1w FinEcon 2024fall v2
Summary
TLDRThis script delves into financial economics, illustrating how individuals make decisions regarding consumption, saving, borrowing, and investment to optimize lifetime utility. It uses the example of Kaleab, who starts a business by borrowing, issuing bonds, and stocks, to explain financial transactions. The script further discusses foreign exchange markets, highlighting spot and forward transactions, and the concept of negative carry in investments. It suggests using repo transactions to mitigate negative carry by leveraging collateral for short-term borrowing.
Takeaways
- 💼 Financial economics involves making decisions about consumption, saving, borrowing, and investment to maximize lifetime utility.
- 💹 The financial system provides tools to manage the gap between consumption and income, as well as to invest available funds.
- 📈 Financial decisions are made under conditions of uncertainty, with costs and benefits spread over time and not always known with certainty.
- 📊 The concept of negative carry arises when the cost of borrowing exceeds the yield from an investment, leading to a loss over time.
- 💲 Currency exchange, or forex, involves transactions that can be immediate (spot) or planned for future settlement (forward).
- 🌐 The script discusses the importance of understanding financial transactions, such as borrowing, bond and stock issuance, and their impact on a company's balance sheet.
- 📚 The case study of Kaleab, who borrows and issues bonds and stocks to fund his cabbage kimchi business, illustrates real-world financial activities.
- 🔄 The script explains how to convert foreign earnings, like USD, into the local currency (KRW) through spot and forward transactions.
- 🏦 The repo market is introduced as a way to borrow money using collateral, such as KTB, to mitigate credit risk and potentially change negative carry to positive.
- ⏳ The script highlights the importance of timing in financial transactions, such as the difference between immediate and future settlement in forex and repo markets.
Q & A
What is the primary focus of financial economics?
-Financial economics is the study of how individuals allocate their scarce resources over time under conditions of uncertainty, focusing on decision-making related to consumption, saving, borrowing, and investment.
Why is the financial system important for an individual's lifetime utility?
-The financial system enables individuals to enhance their lifetime utility by providing mechanisms to manage the gap between consumption and income, offering various financial instruments for investment, and facilitating better decision-making throughout one's life.
What are the three financial transactions Kaleab engaged in to secure his business's operating fund?
-Kaleab engaged in borrowing KRW 5 billion, issuing KW 4 billion in bonds, and issuing KW 1 billion in stock to secure the required operating fund for his business.
How does Kaleab's balance sheet look after securing the funds for his business?
-Kaleab's balance sheet shows KW 10 billion in cash on the right-hand side, with KW 5 billion as short-term borrowing, KW 4 billion from bond issuance, and KW 1 billion from equity issuance.
What does Kaleab do with the USD 5 million he earned from exporting cabbage kimchi to the United States?
-Kaleab converts the USD 5 million into KW, as he needs the local currency for transactions in Korea, through the FX spot market.
What is the difference between FX spot and FX forward transactions?
-FX spot transactions involve the immediate buying or selling of currency, settled within two business days (T+2), whereas FX forward transactions involve a deal to buy or sell currency at a specified future date at a rate agreed upon today.
Why might Kaleab be interested in using FX forward contracts?
-Kaleab might use FX forward contracts to hedge against the risk of currency fluctuations, ensuring a fixed exchange rate for the USD 5 million he will receive in three months, thus managing the uncertainty of future exchange rates.
What is the concept of negative carry in the context of Kaleab's financial transactions?
-Negative carry occurs when the cost of funding an investment, such as through short-term borrowing, is higher than the yield received from the investment, like the 3% yield from KTB, resulting in a net loss over time.
How can Kaleab change a negative carry to a positive carry?
-Kaleab can change a negative carry to a positive carry by replacing his short-term borrowing with a repo transaction, which is a form of short-term borrowing based on collateral, often at a lower rate, thus reducing the cost of funding.
What is the difference between repo sell and repo buy transactions?
-Repo sell transactions involve selling a security and receiving cash in exchange, effectively borrowing against the security as collateral. Repo buy transactions, on the other hand, involve buying a security and lending cash, with the security acting as collateral for the loan.
Outlines
💼 Introduction to Financial Economics
The paragraph introduces the concept of financial economics, focusing on personal financial decisions such as spending, saving, borrowing, and investing. It emphasizes the importance of financial systems in facilitating better economic decisions throughout one's life. The speaker outlines the study of financial economics as understanding how to allocate scarce resources over time under uncertainty. The costs and benefits of financial decisions are often spread over time and are not known with certainty, which introduces volatility and risk. The speaker also mentions that the course will focus on financial derivatives as a subset of financial economics to help make better financial decisions.
💹 Financial Transactions and Business Funding
This paragraph discusses financial transactions, using the example of a character named Kaleab who starts a business to produce cabbage kimchi. Kaleab secures operating funds through borrowing KRW 5 billion, issuing KW 4 billion in bonds, and KW 1 billion in stock. The paragraph explains the difference between short-term borrowing, bond issuance in the primary market, and stock issuance. It also covers the concept of a balance sheet, showing Kaleab's cash, liabilities, and equity. Finally, it touches on currency exchange, explaining how Kaleab would convert USD earnings into KW, the local currency in Korea.
🌐 FX Market and Spot Transactions
The paragraph delves into foreign exchange (FX) markets, explaining the difference between spot and forward transactions. It uses the example of Kaleab receiving USD 5 million in three months for cabbage kimchi exports. The speaker discusses the risk associated with the fluctuating exchange rate and how Kaleab might hedge this risk using FX forward contracts. The concept of settlement in FX markets, typically done on a T+2 basis, is also explained, highlighting the importance of understanding the timing of transactions and settlements in financial dealings.
📈 Investment Strategies and Negative Carry
This paragraph explores investment strategies, specifically focusing on Kaleab's decision to invest KW 5 billion in Korea Treasury Bonds (KTB). It discusses the yield from the KTB investment and compares it with the cost of short-term borrowing. The concept of negative carry is introduced, where the cost of borrowing exceeds the yield from the investment, leading to a daily loss. The paragraph suggests that to change this negative carry to a positive one, alternative financing methods like repo transactions might be considered.
🏦 Repo Transactions and Collateral-Based Borrowing
The paragraph explains repo transactions, which are short-term borrowings secured by collateral, such as KTB in this case. It contrasts repo transactions with unsecured short-term borrowings, emphasizing that the latter relies heavily on the borrower's credit rating. The paragraph outlines the process of repo sell, where Kaleab provides KTB as collateral to borrow KW 5 billion, and repo buy, where he buys back the KTB and returns the borrowed cash. The speaker suggests that repo transactions can be a way to mitigate negative carry by replacing high-cost short-term borrowings with lower-cost repo borrowings.
🔄 Addressing Negative Carry Through Repo Borrowing
The final paragraph reinforces the concept of repo transactions as a strategy to address negative carry. It describes how Kaleab initiates a repo borrowing to replace his short-term borrowing, aiming to improve his financial position by reducing the cost of carry. The paragraph summarizes the key points about repo transactions and their role in managing financial risks and optimizing investment strategies.
Mindmap
Keywords
💡Economics
💡Financial Economics
💡Borrowing
💡Bond Issuance
💡Stock Issuance
💡FX Spot
💡FX Forward
💡Repo Transaction
💡Negative Carry
💡Financial Transaction
Highlights
Economics involves decisions on spending, saving, and managing income versus consumption.
Borrowing and investment are key aspects of financial decision-making.
Financial economics is crucial for managing resources over time and under uncertainty.
The financial system enables individuals to enhance lifetime utility.
Financial economics involves decision-making on consumption, saving, and investment.
Costs and benefits of financial decisions are often spread over time and are uncertain.
Financial transactions include borrowing, bond issuance, and stock issuance.
Caleab's case study illustrates the process of starting a business with financial transactions.
FX spot market involves the immediate conversion of one currency to another.
FX forward market allows for currency exchange agreements settled at a future date.
Investing in Korea Treasury Bonds (KTB) is an example of financial investment.
Negative carry occurs when the cost of borrowing exceeds the return on investment.
Repo transactions involve short-term borrowing using collateral, such as KTB.
Repo sell is a funding operation, while repo buy is a lending operation.
Caleab's strategy to fix negative carry by initiating repo borrowing.
Transcripts
here you know here one thing is
economics
economic and one example is when to
spend how much to spend how long to save
how much to save this is part of
Economics uh right hand side you may
face a decision at the same time what
kind of borrowing for reducing the app
how long to borrow this is also uh
sorting out your gap between uh
consumption and income and what types of
uh instruments for
investment when you have some ID money
available money and you need to invest
then what could be a financial product
for you duration of investment this is
all about decision you need to make for
your entire life
so combining those a financial
economy Financial economics so this one
uh tell you the financial system out
there can enable you to re higher
lifetime
utility if there is no Financial system
probably you make get more
difficult to You Know
Rich you warranted lifetime utility
that's why we uh we need to uh think
about how to make a better decision
through financial system such as decide
on
consumption decide on consumption and
saving decide on how much and how long
to finance decide on how and what to
invest this is all about Financial
economics
okay so in short Financial economics is
a study of how individual how you
allocate your scarce resources over time
under conditions of uncertainty whatever
decision uh you uh make your outcome
your output is not certain that is you
know uh there is you know it has some
volatility you don't know what will
happen that is there is uncertainty this
is the basic uh you know principle in
the
market okay and cost and benefits of
financial decision are spread over time
usually not known with certainty so you
may you may uh you know bear cost right
now but the benefit will uh you gain a
Ron or vice versa you know it's not it's
not fixed but uh but uh at the best you
make it uh you know those gap between
cost and
benefit close to uh close to you know no
Gap then that would be uh you know that
would be better idea uh we are going to
uh we are going to apply through your
financial through your financial
lifetime anyway so this
semester we'll focus on UTC D derivative
products this is subset of financial
economics this can help you to make
a better financial
decision
okay uh uh today we are starting uh
Financial economics before uh getting
into getting into the main concept uh
let me give you what is uh a
financial
transaction so you can some uh get some
Taste of financial uh
transaction okay one uh case study uh
kaleab finds to produce cabbage gim and
sell it
in the United States cavage gim is welln
one one of traditional dishes in
Korea um please enjoy uh while you are
in a stain in Korea a cavity gimchi uh
this cavity gimchi loved by uh Korean
and also uh you know it's popular in uh
Japan and uh South Asia I think and also
uh United States So based on this
information uh kab like to start his his
business to to secure uh required
operating
fund he has
borrowed KRW 5 billion this is number
one this one is borrowing borrowing
through
what let's say
Lo what else
CP uh what
else yeah this is like a you know
shortterm shortterm bwing yeah let's say
shortterm
B and he has issued
KW 4 billion in Bones it's number
two he needed money he ISS B
for uh obtaining uh five billion CW this
is so-called Bond issuance in the
primary Market
third one KW 1 billion in stock stock
means you set up your company and you
list your company
into
krx right right after you know you
resisting into KX the investor or retail
investor or institution
investor uh they may uh trade
they they may buy and sell your stock
into
CarX so this is uh part of like a stock
issurance for your
funding here borrowing and bond issuance
and bond stock issuance is are part of
financial
transaction so cab went through uh these
three uh you know financing
activity so finally what is K balance
sheet s sign he has KW 10 billion cash
right hand
side he has 5 billion KW as a shortterm
borrowing and 4 billion KW from Bond
issuance 1 billion KW from Equity
issuance
this is kab uh simple uh balance
sheet okay now you know cop uh set up
his business and finally has exported
cabage
gimchi to United States and received USD
5 million uh good uh output already
then how he can translate into KW let's
say uh you know you
are
in
Korea then you buy something while you
sell something what money are you spend
what money you
gain KRW this is the main functional
currency in Korea yeah so now
every payment should be uh you know
should be uh completed uh with the KW
but you have USD so absolutely you like
to convert you like to translate that
into KW how to do that FX
spot short short means here
you
cell
USD this is effect spot show then you
gain
KW or the other way now you
earn
KW how to how to transfer this carable
money into your
family
how how how you know you can
transfer not able to transfer KW
directly to your family because KW is
not a settlement currency is not part of
a settlement currency
so you need to
translate
into
USD then and send it to your family
through FX spam Market this
time FX
Spot Long rather than a short so focus
on uh
USD if you buy a USD finally then you
know you can say f effect Spot
Long uh if you sell a USD finally then
you can say uh FX spot
short yeah this is Spa Market FX Spa
Market but here one times you
already you already
seen spot
spot what's the definition of
spot you TR
today and you sett it today this spot
but in the FX
Market uh if you trade today
settlement uh normally
done on t+
2 so either today what t+ 2 we cover uh
this a transaction within uh T plus2
settlement we call it a spot spot
transaction so easily spot transaction
means uh you know buy and sell today and
S today or within uh two day so there is
a spot
okay now shop uh has exported cabage
gimchi and will receive $5 million in
three month yeah that
is uh this is different from the prior
one the prior one says calab has
received 5 million already but here we
receive in 3 months let's Suppose there
is no uh there there is no settlement
failure in in three months you know
100% calab will gain $5
million however in three
months
now what is a homework for
K $5
million now one million $1
$1 is let's say r
[Music]
w
1300 this is prevailing effect rate
between uh you know KW and USD in three
months so
$1
may be
traded
1500 in the case uh KB you know would be
happy because he he can you know he's
able to uh gain uh more KW uh
money
conversely
KW
1100 if this happen uh car you know
Caleb uh is not happy because KW money
will be lesser than the former casee
so but we don't know uh even uh you know
calab doesn't
know how FX rate uh you know is
traded how eff tra how effect rate uh
you know is established in the market in
three months it may go up it may go down
this is a risk so best uh thing uh you
know kab has to do
is uh sell it
now how can do that effect
sh affection
means
K goes to uh W
Bank
and made a transaction to
sell
USD 5
million all
right however
settlement will be done when not now in
three
months in three months
okay now the the time of buy and cell
and time of settlement are
unmatched there is Gap this is FX
forward by
definition if cup did FX forward right
now then goes to you know goes to three
months later if uh you know
fact
1100 but the Caleb are still able
to
sell one
USD one
USD at
1300 because he made FX4
transaction all
right
now Taste of uh financial transaction is
about uh how to uh how to
invest using uh using his uh you know
available money kalea has uh you know
kw5 billion as available so he like to
invest in Korea treasury bond KTB
he goes to uh bond market secondary uh
bond market and like to uh price order
for buying
KTV uh for account opening he goes to
uh
re security
houses
local security houses uh they uh they
have a large inventory of
KTV so
KLA pay
drw 5
billion and
KTB equivalent of equivalent to five
billion KW yeah this is
deal B wrong
Bond Short Bond long FX short uh you
know FX SP short FX F short FS fold long
effects Spot Loan yeah this concept
maybe uh you know maybe confus lat on
but please think about loan means you
buy it sh means you sell
it but problem over here you already
made uh investment in KTV uh with your
available uh KW 5
billion what's an issue over
here uh
you
maybe uh you may be you may uh be woring
over one point regarding the cost and
benefit let's say
ATV gives
you 3% this is
yield but from your
borrowing 5 billion K 5 billion cost is
roughly 5% this is shortterm
borrowing
what's the meaning of uh in a KTV
investment based on uh your short-term
borrowing you pay you pay five uh% cost
and you receive 30%
coupon what is the gap
between 2% 2% is your additional cost
so here I write down K funding cost here
5% is higher than KTV e and if you uh
stay until like one year two year Etc
doesn't change then you are losing day
by day which is negative carry
you carry this investment but your
income your uh profit uh is not is not
positive your profit is negative this is
so-called negative
carry how to I mean uh if you are uh in
that situation uh you are willing to
keep this uh investment or you like to
uh uh change you like to change this uh
status
into
into positive carry from negative carry
how you how you are going to do that
first uh first you know uh transaction
you can make through
repo cell repo cell means what I know
you know you know a shortterm borrowing
based on your credit rating you borrow
from uh you know Banks and your friend
but what is you know how is different
from uh your borrowing from rep
cell
reple usually
means based on
collateral shortterm borrowing you know
normally you don't need to uh provide
collateral
sometimes you know your friend or your
bank um may ask you to
provide uh collector
otherwise they not willing to uh uh land
much much more money just a small amount
money they are fine to uh land but not
much money because you credit uh risk
you uh
default of
probability will be will be uh you know
very harm to you so that's why they're
not willing to uh land lots of
money however repo
Market based on uh collateral
is uh transform a your credit uh risk
into very uh you know safe uh collateral
cred
rating such
asog baru
money M
bank and and
instead C provide
KTB as
col compared to uh shortterm borrowing
or
bank has no reason to worry about your
default because when CB go in
default the
bank uh recreate KTV collateral that you
provided so for you know uh recour so no
uh you know no
uh uh no loss from uh or Bank uh based
on uh you know KTV collateral owned by
hel this is one uh way of repo uh repo
borrowing
so this is basic uh difference uh you
know from from short bwing shortterm
borrowing is uh you know your credit
rating is very important but uh into uh
repo repo cell repo cell
means uh okay let me explain this one
first to
concept means what
H provide
ATV let's see t
w 5
billion
thanks now sell means sell means
uh direction of
oktv you provide you KTV two Banks then
KTV doesn't stay in your pocket anymore
which means you sell
it you follow
now uh at the at the cost of uh your
collateral you receive
uh KW 5 billion as borrowing this is
funding so reposell means bonding you
borrowing
Leo
buy means what instead and uh the other
uh
Direction
K let's save
KTB and land
KW
5
billion
Bank in this
case in this
case you have KTV in your pocket which
means you buy it so Leo buy means you
buy collateral and you
land you land KW uh in a cash so repo
sell
means funding borrowing repo buy means
lending so here taleb triy to uh fix a
negative car he
initiated another repo
borrowing to replace his short-term
borrowing yeah this is one uh a way to
uh figure out negative
carry
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