Financial Market

• Financial market - the market for saving (producers) and borrowing (consumers).

  • The good that is supplied is financial capital, the amount loaned.
  • Interest arises from the expectation that the borrowers will return the money. It effectively acts as the “price”

• Higher interest rates mean that borrowers reduce demand and increase supply.

• How producers save their Money affects supply. Similarly, how consumers borrow money affects demand.

• Usury laws act as price ceilings.

• Financial markets are prone to the problem of incomplete and asymmetric information

Insurance §

• Insurance is used to prevent any single event from having a significant detrimental financial effect.

• Entities make regular payments in the form of premiums priced by the insurance company based on the probability of certain events occurring.

  • These payments must cover the average person’s claims, the cost of running the company, and leave room for the company’s profits.
  • Insured entities are classified into risk groups.

• Insurance inherently plays with imperfect information - the certainty of having a bad event or that an insured person is affected by it.

• Insurance companies earn income from both insurance premiums and investments.

  • If insurance premiums accurately reflect the individual’s risk levels, there is less incentive for high-risk individuals to buy insurance.
  • Government policy may also require consumers to buy insurance to assure insurance companies of an inflow of cash.

• Due to imperfect information, Insurance companies face a moral hazard where people engage in riskier behavior since they know they are insured. It can be reduced in a few ways

  • Investigations to check for insurance fraud
  • Require the policyholder to pay out of their own pocket in the form of deductibles before the company itself pays.
  • Incentivize producers rather than consumers (for example, incentivize healthcare professionals). The producers are paid a flat amount and provided more by the insurance company through copay
    • More copay can be incentivized to those who are not likely to experience something bad covered by insurance

• Insurance buyers also face the adverse selection problem where they have more information about which risk group they belong to more than the insurance company.

  • This means that high-risk individuals buy more insurance without informing the insurance company and low-risk individuals do not buy insurance.
  • This is mitigated through policy — either do not allow high-risk individuals to buy insurance or require low-risk individuals to pay more than a fair amount.

Financial Investments §

The Demand for Capital §

• Firms can raise financial capital in the following ways

  • From early-stage investors
    • This can either come out of pocket from the business owner, or from the owner’s assets as collateral
    • Investors can also come from angel investors or from venture capitalists who invest in small companies with potential and give them advice.
  • By reinvesting profits
    • Profits can be reinvested in additional physical capital.
    • Firms do not rely solely on profits since it can fluctuate
  • By borrowing through banks or bonds - The firm, through reputation, can make a credible promise to pay interest.
    • Here, the firm is more in control on its operations, but it must pay for the loan.
    • Bank borrowing is more customizable than bonds so it tends to be better for smaller businesses.
      • A checking account is one that pays little interest but facilitates transactions easily .
      • A savings account pays some interest but the money requires one to make a trip to the bank to access.
      • A certificate of deposit involves an agreement where the household deposits an amount for a certain period of time, and in exchange the bank will pay them higher interest. There is a penalty for early withdrawal from the account.
    • Larger firms tend to gravitate towards issuing bonds.
      • Junk bonds are bonds that have high interest rates to compensate for the relatively high chance of defaulting.
  • By selling stock
    • Stocks represent shares in firm ownership.
    • An initial public offering (IPO) is when the company first sells its own stock to the public
    • Often, when a firm that buys corporate stock the invested firm does not receive any of the money.
    • Investors are paid direct payments via dividends or indirectly by reselling the stock, in which case they have capital gains.
    • Here, the firm is in less control of its operation, but is more visible

• A corporation is a business that incorporates — it is owned by shareholders not liable to the company’s debt but shares in its profits and losses.

  • A private company is owned by the people who run it. It can either be a sole proprietorship (one person) or a partnership ( group ran)
  • A public company is one which sells stocks and where shareholders own it via a board of director. Stocks dictate ownership.

• Due to imperfect information, Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital.

  • Corporate governance pertains to entities that watch over top executives. This comes in three levels — the shareholders, the auditing company that review the firm’s financial records, and outside investors.
  • Corporate governance aims to mitigate imperfect information

The Supply of Capital §

• Household investments vary in terms of three factors

  • The expected rate of return the investment will pay. This pertains to the expected return on investment (in percentage)
  • The risk that the return will be much lower or higher than expected.
    • Default risk is the risk that the borrower fails to pay back the bond or loan
    • Interest risk is the danger of charging a lower interest rate before the market rate suddenly rises.
  • The investment’s liquidity — how easily it can be exchanged for goods and services.

• A general recommendation for investors is diversification - buy stocks and bonds from a wide range of companies.

  • Mutual funds - consists of a variety of stocks and bunds from different companies. The scope of a mutual fund can vary from broad to very specific. The return is based on how well the fund as a whole performed.
  • Index fund - a mutual fund that seeks only to mimic the market’s overall performance.

• An equity is the monetary value the owner of a property would have after selling these properties and repaying any outstanding bank loans used to purchase the assets.

• Investing in tangible assets can lead to both financial and non-financial returns.

  • The idea here is to pay low and sell high and receive capital gains.
  • The rate of return is moderate if there are non-financial benefits as well (i.e., there is utility to this.)

Option	Return	Risk	Liquidity
Checking Account	Very low	Very little	Very high
Savings Account	Low	Very little	High
Certificate of deposit	Low to medium	Very little	Medium (since withdrawing early is penalized )
Bonds	Low to medium depending on risk	Low to medium depending on volatility of market rates	Medium since investor needs to sell the bond
Stocks	High over extended periods since the trend is generally up	Medium to high due to the volatility of the stock market, especially apparent in the short run	High since stocks can be sold
Mutual Funds	Medium to High due to diversification	Medium to High due to diversification	Medium to High due to diversification
Housing	Medium	Medium	Low
Gold	Medium	High	Low
Collectibles	Low to Medium	High	Low

• It is hard to get rich quick because if many people are trying to do this, because this drives market prices high. Stock price is speculative — it depends on expectations of the firm’s performance. It is hard to become an expert.
• Getting rich relies on making investments — specifically on their own investments, and on saving money early.

Links §

• Shapiro, MacDonald and Greenlaw - Ch. 4, 16 - 17

• Scarcity, Supply, and Demand