Financial Markets - Business Finance - ثاني ثانوي

Link digital esse 2.1 Financial Markets www.en.edu.sa Key Terms Money M-1 Banknote Liquidity Money supply M-2 Term structure of interest rates Yield curve Financial markets perform two exceedingly important functions. Like financial intermediaries, financial markets facilitate the transfer of funds from savers to firms, governments, and individuals who use the funds. Financial markets, however, also facilitate the transfer of existing securities from sellers to buyers. Individuals are willing to make investments because they know these investments may be subsequently sold through the financial markets. What are the benefits of having a singl currency in a country?

2.1a The Role of Money In considering the function of financial markets, it's useful to understand the role of money. Muney is anything that is generally accepted in payment for goods and services or for the retirement of debt. This definition has several important words, especially anything and generally accepted. Anything may perform the role of money, and many different items, including shells, stones, and metals, have served as money. Since the foundation of Saudi Arabia, a variety of coins and banknotes have been used. A banknote is a form of paper money in which the government of issue's central bank promises to pay the bearer the sum of its stated value. One of the great achievements of King Abdulaziz was to bring order and unity to the country's monetary system, through a standardized currency. The other important words are generally accepted. What serves as money in one place may not be money elsewhere. This fact is readily understood by anyone who travels abroad and must convert one currency to another. The currency that serves as money in Saudi Arabia, called Riyals, is not used as money in other countries. A foreign visitor must convert their currency into Saudi Riyals to buy goods in the Kingdom (see Figure 2.2). Manary Anything that is generally accepted as a means of payment Banknom A form of paper money in which the government of issues.central bank promises to pay the bearer the sum of its stated value $ یال Foreign visitors must convert their currency into Riyals to purchase goods in Saudi Arabia Money may also be used to transfer purchasing power to the future. In this second role, money can retain its value from one time period to another. The value of this store may change depending on the surrounding variables. Money, however, is only one of many assets that may be used as a store of value. Stocks, bonds, savings accounts, real estate, gold, barrels of oil, and collectibles are some of the various assets that you may use to store value. Shares can be purchased in a range of Saudi Arabian companies, such Nja'aden and Petro Rabigh. وزارة التعليم FIGURE 2.2 Currency Conversion CHAPTER 2 The Role of Financial Markets and Financial Intermediaries 51

ليدر Liquidity Ease of converting an asset into cast without loss Monty Total amount of currency in circulation M The amount of money in circulation in the form of coins, currency, and demand deposits M-2 The amount of money in circulation in the form of coins currency, demand deposits, savings accounts, and small certificates of deposit While you may store value in these nonmonetary assets, you cannot buy goods and services with them. To do that, you must convert the assets into money. The ease with which an asset may be converted into money without loss is its liquidity. In Saudi Arabia, the supply of money is controlled by the Saudi Central Bank (SAMA), a government organization that is responsible for overseeing the commercial banking system. This function is called monetary supply control. There are equivalent organizations across the world, such as the Federal Reserve in the United States, and the Bank of England in the U.K. While there are some differences in how each operates, these institutions broadly fulfill the same function of setting monetary policy and regulating the banking sector. When conducting international business, an understanding of the financial systems in other relevant countries can prove to be invaluable. Measures of the Supply of Money There are several measures of the composition of the money supply. A traditional measure adopted in many regions (commonly referred to as M-1) is the sum of coins and currency in circulation outside of banks plus demand deposits (including interest-bearing checking accounts and travelers' checks) held by the general public in all depository institutions. A broader definition of the supply of money (commonly referred to as M-2) includes not only demand deposits, coins, and currency but also regular savings accounts and (where applicable in some countries) small certificates of deposit. A comparison of M-1 and M-2 is illustrated in Figure 2.3. This broader definition of the money supply (M-2) is preferred by those economists and financial analysts who stress the ease with which individuals may transfer funds among the components of M-2. Individuals may transfer funds from a savings account or time deposit into a checking account. Such a movement increases M-1 because demand deposits have risen, but the transaction has no impact on M-2 because the increase in demand deposits is offset by the decline in the other account. 52yBusiness Finance

Components included NI-1 M2 Coins Currency Demand deposits Savings accounts Small certificates of deposit X In summary, money is crucial to an advanced economy, for it facilitates the transfer of goods and resources. An advanced economy could not exist without something to perform the role of money. Since a large proportion of the money supply consists of deposits in various depository institutions, the student of finance should understand financial markets, the banking system, and their regulation. 2.1b The Role of Interest Rates In many regions and markets around the world, the words money and interest are often used together, but their meanings differ and they perform different roles. Money is a medium of exchange; its value is related to what it will purchase. Interest, as generally understood in business across the globe, is the cost of credit; it is the price paid for the use of someone else's money. The cost of credit is often expressed as a percentage, that is, the rate of interest. Interest rates play a role in the allocation of scarce credit among competing uses for the funds. Higher interest rates increase the cost of credit and should discourage borrowing, so that the scarce credit is directed toward its best usage. There are many types of loans (such as mortgage loans, trade credit, and bonds). In addition to many debt instruments, there are also many interest rates that reflect the amount borrowed, the length of time the borrower will have the use of the funds, and the creditworthiness of the borrower. Generally, the longer the term of the debt and the riskier (or less creditworthy) the debt instrument, the higher will be the rate of interest. وزارة التعليم FIGURE 2.3 Comparison of M-1 and M-2 Measures of Money Supply CHAPTLH 2 The Role of Financial Markets and Financial Intermediaries 53

Pl Internatio The relationship between yields and the time to maturity for debt with a given level of risk Yield curve A graph selating interest rates and the term to matunty 54Business Finance Debt, and hence interest rates, is often classified as short or long term. The time period is arbitrarily established at one year. Short-term refers to a year or less. Long-term refers to greater than a year. Of course, with the passage of time, long-term debt instruments become short-term when they mature within a year. The Term Structure of Interest Rates The relationship between interest rates (the cost of credit) and the length of time to maturity (the term) for debt in a given risk class is referred to as the term structure of interest rates. This structure is illustrated by a yield curve, which relates the yield on debt instruments with different terms to maturity. Such a yield curve is illustrated in Figure 2.4, which plots the yield on a range of hypothetical government securities. This figure shows that the bonds with the longest term to maturity have the highest interest rates. For example, short-term securities with three months to maturity had yields of 2.99%, five-year bonds paid 3.63%, and bonds that matured after 20 years paid 4.31%. Figure 2.4 also illustrates that generally the relationship between yields (interest rates) and time is positive. In some countries, there have been periods when the opposite has occurred. This happens when short-term rates exceed long-term rates, resulting in an inverted yield curve with a negative slope. This is illustrated in Figure 2.5. Securities maturing in less than a year had yields exceeding 14%, while long-term debt that matured after ten years yielded 13%. Such a yield curve could be the result of a country's central bank responding to inflation by selling short-term government debt securities. Such sales absorb credit by reducing the supply of money and the capacity of banks to lend because paying the central bank for the securities pulls money out of the banking system The sales depress securities prices and increase their yields. While the yields on all debt instruments respond to changes in the supply of credit, the selling of short-term securities has the most impact on short-term rates. In the illustration in Figure 2.5, short-term yields rose above long-term rates, resulting in an "inverted" yield curve. There can also be periods when the yield curve is relatively flat, which indicates that there is little difference between the rates of short-term and long-term securities, as illustrated in Figure 2.6. UTI

$5.0 وزارة التعليم - 4.01 431 3.63 351 3.0 272.99 312 325 2.0 1 3 6 12 Months 15.0% 14.8% 14.0 130 12.0 110 14.2% 5 Time to Maturity 10 201 Yean 10% Months 3 6 12 1 2 5 10 30 40 Years Time to Maturity FIGURE 2.4 Example of a Positively Sloped Yield Curve FIGURE 2.5 Example of a Niecutively Sloped Yield Curve CHAPTER 2 The Role of Financial Markets and Financial Intermediaries 55

FIGURE 2.6 5.0% Example of a Hat Yield Curve 4:0 لبصر 96 Business Finance N 2921-1546 3.0 2.0 1.0 1 $ 6 12 2 3 4 5 6 7 Months Years Time to Maturity 2.1c Financial Markets and the Transfer of Savings After working and eaming income, it is wise to "spend a little, give a little, and save a little." After deciding not to spend and to save, an individual has to make an additional decision: what to do with their savings. Should they put the funds in a bank, like the Saudi National Bank or Riyad Bank, or buy stock or shares in a mutual fund? Rather than letting the funds sit idle. it would be logical to put them to productive use to earn a return. This process is not limited to individuals. Firms also have savings. Earnings that are not distributed and retained are saved, and management will have to decide what to do with the savings. Perhaps the funds will be used for investments in plant and equipment and other productive assets. Management could also invest the funds in financial assets for short periods of time prior to the acquisition of assets such as plant and equipment. The financial managers of governmental institutions go through the same thought process. Many governments around the world collect tax revenues, but do not necessarily spend the funds immediately. The funds may be placed in short-term investments to earn a retum. The same principles apply to nonprofit organizations such as charitable foundations. In each case, the current savings are invested to earn a return. In some cases, nonprofit organizations work directly with financial institutions to invest in activities that support the community. The King Khalid Foundation, for example, has partnered with the Saudi Central Bank to finance social initiatives and promote equal opportunities within the country.

When somebody spends their income, the funds are returned to the economy. If people use their income to give to charity, the funds are used to help other people in the society. Savings are not money, they represent a command over resources that the person is not using. How are these funds returned to the economy? The answer revolves around the role of financial markets. Financial markets are the mechanism to transfer these savings to productive uses. The process of transferring savings into investments is a primary, perhaps the most important, function of the financial system. The process of transferring savings into investments leads to the creation of financial claims such as stock and debt instruments such as bonds. These securities are issued to tap the various sources of savings. Two basic methods exist for transferring funds from savers to users. First is the direct investment. This transfer occurs when you start your own business and invest your savings in the operation. A direct transfer also occurs when securities are initially sold to investors in the "primary" market. Firms and governments issue securities, which may be sold directly to the general public through investment bankers. Once the securities are created, they may be subsequently bought and sold ("traded"). A second important purpose of financial markets is the creation of markets in existing securities. These "secondary" markets, however, do not transfer funds to the users of funds; they transfer ownership of securities among various investors. Sellers trade their securities for cash, and buyers trade cash for the securities. (Secondary markets are not limited to financial assets. The markets for land or antiques are secondary markets. No new assets are created; there is only the transfer of ownership of an existing asset.) Trading in existing securities through secondary markets such as the Tadawul Saudi Stock Exchange receives substantial coverage in the financial press Financial markets have an analogous classification. The "money market" refers to the market for low-risk, large-denomination debt instruments that mature within a year. The "capital market" refers to securities with a longer-term horizon. In the case of a sukuk or bond or mortgage loan, the term may be 10, 20, or more years. In some cases, such as common stock, the time dimension is indefinite. A corporation may exist for centuries. House of Bait Ali Reda Bek organization, for example, was founded in 1845. وزارة التعليم " 2921-9 CHAPTUR 2 The Role of Financial Markets and Financial Intermediaries 57