Chapter 1 introducing money and the financial system Asset anything of value owned by a person or firm Financial asset an asset that represents a claim on someone else for a payment Security a financial asset that can be bought and sold in a financial market Financial market a place or channel for buying or selling stocks bonds and other securities Money anything that is generally accepted in payment for goods and services or to pay off debts Money supply the total quantity of money in the economy Stock financial securities that represent partial ownership of a firm also called equities Dividend a payment that a corporation makes to its shareholders Bond a financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money Interest rate the cost of borrowing funds usually expressed as a percentage of the money borrowed Foreign Exchange units of foreign currency Securitization the process of converting loans and other financial assets that are not tradable into securities Banks have created financial markets to buy and sell loans Financial liability A financial claim owed by a person or firm Financial intermediary 3 party system A financial firm such as a bank that borrows funds from savers and lends them to borrowers Commercial bank a financial firm that serves as a financial intermediary by taking in deposits and using them to make loans Mutual funds hedge funds investment banks etc nonbank financial intermediaries Insurance companies collect premiums from policy holders and invest them Mutual funds sells shares to group investors and then invest funds in a portfolio savers reduce the cost they would incur if buying shares individually Pension funds invest contributions from workers to earn necessary to pay pension benefit payments during retirement Hedge funds like a mutual fund but has no more than 99 investors who are all wealthy investments are more risky and management fee is larger Investment banks don t take in depots Usually don t give loans to households but only companies portfolio a collection of assets such as stocks and bonds Financial markets places or channels for buying and selling stocks bonds and other securities Primary market a financial market in which stocks bonds and other securities Secondary market a financial market in which investors buy and sell existing are sold for the first time securities Financial System Purpose provide channels for transferring funds between lenders and borrowers Savers supply funds Borrowers demand funds 3 MAIN GOVERNMENT REGULATORS FED SEC FDIC Federal Reserve the central bank of the United States often called the fed Monetary policy actions the federal reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives Lender of last resort Federal funds rate the interest rate that banks charge each other on short term loans Securities Exchange Commission SEC Regulates the financial markets Federal Deposit Insurance Corporation FDIC Insures deposits in commercial banks Diversification splitting wealth among many different assets to reduce risk Risk sharing a service the financial system provides that allows savers to spread and transfer risk Liquidity the ease with which an asset can be exchanged for money at a reasonable price Information facts about borrowers and about expectations of returns on financial assets Bubble an unsustainable increase in the price of a class of assets Chapter 2 Interest Rates and rates of return Future Value the value at some future time of an investment made today Compounding the process of earning interest on interest as saving accumulates over time Present Value the value today of funds that will be received in the future Further away payment is expected to be received the lower the present value The higher the interest rate used to discount payments the lower the present value Time value of money the way that the value of a payment changes depending on when the payment is received Discounting the process of finding the present value of funds that will be received in the Debt vehicles Equity vehicles Current Income Interest Dividends Capital gains loss Yes Yes Interest the cost of money Dividend payment that may be made by a firm to its shareholders Capital gains loss an increase in the market value of an asset Realized gains loss asset must be sold Paper gains loss asset is held Total Returns current income capital gain loss Required Return the rate of return that fully compensates an investor for taking risk The minimum expected return an investor will accept to invest Compensates for inflation lost opportunities and chance of not getting expected return government issues debt and not equity 3 month Treasury bill is the risk free rate R f Real world proxy for the return the market will accept for a risk free investment Insolvent term used to describe bank if the value of the banks investments fall below the money owed to depositors Most financial transactions include future payments Interest rates are link to financial present and financial future principal amount of your investment Chapter 3 Transaction costs the cost of a trade or exchange Ex commission paid to real estate agent to sell house Banks find people who need your money and they lend it to them for interest Information cost the costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired Economies of scale the reduction in average cost that results from an increase in the volume of a good or service produced Intermediaries lower transaction costs with economies of scale Asymmetric information the situation in which one party to an economic transaction has better information than does the other party Adverse selection the problem investors experience in distinguishing low risk borrowers from high risk borrowers before making an investment in insurance the problem that most likely to buy insurance are also most likely to file claims Adverse selection leads to credit rationing in bond market makes it difficult except for large firms to sell stock and causes bad cars to push good cars through the market When investors have difficulty obtaining information on goof firms cost of raising funds for these firms increase forcing them to obtain most of their money from internal funds the problem of selecting the least risky investment given a constant risk level or the highest rate of return given a
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