finance and investment global civilization honors seminar spring 2009 february 18, 2009: finance...

Finance and Investment

Global Civilization Honors SeminarSpring 2009

February 18, 2009: FinanceProf. Noémi Giszpenc

Spring 2009 1Global Civilization: Finance, Noémi Giszpenc

What is finance?• Remember from macro class: if households or

government do not spend all of their income, they have savings

• These savings are channeled through banks and lent to borrowers:– businesses that make investments– households to purchase large assets such as houses, cars,

durable goods, and college educations– government to provide public goods

• Finance is the system linking savers to borrowers• Finance: the provision of money at the time it is required.

• International finance makes links across borders

Spring 2009 Global Civilization: Finance, Noémi Giszpenc 2


Every country's financial system is unique

• Countries differ widely in number and types of banks, relationships among financial institutions, regulation, etc.

• Basic functions of a national system:– Keep savings safe– Put money to work through loans– Ease transactions– Create money

• Whoah, really? Yes. Amount of money needs to increase as population and economy grow


First, what is money?• Something that people generally accept in exchange for a good or

a service. • Money performs four main functions:

1. a medium of exchange for buying goods and services; 2. a unit of account for placing a value on goods and services; 3. a store of value when saving; 4. a standard for deferred payment when calculating loans.

• Any item which is going to serve as money should be: – acceptable to people as payment– scarce and in controlled supply – stable and able to keep its value – easily divisible without any loss of value – portable and not too heavy to carry.

Ex: cowrieshell


Types of money

• Commodity moneys– Have value in non-monetary uses equivalent to the

monetary value of the commodity.• Ex: gold, silver, copper, shells, tobacco, oxen

• Fiat money– A monetary standard (usually paper) that people are

required by law to accept as a medium of exchange and/or a standard of deferred payment.

• Money by the "fiat"--the command--of the sovereign. • Fiduciary money

– Based on transferable promises by bank to pay.• Ex: bank notes, checks


In the ancient world

• Division of labor and trade led to necessity of money for settling accounts

• In kingdom of Lydia, hunks of metal stamped with picture of king– First coins– To ensure stability & quality control

• China, 1000 A.D.: innovation of printing paper money


In medieval Europe: Fred's Bank

• Fred is a goldsmith who keeps his gold in a vault. • Other people pay him a small fee to keep their gold in his

vault.– This makes Fred's vault a bank of deposit

• Fred gives his customers receipts for deposits.• Customers begin to use receipts to settle accounts.• Receipts begin to circulate as fiduciary money.

– People have faith (fides) that Fred will repay on demand.– This makes Fred's vault a bank of issue.


Money creation & fractional reserves• Fred notices that only some customers ask for gold back in

any given period.• This means Fred can write more bank notes than he actually

has gold in bank.• Writes notes as loans from bank; charges interest.• Must be careful not to create so much money that if

depositors wanted gold back, vault would be emptied.• So adopts reserve ratio: amount needed in bank for every

banknote (e.g.: 1/3)• In fiduciary money system, amount of money in circulation is

generally a multiple of bank's reserves.


Problems faced by private banks

• If faith in bank falters, depositors and note-holders rush in and demand gold– Hoping to collect before gold runs out

• Banks that failed this way not necessarily insolvent, just illiquid– Solvency: being owed more than one owes– Liquidity: speed and certainty with which assets can be

turned into cash and transferred.• Coin & banknotes very liquid: already cash• Steel mill very illiquid: may take a while to sell, for unknown

amounts of cash.


More problems of private banks

• Confidence– Honest and prudent banks could fail due to panic– Incompetent banks could fail from too many loans to bad

borrowers– Dishonest banks could steal or conceal losses easily

• Competition– To get business, banks could raise interest paid, lower

interest asked, and lend to riskier borrowers• Each of these practices reduce safety & increase risks

• Banks need help from government: regulation, auditing, and ready source of emergency cash


Prudential regulation

• Prudential: rules to ensure banks' safety– Private banks licensed by government– Required to be audited, publish regular accounts, submit

to Central Bank supervision– Rules about kinds of business banks allowed to do– Minimum reserve ratio & form of reserves

• Notes, coins, Central Bank deposits, government bonds and Treasury notes main forms

• Central Bank acts as lender of last resort– Fact that it exists usually enough to prevent runs

• Some Central Banks can force sale of insolvent banks


Economic regulation

• Measures to keep banks safe can also affect:– Investment, employment, inflation, balance of foreign

payments, total supply of money and credit• So governments do regulate banks and other

financial institutions for economic and social purposes, by influencing: – Rates of interest – Quantities and directions of lending– Amounts banks can borrow, how & from where– Dealings with foreign currencies, including

• rates of exchange, rights to buy or borrow foreign funds...


What is investment?

• Investment means to apply resources in ways that you hope will produce more resources later.

• "Wealth creation"• Also necessary to replace and maintain worn-

down resources– Making up for these losses does not add to "net"

investment– "Net" investment adds to a country's store of capital.


What is capital?

• Capital is wealth used to make more wealth. • Wealth is all resources having economic value. • Value is worth in general, but it tends to be measured in a

universal equivalent, that is,• money.

– So the essence of capital is that it is wealth (usually money in some form) capable of increasing its value.

• The modern term capital derives from a medieval banking expression implying an amount of money which grows through accumulating interest.


Relation of investment to economic growth

• Output depends on combining labor, capital, and ingenuity

• Investment in capital raises labor productivity (& thus output)

• Return on investment must overcome other preferences of lenders of capital.

• One theory of economic growth:– rate of economic growth depends on

the growth of capital (directed toward investment)• So, whatever influences practice of lending and

borrowing affects the whole economy.


How do firms decide to invest?

• Based on calculation: "By the book"--will expected returns exceed expected costs by an acceptable margin?– A great deal of uncertainty exists about the

future: a lot of guesswork involved

• Based on confidence: leap in the dark– Expectations about what other investors are doing


A detour into accounting

• Basic accounting equation:Assets = Liabilities + Equity

• Can be seen as a description of capital's Uses and Sources

• Different (combos of) uses bring different returns

• Different sources have different costs


Structure of a balance sheetAssets (Uses)

Liabilities and Equity (Sources)

Current Assets(cash, accounts receivable, inventory)

Current Liabilities(accounts payable, short-term loans)

Non-current Assets(Land, plant, equipment)

Non-current Liabilities(long-term loans, mortgages)

Owners' Equity &Retained Earnings

Total Assets Total Liabilities & Equity


Uses & sources: returns & costs

Annual costs/returns per $100

$ Quantity of funds

Investment projects (uses of capital funds)

Investment 1Investment 2

Investment 3

Investment 4

0

Cost of capital funds(from various sources)


4 sources of capital for investment

• Equity: creating & selling new shares– Pays dividends dependent on performance– "Dilutes" stock of existing shareholders

• Retained earnings: "internal funds"– Cheapest & most common source

• Bonds: promises to pay interest & principal– Buyers of bonds can trade these in markets

• Bank debt: easier to obtain than bond-buyers– Must pay market rate of interest, meet conditions


Effects of different tax regimes

• Net business profit split between dividends to shareholders and retained earnings– Retained earnings lead to investment, growth in

share value --> capital gains for shareholders– Different taxation of dividends & capital gains: can

encourage or discourage retention• Chosen policy depends on beliefs about how firms,

investors choose to invest funds


Why "supply and demand" mechanism doesn't work in credit markets

• The "price" of credit is the rate of interest– Price of using borrowed funds

• If rate of interest rises, demand tends to decline (fewer willing borrowers)--but so does supply (fewer willing lenders)– The lower the rate of interest, the more borrowers can afford to pay

it. – The more sound borrowers there are (ones who can afford to pay),

the more banks are willing to lend.• Credit rationing: At any rate of interest, there are some

borrowers lenders won't trust. – There is no market-clearing price– So loan officers allocate loans administratively


Why does investment fluctuate?

• Lumpy capital– Much productive building & equipment can be paid for

over time but must be acquired all at once• Innovation

– New product to be produced or new process• Expectations

– Better to invest when strong demand expected– Firms tend to invest when others are investing

• Acceleration and deceleration– Intensifies booms and slumps


Portfolios of investments• "hedge": reduce overall risk by spreading

investment over many independent projects– Note: some "hedge funds" may not actually hedge

their investments, and in particular may use short selling and other "hedging" methods to increase rather than reduce risk, with the expectation of increasing return.

• The word risk from sailors' word for steep rock: merchants could lose all their investment in one cataclysm– So they invented insurance


What is insurance?

• To make sure. To remove uncertainty and protect against risk.

• People prefer certainty: they have an aversion to risk.

• In particular people would not like to see income (or rather consumption) dip below a certain minimum. – Willing to pay to "smooth" consumption

Finance is inherently risky

• By some definitions an "investment" has no risk, while "speculation" is the assumption of risk of loss in return for an uncertain reward. – Ways to reduce risk include insurance, guarantees by third

parties, letters of credit from banks: all are promises to pay

– Insurers can default or even go out of business too – Therefore, since even a rock-solid "investment" carries the

possibility of loss, almost all investments are "speculative"• The measurement of risk is a huge part of finance, but

it is an inexact science– Credit rating agencies charged with classifying risk


Speculation• Speculators hope to make money from changes in an

asset's prices rather than from the income that the asset can generate

• Speculators add liquidity to markets—more buyers and sellers mean more competition– their provision of capital and information may help

stabilize prices closer to their true values• But if speculation is subject to positive feedback loops

• Speculators may keep buying because others are buying and they hope the price will continue to rise: bubble

• May also sell because others are selling and they expect prices to fall: crash


International Finance

• What happens when savings cross borders?• Changing currency means that exchange rates

matter.– If you are a company borrowing in dollars and

earning money in bhat, sharp changes in exchange rates could make you instantly insolvent

• Rules for investment may change– WTO tries to harmonize rules and assure

investors’ rights, but countries still have own rules


Relation between international finance and trade

• Recall from macro class that a trade surplus or deficit implies a corresponding amount of lending to or borrowing from abroad– A borrowing country is technically being

“invested in” by the rest of the world– If the investment starts to look bad (might not

repay), can spark selling of assets – leading to depreciation of currency – leading to more difficulty for country to pay back

– Persistent surpluses or deficits lead to instabilitySpring 2009 Global Civilization: Finance, Noémi

Giszpenc 29

Addressing imbalances

• Keynes recommended that international systems help limit trade imbalances and help countries through temporary difficulties paying: proposed role of the IMF

• There currently is no such system in place, but there are many proposals

• One main goal is to get savings from creditor countries to be put to productive use and not just held as reserves


Conclusion

• Production leads to income, some of which is spent and some saved

• Savings need to be channeled to productive investments for production to continue & thrive

• Sounds simple. But investment is largely about the future, thus it deals with uncertainty– Susceptible to positive feedback loops

• Hard enough to manage within a country• Even harder internationally, where no central

authority is in chargeSpring 2009 Global Civilization: Finance, Noémi

Giszpenc 31

finance and investment global civilization honors seminar spring 2009 february 18, 2009: finance...

Documents

nomi giszpenc spring

nomi giszpenc slide

fiduciary money

borrowers finance

provision of money

necessity of money

money whoah

money needs