FIN3244 EXAM 1 Fundamentals of Investing Chapter 1 4 Chapter 1 Introducing Money and the Financial System 1 1 Key Components of the Financial System The 3 major components of the financial system 1 Financial assets 2 Financial institutions 3 The Federal Reserve and other financial regulators Financial Assets Asset anything of value owned by a person or a firm Financial asset an asset that represents a claim on someone else for a payment Ex A bank checking account a claim you have against a bank to pay you an amount of money equal to the dollar value of your account an asset but not a security Financial assets are divided into those that are securities and those that are not Security a financial asset that can be bought and sold in a financial market tradable Ex shares of stock bonds Financial market a place or channel for buying or selling stocks bonds and other securities Ex The New York Stock Exchange The 5 key categories of assets 1 Money 2 Stocks 3 Bonds 4 Foreign exchange 5 Securitized loans Money anything that is generally accepted in payment for goods and services or to pay off debts includes coins paper currency and funds in checking accounts Money supply the total quantity of money in the economy Stock financial securities that represent partial ownership of a firm also called equities when you buy a stock you become a shareholder when a firm sells stock this increases its financial capital and increases the number of the firm s owners Dividend a payment that a corporation makes to its shareholders typically made every quarter Bond a financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money Interest rate the cost of borrowing funds or the payment for lending funds usually expressed as a percentage of the amount borrowed Bonds typically pay interest in fixed dollar amounts called coupons When a bond matures the seller of the bonds repays the principal A short term bond is one that matures in one year or less A long term bond is one that matures in more than one year To buy foreign goods and services or foreign assets a domestic business or a domestic investor must first exchange domestic currency for foreign currency Foreign exchange units of foreign currency Page 1 FIN3244 EXAM 1 most important buyers and sellers of foreign exchange are large banks who engage on behalf of investors and firms Securitization the process of converting loans and other financial assets that are not tradable into securities Ex buying mortgage backed securities from a government agency or financial firm the bank that grants originates the original mortgages still collect interest paid by the borrowers Financial liability a financial claim owed by a person or firm Financial Institutions The financial system matches savers and borrowers through 2 channels and these are distinguished by how funds flow from the savers lenders to the borrowers and financial institutions involved 1 Banks and other financial intermediaries 2 Financial markets Financial intermediary a financial firm such as a bank that borrows funds from savers and lends them to borrowers indirect finance getting a loan from a bank to buy a car direct finance buying stock that a firm had just issued Savers receive their returns through dividend payments on stock coupon payments on bonds and interest payments on loans Commercial bank a financial firm that serves as a financial intermediary by taking in deposits and using them to make loans the most important financial intermediary commercial banks take in deposits from households and firms and invest most of those deposits either by making loans to households and firms or by buying securities such as government bonds or securitized loans households rely on borrowing money from banks when they purchase big ticket items like cars or homes many firms rely on bank loans to meet their short term needs for credit such as funds to pay for inventories or meet their payrolls many firms rely on bank loans to bridge the gap between paying for inventories meeting their payrolls and when they receive revenues from goods services some firms also rely on bank loans to meet their long term credit needs such as funds they require to physically expand the firm commercial real estate loans allow firms to construct or purchase office buildings factories and shopping malls The financial system transfers funds from savers to borrowers Borrowers transfer returns back to savers through the financial system Savers and borrowers include domestic and foreign households businesses and governments Small businesses are impacted by a financial crisis because unlike large businesses they can t raise funds on financial markets by selling stocks and bonds They must rely on loans from banks During the financial crisis that began in mid 2007 the number of households and firms defaulting on loans turned out to be much higher than banks had predicted Loan losses during 2007 2009 were very severe by far the largest since the Great Depression of the 1930s Loan losses began rising in the spring of 2008 and by the end of 2009 they were four times greater than at the end of 2007 As a result bank loans declined sharply Small businesses had to resort to drastic measures like borrowing money from Page 2 FIN3244 EXAM 1 pawn shops running up balances on their credit cards or borrowing from friends and family members Nonbank financial intermediaries savings and loans savings banks credit unions insurance companies pension funds mutual funds hedge funds and investment banks Insurance companies write contracts to protect their policyholders from the risk of financial losses associated with particular events They collect premiums from policyholders which they then invest Pension funds invest contributions from workers and firms in stocks bonds and mortgages to earn the money necessary to pay pension benefit payments during worker s retirements Mutual funds obtain money by selling shares to investors then invest the money in a portfolio and charging a management fee for its services These lower investment risk and provide savers easy access to their money because they are willing to buy back shares at any time Portfolio a collection of assets such as stocks and bonds Hedge funds accept money from investors and use the funds to buy a portfolio of assets but it typically has no more than 99 investors all wealthy individuals or institutions They are riskier investments and charge
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