Financial Markets Institutions and International Finance FIN3244 Section 1 Exam 1 Study Guide Chapter 3 Overview of the Financial System 1 What is the purpose of the financial system a The system brings together savers and borrowers b Savers lenders and investors are suppliers of the funds These promises to be paid back are financial assets c Borrowers are the demanders of funds i i ii i ii These promises to pay back are financial liabilities Example is your car loan is a liability for you and an asset for the bank d Firms do both saving and borrowing 2 Financial markets Issue claims on individual borrowers directly to savers a b Examples are stock market and bond market c Example you want 100 shares of IBM stock and the market arranges trade you know where your money goes 3 Financial Institutions Intermediaries a Act as go betweens by holding a portfolio of assets and issuing claims based on that b Examples are banks mutual funds insurance companies c Example your money in the bank goes to a mortgage you don t know where your money is portfolio to savers going 4 Key Services Provided by the Financial System In addition to matching savers and borrowers a b Three key services Risk sharing 1 Risk chance that the value of financial assets will change relative to what you expect 2 Portfolio collection of assets 3 Risk sharing diversification of portfolio and probability of something happening where you lose money holding many assets Liquidity 1 Turning an asset into money quickly 2 Savers view liquidity as a benefit because it allows an individual or firm to respond quickly to a new opportunity 3 An example is retirement funds eventually need to be liquidated iii i ii iii v i 4 Another example is keeping your money in a bank You are willing to sacrifice making returns for liquidity Information Information about borrowers and expectations about returns on financial assets 1 2 Financial system is responsible for communication of information to buyers and sellers 5 Financial Markets buyer b Primary markets a Direct finance an individual saver holds financial claims issued directly by an individual Those in which newly issued claims are sold to initial buyers 1 Businesses primary markets to raise funds 2 Government uses to finance budget deficits Most commonly used claim is debt 1 Requires the borrower to repay principal the amount borrowed plus interest 2 Maturity the length of the period of time before the debt instrument expires Other type of claim is equity 1 An ownership claim to a share in the profits and assets of a firm 2 Allows for variables payments from the borrower to the lender 3 an example is common stock stockholders get their share of the firm s profits 4 dividends periodic payments from the firm to stockholders c Secondary markets i ii iii iv Those in which previously issued claims are resold The initial seller of the stock in primary market does not receive proceeds of resale Risk sharing liquidity and information services are provided in secondary markets Categorize Secondary markets by three things 1 What maturity level characterizes claims being traded 2 How trading takes place 3 When settlement takes place Information services relate to stock prices if the price is high the expectation is that the firm will increase profits in the future d Types of secondary markets Maturity money and capital markets how long does the entity last 1 Money markets maturity is short term less than 1 year i ii iii iv Small increases or decreases in price therefore less risky Generally more liquid Information costs are lower Examples are US Treasury bills commercial paper repurchase agreements trades between banks federal funds Eurodollars negotiable bank certificate of deposit 2 Capital markets maturity is greater than a year or no fixed maturity i Examples are US Treasury securities US government agency securities state and local government bonds stocks corporate bonds mortgages and commercial bank loans Trading auction and over the counter markets 1 Auction markets prices are set by competitive bidding by traders representing buyers Examples are New York and American Stock Exchanges 2 OTC over the counter markets not between two individuals computerized trading An example is NASDAQ Settlement cash and derivative markets 1 Cash market actual claims are bought and sold with immediate settlement i Examples are stock and bond markets 2 Derivative markets trades are made now but settlement is due later to avoid fluctuations in market prices i Examples are financial futures and options derives its value from underline stock sets the price today and settlement is in the future 1 A stock option is buying the right to buy or sell the stock for some time length 2 Example XYZ is 50 stock option allows you to buy 50 price for 3 months If price goes up or down it remains 50 6 Financial Intermediaries in the Financial System a Tasks i ii Matching savers and borrowers Providing risk sharing liquidity and information services b Financial intermediaries are the largest group in the financial system 7 Competition and Change a Financial innovation comes about over time because financial intermediaries attempt to tailor their services to gain more customers b Financial integration the way in which financial markets are tied together geographically Grows closer every day because of global communication c Globalization has two effects Easy flow of capital across national boundaries helps countries have more opportunities Reduces the cost of allocating savers funds to the highest valued uses 8 Goals of Financial Regulation a Provision of Information Securities and Exchange Commission mandates that corporations issuing stocks or bonds disclose information about earnings sales assets and liabilities b Maintenance of Financial Stability Stability the ability of financial services to provide risk sharing liquidity and information ii iii i i ii i i ii Reduction in these key services raise the cost of moving funds from savers to borrowers c Controlling the money supply Federal Reserve System Fed requires banks to keep fraction of their deposits in cash If the supply of money goes UP interest rates go DOWN d Encouraging particular activities An example is policies encouraging home ownership Another example is allowing student loans with low interest encouraging education i ii i ii 9 Effects of Regulation a Regulation affects the abilities of financial markets and institutions to provide the three key services
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