FIN3244 Test 1 Study Guide 02 09 2012 1 Purposes of the Financial System The financial system provides channels to transfer funds from individuals and groups who have saved up money i e the savers lenders to groups who want to borrow money borrowers Savers suppliers of funds to borrowers in return for promises of repayment of more funds in the future Borrowers demanders of funds promising to repay based on their own expectation of a higher future income The promises of funds are financial liabilities for the borrower and assets for the saver Use of funds asset source of funds liability 2 Financial Markets Ex stock and bond markets issue claims on individual borrowers directly to savers 3 Financial Intermediaries banks mutual funds ins Companies act as go betweens by holding a portfolio of assets and issuing claims based on that portfolio to savers Channels funds from savers to borrowers indirectly by raising funds from savers and investing in the debt or equity of borrowers Known as financial intermediation Tasks Matching savers to borrowers Pool funds of savers to lend to borrowers Pay interest to savers in exchange for use of money banks make money by charging the borrower a higher rate of interest than the saver receives Risk sharing liquidity information services Banks have a large quantity of deposits which allows them to diversify risk sharing They are liquid and banks collect information on borrowers lowering the cost of this information for the saver Mutual funds and banks offer savers an opportunity to invest in the fund while also diversifying their portfolio at a level that could not be reached individually risk sharing Where savers invest their money depends on their financial situation For low degrees of risk one can invest in US govt or well known corporations To get a diversified portfolio w out doing research turn to a financial intermediary 4 Shadow Banking unregulated activities of regulated funds Such as hedge funds 5 Financial Regulations reasons for regulation 1 Ensure that participants have access to info and that markets and intermediaries give out accurate timely info o Because private firms are not always able to give accurate information about corporations to investors govt requires issuers of financial instruments to disclose their financial standings Leading regulatory body S E C SEC limits trading by managers of large corporations and prevents insider trading 2 Maintain financial stability o Most US financial assets are held by intermediaries so financial regulation must ensure the ability to provide the 3 services stays intact 3 Can advance economic policy by interacting with the financial system o Banks effect movements in the money supply which influences larger economic variables Thus the Federal Reserve system requires banks to deposit a fraction of their assets into the Fed so that it can partially control the supply of money o Govt regs foster home ownership by allowing people to deduct interest paid on their mortgage from income subject to federal taxes Effects of Regulation Affects ability of fin markets and institutions to provide the three Restrictions on types of instruments that can be traded in markets services effect liquidity 6 Risk Sharing Services One of the three services provided by the financial system the other two are liquidity and information services By risk we mean the chance that the value of financial assets you invest in will change relative to what you expect A collection of assets is called a portfolio the financial system provides risk sharing services by allowing savers to hold many assets at one time reducing risk diversification of portfolio 7 Liquidity Another key service provided by the financial system Liquidity refers to the ease in which an asset can be exchanged for money to purchase other assets or exchange for goods services It is a benefit to the investor because it allows individual to respond quickly to new opportunities or unexpected events Markets intermediaries provide systems for making assets more liquid Ex investors can readily sell their holdings in govt securities making them very liquid 8 Information the financial system and financial intermediaries provide information about expectations on future returns on financial assets and facts about borrowers and how they will use their money Provide for specialized arrangements to prevent asymmetric information when one party knows certain circumstances effecting a deal giving them an advantage Financial system provides communication of information concerning prices of stocks and financial assets Incorporates this information into asset returns 9 Risk and Return Most investors prefer to have more stable earnings throughout the time they hold their assets in that investment High volatility price fluctuation in a financial instrument is typically avoided 10 Debt Most commonly used claim requires borrower to repay the principal and interest Debt instruments promises to repay the amount owed expires at maturity student loans govt bonds corporate bonds other loans Lenders face the risk that the borrower will default Short term debt instruments Maturity one year Long term 10 years or more Intermediate term between 1 10 years 11 Equity An ownership claim to assets of a firm Periodically pays out dividends to shareholders the owners of a firm all of whom make up its equity 12 Primary Markets Newly issued claims are sold to initial buyers by the borrower directly This is known as direct finance investors lend their savings directly to the firm through financial markets Typically only large investments are done this way Primary markets are efficient in matching savers and borrowers while secondary markets see below satisfy the risk sharing liquidity and information services 13 Secondary Markets markets in which claims that have already been issued are sold by one investor to another Investors purchase funds from X Co in primary markets and resell them in secondary markets Most primary market transactions are sales of new debt of equity and done behind closed doors Buyer in secondary market pays the seller The initial seller the corporation govt receives nothing Examples of secondary markets NYSE new york stock exchange Tokyo markets etc Already issued equities are sold here These markets make it easier for investors to reduce risk through diversified portfolios and promotes liquidity making investors more willing to hold financial instruments making it easier for
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