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Flow of Funds

Section 4, Lecture 6
Lesson 3 - Flow of Funds The flow of funds plays a vital role in determining stock market
valuation. Hence, understanding the flow of funds can help us in the assessment of the stock
market.
There are four important topics that we need to know in this lesson.
1. The fund that is available within the financial marketplace
2. The fund that is outside the financial markets
3. The cost of funds
4. The influence that central bank policy has on all of these variables

1. Funds Within the Financial Marketplace
Let us understand how money flows in the financial system and what it indicates.

Money Market Funds: When investors or traders feel edgy about the stock market,
they move their money from the stock market to the money market. And when the situation
improves again money market fund is reinvested back into the stock market. Hence, the
level of money market fund assets can be a contrary opinion sentiment indicator.

Margin Debt: When the market became speculative it attracts the amateur
investors and traders, who begin to trade on margin, thus higher margin debt indicates that
the market is near peak. However, with the development of new financial instrument, new
age speculators have started using highly leveraged derivatives such as options and futures
instead of margin debt. Thus, the market debt figures based indicators are dynamic and
hence it should be continually adjusted.

Secondary Offerings: A secondary offering is the offering of additional shares of
stock in a company that is already publicly traded. Secondary Equity Offerings is a leading
indicator of an imminent market downturn. At one hand, it is a sign that more supply is
coming into the marketplace to soaking up the available funds. On another hand, it indicates
that the sellers (i.e. corporate), are liquidating. These corporate will try to sell the stock at
times when they think the price is relatively high. Thus, an increase in secondary public
offerings is bearish in nature.

it can be said that the growth and contraction of bank lending has a bearing on interest rates and the stock market.  Bank Loans: When loan demand increases.2. It is also the reward that lenders receive for letting someone borrow their money. Cost of Funds The cost of funds is the cost that borrowers have to pay to use the money. Let us understand it in detail. Conversely.  Short-Term Interest Rates: Investors make a decision to place their investible funds either in interest-bearing securities or the stock market.To know when a major switch in the direction in shortterm interest rates has occurred is critical knowledge as to a probable switch in stock market . While determining portfolio allocation to different market Investors compare their expected return with the cost of funds to see does it make sense to invest in stock market or not at current cost. Hence. Conversely. While liquid assets can be converted to cash quickly whereas illiquid asset cannot be converted to cash quickly.  Money Supply: The money supply is positively correlated with the growth in the economy. when interest rates are low. Thus. the increase in bank loans indicates an overheated economy and a high likelihood of a stock market decline. Money Outside the Security Market The funds outside the security market also play a crucial role in determining market conditions. the rise in credit can also be a sign of increased speculation. Money supply determines the purchasing power and therefore potential demand for products and services. But. They have both physical assets as well as financial assets. Stock prices tend to move higher when the money supply in an economy is high.  Household Financial Assets: Households have different kinds of assets. 3. the more they can invest in stocks. a decrease in loan demand puts downward pressure on interest rates. Money supply is measured by taking in account M1 (Currency in circulation + Traveller’s checks + Demand deposits + Other checkable deposits ) and M2 ( M1 + Small-denomination time deposits + Savings deposits including money-market deposit accounts + Retail money market mutual fund shares). Interest-bearing securities look attractive when interest rates are high. Hence. Measuring money supply can be a good indicator for the stock market. High liquidity ratio of household is favourable for the stock market while low liquidity is negative for the stock market. Financial assets are either liquid or illiquid. The more liquid households are. An increase in loan activity is a sign of increased business activity. then stock market seems more appealing. it puts upward pressure on interest rates.

and when long-term interest rates fall. and hence it reflects inflationary pressure. and fewer banks wish to lend in the federal funds market. Long-term interest rates basically move in the opposite direction to the stock market. Similarly. It is calculated as a ratio of Nominal GDP to M1or M2 . stock prices fall. The federal policy tells the public whether the Federal Reserve is pursuing a restrictive or expansionist policy. The Federal Reserve or Fed uses three main tools for adjusting the money supply First. the more pressure exists on prices. higher inflationary pressures a damper for the stock market. Fewer banks will need to borrow reserves from other banks.  Money Velocity: The velocity of money indicate how fast money is moving in the economy. Although the federal funds rate is not set by the Federal Reserve. 4. and more Banks will have excess reserves that they want to lend. more banks want to borrow. Thus. If the Federal Reserve makes open market purchases. stock prices rise. The Fed uses this tool to achieve a federal funds rate target (The federal funds rate is the interest rate at which banks borrow from each other). when the Fed sells securities. Money velocity is positively correlated with inflation. The Central Bank policy indicators and short-term interest rates are usually very accurate as a forecaster of stock market direction. the federal funds rate will rise.S. the faster money circulates. Fed can buy and sell U. This action pushes the federal funds rate down. . When long-term interest rates rise. the Fed can change the amount of reserves that banks are required to hold Second. It is important to be aware of Fed policy as Fed policies primarily impact short-term interest rates. And short-term interest rates are important to the stock market.direction. Fed can change the discount rate Third. Evidently.  Long-Term Interest Rates: Long-term interest rates and stock prices are inversely related. bank reserves decrease. Central Bank Policy Fed Policy: The Federal Reserve’s policy has a crucial bearing on all the variables discussed earlier in this lesson. and as a leading indicator of long-term interest rates. and as bank reserves decline. banks will have more money in reserve. Fed action significantly impacts this rate. Treasury and federal agency securities in its open market operations.

.By keeping a close eye on the Fed's move. one can understand where the short-term interest rates are heading and thus can predict the stock market movement.