Exam 1 Study Guide Chapter 1 2 3 and 10 Chapter 1 Introducing Money and the Financial System KEY COMPONENTS OF THE FININACIAL SYSTEM First you should be familiar with the three major components of the financial system o Financial assets o Financial institutions o The federal Reserve and other financial regulaors 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 payments o Example A bank checking account is a financial asset because it represents a claim you have against a bank to pay you an amount of money equal to the dollar value of your account Economist divide financial assets into those that are securities and those that aren t o Security a financial asset that can be bought and sold in a financial market Financial market a place or channel for buying or selling stocks bonds and other securities o So checking account is an asset but not a security The following are five key categories of assets o Money Anything that is generally accepted in payments for goods and services or to pay off debts Money supply the total quantity of money in the economy o Stocks financial securities that represent partial ownership of a firm also called equitites When company sells additional stock they are increasing the funds available to the firm its financial capital Firms keep some of their profits as retained earnings and pay the remainder to shareholders in the form of dividends Dividend a payment that a corporation makes to its shareholder o Bonds 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 amount called coupon A bond that matures in on year or less is a short term bond A bond that matures in more than one year is a long term bond o Foreign exchange units of foreign currency The most important buyers and sellers of foreign exchange are large banks Banks engage in foreign currency transaction on behalf of investors who want to buy foreign financial assets Banks also engage in foreign currency transactions on behalf of firms that want to import or export goods and services or to invest in physical assets such as factories in foreign counties o Securitized loans Securitization the process of converting loans and other financial assets that are not tradable into securities Example a bank might grant a mortgage which is a loan a borrower uses to buy a home and sell It to a government sponsored enterprise of a financial firm that will bundle the mortgage together with similar mortgages granted by other banks This bundle of mortgages will form the basis of a new security called mortgage backed security that will function like a bond Financial liability a financial claim owed by a person or a firm FINANCIAL INSTITUITIONS The financial system matches savers and borrowers through two channels o Banks and other financial intermediaries A financial firm such as a bank that borrows funds from savers and lends them to borrowers o Financial markets Example if you get a loan from a bank to buy a car economists refer to this flow of funds as indirect finance The flow is indirect because the funds the bank lends you come from people who have put money in checking or savings deposits in the bank in that senses the bank is not lending its own funds directly to you On the other hand if you buy a stock that a firm has issued the flow of funds is direct finance because the funds are flowing directly from you to the firm Financial intermediaries o Commercial banks are the most important financial intermediaries Commercial banks a financial firm that serves as a financial intermediary by taking in deposits and using them to make loans PAWN SHOP FINANCE WHAT HAPPENS TO SALL BUSINESSES WHEN BANK LENDING DRIES UP Large businesses can raise funds on financial markets by selling stocks and bonds but small business doesn t have this option Because its costly for investors to gather information on small businesses these businesses cannot sell stocks and bonds and must rely instead on loans from banks Nonbank financial intermediaries o Example when you and other people buy an automobile insurance policy the insurance company may lend premium you pay to a hotel chain that needs funds to expand Insurance companies Pension funds Mutual funds o Obtain money by selling shares to investors o The mutual fund then invest the money in a portfolio of financial assets such as stocks and bonds typically charging a small management fee for its service Portfolio a collection of assets such as stocks and bonds o By buying shares in a mutual fund savers reduce the cost they would incur if they were to buy many individual stocks and bonds o Small savers who have only enough money to buy a few individual stocks and bonds can also lower their investment risk by buying shares in a mutual fund because most mutual funds hold a large number of stocks and bonds o Are similar to mutual funds in that they accept money from investors and use the fund to buy a portfolio of assets However a hedge fund typically has no more than 99 investors all of whom are wealthy individual or institutions such as pension funds o Hedge funds typically make riskier investments than do mutual funds and they charge Hedge funds investors much higher fees Investment banks mergers with other firms o They concentrate on providing advice to firms issuing stocks and bonds or considering o They also engage in underwriting in which they guarantee a price to a firm issuing stocks or bonds and they make a profit by selling stocks or bonds at a higher price Financial market o are places or channels for buying and selling stocks bonds and other securities o Electronically between dealers linked by computers and is referred to as over the counter trading o Economist make a distinction between primary markets and secondary markets Primary market a financial market in which stocks bonds and other securities are sold for the first time Secondary market a financial market in which investor buy and sell exisiting securities THE FEDERAL RESERVE AND OTHER FINANCIAL REGULATORY The federal government of the United States has several agencies that are devoted to reregulating the financial system including thee The Securities and Exchange Commission SEC
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