Financial Markets, Institutions and International FinanceFIN3244-Section 1Exam 1 Study GuideChapter 3: Overview of the Financial System1. What is the purpose of the financial system?a. The system brings together savers and borrowersb. Savers (lenders and investors) are suppliers of the fundsi. These promises to be paid back are financial assetsc. Borrowers are the demanders of fundsi. These promises to pay back are financial liabilitiesii. Example is your car loan is a liability for you and an asset for the bankd. Firms do both saving and borrowing2. Financial marketsa. Issue claims on individual borrowers directly to saversb. Examples are stock market and bond marketc. Example) you want 100 shares of IBM stock and the market arranges trade (you know where your money goes)3. Financial Institutions/Intermediariesa. Act as go-betweens by holding a portfolio of assets and issuing claims based on that portfolio to saversb. Examples are banks, mutual funds, insurance companiesc. Example) your money in the bank goes to a mortgage (you don’t know where your money isgoing)4. Key Services Provided by the Financial Systema. In addition to matching savers and borrowers”b. Three key servicesi. Risk sharing1. Risk = chance that the value of financial assets will change relative to what you expect2. Portfolio = collection of assets3. Risk sharing = diversification of portfolio and probability of something happening where you lose money (holding many assets)ii. 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 opportunity3. An example is retirement funds eventually need to be liquidated4. Another example is keeping your money in a bank. You are willing to sacrifice making returns for liquidityiii. Information1. Information about borrowers and expectations about returns on financial assets2. Financial system is responsible for communication of information to buyers and sellers5. Financial Marketsa. Direct finance = an individual saver holds financial claims issued directly by an individual buyerb. Primary marketsi. Those in which newly issued claims are sold to initial buyers1. Businesses primary markets to raise funds2. Government uses to finance budget deficitsii. Most commonly used claim is debt1. Requires the borrower to repay principal (the amount borrowed) plus interest2. Maturity = the length of the period of time before the debt instrument expiresiii. Other type of claim is equity1. An ownership claim to a share in the profits and assets of a firm2. Allows for variables payments from the borrower to the lender3. an example is common stock (stockholders get their share of the firm’s profits)4. dividends = periodic payments from the firm to stockholdersc. Secondary marketsi. Those in which previously issued claims are resoldii. The initial seller of the stock (in primary market) does not receive proceeds of resaleiii. Risk-sharing, liquidity and information services are provided in secondary marketsiv. Categorize Secondary markets by three things:1. What maturity level characterizes claims being traded2. How trading takes place3. When settlement takes placev. Information services relate to stock prices (if the price is high, the expectation is thatthe firm will increase profits in the future)d. Types of secondary marketsi. Maturity: money and capital markets (how long does the entity last?) 1. Money markets- maturity is short term (less than 1 year) i. Small increases or decreases in price, therefore less riskyii. Generally more liquidiii. Information costs are loweriv. Examples are US Treasury bills, commercial paper, repurchase agreements (trades between banks), federal funds, Eurodollars, negotiable bank certificate of deposit2. 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 loansii. Trading: auction and over the counter markets1. Auction markets: prices are set by competitive bidding by traders representing buyers. Examples are New York and American Stock Exchanges2. OTC (over the counter) markets: not between two individuals, computerized trading. An example is NASDAQiii. Settlement: cash and derivative markets1. Cash market: actual claims are bought and sold with immediate settlementi. Examples are stock and bond markets2. 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 length2. Example: XYZ is $50, stock option allows you to buy $50 price for 3 months. If price goes up or down it remains $506. Financial Intermediaries in the Financial Systema. Tasksi. Matching savers and borrowersii. Providing risk-sharing, liquidity and information servicesb. Financial intermediaries are the largest group in the financial system7. Competition and Changea. Financial innovation comes about over time because financial intermediaries attempt to tailor their services to gain more customersb. Financial integration = the way in which financial markets are tied together geographicallyi. Grows closer every day because of global communicationc. Globalization (has two effects)i. Easy flow of capital across national boundaries helps countries have more opportunitiesii. Reduces the cost of allocating savers’ funds to the highest-valued uses8. Goals of Financial Regulationa. Provision of Informationi. Securities and Exchange Commission mandates that corporations issuing stocks or bonds disclose information about earnings, sales, assets and liabilitiesb. Maintenance of Financial Stabilityi. Stability = the ability of financial services to provide risk-sharing, liquidity and informationii. Reduction in these key services raise the cost of moving funds from savers to borrowersc. Controlling the money supplyi. Federal Reserve System (Fed) requires banks to keep fraction of their deposits in cashii. If the supply of money goes UP, interest rates go DOWNd. Encouraging particular activitiesi. An example is policies encouraging home ownershipii. Another example is allowing student loans with low interest, encouraging education9. Effects of
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