CHAPTER 1 Components of the Financial System 1 Financial assets An asset is anything of value owned by a person or firm A Financial Asset is an asset that represents a claim on someone else for payment Financial assets are often divided into those that are securities and those that aren t Securities are tradable being able to be bought or sold on financial markets places for buying and selling securities like the New York Stock Exchange a Money b Stocks i Anything people are willing to accept in payments of goods or services or to pay off debt i Also called equities equity securities ii Are financial securities that represent partial ownership of a company iii Dividends are payments to shareholders coming from the retained earnings of the company c Bonds i Debt securities ii Financial securities issued by a corporation or government that represents a promise to repay a fixed amount of money iii Interest Rate the cost of borrowing funds expressed as a percentage of the amount borrowed iv Short term bonds mature in 1 year or less Long Term bonds mature in more than 1 year d Foreign exchange i Refers to units of foreign currency ii For use in buying financial assets of another country e Securitized loans i Are loans that can be traded in financial markets ii Securitization process of converting loans or some other financial assets that are not tradable into securities iii Example 1 A mortgage is a loan used to buy a home 2 A bank may sell that loan to a government enterprise or financial firm that will bundle the mortgage together with other mortgages a This bundle creates a security called a mortgage backed security that is just like a bond The interest paid on the original mortgage is sent out to whatever firm that bought the mortgage backed security iv Financial Liability a financial claim owed opposite of financial asset 2 Financial institutions a Financial Intermediaries i Indirect vs Direct Finance 1 Indirect where the money doesn t come directly from who s handing it out such as a bank giving a loan because that money given actually comes from people s checking accounts within the bank 2 Direct where the money is directly from or to the party handling it such as stock in a firm because the flow of funds is going directly between you and the firm ii Financial intermediaries financial firm that borrows funds from savers and lends them to borrowers 1 Commercial Banks a Most important financial intermediary b Takes in deposits and uses them to make loans 2 Insurance companies a Insurance holders pay a premium to protect themselves from certain events the company then uses the premiums to pay claims and cover their costs that they owe 3 Pension funds a Invest contributions from workers and firms in stocks bonds and mortgage to earn money necessary to pay pension benefits during workers retirement 4 Mutual funds a Obtains money by selling shares to investors b The mutual fund then invests in a portfolio or financial assets such as stocks and bonds c This reduces the costs and the risk of investing by distributing it amongst many investors and then being able to sell back your shares at any time 5 Hedge funds a Same concept as Mutual Funds b Rarely more than 99 investors most of who are very wealthy c Typically make riskier investments and charge higher fees 6 Investment banks a Don t take in deposits and rarely lend directly to households b More concentrate on giving advice to firms issuing stocks or considering mergers with other firms b Financial markets the first time securities i Primary market where stocks bonds and other securities are sold for 1 Initial Public Offering IPO when a firm first sells stock ii Secondary Market where investors buy and sell already existing 3 The Federal Reserve the Fed and other financial regulators a Other financial regulators i Securities and Exchange Commission SEC regulates financial markets ii Federal Deposit Insurance Corporation FDIC insures deposits in banks iii Office of the Comptroller of the Currency regulates federally chartered banks b Federal Reserve i Central bank of the U S and lender of last resort they lend to banks not to individual people ii MAIN function is to control Monetary Policy actions taken by the Fed to manage the money supply and interest rates to pursue macroeconomic policy objectives iii Federal Funds Rate the interest rate that banks charge each other on short term loans What the Financial System provides for Savers and Borrowers Risk Sharing Liquidity a car Information o Allows savers to spread and transfer risk o Diversification splitting wealth among many different assets to reduce risk o How easy an asset can be exchanged for money o Stocks bonds checking accounts etc are MORE liquid than physical assets like o Facts about borrowers and about the expectations of returns on financial assets Bubble an unsustainable increase in the price of a class of assets like the housing bubble from 2000 2005 CHAPTER 2 Interest Rate Present Value and Future Value Why Interest is charged Compensation for inflation Compensation for default risk chance the borrower won t pay back the loan Compensation for the opportunity costs of waiting to spend your money the fee for receiving money NOW Future Value FV The value at some future time of an investment made today Bank Certificate of Deposit o Known as CDs Equals o FV Principal 1 i o Interest rate i o Equals FV Principal 1 i n Interest rate i Number of years n Compounding process of earning interest on interest as savings accumulate over time Present Value PV The value today of funds that will be received in the future Also called present discounted value o Time Value of Money The way that the value of a payment changes depending on when the payment is received Funds in the future are worth less than funds in the present so funds in the future have to be reduced discounted to find their present value Process of finding the present value of funds that will be received in the o Discounting future Equals FV n 1 i n CHAPTER 10 Components of Return Income o Cash that investors receive as a result of owning an investment Such as dividends or interest Capital Gains or Losses o Amount by which a sale of an investment exceeds its original price Total Return o Called Return on Investment ROI Profit gained from making an investment o Income Capital Gain Factors affecting Returns Internal Characteristics o Asset type quality of management capital structure firm size External Forces o Such as
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