Exam 1 Study Guide Chapter 1 The financial system The financial system is circular continuous Broad two part system o Financial markets Channels for buying and selling financial securities o Two party system Only within between the buyers and sellers Financial intermediaries institutions o Indirect three party system Someone in between the buyer and seller o Example Commercial banks deposits lending to bank Mutual finds pension funds hedge funds and insurance firms Investment banks firms no deposits New capital invest premium into three parties Banks can give lenders interests or services ex Writing checks paying bills etc Players of system o Government agencies Federal state and local Taxes decrease in tax revenues recently ex Gas taxes o Businesses large and small Small business owners pay taxes as individuals o Households retail small investors Lower middle and upper class Investments future uncertainties Financial system purpose provides channels for transferring funds between lenders and borrowers o Savers supply funds o Buyer demand funds Financial Assets o An asset is anything of value owned by a person or a firm while a financial asset is a financial claim which means that if you own a financial asset you have a claim on someone else to pay you money Example a bank checking account is a financial asset o Economists divide financial assets into those that are securities and A security is tradable bought and sold in financial market those that aren t o Five key financial assets Money Stocks equities Anything that people are willing to accept in payment for goods and services or to pay off debts Money supply total quantity of money in the economy Represent partial ownership of a corporation When Microsoft sells additional stock it is doing the same thing that the owner of a small firm does when she takes on a partner increasing the funds available to the firm its financial capital in exchange for increasing the number of the firm s owners o Firms keep some of their profits as retained earnings and pay the remainder to shareholders in the form of dividends which are payments corporation typically make every quarter When issued you are lending the corporation or the government a fixed amount of money o The interest rate is the cost of borrowing funds or the payment for lending funds Bonds typically pay interest in fixed dollar amounts called coupons Bonds can be bought and sold in the financial markets Bonds like bonds Foreign exchange Many goods and services purchased in a country are produced outside that country so country must convert exchange The most important buyers and sellers of foreign exchange are large banks o Banks engage in foreign currency transactions on behalf of investors who want to buy foreign financial assets o Banks also engage in foreign currency transactions on behalf of firms that import and export goods Securitized Loans Loans that banks could sell on financial markets became securities so the process of converting loans into securities is known as securitization o Example a bank might grant a mortgage and bundle it together with similar mortgages granted by other banks mortgage backed security that will function like a bond What a saver can be a household firms or the government views as a financial asset a borrower can either be a household firms or the government views as a financial liability Financial Liability financial claim owed by a person or a firm o Ex If you take out a car loan from a bank the loan is an asset from the viewpoint of the bank because it represents a promise by you to make a certain payment to the bank every month until the loan is paid off on the other hand the loan a is a liability to you the borrower because you owe the bank the payments specified in the loan What does the financial system do o Economists believe there are three key services that the financial system provides to savers and borrowers firms provide these services in different ways which makes different financial assets and liabilities more or less attractive to individual savers and borrowers Risk sharing Liquidity Risk is the chance that the value of the financial assets will change relative to what you expect o One advantage of using the financial system to match individual savers and borrowers is that it allows the sharing or risk o One way to decrease risk is the splitting of wealth into many assets known as diversification The financial system provides risk sharing by allowing savers to hold many assets The ease with which an asset can be exchanged for money Savers view liquidity of financial assets as a benefit o More liquid assets can be quickly and easily exchanged for money while less liquid or illiquid assets can be exchanged for money only after a delay or by incurring costs In general we can say that assets created by the financial system such as stocks bonds or checking accounts are more liquid than are physical assets such as cars machinery or real estate Financial markets and intermediaries help make financial assets more liquid Facts about borrowers and expectations of returns on financial assets Information Financial markets convey information to both savers and borrowers by determining the prices of stocks bonds and other securities o Ex When the price of your shares of apple rises you know that other investors must expect that apple s profits will be higher this information can help you decide whether to continue investing in apple stock Money human creation o We can always create o Allows us to do Medium of exchange fair trade Constantly evaluating because everything has different values Need to figure out relationships o There is no gold system gold standard anymore Dollar bill isn t backed by anything o Value of money is created when you believe the exchange is fair Market is based on what we believe expectations are extremely important Main Government Regulators o The Federal Reserve The Fed Do not take deposits Fed s Dual mandate Low inflation and low unemployment Center bank of the United states 12 locations countrywide Lender of last resort bank borrow to pay depositors Conduct monetary policy hard currency in supply Does not deal with creating money o The treasury deals with fiscal policy taxes printing of money budget and spending o Securities and exchange commission SEC Regulates the financial markets bond stock derivates o Federal Deposit Insurance Corporation FDIC Insures deposits in commercial bank FDIC was created to help
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