Part 2: THE FINANCIAL SYSTEM I THE RATIONALE OF SAVING DECISION This chapter examines the nature of surplus and

deficit spending units, describes the characteristics of financial claims, identifies the distinguishing features of major financial institutions, and explains financial markets. Surplus and Deficit Spending Units Surplus spending unit (SSU) a spending unit who prefers to spend on current consumption and/or investment goods less than his or her current income at current market rates of interest. Deficit spending unit (DSU) a spending unit who prefers to spend more on current consumption and/or investment goods than his or her current income at current market rates of interest. FACTORS AFFECTING THE DIVISION OF SPENDING UNITS BETWEEN SURPLUS AND DEFICIT 1. 2. 3. 4. 5. 6. 7. 8. 9. CURRENT INCOME EXPECTED INCOME WEALTH AGE HEALTH EDUCATION FAMILY STATUS TASTES CURRENT INTEREST RATES

RELATIONSHIP BETWEEN AGE AND SPENDING UNIT Throughout the early years of formal schooling, the average person is a deficit spending unit borrowing primarily from family.

]A person continues to be a DSU upon marriage and through the expenses of starting a new household.

The unit becomes an SSU until his or her children attain college age, when the SSU may temporarily revert to DSU status.

When the children complete their schooling, the unit continues as an SSU until retirement.

At this point he or she again becomes a DSU

Over the entire lifespan, the average person tends to be a moderate SSU leaving unspent savings to children.

The surplus spending units have three primary 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. The deficit spending units also have three primary options. Reduce their money balances Sell claims on others acquired when they were SSUs Sell new claims on themselves to current SSUs.

The choice of adjustments depends, in part, on the characteristics of.

FINANCIAL 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. FACTORS EXPLAINING DIFFERENCES IN INTEREST RATES ON FINANCIAL 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.

MAJOR FINANCIAL CLAIMS RANKED BY 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. 3. SAVINGS DEPOSITS AT COMMERCIAL BANKS MUTUAL SAVINGS BANK SAVINGS AND LOAN ASSOCIATIONS 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 to business firms and government units. 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 to finance a federal budget deficit. 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 shortterm, unsecured promissory notes issued by firms with a high credit standing. Most commercial paper issues have maturities ranging from 3 to 270 days. 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. 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.

FINANCIAL 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 and lenders are brought together on the private capital market by investment bankers. 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. 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.

FLOW OF FUNDS FOR FINANCIAL INSTITUTIONS AND MARKETS

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

FINANCIAL 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. 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

Financial Markets categorized by the Age of the claims 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.

Because securities with shorter maturities are more likely to be refinanced more frequently, this measures gives greater weight to short-term securities. Thus, a primary market that sells $10 million of one-month securities every month or $120 million in one year may be considered larger than a market that sells a single issue of $100 million of one-year securities once a year. 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. Conventional residential mortgages, while legally negotiable, trade only infrequently on the secondary market because of high transaction costs arising from their odd denominations, nonstardadized loan contracts, and limited information on the creditworthiness of the ultimate DSUs. On the other hand, securities of the U.S. Treasury and major business corporations trade frequently because of low transaction costs, reflecting large and common denominations, standardized loan contracts, and more readily available information on the creditworthiness of the borrower.

Financial Markets categorized by the Type of intermediary between ultimate DSUs and 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.

Financial Markets categorized by the Unit size of 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.

Financial Markets categorized by the 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. HOW THE STOCK MARKET WORKS 1. The corporation goes to the state capitol to get a corporate charter, and permits to sell shares. 2. The corporation goes to an investment banker and shows the corporations past performance and plans for future expansion.

3. When the investment banker decides to help the corporation sell shares of stocks, he will assist the corporation to file the necessary documents to the SEC. 4. After the SEC approves the registration of the corporation, the investment banker pays the corporation in exchange for the number of shares of stocks. 5. The investment banker sell shares of stocks to people who become stockholders of the company. 6. The money received by the corporation is used for building new and better plants that will generate income. 7. The stockholders receive dividends as their share out of the declaration of dividends by the corporations Board of Directors. 8. When the corporation receives more orders and needs more capital to satisfy the demands, they have to sell more stocks. 9. The corporation will go to the Stock Exchange and requests for its stocks to be listed for trading. 10. The SEC will conduct a thorough examination of the documents submitted. 11. When the SEC approves the listing of the stocks of the corporation, its name is abbreviated and used on a ticker tape. The stocks are sold and bought by traders nationwide through the brokers. 12. A prospective investor will go to the broker and offers to buy shares at a specified price approximately the same amount as the last price of the stocks in the stock exchange. 13. The broker calls the main office and inform it that somebody wants to buy shares of stocks. 14. The order of stocks is given to the firms floor partner that becomes the representative of the buyer. 15. The floor partner goes to the counter where the stocks are traded. The representative of the buyer bids for the number of shares at specified price by the buyer. 16. If a stockholder is in need of cash and wants to sell his stocks, he will call the broker in the main stock exchange and inform that he is selling his stocks at the same specified price with that of the buyer.

17. The broker at the main will call the representative or the firms floor partner in the main stock exchange and the representative will offer to sell the shares at the offer price. 18. If the buyers floor partner and the sellers floor partner agreed on the offer price, a transaction is made. 19. The prospective investor becomes a stockholder of the corporation. What is 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. Why do we SAVE money? To finance the needs of old age. To give insurance against the contingency of being unemployed. To give protection for the family. To enjoy fully the retirement period in comfort and leisure. To earn interest or additional income. To save because there is no other alternative but to save.

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

Savings = Wealth This is known as the Accumulation Identity. It provides the tie-up between the stock variables (assets, liabilities, and wealth) and flow variables (income, consumption, and saving). Activities: 1. Watch the video How the Stock Market Works? 2. GROUP ACTIVITY: Review the Terminologies about money and financial systems by playing BOARD GAMES powered by ppt. 3. 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.