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FSU FIN 3244 - CHAPTER 1

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CHAPTER 1Components of the Financial System1. 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. Moneyi. Anything people are willing to accept in payments of goods or services (or to pay off debt)b. Stocksi. Also called equities (equity securities) ii. Are financial securities that represent partial ownership of a companyiii. Dividends: are payments to shareholders coming from the retained earnings of the companyc. Bondsi. Debt securitiesii. Financial securities issued by a corporation or government that represents a promise to repay a fixed amount of moneyiii. 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 exchangei. Refers to units of foreign currencyii. For use in buying financial assets of another countrye. Securitized loansi. Are loans that can be traded in financial marketsii. 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 home2. 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 Finance1. 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 borrowers1. Commercial Banks a. Most important financial intermediary b. Takes in deposits and uses them to make loans2. 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 owe3. Pension fundsa. Invest contributions from workers and firms in stocks, bonds, and mortgage to earn money necessary to pay pension benefits during workers’ retirement4. Mutual funds a. Obtains money by selling shares to investorsb. The mutual fund then invests in a portfolio or financial assets, such as stocks and bondsc. 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 time5. Hedge funds a. Same concept as Mutual Fundsb. Rarely more than 99 investors, most of who are very wealthyc. Typically make riskier investments and charge higher fees6. Investment banks a. Don’t take in deposits and rarely lend directly to householdsb. More concentrate on giving advice to firms issuing stocks or considering mergers with other firmsb. Financial marketsi. Primary market = where stocks, bonds, and other securities are sold for the first time1. Initial Public Offering (IPO): when a firm first sells stockii. Secondary Market = where investors buy and sell already existing securities3. The Federal Reserve (the Fed) and other financial regulators a. Other financial regulators i. Securities and Exchange Commission (SEC): regulates financial marketsii. Federal Deposit Insurance Corporation (FDIC): insures deposits in banksiii. Office of the Comptroller of the Currency: regulates federally chartered banksb. 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 objectivesiii. Federal Funds Rate= the interest rate that banks charge each other on short-term loansWhat the Financial System provides for Savers and Borrowers• Risk Sharingo Allows savers to spread and transfer risko Diversification: splitting wealth among many different assets to reduce risk• Liquidityo How easy an asset can be exchanged for moneyo Stocks, bonds, checking accounts, etc. are MORE liquid than physical assets like a car• Informationo Facts about borrowers and about the expectations of returns on financial assetsBubble: an unsustainable increase in the price of a class of assets (like the “housing bubble” from 2000-2005) CHAPTER 2Interest Rate, Present Value, and Future ValueWhy 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 • Compounding: process of earning interest on interest as savings accumulate over timeo Equals: FV = Principal * (1 + i)n  Interest rate = i Number of years = nPresent 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 valueo Discounting  Process of finding the present value of funds that will be received in the future Equals:•FVn(1+i)nCHAPTER 10Components of Return• Incomeo Cash that investors receive as a result of owning an investment  Such as dividends or interest• Capital Gains or Losseso Amount by which a sale of an investment exceeds its original price


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