
units
have
have three
three primary
primary options.
options.
Hold their surplus income as
money balances
Repurchase and retire their own
outstanding financial claims sold
at times they were DSUs
Temporarily rent out purchasing
power to current DSUs by
purchasing financial claims
issued by them.
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The
The deficit
deficit spending
spending units
units
also
also have
have three
three primary
primary
options.
options.
Reduce their money
balances
Sell claims on others
acquired when they were
SSUs
Sell new claims on
themselves to current SSUs.
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The
The choice
choice of
of adjustments
adjustments
depends,
depends, in
in part,
part, on
on the
the
characteristics
characteristics of.
of.

FINANCIAL
FINANCIALCLAIMS
CLAIMS
FINANCIAL
FINANCIAL
INSTITUTIONS
INSTITUTIONS
FINANCIAL
FINANCIALMARKETS
MARKETS
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FINANCIAL
FINANCIALCLAIMS
CLAIMS
These are future claims on real resources. Until maturity,
they transfer purchasing power from spending units who
purchase the claims (SSUs) to spending units who sell
the claims (DSUs).

Until the claim is converted into

real goods and services, it
typically generates interest. This
rewards the claim for leasing his
or her purchasing power and for
abstaining from using it.
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FACTORS
FACTORSEXPLAINING
EXPLAININGDIFFERENCES
DIFFERENCESIN
ININTEREST
INTEREST
RATES
RATESON
ONFINANCIAL
FINANCIALCLAIMS
CLAIMS
The longer the term to maturity is, the higher the interest
rate demanded by the claim purchaser.
The greater the marketability of a claim prior to its maturity in terms
of both lower transaction costs and ability to obtain quickly the
purchase price or close to purchase price, the lower the interest rate
demanded.

The greater the risk the default is, the higher the interest
rate demanded by the purchaser.
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MAJOR
MAJOR FINANCIAL
FINANCIALCLAIMS
CLAIMS
RANKED
RANKED BY
BYMONEYNESS
MONEYNESS
1. CURRENCIES Among the currencies regarded as
being major are the British point sterling (), the
European Union euro (), the Japanese yen (), and
the Canadian dollar (C$), and of course, the U.S.
dollar (US$). The value of two currencies with respect
to each other, or their foreign exchange rate, is
expressed as follows:
US$1.00 = 108.37
1.00 = US$0.009228
2. DEMAND DEPOSITS technically the checking
accounts are deposits at commercial banks that can
be transferred immediately by written order of the
depositor to a designated second party in any
denomination less than or equal to the amount of the
writers deposit balance.
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MAJOR
MAJOR FINANCIAL
FINANCIALCLAIMS
CLAIMS
RANKED
RANKED BY
BYMONEYNESS
MONEYNESS
3. SAVINGS DEPOSITS AT
a. COMMERCIAL BANKS
b. MUTUAL SAVINGS BANK
c. SAVINGS AND LOAN ASSOCIATIONS
d. CREDIT UNIONS

4. CERTIFICATES OF DEPOSIT AT
COMMERCIAL BANKS
a. Consumer certificates of deposit issued in
designated denominations, have fixed maturity dates,
and bear fixed rates of interest to maturity. They can
be redeemed prior to maturity. They can be redeemed
prior to maturity only in emergency and at a penalty.
b. Negotiable certificates of deposit - commonly
referred to as CDs, are very large certificates of
deposit, usually issued in denominations of $1 million
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to business
firms and government units.

10

MAJOR
MAJOR FINANCIAL
FINANCIALCLAIMS
CLAIMS
RANKED
RANKED BY
BYMONEYNESS
MONEYNESS
5. RESERVES OF LIFE INSURANCE COMPANIES
reserves or protection against the loss of income from
actuarially premature death or retirement.

6. GOVERNMENT ISSUES:
a. TREASURY SAVINGS BONDS the longest term
securities issued by the Treasury. They have original terms to
maturity of ten years or more.
b. TREASURY BILLS are issued with a term to maturity
of one year or less. They are sold at a discount from maturity
value. These bills are auctioned weekly.
c. TREASURY NOTES coupon issues sold from one to
ten years to maturity. Unlike bills, notes are sold not on a
regular
schedule but at times when new funds must be raised
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to finance a federal budget deficit.

11

MAJOR
MAJOR FINANCIAL
FINANCIALCLAIMS
CLAIMS
RANKED
RANKED BY
BYMONEYNESS
MONEYNESS
7. BANKERS ACCEPTANCES being issued by
banks that serve as guarantee of a business
transaction; sold at a discount from maturity value.
These have maturity of 1 to 3 months.

8. SHORT-TERM CORPORATE DEBT

(COMMERCIAL PAPER) a form of financing that
consists of short-term, unsecured promissory notes
issued by firms with a high credit standing. Most
commercial paper issues have maturities ranging from
3 to 270 days.

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12

MAJOR
MAJOR FINANCIAL
FINANCIALCLAIMS
CLAIMS
RANKED
RANKED BY
BYMONEYNESS
MONEYNESS
9. MUNICIPAL GOVERNMENT DEBT - sold by state,
city, and other local governments. They are
collateralized either by full taxing powers of the issuing
municipality (general obligation bonds) or by revenues
derived from the particular project the bonds financed
(revenue bonds). Maturities vary from a few weeks to
30 or more years.

10. LONG-TERM CORPORATE DEBT a long term

debt instruments indicating that a corporation has
borrowed a certain amount of money and promises to
repay it in the future under clearly defined terms. Most
bonds are issued with maturities of 10 to 30 years and
with a par value, or face value, of $1,000.
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13

MAJOR
MAJOR FINANCIAL
FINANCIALCLAIMS
CLAIMS
RANKED
RANKED BY
BYMONEYNESS
MONEYNESS
11. CORPORATE EQUITY consists of long-term
funds provided by the firms owners, the stockholders.
A firm can obtain equity capital either internally, by
retaining earnings rather than paying them out as
dividends to its stockholders, or externally, by selling
common or preferred stock.

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14

FINANCIAL
FINANCIALINSTITUTIONS
INSTITUTIONS
These serve as intermediaries by channeling the
savings of individuals, businesses, and governments into
loans or investments. The financial institutions expedite
the exchange of claims for money.

Savers
Saversand
andlenders
lendersare
are
brought
broughttogether
together on
onthe
the
private
privatecapital
capitalmarket
market by
by
investment
investment bankers.
bankers.
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15

INVESTMENT BANKERS
BROKERS provide a pure search service; they
do not take legal possession of the claims traded.
Brokers locate the participants in a pending
trade before the trade occurs and receive a
commission from both parties for his service
upon doing the trade.

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DEALERS - take legal possessions of the claims

by buying the claims from DSUs for their own
inventories and subsequently selling the claims
to SSUs from these inventories. Dealers income
is derived from the spread between the buying
and selling prices of the claim; the greater the
spread, the greater the earnings.16

FLOW OF FUNDS FOR FINANCIAL

INSTITUTIONS AND MARKETS
Funds
Deposits/
Shares

Funds

Financial
Institutions

Loans

Fu
nd
s

Funds

Suppliers of
Funds (SSUs)

Private
Placements
Securities

Funds

Securities
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Demanders of
Funds (DSUs)

Se
cu
riti
es

Funds

Financial
Markets

Securities
17

Private
Private placement
placement means
means
that
that the
the firm
firm sells
sells new
new
securities
securities directly
directly to
to an
an
investor
investor or
or group
group of
of investors.
investors.

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18

TYPES
TYPES OF
OFFINANCIAL
FINANCIALINTERMEDIARIES
INTERMEDIARIES
COMMERCIAL BANKS the largest, most important,
and most diversified of all financial intermediaries. They
are commonly referred to as the department stores of
finance.
SAVINGS AND LOAN ASSOCIATIONS primarily
personal savings and mortgage lending institutions.
They effectively borrow short- and intermediate-term
through passbook savings and savings certificates for
which they compete with commercial banks, and lend
long-term on real estate collateral.
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19

TYPES
TYPES OF
OFFINANCIAL
FINANCIALINTERMEDIARIES
INTERMEDIARIES
LIFE INSURANCE COMPANIES raise funds by
selling protection against the loss of income from
actuarially premature death or retirement.

PRIVATE PENSION FUNDS collect contributions

from the employee and/or employer during the
employees working years and make monthly
payments upon his or her retirement.

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20

TYPES
TYPES OF
OFFINANCIAL
FINANCIALINTERMEDIARIES
INTERMEDIARIES
MUTUAL SAVINGS BANK gather funds primarily from
households through passbook savings accounts and savings
certificates and invest primarily in residential mortgages.

FINANCE COMPANIES make loans to business firms and

households.
a. Business finance companies specialize in lending to firms.
b. Sales finance companies specialize in lending to households
for the purchase of automobiles and large consumer durables
c. Personal finance companies specialize in financing small
consumer purchases and extending small personal loans to
reasonably high-risk borrowers.

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21

TYPES
TYPES OF
OFFINANCIAL
FINANCIALINTERMEDIARIES
INTERMEDIARIES
CASUALTY INSURANCE COMPANIES sell
protection against loss resulting from accident, fire,
theft, negligence, and other actuarially predictable
causes.
MUTUAL FUNDS differ from other financial
intermediaries in that both the secondary securities they sell
and the primary securities they purchase are primarily
equity securities. In effect, mutual funds permits
individuals to participate in equity investments in any
denomination, with reduced risk resulting from
diversification and the assistance of professional
management and counsel.
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22

TYPES
TYPES OF
OFFINANCIAL
FINANCIALINTERMEDIARIES
INTERMEDIARIES
CREDIT UNIONS small consumer oriented savings
and lending institutions. They are typically organized by
members of an employees group, a profession, or a
neighborhood to gather savings and extend loans to
members of the group.

REAL ESTATE INVESTMENT TRUSTS invest in

commercial land, and short-term commercial
mortgages. Funds are raised through both debt and
equity sales in about a 2:1 ratio.
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23

FINANCIAL
FINANCIALMARKETS
MARKETS

Financial institutions buy and sell

their securities on financial
markets. FINANCIAL
MARKETS are forums in which
suppliers of funds (SSUs) and
demanders of funds (DSUs) can
transact business directly.

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24

Financial markets may be categorized by

the following:
Age of the claims traded
Type of intermediary between
ultimate DSUs and SSUs
Term to maturity of the claims traded
Unit size of trade
Location

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25

Financial
Financial Markets
Markets categorized
categorized
by
by the
the Age
Age of
of the
the claims
claims traded
traded
1. PRIMARY MARKET trade in newly created claims. All
financial claims whether debt or equity have primary markets. A
security can be traded on the primary market once at the time it
is issued.
The size of the primary market has both stock and flow dimensions.
The stock dimension measures the size of the market by
the aggregate dollar amount of all claims outstanding.
The flow dimension incorporates time: it measures the size
of the market by the dollar volume of new issues sold in a
particular period of time, say, one month or one year.
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26

Because
Becausesecurities
securitieswith
withshorter
shorter
maturities
maturitiesare
aremore
morelikely
likelyto
tobe
be
refinanced
refinancedmore
morefrequently,
frequently,this
this
measures
measuresgives
givesgreater
greaterweight
weightto
to
short-term
short-termsecurities.
securities.

Thus,
Thus,aaprimary
primarymarket
marketthat
thatsells
sells
$10
$10million
millionof
ofone-month
one-monthsecurities
securities
every
everymonth
monthor
or$120
$120million
millionin
inone
one
year
yearmay
maybe
beconsidered
consideredlarger
largerthan
than
aamarket
marketthat
thatsells
sellsaasingle
singleissue
issueof
of
$100
$100million
millionof
ofone-year
one-yearsecurities
securities
once
onceaayear.
year.

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27

Financial
Financial Markets
Markets categorized
categorized
by
by the
the Age
Age of
of the
the claims
claims traded
traded
2. SECONDARY MARKET trades in outstanding securities.
To be traded on the secondary market, a security needs to be
legally negotiable. A security can be traded any number of times
on the secondary market.

While a security needs to be legally negotiable to

be eligible for trade on the secondary market,
negotiability does not insure marketability.

The volume of trading on the secondary market is

directly related to transaction costs.
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28

Conventional
Conventionalresidential
residentialmortgages,
mortgages,while
whilelegally
legally
negotiable,
negotiable,trade
tradeonly
onlyinfrequently
infrequentlyon
onthe
thesecondary
secondarymarket
market
because
becauseof
ofhigh
hightransaction
transactioncosts
costsarising
arisingfrom
fromtheir
theirodd
odd
denominations,
denominations,nonstardadized
nonstardadizedloan
loancontracts,
contracts,and
andlimited
limited
information
informationon
onthe
thecreditworthiness
creditworthinessof
ofthe
theultimate
ultimateDSUs.
DSUs.

On
Onthe
theother
otherhand,
hand,securities
securitiesof
ofthe
theU.S.
U.S.
Treasury
Treasuryand
andmajor
majorbusiness
business
corporations
corporationstrade
tradefrequently
frequentlybecause
because
of
oflow
lowtransaction
transactioncosts,
costs,reflecting
reflecting
large
largeand
andcommon
commondenominations,
denominations,
standardized
standardizedloan
loancontracts,
contracts,and
andmore
more
readily
readilyavailable
availableinformation
informationon
onthe
the
creditworthiness
creditworthinessof
ofthe
theborrower.
borrower.

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29

Financial
Financial Markets
Markets categorized
categorized by
by the
the
Type
Type of
of intermediary
intermediary between
between ultimate
ultimate
DSUs
DSUs and
and SSUs
SSUs
1. PRIVATE MARKETS (Direct financial market) the market
wherein the new security issue are sold to an investor or group
of investors, such as an insurance company or pension fund.
2. INTERMEDIATION MARKET (Indirect
financial market) able to reduce transaction
costs and increase the efficiency of the
financial markets. It can be classified into:
a. Equity intermediation market ex. Investment Funds
b. Debt intermediation market ex. Commercial Banks,
Mutual Savings Banks, Savings and Loan Associations.
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30

Financial
Financial Markets
Markets categorized
categorized by
by the
the
term
term to
to maturity
maturity of
of the
the claims
claims traded
traded
marketable
securities
SHORT-TERM DEBT
INSTRUMENTS

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money market

bonds

stocks

LONG-TERM DEBT
INSTRUMENTS

capital
market
31

Financial
Financial Markets
Markets categorized
categorized by
by the
the
Unit
Unit size
size of
of trade
trade
1. CENTRALIZED MARKETS the market wherein securities in large
units, say, of $1 million or more, are traded. The trades are centralized to
limited number of major cities called financial centers. These would
include the countrys ten largest banks, four largest insurance
companies, the largest mutual savings bank, largest organized stock
exchanges, and almost all large security dealers and brokers.

2. DECENTRALIZED MARKETS
markets for smaller trading units
that exist in every city throughout
the country.

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32

Financial
Financial Markets
Markets categorized
categorized by
by the
the
Location
Location
1. ORGANIZED MARKETS commonly referred to as an exchange.
Buyers and sellers frequently trade through agents of an exchange, not
with each other. The exchange matches the orders and establishes the
equilibrium prices. The largest organized exchange in the United States
is the New York Stock Exchange.

2. OVER-THE-COUNTER MARKETS exists

wherever financial claims are sold under
conditions different from those for an organized
exchange. Every dealer and intermediary operates
an over-the-counter market in their own shop when
they buy or sell claims for their own account.
Buyers and sellers trade directly with each other
conducted largely by telephone.
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33

What
What is
is WEALTH?
WEALTH?
Wealth is anything which has
economic value.
This means it has a price and it
also generates prestige and power.
One way to create wealth is
through SAVINGS.

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34

Why
Why do
do we
we SAVE
SAVE money?
money?
To
Tofinance
finance the
the needs
needs of
of old
old age.
age.
To
Togive
giveinsurance
insuranceagainst
againstthe
the
contingency
contingencyof
ofbeing
beingunemployed.
unemployed.
To
Togive
giveprotection
protectionfor
forthe
thefamily.
family.
To
Toenjoy
enjoyfully
fullythe
theretirement
retirementperiod
periodin
in
comfort
comfortand
andleisure.
leisure.
To
Toearn
earninterest
interestor
oradditional
additionalincome.
income.
To
Tosave
savebecause
becausethere
thereisisno
noother
other
alternative
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alternativebut
butto
tosave.
save.

35

SAVING
SAVING EQUATIONS
EQUATIONS
Asset
Asset Liabilities
Liabilities =Wealth
=Wealth
This is known as the Balance Sheet Identity. An individual may be
described as net creditor if wealth is positive; if on the opposite, he is
referred to as net debtor

Income
Income Consumption
Consumption == Savings
Savings
Consumption
Consumption ++ Savings
Savings == Income
Income
These are known as the Saving Identity. These exemplify the fact that
consumption and savings are the two alternative functions of income.

Savings
Savings == Wealth
Wealth
This is known as the Accumulation Identity. It provides the tie-up
between
the stock variables (assets, liabilities, and wealth)
11/25/12
36 and flow
variables (income, consumption, and saving).

GROUP ACTIVITY:
Review the Terminologies about money and financial
systems
For group activity, answer and explain the following:
a. Why do we save? Is it good to save money in the
bank during prolonged inflation? Why?
b. If current consumption is greater than current
income, how could this be sustained? Explain your
behavioral aspects in saving decision.

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37