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Chapter 2
Financial Assets, Money,
Financial Transactions, and Financial Institutions
Introduction: The Role of Financial Assets
• The financial system is the mechanism through which loanable funds reach borrowers.
• Through the operation of the financial markets, money is exchanged for financial claims in the form of stocks, bonds, and other securities, thereby transforming savings into investment so that the economy can grow.

The Creation of Financial Assets
A financial asset is :
• a claim against the income or wealth of a business firm, household, or unit of government,
• represented usually by a certificate, receipt, computer record file, or other legal document,
• and usually created by or related to the lending of money.
Characteristics of Financial Assets
• Financial assets are sought after because they promise future returns to their owners and serve as a store
• They do not depreciate like physical goods, and their physical condition or form is usually not relevant in determining their market value.
• They have little or no value as a commodity and their cost of transportation and storage is low.
• Financial assets are fungible – they can easily be changed in form and substituted for other assets.

Different Kinds of Financial Assets
 Any financial asset that is generally accepted in payment for purchases of goods and services is money. Currency and checking accounts are forms of money.
 Equities represent ownership shares in a business firm and are claims against the firm’s profits and against proceeds from the sale of its assets. Common stock and preferred stock are equities.
3 Debt securities entitle their holders to a priority claim over the holders of equities to the assets and income of an economic unit. They can be negotiable or nonnegotiable. Examples include bonds, notes, accounts payable, and savings deposits.
4 Derivatives have a market value that is tied to or influenced by the value or return on a financial asset. Examples include futures contracts, options, and swaps

How Financial Assets Are Born
• To acquire assets, households and business firms may use current income and accumulated savings – internal financing.
• An economic unit may also raise funds by issuing financial liabilities (debt) or stock (equities), provided that a buyer can be found – external financing.

Financial Assets and the Financial System
• The act of borrowing or of issuing new stock simultaneously gives rise to the creation of an equal volume of financial assets.
• All financial assets are recorded as a liability or claim on some other economic unit’s balance sheet.
 Volume of financial assets created for lenders
= Volume of liabilities issued by borrowers
• For the balance sheet of any economic unit,
Total assets = Total liabilities + Net worth
where assets = real assets + financial assets
• For the whole economy and financial system,
Total financial assets = Total liabilities
 So, for the economy as a whole,
Total real assets = Total net worth
• So, society increases its wealth only by saving and increasing the quantity of its real assets, for these assets enable the economy to produce more goods and services in the future.
• However, the financial system provides the essential channel necessary for the creation and exchange of financial assets between savers and borrowers so that real assets can be acquired.
Lending and Borrowing in the Financial System
• Economists John Gurley and Edward Shaw pointed out that each business firm, household, or unit of government active in the financial system must conform to:
R – E = DFA – DD
where R = Current income receipts
E = Expenditures out of current income
DFA = Change in holdings of financial assets
DD = Chang e in debt and equity outstanding

• So, for any given time period, each economic unit must fall into one of three groups:
 Deficit-budget unit (DBU):
E > R, so DD > DFA (net borrower of funds)
 Surplus-budget unit (SBU):
R > E, so DFA > DD (net lender of funds)
 Balanced-budget unit (BBU):
R = E, so DD = DFA (neither net lender nor borrower)
Lending and Borrowing in the Financial System
• The global financial system permits businesses, households, and governments to adjust their financial position from that of net borrower (DBU) to net lender (SBU) and back again, smoothly and efficiently.
What is Money?
• All financial assets are valued in terms of money, and flows of funds between lenders and borrowers occur through the medium of money.
Money itself is a financial asset, because all forms of money in use today are claims against some public or private institution

The Functions of Money
 Money serves as a standard of value (or unit of account) for all goods and services.
 Money serves as a medium of exchange, such that buyers and sellers no longer need to have an exact coincidence of wants in terms of quality, quantity, time, and location.
 Money serves as a store of value – a reserve of future purchasing power. However, the value of money can experience marked fluctuations.
4. Money functions as the only perfectly liquid asset in the financial system. It exhibits price stability, ready marketability, and reversibility.

The Value of Money and Other Financial
Assets and Inflation
• Inflation refers to a rise in the average price level of all goods and services.
• Inflation lowers the value or purchasing power of money and is a special problem in the money and capital markets because it can damage the value of financial contracts.
The opposite of inflation is deflation, where the average level of prices for goods and services actually declines
• Inflation is commonly measured using price indices, such as:
- the Consumer Price Index (CPI),
- the Producer Price Index (PPI), or
the Gross Domestic Product (GDP) Deflator Index
• Suppose the U.S. CPI rises from 100 to 125 over a five-year period.
 Over the five-year period, the cost-of-living index climbed

The Evolution of Financial Transactions
• Financial systems change constantly in response to shifting demands from the public, the development of new technology, and changes in laws and regulations.
• Over time, the ways of carrying out financial transactions have evolved in complexity.
• In particular, the transfer of funds from savers to borrowers can be accomplished in at least three different ways.

Classification of Financial Institutions
• Depository institutions derive the bulk of their loanable funds from deposit accounts sold to the public.
- Commercial banks, savings and loan associations, savings banks, credit unions.
• Contractual institutions attract funds by offering legal contracts to protect the saver against risk.
- Insurance companies, pension funds.
• Investment institutions sell shares to the public and invest the proceeds in stocks, bonds, and other assets.
Mutual funds, money market funds, real estate investment trusts.

Portfolio (Financial-Asset) Decisions by Financial Institutions
Portfolio decisions – deciding what financial assets to buy or sell – are affected by:
 The relative rate of return and risk attached to different financial assets.
 The cost, volatility, and maturity of incoming funds provided by surplus-budget units.
- Hedging principle – the approximate matching of the maturity of financial assets held with liabilities taken on.
 The size of the individual financial institution.
- Larger financial institutions tend to have greater diversification in their sources and uses of funds and economies of scale.
 Regulations and competition.

Disintermediation of Funds
• Disintermediation refers to the withdrawal of funds from a financial intermediary by the ultimate lenders (SBUs) and the lending of those funds directly to the ultimate borrowers (DBUs).
• Disintermediation involves the shifting of funds from indirect finance to direct and semidirect finance.
• Some new forms of disintermediation have appeared in recent years.
 Initiation by financial intermediaries: Some banks sold off some of their loans because of difficulties in raising capital.
Initiation by borrowing customers: Some borrowing customers learned how to raise funds directly from the open market
Bank-Dominated Versus Security-Dominated Financial Systems
• Lesser-developed financial systems are often bank-dominated financial systems, in which banks and other similar institutions dominate in supplying credit and attracting savings.
• The more mature systems today are becoming security-dominated financial systems, in which traditional intermediaries play lesser roles and growing numbers of borrowers sell securities to the public to raise the funds they need.