FIN3244 Exam 1 Notes Chapter 1 Introducing Money and the Financial System Key Components of the Financial System o The 3 major components of the financial system are Financial Assets Financial Institutions The Federal Reserve and other financial regulators o An asset is anything of value owned by a person or firm o A financial asset is a financial claim which means you own a financial asset you have a claim on someone else to pay you money o A security is a tradable financial asset which means it can be bought and sold in o Financial markets are places for buy and selling securities stocks and bonds a financial market I e the NYSE o The 5 key financial assets are Money anything that people are willing to accept in payment for goods and services or to pay off debts Money supply is the total quantity of money in the economy Stocks also known as equities are financial securities that represent partial ownership of a corporation As an owner of a share of stock you have a legal claim to a share of the corporation s assets and to a share of its profits Firms keep some profits as retained earnings and the rest is paid to shareholders in the form of dividends payments corporations typically make each quarter to the shareholders Bonds a financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money When you buy a bond you are lending the issuer a fixed amount of The interest rate is the cost of borrowing funds Bonds pay interest in fixed dollar amounts called coupons When a bond reaches maturity the seller of the bond repays the money principal Foreign Exchange refers to units of foreign currency To buy foreign goods services or assets a domestic business or investor must first exchange the domestic currency for the foreign currency I e Best Buy exchanges U S dollars for Japanese yen when importing Sony TVs Securitized Loans loans that are securitized and traded on the market Securitization is the process of converting loans and other financial assets that are not tradable into securities Securitized loans are also known as mortgage backed securities and they function like a bond A financial liability is a financial claim owed by a person or firm Financial Institutions o The financial system matches savers and borrowers through Banks and other financial intermediaries and financial markets o A financial intermediary is a financial firm that borrows funds from savers and lends them to borrowers o If you get a loan from a bank to buy a car this is known as indirect finance because the funds the bank lends you come from people who have put money in a checking or savings account the bank is not lending its own funds to you o If you buy stock that a firm has just issued this is direct finance because the funds are flowing directly from you to the firm o Financial Intermediaries Commercial Banks are financial firms that serve as financial intermediaries by taking and deposits and using them to make loans Commercial banks may also invest these funds in securities Nonbank Financial Intermediaries Insurance Companies o Insurance companies specialize in writing contracts to protect their policyholders from the risk of financial losses i e car accidents o Insurance companies collect premiums from policy holders which is then invested to obtain the funds necessary to pay claims to policyholders and cover their other costs Pension Funds Mutual Funds o Pension Funds invest contributions from workers and firms in securities to earn the money necessary to pay benefit payments during the workers retirements o A mutual fund obtains money by selling shares to investors The mutual fund then uses those funds to invest in a portfolio of financial assets typically charging a small management fee Hedge Funds o Hedge Funds operate similarly to mutual funds in that they obtain money from investors and use the funds to buy a portfolio of assets However hedge funds typically have very few investors and they often make riskier investments and charge higher management fees Investment Banks o Investment banks unlike commercial banks rarely take in deposits and rarely loan to households o They namely focus on providing advice to firms issuing stocks and bonds or considering mergers with other firms o They also engage in underwriting in which they guarantee a price to a firm issuing stocks or bonds and then make a profit by selling the stocks or bonds at a higher price o Investment banks also engaged in proprietary trading in which they profit from buying and selling securities themselves o Financial Markets Financial Markets are places channels for buying and selling stocks bonds and other securities A primary market is a financial market in which stocks bonds and other securities are sold for the first time I e a market for IPOs initial public offerings A secondary market is a financial market in which investors buy and sell existing securities The Federal Reserve o The Federal Reserve is the central bank of the U S o The Federal Reserve conducts Monetary Policy which are actions taken to manage the money supply and interest rates to pursue macroeconomic objectives o The Fed is run by a board of governors which consists of 7 members the Fed is o The Federal Open Market Committee FOMC is the main policymaking body of also divided into 12 districts the Fed o The Fed controls the Federal Funds Rate which is the interest rate that banks charge each other on short term loans o Economists believe there are 3 key services that the financial system provides Risk sharing A service the financial system provides that allows savers to spread and transfer risk Risk is the chance that the value of a financial asset will change relative to what you expect Diversification is splitting wealth among many different assets to reduce risk Liquidity the ease at which an asset can be exchanged for money Information facts about borrowers and about expectations of returns on financial assets The Financial Crisis o A bubble is an unsustainable increase in the price of a class of asset o Fannie Mae and Freddie Mac sell bonds to investors and use the funds to purchase o Mortgage backed securities often paid higher interest rates than other securities o Subprime and Alt A borrowers began defaulting on their loans as housing prices mortgages from banks with comparable default risk decreased o Moral Hazard Problem is the possibility that managers of financial firms such as Bear Stearns might
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