Introduction to Finance Phillip LeBel, Ph.D. Professor of Economics School of Business Montclair State University Upper Montclair, New Jersey 07043 Lebelp@mail.montclair.edu 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 25.00 20.00 15.00 10.00 5.00 0.00 0.00 0.50 1.00 1.50 2.00 Qd 2.50 Qs 3.00 3.50 4.00 4.50 5.00 Pe • 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 and d ln(S / X ) r 2 / 2 t t 1 The Black-Scholes Option Pricing Model Value at Risk Models Earnings at Risk Models Economic Value Added Models Expected Default Frequency Models t Fundamental Principles in Finance • Financial institutions are essential to the efficient allocation of resources • 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.