This document contains information about various financial concepts such as money, markets, banking, and monetary policy. It defines money and describes its functions. It also defines different types of markets including money markets, capital markets, primary markets, secondary markets, and over-the-counter markets. Additionally, it discusses financial institutions and their role in the economy, central banks and monetary policy, and the functions and balance sheet of banks.
Understanding Money, Banking, Financial Markets and Policy
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Assignment
Submitted To:
Jhumi Azad.
Lecturer
Dept’ Of Business Administration.
Stamford University Bangladesh.
Submitted By:
Name ID
Niloy Saha BBA 054 16669
Rimon Khan BBA 054 16679
Saiful Islam Saif BBA 054 16695
Batch: BBA-54 (FIN-A)
Date of Summation: 20th
February, 2017
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Money:
Anything of value that serves as a (1) generally accepted medium of financial exchange, (2)
legal tender for repayment of debt, (3) standard of value, (4) unit of accounting measure,
and (5) means to save or store purchasing power. See also cash.
For example: For Having a AUDI (A5-2017) Car You have to pay BDT 10.5 million.
Why Study Financial Institutions?
Financial institutions—the corporations, organizations, and networks that operate the so-
called “marketplaces.” These institutions play a crucial role in improving the efficiency of the
economy.
Central Banks and the Conduct of Monetary Policy The role of the Fed and foreign
counterparts.
Market:
An actual or nominal place where forces of demand and supply operate, and where buyers
and sellers interact (directly or through intermediaries) to trade goods, services, or contracts
or instruments, for money or barter.
Markets include mechanisms or means for (1) determining price of the traded item, (2)
communicating the price information, (3) facilitating deals and transactions, and (4)
effecting distribution. The market for a particular item is made up of existing and potential
customers who need it and have the ability and willingness to pay for it.
*Flow Chat Of Market.
Market
Money
Market
Primary Market
Secondary
Market
Over-The-
Counter Market
Capital
Market
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Money Market
The money market is a segment of the financial market in which financial instruments with
high liquidity and very short maturities are traded. The money market is used by
participants as a means for borrowing and lending in the short term, from several days to
just under a year. Money market securities consist of negotiable certificates of deposit
(CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes,
Eurodollars, federal funds and repurchase agreements (repos). Money market investments
are also called cash investments because of their short maturities.
Capital Markets
A capital market is one in which individuals and institutions trade financial securities.
Organizations and institutions in the public and private sectors also often sell securities on
the capital markets in order to raise funds. Thus, this type of market is composed of both
the primary and secondary markets.
Primary Market
A primary market issues new securities on an exchange for companies, governments and
other groups to obtain financing through debt-based or equity-based securities. Primary
markets are facilitated by underwriting groups consisting of investment banks that set a
beginning price range for a given security and oversee its sale to investors.
Secondary Market
The secondary market is where investors buy and sell securities they already own. It is what
most people typically think of as the "stock market," though stocks are also sold on the
primary market when they are first issued. The national exchanges, such as the New York
Stock Exchange (NYSE) and in Bangladesh the DSE and CSE, are secondary markets.
Over-The-Counter Market
A decentralized market, without a central physical location, where market participants trade
with one another through various communication modes such as the telephone, email and
proprietary electronic trading systems. An over-the-counter (OTC) market and an exchange
market are the two basic ways of organizing financial markets. In an OTC market, dealers act
as market makers by quoting prices at which they will buy and sell a security or currency.
Stock Market
A stock market, equity market or share market is the aggregation of buyers and sellers (a
loose network of economic transactions, not a physical facility or discrete entity) of stocks
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(also called shares), which represent ownership claims on businesses; these may include
securities listed on a stock exchange as well as those only traded privately.
*Relation between Stock and Interest Rates
Why Study Money, Banking, and Financial Markets
• To examine how financial markets such as bond, stock and foreign exchange markets work
• To examine how financial institutions such as banks and insurance companies work
• To examine the role of money in the economy
Why Study Money and Monetary Policy?
Monetary policy affects the business cycle, inflation, and interest rates. Financial markets
and institutions operate in an environment that is sensitive to changes in monetary policy.
Money and Inflation
• The aggregate price level is the average price of goods and services in an economy
• A continual rise in the price level (inflation) affects all economic players
• Data shows a connection between the money supply and the price level
Monetary and Fiscal Policy
• Monetary policy is the management of the money supply and interest rates
•Conducted in the Bangladesh by the Bangladesh Bank (BB)
• Fiscal policy is government spending and taxation
• Budget deficit is the excess of expenditures over revenues for a particular year
• Budget surplus is the excess of revenues over expenditures for a particular year
Any deficit must be financed by borrowing.
Role of Money
Money makes it easier to trade, borrow, save, invest, and compare the value of goods and
services.
Stock
Maturity
*as long as hold
by the holder
Risk
*low to high
Return
*low to high
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Money is anything widely accepted as final payment for goods and services.
Money encourages specialization by decreasing the costs of exchange.
The basic money supply in the United States consists of currency, coins, and checking
account deposits.
In many economies, when banks make loans, the money supply increases; when
loans are paid off, the money supply decreases.
Role of Interest Rates
Interest rates, adjusted for inflation, rise and fall to balance the amount saved with the
amount borrowed, which affects the allocation of scarce resources between present and
future uses.
An interest rate is the price of money that is borrowed or saved.
Like other prices, interest rates are determined by the forces of supply and demand.
The real interest rate is the nominal or current market interest rate minus the
expected rate of inflation.
Unemployment and Inflation
Unemployment imposes costs on individuals and nations. Unexpected inflation imposes
costs on many people and benefits some others because it arbitrarily redistributes
purchasing power. Inflation can reduce the rate of growth of national living standards
because individuals and organizations use resources to protect themselves against the
uncertainty of future prices.
Inflation is an increase in most prices; deflation is a decrease in most prices.
Inflation reduces the value of money
When people’s incomes increase more slowly than the inflation rate, their
purchasing power declines.
The costs of inflation are different for different groups of people. Unexpected
inflation hurts savers and people on fixed incomes; it helps people who have
borrowed money at a fixed rate of interest.
Inflation imposes costs on people beyond its effects on wealth distribution because
people devote resources to protect themselves from expected inflation.
Monetary and Fiscal Policy
Federal government budgetary policy and the Federal Reserve System’s monetary policy
influence the overall levels of employment, output, and prices.
Monetary policies are decision by the Federal Reserve System that lead to changes in
the supply of money and the availability of credit. Changes in the money supply can
influence overall levels of spending, employment, and prices in the economy by
inducing changes in interest rates charged for credit and by affecting the levels of
personal and business investment spending.
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Money:
Anything of value that serves as a (1) generally accepted medium of financial exchange, (2)
legal tender for repayment of debt, (3) standard of value, (4) unit of accounting measure,
and (5) means to save or store purchasing power. See also cash.
Function Of Money
Money is any good that is widely accepted in exchange of goods and services, as well as
payment of debts. Most people will confuse the definition of money with other things, like
income, wealth, and credit. Three functions of money are:
1. Medium of exchange: Money can be used for buying and selling goods and services. If
there were no money, goods
would have to be exchanged
through the process of barter
(goods would be traded for other
goods in transactions arranged on
the basis of mutual need). For
example: If I raise chickens and
want to buy cows, I would have
to find a person who is willing to
sell his cows for my chickens.
Such arrangements are often
difficult. But Money eliminates
the need of the double
coincidence of wants.
2. Unit of account: Money is the
common standard for measuring
relative worth of goods and
service.
3. Store of value: Money is the most liquid asset (Liquidity measures how easily assets can
be spent to buy goods and services). Money’s value can be retained over time. It is a
convenient way to store wealth.
For a commodity to function effectively as money it has to meet several criteria-
must be easily standardized, making it simple to ascertain its value.
it must be widely accepted.
it must be divisible, so that it is easy to"make change”
it must be easy to carry
It must not deteriorate quickly
Function
Of
Money
Medium
Of
Exchange
Store Of
Value
Unit Of
Account
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Evolution of Payment System:
A payment system is any system used to settle financial transactions through the transfer of
monetary value, and includes the institutions, instruments, people, rules, procedures,
standards, and technologies that make such an exchange possible.[1][2] A common type of
payment system is the operational network that links bank accounts and provides for
monetary exchange using bank deposits.
Commodity Money:
Commodity money is money whose value comes from a commodity of which it is made.
Commodity money consists of objects that have value in them as well as value in their use
as money.
Example of commodities that have been used as mediums of exchange include gold, silver,
copper, salt, peppercorns, tea, large stones (such as Rai stones), decorated belts, shells,
alcohol, cigarettes, cannabis, candy, cocoa beans, cowries and barley. These items were
sometimes used in a metric of perceived value in conjunction to one another, in various
commodity valuation or price system economies.
Fiat Money
Fiat money is a currency established as money by government regulation or law. The term
derives from the Latin fiat ("let it become", "it will become") used in the sense of an order or
decree. It differs from commodity money and representative money. Commodity money is
created from a good, often a precious metal such as gold or silver, which has uses other
than as a medium of exchange (such a good is called a commodity), while representative
money simply represents a claim on such a good.
Checks
A check is a written, dated and signed instrument that contains an unconditional order from
the drawer that directs a bank to pay a definite sum of money to a payee. The money is
drawn from a banking account, also known as a checking account.
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Electronic Payment
Electronic money is the money balance recorded electronically on a stored-value card.
These cards have microprocessors embedded which can be loaded with a monetary value.
Another form of electronic money is network money, software that allows the transfer of
value on computer networks, particularly the internet. Electronic money is a floating claim
on a private bank or other financial institution that is not linked to any particular account.
Examples of electronic money are bank deposits, electronic funds transfer, direct deposit,
payment processors, and digital currencies.
E-Money
E-money is electronic money which is exchanged electronically over a technical device such
as a computer or mobile phone. E-money in circulation operates as a pre-paid bearer
instrument. The best known example of e-money is the Bitcoin, which can be bought with
real money and traded on an exchange like any other currency.
Example: Debit Card, Credit Card, Stored-Value card, E-Cash.
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Transaction Cost
Transaction costs are expenses incurred when buying or selling a good or service.
Transaction costs represent the labor required to bring a good or service to market, giving
rise to entire industries dedicated to facilitating exchanges. In a financial sense, transaction
costs include brokers' commissions and spreads, which are the differences between the
price the dealer paid for a security and the price the buyer pays.
Asymmetric Information
Asymmetric information, sometimes referred to as information failure, is present whenever
one party to an economic transaction possesses greater material knowledge than the other
party. This normally manifests itself when the seller of a good or service has greater
knowledge than the buyer, although the opposite is possible. Almost all economic
transactions involve information asymmetries.
1. Adverse selection
Adverse selection is a concept in economics,
insurance, and risk management, which
describes a situation where market
participation is affected by asymmetric
information. When buyers and sellers have different information, it is known as a state of
asymmetric information. Traders with better private information about the quality of a
product will selectively participate in trades which benefit them the most, at the expense of
the other trader. A textbook example is Akerlof's market for lemons.
2. Moral Hazard
In economics, moral hazard occurs when one person takes more risks because someone else
bears the cost of those risks. A moral hazard may occur where the actions of one party may
change to the detriment of another after a financial transaction has taken place.
How Moral Hazard Affects the Choice Between Debt and Equity
Contracts:
Called the Principal-Agent Problem
Principal: less information (stockholder)
Agent: more information (manager)
Separation of ownership and control of the firm
Managers pursue personal benefits and power rather than the profitability of the
firm
Asymmetric
Information
Adverse
Selesction
Moral
Hazard
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Tools to help solve the Principal-Agent Problem:
Monitoring
Government regulation to increase information
Fact 5
Financial Intermediation
Venture capital firms provides the equity and place their own people in
management
Use Debt
Reduces the need to monitor as long as borrower is performing. Explains Fact 1,
why debt is used more than equity
How Moral Hazard Influences Financial Structure in Debt Markets:
• debt is still subject to moral hazard. Debt may create an incentive to take on very risky
projects.
• Most debt contracts require the borrower to pay a fixed amount (interest) and keep any
cash flow above this amount.
• For example, suppose a firm owes $100 in interest, but only has $90? It is essentially
bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed
cash.
Tools to Help Solve Moral Hazard in Debt Contracts
Lenders need to find ways ensure that borrower’s do not take on too much risk.
Net worth and Collateral
Monitoring and Enforcement of Restrictive covenants
Financial Intermediation
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The Bank balance sheet:
A balance sheet (aka statement of condition, statement of financial position) is a financial
report that shows the value of a company's assets, liabilities, and owner's equity on a
specific date, usually at the end of an accounting period, such as a quarter or a year. An
asset is anything that can be sold for value. A liability is an obligation that must eventually
be paid, and, hence, it is a claim on assets. The owner's equity in a bank is often referred to
as bank capital, which is what is left when all assets have been sold and all liabilities have
been paid. The relationship of the assets, liabilities, and owner's equity of a bank is shown
by the following equation:
Bank Assets = Bank Liabilities + Bank Capital
A bank uses liabilities to buy assets, which earns its income. By using liabilities, such as
deposits or borrowings, to finance assets, such as loans to individuals or businesses, or to
buy interest earning securities, the owners of the bank can leverage their bank capital to
earn much more than would otherwise be possible using only the bank's capital.
Assets and liabilities are further distinguished as being either current or long-term. Current
assets are assets expected to be sold or otherwise converted to cash within 1 year;
otherwise, the assets are long-term (aka noncurrent assets). Current liabilities are expected
to be paid within 1 year; otherwise, the liabilities are long-term (aka noncurrent liabilities).
Working capital is the excess of current assets over current liabilities, a measure of its
liquidity, meaning its ability to meet short-term liabilities:
Working Capital = Current Assets – Current Liabilities
Generally, working capital should be sufficient to meet current liabilities. However, it should
not be excessive, since capital in the form of long-term assets usually has a higher return.
The excess of the bank's long-term assets over its long-term liabilities is an indication of its
solvency, its ability to continue as a going concern.
Cash and Cash Equivalents
One of the major services of a bank is to supply cash on demand, whether it is a depositor
withdrawing money or writing a check, or a bank customer drawing on a credit line. A bank
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also needs funds to pay bills, but while bills are predictable in both amount and timing, cash
withdrawals by customers are not.
Hence, a bank must maintain a certain level of cash compared to its liabilities to maintain
solvency. A bank must hold some cash as reserves, which is the amount of money held in a
bank's account at the Federal Reserve (Fed). The Federal Reserve determines the legal
reserves, which is the minimum amount of cash that banks must hold in their accounts to
ensure the safety of banks and also allows the Fed to effect monetary policy by adjusting
the reserve level. Often, banks will keep excess reserves for greater safety.
Securities
The primary securities that banks own are United States Treasuries and municipal bonds.
These bonds can be sold quickly in the secondary market when a bank needs more cash, so
they are often referred to as secondary reserves.
Loans
Loans are the major asset for most banks. They earn more interest than banks have to pay
on deposits, and, thus, are a major source of revenue for a bank. Often banks will sell the
loans, such as mortgages, credit card and auto loan receivables, to be securitized into asset-
backed securities which can be sold to investors. This allows banks to make more loans
while also earning origination fees and/or servicing fees on the securitized loans.
Loans include the following major types:
business loans, usually called commercial and industrial (C&I) loans
real estate loans
residential mortgages
home equity loans
commercial mortgages
consumer loans
credit cards
auto loans
interbank loans
Liabilities: Sources of Funds
Liabilities are either the deposits of customers or money that banks borrow from other
sources to use to fund assets that earn revenue. Deposits are like debt in that it is money
that the banks owe to the customer but they differ from debt in that the addition or
withdrawal of money is at the discretion of the depositor rather than dictated by contract.
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Checkable Deposits
Checkable deposits are deposits where depositors can withdraw the money at will. These
include all checking accounts. Some checkable deposits, such as NOW, super-NOW, and
money market accounts pay interest, but most checking accounts pay very little or no
interest. Instead, depositors use checking accounts for payment services, which, nowadays,
also includes electronic banking services.
General Principles of Bank Management:
To be a successful bank it should have a strong management of its Liability, Liquidity, Asset
and Capital which are termed as the pillars of the bank.
Liability management: The acquisition of funds at low cost to increase profits.
Liquidity management: The decisions made by a bank to maintain sufficient liquid
assets to meet the banks obligations to depositors.
Asset management: The acquisition of assets that have a low rate of default and
diversification of asset holdings to increase profits.
Capital adequacy management: A bank's decision about the amount of capital it
should maintain and then acquisition of the needed capital.
Capital Adequacy Management:
A bank's decision about the amount of capital it should maintain and then acquisition of the
needed capital.
Banks have to make decisions about the amount of capital they need to hold for three
reasons.
I. To prevent bank failure
II. Trade-off between safety and returns to equity holders
III. Bank capital Requirement
Bank
Managment
Liability
management
Liquidity
management
Asset
management
Capital
adequacy
management
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Measuring Interest Rate Sensitivity:
The most commonly used measure of the interest sensitivity position of a financial
institution is GAP analysis.
GAP:
The GAP is the different between the amount of interest rate-sensitivity assets (RSAs) and
interest rate-sensitive liabilities (RSLs).
Duration gap:
The difference between the duration of assets and liabilities held by a financial entity.