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Finance, Banking, "the Markets"

15 May 2015 06:55

Probably for as long as there has been money, there have been people who had more of it than they wanted to spend right away, and many more people who wanted to spend more money than they had. If money could somehow pass from the first group to the second, people would be better off; the function of financial markets is to ease this passage. Their point is to keep excess funds from sitting idle, by allocating them among the different people and projects asking for money. Ideally, just as ordinary markets allocate goods and services to those for whom they are most "valuable" (i.e., have the highest combination of desire and ability to pay), financial markets should allocate money — which is, after all, a claim on the resources of the community — to its most valuable, most productive uses.

Such markets are necessarily strange: those who have the money, the savers, by definition do not want any tangible good or service those on the other side, the borrowers, can currently sell. (Otherwise, it would be an ordinary commercial transaction and not finance.) The trick is that borrowers sell savers promises of more money in the future, in return for which they get money now. Etymiologically, at least, to extend credit is to believe (Latin credere) this promise. All this has been going on since Gilgamesh was king in Uruk.

To give some concrete examples: A corporate bond is a promise by the corporation to make regular interest payments for a number of years, ending with a lump-sum principal payment of the bond's face value. A common stock is a promise to get a fixed share of a firm's profits, along with a vote in how it is run. The once-standard home mortgage was a promise to make regular payments over, say, 30 years at a fixed interest rate, with the house, and a down payment on it, as hostages for the fulfillment of this promise.

Because financial instruments are promises, there is an intimate connection between them and predictions. All else being equal, how much you should pay for a bond depends on how much you prefer money now to money later, but also on how likely it is that the company will fulfill its promises. Turned around, a company which is widely believed to be able to keep its promises can offer to pay back less than one which is widely predicted to have trouble coming. Similarly for stock: if you just buy and hold on to a stock, the price to pay for a share depends on your prediction of the firm's future profits.

Since, as the saying goes, "prediction is difficult, especially of the future", this makes pricing financial instruments hard enough, but there are further complications. There are often times when lenders wish they had money now, rather than just a promise. Demanding immediate repayment from their debtors, while it certainly happens, often yields disappointingly little, and can disrupt or even crush a useful enterprise that could have kept making ordinary payments. The second big trick of financial markets is to make promises of payment re-sellable, so that the payments go to whoever currently owns the promise, not the original lender; the promise becomes a marketable "security". When we speak of "the financial markets", we usually mean the secondary markets in promises. When one of these secondary markets exists, the value of a security depends not just on the direct, promised payments, but also on the resale price of the security --- most notably, the value of a share of stock depends not just on what the firm's profits will be, but also on what other people will be willing to pay for a share of them. The latter price, will of course, depend on the same things, but even further into the future, and so on.

At this point, it might seem that the original objective of figuring out good uses for the community's capital has fallen out of view; this is superficial impression is, of course, correct. A large and able school of economists has created a great deal of confusion on this score by pushing something they call "the efficient markets hypothesis", which holds that it is basically impossible to anticipate the evolution of financial market prices. This is not quite true — it is merely very difficult and hazardous — but in any case it is very much a separate issue from whether securities prices actually are reliable signals about the relative value of different uses for capital. Nonetheless, in this age of the world we have, collectively, come to decide that financial markets beat any conceivable alternative at this, and accordingly loaded them with more and more power and responsibility; with what results, you can see around you.

— This does not explain how a socialist with no formal training in economics came to write for Quantitative Finance and teach in a computational finance program, but another time.

See also: Corporations and Corporate Finance; Economics; Globalization; Time Series


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