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The Money Machine

Introduction

This book is about basic financial principles applicable to Mr Smith, the grocery store and Barclays.

The City

The business of financial institutions is the handling of money.

City of London is the heart of the UK financial system. The primary function f this system is to connect people who lend with people who want to borrow. Financial institutions are middle men. Their job is the job of handling money.

Why do we need middle men? Often the needs of borrowers cannot be matched by lenders. Borrowers such as governments and companies need large sums of money, lenders usually lend small amounts. Also lenders often want to withdraw their money quickly. Companies need money for longer periods of time. People with mortgages want to borrow for the next 25 years.

Two variables when lending money:

  • time to return/withdraw (related to liquidity)
  • amount (related to liquidity)

Borrowers:

  • businesses - using shares
  • governments - using bonds

Lenders (need to be net savers)

  • private people
  • working class

Middle man:

  • banks
  • building societies
  • pension schemes
  • life insurances

The Institutions

Banks (short term loans):

  • commercial (rely on people deposits)
  • investment banks (deal with takeovers, trading)

Investment institutions (long period loans)

  • pension funds
  • life insurance

Trading companies

  • hedge funds
  • private equity firms (prop trading)
  • market makers

Exchanges

  • Stock exchanges are the most popular (NYC, LSE)
  • Commodity exchanges

The Instruments

Money is just one of the many financial assets. What distinguishes all financial assets is their liquidity.

Greater risk demands greater reward.

Lesser liquidity demands greater reward.

  • Loans.Extra returns come from interest rate.
  • Bonds. Loan from government which you can choose to be paid back at expiry or you can trade it before expiry. Bond also pay interest rate called coupons,
  • Equities = Shares. Loan which you would never be returned but you can trade. May receive dividends (small interest rate), Rely solely on growth.

If company goes south, lenders and bondholders come first and then equity investors. However in case of growth, equity investors benefit more.

  • Derivatives are financial assets that are based on other products; their value is derived from elsewhere. Among the best-known derivative instruments are futures, options and swaps.

  • Leverage gives the investor an opportunity for a large profit with a small stake.

Liquidity range: The range of financial assets extends from cash to long-term loans.

The International Financial Revolution

Old system - Bretton Woods had fixed exchange rates with strict controls on capital flows. This system went down in 1970s. Sterling was moved to floating point with the US dollar.

Floating exchange rates added risks for companies trading worldwide. This was opportunity for financial companies to mitigate foreign-exchange rate.

There are 3 elements of monetary policy:

  • exchange rates
  • interest rates
  • capital controls

Under Bretton Woods system, countries controlled their exchange rates and capital flows.

The absence of takeovers meant there was no market discipline on poor companies to perform well.

The free-market model: lower taxes, reduced government deficits and open capital markets.

Globalization

What is globalization? It is one of those terms that is often used, but more rarely defined. Broadly speaking, it is a trend whereby trade, investment and culture have become ever more international.

Money and Interest Rates

Money

There are a variety of functions which money serves:

  • measure of value
  • store of value (can be saved until needed)

Creditors will accept money as a future payment, confident that its value will remain stable in the meantime.

Barter system (goat for cow) -> Gold and Silver -> Paper money.

Why change from gold to paper money?

  • Supplies of gold and silver were outstripped by the demands of society.
  • Bad money drives out good. People with pure gold would strip it out a bit. Only worst coins circulated.

Banknotes and Cheques

Banknotes were, in origin, claims on gold and silver.

Now money depends on the confidence of its users in the strength of the economy.

Banknotes, Cheques, Cash, Credit and Debit cards. The system depends on the confidence of all those concerned.

Bank accounts are therefore money in the same sense as notes and coins are, since they can be used instantly to purchase goods.

Defining money supply

Level of inflation are closely related to the rate of increase of the money supply.

narrow money = notes and coins in circulation with the public

broad money,known as M4 = consists of lending by UK banks and building societies to the private sector.

Interest rates

Interest rate is essentially the price of money

The price is paid by the borrower in return for the use of the lender ’s money. The lender is compensated for not having the use of his money.

  • simple
  • compound

Yield

When dealing with a bond or with a share, it is more important to talk of the yield than merely of the interest rate or dividend.

The interest rate or dividend, expressed as a percentage of the price of the asset, is the yield