Financial Literacy

1. Financial Markets: Essential Jobs for Society

Every financial transaction or product is trying to do at least one of these jobs or functions, and in many cases, a single financial product will be doing more than one of these six jobs (as follows) at once.

Six functions. Financial markets perform six essential functions for society: transferring resources across time and space, pooling resources and sharing ownership, discovering financial prices, dealing with information problems, clearing and settling payments, and managing risks. These functions underpin economic activity by facilitating borrowing, lending, investment, and risk mitigation.

Transferring resources. Borrowing, lending, saving, and investing enable individuals and businesses to transfer resources across time and space. This allows for immediate consumption or investment, bridging the gap between income and expenses. Without this function, economic growth would be severely hampered, as individuals and businesses would be limited to their current resources.

Pooling and pricing. Financial markets also pool resources to fund large-scale projects and share ownership through instruments like stocks and bonds. They discover prices for financial services, ensuring efficient allocation of capital. By addressing information problems and managing risks, financial markets enhance economic stability and promote informed decision-making.

2. Financial Wealth: Measuring the Value

Each asset should be earning some kind of return, too.

Financial market size. The financial markets' worth is immense, often dwarfing the real economy. The total value of financial assets, including debt and equity, can be several times the gross domestic product (GDP) of a country. This reflects the interconnectedness and complexity of the financial system.

Money flow. The flow of money through the financial markets creates financial assets and alters their value. Each transaction leaves a mark, generating wealth and facilitating economic activity. The more complex the path money takes from lender to borrower, the larger the financial system appears.

Household savings. Households are the primary source of savings that fuel the financial markets. They supply the money for borrowing, lending, and trading, either directly or indirectly. Understanding the flow of funds and the distribution of wealth is crucial for comprehending the dynamics of the financial system.

3. Information Asymmetry: Adverse Selection and Moral Hazard

The information problems that you will learn about in this lecture generally can’t be completely resolved, and in many cases, they still cause a lot of trouble in the financial markets.

Unequal distribution. Information asymmetry, where one party in a transaction has more information than the other, creates significant challenges in financial markets. This leads to two primary problems: adverse selection and moral hazard, both of which can undermine trust and efficiency.

Hidden types. Adverse selection occurs when those with hidden negative characteristics are more likely to participate in a transaction. For example, bad borrowers may pretend to be good borrowers, making it difficult for lenders to assess risk accurately. Lenders combat this by gathering more information, requiring collateral, and using down payments.

Hidden actions. Moral hazard arises when one party changes their behavior after entering a transaction, to the detriment of the other party. For instance, borrowers may take on riskier projects after securing a loan. Lenders mitigate moral hazard through monitoring, incentives, and short-term lending.

4. Credit Analysis: The Five Cs

The traditional system of credit analysis is often referred to as an expert system—because it relies on a human expert, like a loan officer in a bank, to use his or her analytical skills and experience to judge whether a potential borrower is creditworthy.

Lender's perspective. Credit analysis is the process lenders use to evaluate a borrower's creditworthiness and determine loan terms. This involves gathering information and assessing the borrower's ability and willingness to repay the loan. The traditional framework for credit analysis is the "Five Cs."

Five factors. The Five Cs of credit analysis are capacity, conditions, collateral, capital, and character. Capacity refers to the borrower's ability to repay the loan, based on income and existing debts. Conditions encompass the economic environment and industry outlook. Collateral is the assets pledged to secure the loan.

Capital and character. Capital represents the borrower's net worth and financial resources. Character assesses the borrower's integrity and repayment history. By evaluating these factors, lenders can make informed decisions about loan approvals and terms.

5. Financial Contracts: The Fine Print

But at the heart of just about every financial contract is a simple exchange, or a sale.

Underlying agreements. Financial instruments are based on contracts that outline the terms and conditions of the agreement. These contracts specify the obligations of each party, including payment schedules, interest rates, and covenants. Understanding the fine print is crucial for borrowers, lenders, and traders.

Promissory notes. The promissory note is a common financial contract that details the terms of a loan, including the amount, interest rate, and repayment schedule. It also includes covenants, which are additional conditions that the borrower must fulfill. Covenants can be positive, requiring certain actions, or negative, restricting certain behaviors.

Loan types. Loans can be amortizing, with gradual principal repayment, or revolving, allowing flexible repayment. Amortizing loans have fixed monthly payments calculated using the annuity formula. Revolving loans, like credit cards, charge interest based on the average daily balance.

6. Banks: Financial Intermediaries

Banks are simply better at the business of lending than other institutions.

Financial intermediaries. Banks act as financial intermediaries, connecting borrowers and lenders. They take deposits from individuals and businesses and lend that money out to others. This process facilitates the flow of funds through the economy.

Payment services. Banks provide essential payment services, including clearing and settling payments. They process checks, electronic funds transfers, and other transactions, ensuring the smooth functioning of the economy. Payment system failures can lead to economic recessions.

Profit from lending. Banks generate profits by charging interest on loans. They offer various deposit accounts, including demand deposits and time deposits, and pay interest on these accounts. The net interest margin, the difference between interest earned and interest paid, is a key measure of a bank's profitability.

7. Bonds: Borrowing Through IOUs

In terms of lending, bonds pick up where banks leave off, making it possible for companies and governments to borrow astounding amounts of money, for very long periods of time.

Debt instruments. Bonds are debt instruments used by companies and governments to borrow money. They differ from bank loans in several ways, including repayment schedules, the number of lenders, and the level of restrictive covenants. Bonds typically have semiannual coupon payments and repay the principal at maturity.

Bond issuance. Companies issue bonds to raise capital from a large group of investors. Each bond represents a fraction of the total amount the company wants to borrow. Investment banks play a key role in marketing bonds to potential investors.

Credit rating agencies. Credit rating agencies, such as Fitch, Moody's, and Standard & Poor's, assess the creditworthiness of bond issuers and assign ratings. These ratings help investors evaluate the risk of default. The bond rating process is not without its conflicts of interest.

8. Stocks: Ownership and Lending

The main job of stocks is to pool resources and share ownership of assets, but they also facilitate borrowing and lending.

Double identity. Stocks serve a dual purpose: pooling resources and sharing ownership, and facilitating borrowing and lending. From the buyer's perspective, buying stock is similar to making a loan, with the expectation of future returns. However, stocks have no explicit maturity and dividend payments are not guaranteed.

Company structure. Businesses can be organized as proprietorships, partnerships, or corporations. Corporations offer limited liability, protecting owners from personal responsibility for the company's debts. Ownership is divided into shares, and shareholders have control rights over the company.

Seniority and control. There is a tradeoff between seniority and control in financial instruments. Stocks have the lowest seniority but the strongest control rights. This reflects the seniority-control compromise, where lenders agree to trade off seniority for control.

9. Securities Marketing: The Sell Job

Investment banks play a key role in the marketing of bonds, stocks, and other publicly traded securities.

Public vs. private. Securities can be publicly traded or privately held. Publicly traded securities are registered with the SEC and can be freely bought and sold by the general public. Privately held securities are exempt from registration and are typically sold to sophisticated investors.

Investment banks. Investment banks play a crucial role in marketing securities, forming a bridge between issuers and investors. They advise companies on the timing and structure of securities offerings and help distribute the securities to the market. IPOs are a prime example of this process.

Accredited investors. Privately held securities are often sold to accredited investors, who meet certain income and asset thresholds. These investors are presumed to be sophisticated enough to evaluate investment risks on their own. Private placements offer companies a way to raise capital without the regulatory burden of public offerings.

10. Money Market: Short-Term Lending

The vast majority of money market instruments have maturities that are much shorter than one year, and in fact, a huge part of the money market has overnight maturity, or just a few days.

Short-term instruments. The money market encompasses financial instruments with maturities of up to one year. These instruments are used for short-term borrowing and lending by governments, banks, and corporations. Speed and liquidity are essential in the money market.

Treasury bills. Treasury bills (T-bills) are short-term government bonds issued with maturities of three months, six months, or one year. They are considered risk-free and serve as a benchmark for other interest rates. T-bills are issued in denominations as small as $1,000, making them accessible to individual investors.

Commercial paper. Commercial paper (CP) is unsecured corporate debt with maturities of 1 to 270 days. It is used by businesses to fund day-to-day operations. Money market mutual funds are a major source of demand for commercial paper.

11. Global Finance: International Lending

International borrowing and lending is a big story in the financial markets—and has been ever since banks and securities have existed.

Cross-border finance. International borrowing and lending involve transactions across national borders. These transactions are driven by differences in interest rates and investment opportunities. However, they are complicated by foreign currencies and exchange rates.

Eurodollar market. The Eurodollar market is an international borrowing and lending market in which all transactions are done in U.S. dollars but take place outside the United States. It facilitates international trade and investment by providing a source of U.S. dollar funding.

Currency risk. Exchange rate fluctuations can significantly impact international borrowing and lending. Borrowers and lenders must manage currency risk to protect themselves from losses. The carry trade is an investment strategy that involves borrowing in a low-interest-rate currency and investing in a high-interest-rate currency.

12. Financial Regulation: Rules of the Game

Financial markets always have been and always will be plagued by fundamental market imperfections.

Addressing imperfections. Financial regulation aims to address market imperfections, such as asymmetric information, market power, and systemic risk. It seeks to promote fair competition, protect investors, and maintain the stability of the financial system. Regulation is needed to promote and coordinate the adoption of common rules and standards.

Systemic risk. Systemic risk is the risk that the failure of one financial institution will trigger a cascade of failures throughout the system. It is a major justification for financial regulation. Regulators use various tools, including monitoring, enforcement, and capital requirements, to mitigate systemic risk.

Regulatory bodies. Financial regulation is typically divided among multiple government agencies and self-regulatory organizations. Many countries are moving towards consolidating regulatory authority into a single body or their central bank. The goal is to create a more efficient and coordinated regulatory framework.

Last updated: March 22, 2025