FIN3244 EXAM 1 REVIEW Bold indicates vocabulary words Class Review 1 Borrowers impacted by the financial crisis page 5 Due to the fact that many banks cut small businesses off from their normal source of credit small businesses found themselves borrowing from pawnshops Pawnshops offered interest rates that were nearly 20 times the interest rates of banks in addition pawnshops only gave loans in exchange for collateral in the form of jewelry or other easy to sell property 2 Bank lending impact on community pages 4 35 47 52 53 Most households rely on borrowing money from banks when they purchase big ticket items such as cars or homes Similarly many firms rely on bank loans to meet their short term needs for credit In other words many firms rely on bank loans to bridge the gap between the time they must pay for inventories or meet their payrolls and when they receive revenues from the sales of goods and service In addition some firms rely on bank loans to meet their long term credit needs such as funds they require to physically expand the firm During the Financial Crisis the banks created stricter policies on lending money This restriction of lending is also known as credit rationing It was nearly impossible for small and medium sized businesses to convince banks to lend them money because the risk was far too high Due to default fears banks typically only gave loans to low risk big business that had financial healthy information available to the public In addition households have difficulties borrowing money from banks unless they can provide collaterals 3 Monetary policy page 11 Monetary policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macro policy objectives These policy objectives include high levels of employment low rates of inflation high rates of growth and stability in the financial market 4 Bond market features pages 3 42 47 A bond is a financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money The bond market is an important external fund to corporations This is because bonds reduce the risk of moral hazard the problem investors experience in verifying that the borrowers are using their funds as intended When you buy a bond you only need the firm to make the coupon payments and a final face value payment when the bond matures and a key way investors try to reduce moral hazard in bond markets is by writing restrictive covenants into bond contracts which places limits on the uses of funds that a borrower receives 5 PV and FV calculations page 24 26 Future Value FV formulas are compounding Present Value PV formulas are discounting FV formula for one year PV 1 i FV1 PV 1 i n FVn PV formula for one year PV FV1 1 i FV formula for two or more years PV formula for two or more years PV FVn 1 i n Note I the interest rate and n the number of years Note if there are different interest rates in multiple years you must use the formula for one year For example an interest of 10 in the first year 5 in the second year and 1 in the third year 6 Time value of money concept page 26 Economists refer to the way that the value of a payment changes depending on when the payment is received as the time value of money Funds in the future are worth less than funds in the present because of three reasons Dollars in the future will usually buy less than dollars today Dollars that are promised to be paid in the future may not actually be received There is an opportunity cost in waiting to receive a payment because you cannot get the benefits of the goods and services you could have bought if you had the money today 7 Information transaction costs page 32 33 Transaction costs the cost of a trade or exchange for example the brokerage commission charged for buying or selling a financial asset Information costs the costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired Example using both costs You would think it is so much simpler to just bring savers and borrowers together to make a deal lending money that would benefit both instead of banks for instance lending savers money to borrowers Well that s not the case The financial system is far more complex Let s suppose you had 500 to invest If you invested in a stock your commissions will be relatively high transaction cost defeating the purpose of making money Let s assume you wanted to buy a bond from Microsoft but the bond s face value is 1000 transaction cost you clearly lack the money to buy the bond So we ll assume you re having no luck in the financial market Conveniently your friend needs 500 to develop an app But how do you know he s actually good at developing apps information cost to find out How do you know he ll even pay you back if you have absolutely no knowledge of his credit history information cost to find out Then you discover another problem Your friend in law school 8 Adverse selection page 33 37 tells you that to draw up a contract spelling out the terms of the loan would cost you 300 transaction cost which is more than half of your investing money You decide to forget about investing your 500 which is bad news for you and your app developing friend The problem investors experience in distinguishing low risk borrowers from high risk borrowers before making an investment in insurance the problem that those most likely to buy insurance are also most likely to file a claim George Akerlof was the first economist to analyze this problem Akerlof s example of adverse selection the seller of a used car will have more information on the true condition of the car than the potential buyer Car dealers act as intermediaries between used car buyers and sellers To find the expected value of a used car Expected value probability car is good value if good probability car is a lemon value if a lemon Congress established the SEC to regulate the stock and bond markets in an attempt to reduce adverse selection Lenders often require borrowers to pledge some of their assets as collateral which the lender claims if the borrower defaults in order to reduce adverse selection problems Lenders can also reduce the chance of adverse selection by restricting their lending to high net worth firms firms with a higher value in assets than liabilities Banks can also reduce the chance of adverse selection because of the information advantage they gain from relationship banking 9 Bank
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