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Introduction to Finance
Phillip LeBel, Ph.D.
Professor of Economics
School of Business
Montclair State University
Upper Montclair, New Jersey 07043
The Significance of Financial Institutions
• Finance is an essential tool in the creation of capital goods
• Financial institutions serve as intermediaries between savers and
investors for the efficient allocation of resources
• Financial institutions include government agencies, banks, private
equity markets, as well as individual savings organizations
• Interactions between savers and investors are governed by the
pricing of credit, and which is reflected in given rates of interest
• While central banks are major players in the determination of
interest rates, other actors play important roles as well, notably,
the World Bank, the IMF, and other financial institutions.
The Determination of Interest Rates
Basic Market Equilibrium
• Interest rates are set by a combination of market and public
intervention decisions
• Central banks typically set interest rates equal to the opportunity
cost of capital, namely, what it costs the central bank to obtain a
given level of credit
• Interest rates can be distorted in the presence of market
imperfections, with the result that capital flows are inefficient, thus
reducing an economy’s potential rate of growth.
Market Forces in Interest Rate Determination
• When central banks intervene in capital markets they can do so by
a variety of means
• One is through open market operations, by which the buying of
government securities increases their price and lowers the
underlying rate of interest - however, for this to work efficiently
depends on the orderly functioning of a securities market
• A second instrument is through the setting of required reserve
ratios across the banking systems. Higher reserve ratios mean
fewer lendable reserves, in which case banks ration credit through
higher interest rates.
In addition, central banks can also use selective credit controls to favor
some sectors over others. Such was the case with the conversion of the
U.S. economy from producing civilian to military goods during the Second
World War, and in the now abandoned use of Regulation Q to favor
housing construction in the U.S.
Apart from the question of an orderly functioning of a securities market,
one additional problem is if government treasury operations require the
issuance of new debt to cover obligations while the central bank may be
pursuing a contractionary monetary policy - there will be no effect on the
supply of money as long as the private sector purchases all new
government debt, whereas if the central bank does so, there will be an
expansionary effect on the supply of money, thus undercutting a
contractionary central bank monetary policy.
Private equity markets are an important complement to debt institutions.
Transparency in the structure and operation of equity markets is an
essential condition for their role in the efficient allocation of resources
The Mix of Financial Institutions
• While a securities market is an important type of financial
institution, other institutions enable capital flows to be priced
according to different levels of risk.
• Risk reflects financial, economic, political, and environmental
factors that influence the level and efficiency of capital flows.
• In addition, to government securities markets, other institutions
include private equity markets, along with a mix of financial risk
management products such as derivatives.
Financial Risk Management Products
Call  SN d1   Xe rt N d2 
Put  Xe rt N d2   SN d1, where :
d1 
d2 
ln(S / X )  r   2 / 2 t
 t
  d 
ln(S / X )  r   2 / 2 t
 t
The Black-Scholes
Option Pricing Model
Value at Risk Models
Earnings at Risk Models
Economic Value Added Models
Expected Default Frequency Models
Fundamental Principles in Finance
• Financial institutions are essential to the efficient allocation of
• Distortions in capital markets exist from a combination of factors:
the absence of financial intermediation, the inefficiency of capital
markets, and mis-placed government intervention designed to
accomplish other ends
• Financial risk management products can improve the functioning
of capital markets but they can not eliminate risk. Diversification
is an essential step in risk management, but works better in the
presence of derivative contracts than in their absence.