Introducing Money and Financial System I Key Components of the Financial System A Financial Assets an asset is anything of value owned by a person or a firm i A financial asset is a claim that someone else owes you money ii There are two types 1 Securities can be bought and sold 2 Non securities iii There are five categories 1 Money 2 Stock Equity 3 Bonds 4 Foreign Exchange 5 Securitized Loans iv Financial liability a financial claimed that is owed The person it is owed to views it as an asset B Financial Institutions i There are two channels 1 Financial Intermediary a financial firm that borrows funds from savers and lends them to borrowers Insurance companies a Commercial banks b c Pension funds d Mutual funds e Hedge funds f Investment banks 2 Financial Markets places or channels for buying and selling stocks bonds other securities a Primary Markets a financial market in which securities are sold for the first time b Secondary Market a financial market in which investors buy and sell existing securities ii Indirect vs Direct 1 Direct two parties you and the bank 2 Indirect three or more parties C The Fed and Other Financial Regulators i The Federal Reserve 1 Central bank of the US 2 Monetary policy a High employment b Low rates of inflation c High growth rate d Stability 3 Federal funds rate ii The FDIC 1 Lender of last resort iii Securities and Exchange Commission 1 Monitors stocks and bonds D What Does the Financial System do i Risk Sharing 1 Risk the chance that the value of financial assets will change relative to what you expect 2 Diversification splitting of wealth into many assets ii Liquidity the ease with which an asset can be sold for money at a reasonable price 1 In general assets created by the financial system are more liquid then physical assets iii Information Facts about borrowers and expectations of returns on financial assets II The Financial Crisis of 2007 2009 A Origins i The housing bubble of 2000 2005 1 Bubble an unsustainable increase in the price of a class of assets ii This was caused by 1 Investment banks creating and selling mortgage backed securities 2 So lenders loosened the standard for obtaining a mortgage loan 3 When housing prices began to fall so did the value of mortgage backed securities 4 Which led to a decrease in investors 5 Banks became strict about issuing credit 6 And the flow of funds from savers to borrowers reduced greatly Interest Rates and Rates of Return I Interest Rate Present Value and Future Value A Interest Rates the cost of credit a Interest rate covers the opportunity cost of supplying credit b Consider three things when deciding how much interest to charge Inflation i ii The risk someone might default on a loan iii Opportunity cost B Future Payments a Interest rates are key because most financial transactions involve payments in the future C Compounding and Discounting a Future Value the value at some future time of an investment made today i FV Principal x 1 i b Compounding the process of earning interest on interest as savings accumulate over time i FV n Principal x 1 i n 1 Where n number of years c Present Value the value today of funds to be received in the d Discounting the process of finding the present value of funds future i PV FV 1 i that will be received in the future i PV FV n 1 i n e Some important notes i Present value present discounted value ii The further in the future a payment is to be received the smaller it s present value iii The higher the interest rate used to discount future payments the smaller the present value of the payments iv The present value of a series of future payment is the sum of the discounted value of each individual payment f Note i Interest rates should always be converted to decimals 1 5 0 05 g Discounting and the Pricing of Financial Assets i Most financial assets are basically promises by the borrower to make certain payments to the lender in the future ii Discounting lets us compare the values of different financial assets by giving us a means of determining the present value of payments to be received in the future iii Discounting gives us a way to determine the prices of financial assets Return and Risk I Return A The Concept of Return a The return is the level of profit from an investment b Some investments guarantee a return but most do not B Components of Return i Return on Investment ROI may come from more then one source b Periodic payments i Depends on interest c Income i Must be cash or easily converted into cash ii Is usually cash periodically received as a result of owning an investment C Why Return is Important 1 Ex dividends from stock d Capital gains losses i Capital gain the amount by which the proceeds from the sale of an investment exceeds it s original purchase price ii Capital loss if an investment sells for less then it s original purchase price e Total return Income Gain or loss f It is preferable to compare percentage returns then total returns a An asset return is a key variable because it indicates how quickly an investor can build wealth b Historical performance i Past data is not a guarantee of future performance ii But it can provide a meaningful basis iii Shows the average level of return overtime generated Important to see if returns are usually constant or if iv they vary greatly from year to year c Expected return i But all that really matters is the future return ii Expected return is a vital measure of performance D Level of Return a Internal characteristics i Type of investments 1 Ex Stocks or bonds ii Quality of the firm s management iii If the firm finances its operations with debt or equity b External forces i Federal Reserve actions ii Shortages iii War iv General level of price changes 1 Inflation increase in prices a Positive impact on investments such as real estate and a negative impact on stocks and fixed income securities 2 Deflation decrease in prices E Historical Returns a Historically stocks earn higher returns then government bonds which in turn earn higher average returns then short term government bills F Time Value of Money and Returns a The sooner you receive cash the better i Ex A 1000 two year investment that earns 50 per year is better then the same investment that only earns 100 at the end of year 2 because the 50 at the end of year one can be reinvested sooner II Measuring Return A Real Risk Free and Required Returns a Inflation and Return b Risk and Returns i With 3 inflation 1 buys 3 fewer goods ii So if investors seek
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