Financial Markets Book Notes 09 03 2013 Can The Fed Restore The Flow of Money Financial system is like an irrigation system but it is money not The crisis that began in 2007 cut off flow of funds from different water that flows sections of the us economy More than 8 million jobs were lost and unemployment rose to 10 Bankruptcy of GM and Chrysler Key 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 firm Financial Asset A financial claim which means that if you own a financial asset you have a claim on someone else to pay you money o 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 Economists divide financial assets into those that are securities and Securities Tradeable which means that they can be bought and those that aren t sold in a financial market Financial Market Places or channels for buying and selling stocks bonds and other securities such as NYSE If you own a share of stock in Apple or Google you own a security because you can sell that share in the market If you have a checking account at Citibank or Wells Fargo you can t sell it So your checking account is an asset but not a security Key Categories of Assets o Money Anything that people are willing to accept in payment for goods and services or to pay off debts o Stocks o Bonds Also called equities are financial securities that represent partial ownership or a corporation When a company sells stock it increases the funds available to the firm Firms keep some of their profits as retained earnings and pay the remainder to shareholders in the form of dividends You are lending the corporation or the government a fixed amount of money Interest rate is the cost of borrowing funds Bonds pay interest in fixed dollar amounts called A bond that matures in a year or less is a short term A bond that matures in more than one year is a long coupons bond term bond Can also be bought and sold in financial markets so like stocks bonds are securities o Foreign Exchange o Securitized Loans 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 refers to units of foreign currency Large banks usually do most of the buying selling Loans that banks could sell on financial markets became securities so the process of converting loans into securities is known as Securitization 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 or a financial firm that will bundle the mortgage together with similar mortgages granted by other banks The bundle of mortgages will form the basis of a new security called a Mortgage backed security that will function like a bond Just like an investor can buy a bond the investor can buy a mortgage backed security from the government agency or financial firm The banks that grants or originates the original mortgages will still collect the interest paid by the borrowers and send those interest payments on to the government agency or financial firm to distribute to the investors The bank will receive fees for originating the loan and for collecting the loan payments from borrowers and distributing them to lenders Note that what a saver views as a financial asset a borrower views as a financial liability Financial Liability a financial claim owed by a person or a firm If you take out a car loan from a bank the loan is an asset from the view point 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 But the loan is a liability to you the borrower because you owe the bank the payments specified in the loan Financial Institutions The financial system matches savers and borrowers through two channels 1 Banks and other Financial Intermediaries 2 Financial Markets Funds flow from lenders to borrowers indirectly through Financial Intermediaries such as banks or directly through financial markets such as the NYSE o 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 So in that sense the bank is not lending its own funds directly to you On the other hand if you buy stock that a firm has just issued the flow of funds is Direct Finance because the funds are flowing directly from you to the firm Financial Intermediaries Commercial banks are the most important financial intermediaries Take deposits from households firms and invest most of those deposits by either making loans to households and firms or by buying securities such as government bonds or securitized loans Both households and firms rely on banks to help them with their financial needs Making the Connection Collateral If a borrower fails to pay back the loan the bank could sell the item put down It is costly for investors to gather information on small businesses these businesses cannot sell stocks and bonds and must rely instead on loans from banks Large banks typically have fixed guidelines for granting loans that left little room for the personal judgment traditionally exercised by loan officers of small banks Nonbank Financial Intermediaries Insurance Companies o Specialize in writing contracts to protect their policyholders from the risk of financial losses associated with particular events such as auto accidents o Collect premiums from policyholders which the companies then invest to obtain funds necessary to pay claims to policyholders and to cover costs Pension Funds o Invest contributions from workers and firms in stocks bonds and mortgages to earn the money necessary to pay pension benefit payments during workers retirements o Important source of demand for financial securities Mutual Funds o Obtains money by selling shares to investors o Then invests the money in a portfolio of financial assets stocks and bonds typically charging a small management fee for its services o Savers reduce the costs they would incur if they were to buy many individual stocks and bonds o Willing to buy back their shares at any time which provide savers with easy access
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