Study Guide for Exam 1 FIN3244 Purposes of the financial system The financial system channels funds from savers to borrowers and makes it possible for both to achieve their objectives Provides channels to transfer funds from savers to borrowers o Savers lend money to borrowers in return for promise of repayment of more funds o Borrowers promise to repay borrowed funds based on expectation of higher income in the future o These promises are liabilities for the borrower and assets for the savers Financial system provides three key services for savers and borrowers o Risk sharing many assets o Liquidity The financial system provides risk sharing by allowing savers to hold Diversification the splitting of wealth into many assets The ease with which an asset can be exchanged for money to purchase other assets or exchanged for goods and services Financial markets and intermediaries provide trading systems for making financial assets more liquid o Information Facts about borrowers and expectations about returns on financial assets Problem Asymmetric information borrowers possess info that lenders do not about what they are actually going to do with money increased risk for lenders Communication of info important for financial system Financial Markets borrower Markets that issue claims on individual borrowers directly to savers o Examples Stock market bond market Direct finance individual saver holds financial claims issued directly by an individual Capital markets debt instruments with maturity greater than one year traded here Money markets short term maturity of less than one year o Money market instruments are generally more liquid than capital market instruments because their trading volume is greater and the cost of buying and selling is low o Information costs are lower for money market instruments because the borrowers are well known and the length of time for which funds are loaned is relatively short Cash markets markets in which actual claims are bought and sold with immediate settlement o Examples stock and bond markets Derivative markets trades are made now but settlement is made at a later date o Financial futures require settlement of a purchase of a financial instrument at a specified future date with the price determined at the outset o Options on financial contracts confer on the trader the right or option to buy or sell a particular asset within a specified time at a specified price Financial Intermediaries Institutions Act as go betweens by holding a portfolio of assets and issuing claims based on that portfolio to savers Examples banks mutual funds insurance companies Intermediaries have the same two tasks as financial markets o Intermediaries pay interest to savers in exchange for the use of savers funds and earn a profit by lending money to borrowers and charging borrowers a higher rate of interest on the loans o Banks have a large quantity of deposits and access to numerous borrowers and investments they can diversity and provide risk sharing services to you at a lower cost than you could obtain on your own o Bank deposits and other intermediary claims are liquid o Banks are information warehouses can easily obtain info from them Shadow banking Collection of financial entities infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned regulation Includes hedge funds money market funds and structured investment vehicles Shadow banks are not regulated in the same ways as depository banks They are usually intermediaries between investors and borrowers They facilitate the credit availability to businesses by providing funding to traditional Shadow banking system makes up 25 30 of the total financial system banks Shadow banks can increase the rewards they get from investments by leveraging up much more than other banks which can lead to higher risks Financial Regulations reasons Governments around the world regulate financial markets and institutions for three o Governments want to ensure that all participants in the financial system have access to information and that markets and intermediaries give savers and borrowers accurate and timely information Some firms earn profits by selling the information to individual investors Quality of goods and services can be difficult to judge by potential investors or buyers Leading federal regulatory body for financial markets in the U S is the SEC In derivative markets the Commodities Futures Trading Commission guards against fraud in futures trading o Governments regulate the financial system to maintain financial stability Market failures can undermine the efficiency with which the economy s resources are allocated o The government can advance economic policy by interacting with the financial system These objectives include controlling the money supply and encouraging particular activities such as ownership Fed government allows the deduction of interest paid on a home mortgage from income subject to federal income taxes Restrictions on the types of instruments that can be traded in markets affect liquidity Competition Financial engineering innovation Changes in costs of providing risk sharing liquidity or information services or changes in demand for these services encourage financial markets and intermediaries to alter their operations and to offer new types of financial assets and liabilities These improvements in the financial system are called financial innovation o Can benefit everyone Financial integration geographic global linkage One measure of the system s efficiency is its degree of financial integration o The way in which financial markets are tied together geographically In history early financial markets were fragmented eastern capital was used in the East and western in the West Interest rates charged to borrowers tended to be different in different parts of the country Now borrowers who raise funds through securities have access to national markets Globalization of financial markets has two effects o Easy flow of capital across national boundaries helps countries with productive opportunities to grow even if their current resources are insufficient o Increasing financial integration around the world reduces the cost of allocating savers funds to the highest valued uses wherever they may be The costs of buying or selling a financial instrument such as a stock or bond Information costs are the costs that savers incur to determine the
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