1w FinEcon 2024fall v2

Summary

This 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

00:00

💼 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.

05:04

💹 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.

10:05

🌐 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.

15:12

📈 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.

20:14

🏦 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.

25:15

🔄 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.

Keywords

💡Economics

Economics is the social science that studies the production, distribution, and consumption of goods and services. In the video, economics is mentioned as a field that helps individuals make informed decisions about spending, saving, and investing. It is integral to understanding how to manage resources over time and under conditions of uncertainty, which is a central theme of the video.

💡Financial Economics

Financial Economics is a branch of economics that deals with the allocation of resources over time under conditions of risk and uncertainty. The video emphasizes that financial economics is crucial for making decisions about consumption, saving, borrowing, and investing. It's about how individuals allocate their scarce resources and manage the gap between consumption and income.

💡Borrowing

Borrowing refers to the act of obtaining money or assets temporarily from a lender with the promise to return the same amount plus interest. In the video, Kaleab's decision to borrow KRW 5 billion is an example of borrowing, which is a financial transaction that enables him to secure the necessary operating funds for his business.

💡Bond Issuance

Bond issuance is the process by which a company or government raises funds by selling bonds to investors. In the video, Kaleab's company issues KW 4 billion in bonds to obtain the necessary capital. This is a financial transaction that involves the primary market and is part of the broader financial economics discussed.

💡Stock Issuance

Stock issuance is the process of offering shares of a company's stock to the public for the first time. It is a method of raising capital for the company. The video mentions that Kaleab's company lists its stock on KRX, which is an example of stock issuance, allowing the company to raise funds from investors.

💡FX Spot

FX Spot refers to the current price of one currency for immediate delivery against another. The video explains that after exporting cabbage kimchi to the United States, Kaleab receives USD 5 million, and he needs to convert this into KW. The FX spot market is where this currency conversion would take place.

💡FX Forward

FX Forward is a financial instrument used to exchange one currency for another at a specified future date, at a rate agreed upon today. In the video, Kaleab is expecting to receive USD 5 million in three months, and the FX forward market is where he could hedge against the risk of currency fluctuations by locking in an exchange rate today for settlement in the future.

💡Repo Transaction

A repo transaction (short for repurchase agreement) is a short-term borrowing for cash using securities as collateral. In the video, Kaleab uses a repo transaction to replace his short-term borrowing with a lower-cost repo borrowing, thereby addressing the negative carry situation. This is an example of how financial instruments can be used to manage financial risks and costs.

💡Negative Carry

Negative carry occurs when the cost of holding an investment exceeds the income it generates. In the video, Kaleab's investment in KTB (Korea Treasury Bond) has a yield of 3%, but his cost of borrowing is 5%, resulting in a negative carry. This concept is important in financial economics as it highlights the risk of losses due to mismatched costs and returns.

💡Financial Transaction

A financial transaction is an event that involves the exchange of money or assets between parties. The video provides several examples of financial transactions, such as borrowing, bond issuance, and stock issuance, which are all part of Kaleab's business operations. These transactions are essential for understanding the flow of funds and the management of financial risks in the context of financial economics.

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