Transcript No Slide Title

Investment, Information, and Allocation
Mechanism: Channels of Technological
Change and Economic Efficiency
Philip Obazee
Finance and Investment Workshop
Edo Okpamakhin Annual Convention
Boston, MA
July 3 - 4, 2004
Contents
 Introduction
 Functional Separability
 Uncertainty, Information, and Incomplete
Contracting
 Informational Role of Financial Markets
 Allocation Role of Financial Markets
 Overarching Theme
 Two Models of Financial Economies
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Contents
 What is Investment?
 Financial System - a Conduit for Channeling
Savings into Investments
 Functions of Financial Markets
 Flow of Financial Transactions
 Role of Financial Intermediaries
 Biography
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introduction…
• What explain the differences in economic performance among
countries, across states in the same country, and across firms in
the same industries?
• Recent research findings report a strong relationship between
indicators of financial development and economic performance in
the real sector.
• The central role of financial markets (money and capital markets)
is allocating risk capital that results from savings, risk-pooling
and sharing. These markets also mitigate agency problems by
promoting responsible governance.
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introduction…
• Financial system positively affects economic growth and
productivity through improving efficient utilization of
resources and enabling technological inventions and innovation.
• Monitoring and governance role of financial markets help
induce improvements in efficiency. The allocation role helps
accelerate technological advances.
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functional separability…
• The allocation function of financial markets involves channeling
savings from economic units with excess capital to individuals
with entrepreneurial skills augmenting risk-pooling and sharing.
• Monitoring and governance roles involve how well financial
system helps in reducing the agency problem between
stakeholders.
• The degree to which a financial system influences economic
performance in the real sector depends on how effectively it
carries out its allocation , monitoring and governance functions.
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uncertainty, information and incomplete
contracting…
• Uncertainty, imperfect information, incomplete contracting and
moral hazard problems may prevent the first-best value
maximizing investment behavior.
• Financial markets mitigate the consequence of imperfect
information, and moral hazard by producing information that
facilitates monitoring.
• Financial markets process information from diverse market
participants by extracting it from the trading behaviors and
price signals.
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informational role of financial markets…
• Financial assets’ prices convey valuable information about the
profitability of current investment opportunities thereby guiding
entrepreneurial and managerial decisions.
• Based on information available to investors, mangers, and
entrepreneurs, bad firms’ management teams or projects do
not get funding.
• Inefficient managers get forced out through the mechanism of
market for corporate control.
• Threat of takeover induces managerial discipline, preventing
managerial actions that waste resources.
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allocation role of financial markets…
• Financial system aggregates small savings of numerous
individuals for use by economic agents with entrepreneurial
skills, who use the funds for capital investments.
• Availability of capital and ability to share risk, influence the
degree of risk tolerance, and choice of technologies in the
economy.
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allocation role of financial markets…
• One see a link between the allocation role of financial markets and
technological innovation through:
1. Adoption of technologies requires a large sum of capital
that is easier to mobilize in a well-developed financial
system.
2. Risk-pooling and sharing functions of capital markets
promote the assimilation of specialized and risky
technologies.
3. Economies with mature financial markets should achieve
higher rates of technological change, which translates to
higher productivity and economic growth.
•
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overarching theme…
• The strong relationship between economic performance and
the effectiveness of financial markets suggests the importance of
financial markets development as a policy for accelerating
economic growth.
• Policies that promote financial markets’ functional capacities
lead to better real economic performance.
• Mere launching of financial markets and institutions is not
sufficient for accelerating economic growth. Efficient functioning
of these markets is the most important consideration.
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two models of financial economies…
• Anglo-American Decentralized Market-Based System
• Germano-Japanese Centralized Bank Based System
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anglo-american decentralized marketbased system…
• Pooling and risk sharing among diverse Participants
• Price system as a source of relative value
• Information is publicly available from prices
• Accounting standard is important to information
transmission
• Monitoring and control are costly
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germano-japanese centralized bankbased system…
• Pooling and risk sharing limited to fewer
participants
• Banking system is predominant
• Information is not readily available from prices
• Monitoring and control are under a unified institution
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what is investment?…
• Investment is a ubiquitous concept, and means
many things to many people.
• Examples:
1. A collector that spend millions of dollars to
acquire a Degas painting at major auction house;
2. IBM Corporation spending millions of dollars on research
and development;
3. A house wife buying a common stock of Microsoft;
4. A young couple buying their first home, etc.
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what is investment?…
• Economists speak of postponing of consumption,
which facilitates savings, and savings, which are
turned into investment opportunities by the
entrepreneurial class in tracing the evolution of
investment.
• Key Attributes Of Investment: Time and Risk
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what is investment?…
• In every investment decision there is a time element
because you are making sacrifice today, for which the
reward would come at a later date. The reward is not
necessary guaranteed, so there is an element of risk.
• Working Definition: In the broadest sense, by
investment I mean the sacrifice of certain present
value for “possibly” uncertain future value.
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what is investment?…
• Example: if you have $1,000 today and decide to buy
U.S. Government bond that pays a semi-annual
coupon of 3% and matures in 10 years, in all
likelihood you will receive your 19 coupon payments
plus the return of principal and the last coupon payment.
• This type of investment is considered to be risk-free,
and serve as a benchmark for pricing risky
investments. The dominating element in this
investment is time and the purchasing power of the
dollar.
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real vs. financial investments …
• Buying and selling bonds and common stocks are
examples of financial investments because
they represent claims on the assets of a firm.
• Buying equipment, land, and mining rights are examples of
real investment.
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financial system - a conduit for
channeling savings to investments …
There are three types of markets:
•
Factor market: Factors of production like land,
capital, labor, and entrepreneurial skills are sold to
business firms and governments in return for income
in the form of wages and other payments.
•
Product market: Goods and services are sold.
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financial system - a conduit for
channeling savings to investments …
•
Financial market: Financial claims are channeled
between the surplus budget units (SBU), and the
deficit budget units (DBU).
SBU are individuals that make more money than they
spend, and are capable of saving. DBU are
individuals that spend more than they make, and are
capable of borrowing from the SBU.
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financial system - a conduit for
channeling savings to investments …
In general, the following fundamental identity applies
in a financial system:
Current Income receipt - Expenditures out of current income
=
Change in the holdings of financial assets - Change in debt and equity
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financial system - a conduit for
channeling savings to investments …
Using this identity, if current expenditures exceed
current receipts, the difference is made up by:
(1) reducing our holdings of financial assets (for example
withdrawing money from savings accounts);
(2) issuing IOU, debt or stock; or
(3) using a combination of both.
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financial system - a conduit for
channeling savings to investments …
If the current period receipts are greater than current
expenditures, we can:
(1) Build our holdings of financial assets,
(for example, by placing money in a saving account);
(2) Pay off debt or buy back common stock; or
(3) Utilize some combination of both.
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financial system - a conduit for
channeling savings to investments …
For any given period, an individual economic unit
(household, business or government) must belong to
one of the following groups:
(1) Deficit-budget unit (DBU),
(2) Surplus-budget unit (SBU), or
(3) Balanced-budget unit (BBU).
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functions of financial system…
• Savings function– providing a potentially profitable
and low-risk outlet for public savings.
• Liquidity function– providing a means of raising
funds by converting securities and other financial
assets to cash balances.
• Payments function – providing mechanism for
making payments to purchase goods and services.
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functions of financial system…
• Policy function – providing a channel for government
policy to achieve a society’s goal of high employment,
low inflation, and sustainable economic growth.
• Wealth function – providing means to store
purchasing power until needed for future spending
on goods and services.
• Credit function – providing a supply of credit to
support both consumption and investment spending
in the economy.
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functions of financial system…
• Risk function –providing a means to protect
businesses, consumers and governments against
risks to people, property, and income.
In general, a financial system, whether simple or complex,
performs one major function, which is to move scare
financial resources from those who save and lend (SBU)
to those who wish to borrow and invest (DBU).
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flow of financial transactions…
• Direct Finance: Is a financial transaction between SBU,
and DBU in which borrowers and lenders meet each
other and exchange funds in return for financial
claims. For example, when you borrow from a friend
or family and give them an IOU.
• Problems: (1) there must be coincidence of wants
between DBU and SBU in terms of the size of the loan
and the form of the loan. (2) Information and
search costs; borrowers may have to contact many
lenders to find suitable terms of the loan.
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flow of financial transactions…
• Semi-direct Finance: A financial transaction
intermediated by security brokers, dealers and
investment bankers, for which there is a transfer of
fund from SBU to DBU.
Brokers, in contrast to dealers do not take a position
in the financial claim. Instead facilitate the
transaction by providing information about possible
purchases and sales of financial assets. Dealers actually
take a position in financial assets hoping to sell it
for a profit.
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flow of financial transactions…
• Indirect Finance: Financial transactions are carried out
with the help of financial intermediaries or financial
service firms. Examples of such firms include; commercial
banks, insurance companies, credit unions, finance companies,
savings- and-loan associations, savings banks, pension funds,
mutual funds, etc. Financial intermediaries issue their own
secondary securities to the ultimate lender (demand deposits,
savings account, life insurance policies) and at the same time
accept IOUs from borrowers in the form of primary securities
(loans).
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role of financial intermediaries…
• Payment Services: Providing payment accounts
against which customers can write checks or wire
funds to pay for purchases of goods and services.
• Thrift Services: Providing financial instruments with
adequate safety and yield to encourage people,
businesses, and governments to save for their future
needs.
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role of financial intermediaries…
• Insurance Services: Providing protection from loss of
income or property in the event of death, disability,
negligence, and other adverse conditions.
• Credit Services: Providing loanable funds to
supplement current income.
• Hedging Services: Providing protection against loss
due to unfavorable movements in market prices or
interest rates.
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role of financial intermediaries…
• Agency Services: Providing services by acting as
an agent for customers in managing retirement funds, or
other property.
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Biography
Mr. Philip Obazee is a Vice President at Delaware Investments. He is responsible for
the management of derivative portfolios. In addition to this responsibility, he
also maintains a risk management leadership role. He joined Delaware Investments
from First Union Securities Inc., where he served as Vice President of Quantitative
Research. Prior to that responsibility, Mr. Obazee was a Managing Director of
Structured Derivative Products and Agency Debt Origination at CoreStates Securities
Corp. and Vice President and Head of Financial Analytics and Structured
Transactions at CoreStates Capital Markets. From 1993 to 1996, he served as
Vice President of Trading and Hedging in the Interest Rate Group of Meridian
Capital Markets (Division of Meridian Bank). He has also held
academic positions in colleges and universities in the southern and northeastern
United States. Philip has contributed several chapters to professional books in
fixed income as well as articles to professional journals. He holds BS and MBA
degrees and did doctoral studies in mathematical finance at the
University of Pennsylvania.
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