FIN3244 Exam 1 Study Guide ALSO REVIEW THE ASCENT OF MONEY VIDEO WE WATCHED IN CLASS NOT SURE IF IT IS ON TEST Chapter 1 The purpose of the financial system is to move money between lenders and borrowers o Financial Institutions 3 Part systems Indirect ex Banks Insurance Companies Pension Funds and Mutual Funds The flow is indirect because the funds the bank lends you come from people who have put money in checking or saving deposits in the bank in that sense the bank is not loaning its own funds directly to you Also known as financial intermediaries Commercial Banks are the most important financial intermediaries because most people rely on borrowing bank money on big ticket items such as cars or homes Firms rely on bank loans to meet their short term needs for credit Nonbank Financial Intermediaries Insurance Companies Specialize in writing contracts to protect their policy holders from the risk of financial losses associated with particular events such as a fire or accident Pension Funds Invest contributions from workers and firms in stocks bonds and mortgages to earn the money necessary to pay pension benefit payments during workers retirements Mutual Funds Obtains money by selling shares to investors The mutual fund then invests the money in a portfolio of financial assets such as stocks and bonds typically charging a small management fee for its services Hedge Funds Similar to Mutual Funds but have no more than 99 investors Hedge funds typically make riskier investments and charge higher fees to investors Investment Banks Concentrate on providing advice to firms issuing stocks and bonds or considering mergers with other firms They also engage in underwriting in which the guarantee a price to a firm issuing stocks or bonds and make a profit by selling the stocks or bonds at a higher price o Financial Markets 2 Part systems Direct ex Stock Market Bond Market Foreign Exchange Market and Derivative Market The flow is direct finance because the funds are flowing directly from you to the firm Today most securities trading take place electronically between dealers linked by computers and is referred to as Over the Counter trading Primary Markets Stock bonds and other securities sold for the first time Secondary Markets Financial Market where investors buy and sell existing securities Key Components of the Financial System o Equity Securities Usually stocks which are financial securities that represent partial ownership of the firm Stock owners are usually paid out in the form of quarterly dividends o Debt Securities Usually bonds financial securities are issued by a firm or government to borrow money that represents a promise to repay a fixed amount of money o Securitized Loans Loans that are tradable in the financial market Securitized loans provide all three key financial services Key services of the financial system Risk is the chance that returns will be other than expected o Risk Sharing A service the financial system provides that allows savers to spread and transfer risk Makes savers more willing to buy stocks bonds and other financial assets The willingness increases the ability of borrowers to raise funds in the financial system o Liquidity The ease with which an asset can be exchanged for money More liquid assets stocks bonds etc can be quickly and easily exchanged for money while less liquid assets cars machinery real estate can be exchanged for money only after a delay or by incurring costs Savers are willing to accept lower interest rates on assets with greater liquidity which reduces the costs of borrowing for many households and firms o Information Facts about borrowers and about expectations of returns on financial assets Includes data collection and communications about borrowers and returns Main Government Regulators o The Federal Reserve Also known as The Fed is the central bank of The United States It was initially created to be a lender of last resort and make short term loans but due to The Great Depression and the evolution of the economy it is now responsible for monetary policy Managing high employment levels low inflation rates high rates of growth and stabilizing the financial system The Fed is divided into 12 districts each having its own district bank o The Securities Exchange Commission SEC which regulates financial markets o The Federal Deposit Insurance Corporation FDIC which insures deposits in banks with a limit of 250 000 per account The Financial Crisis of 2007 2009 o Housing Bubble of 2000 2005 Bubble is an unsustainable increase in the price of a class of assets such as stocks issued by high tech companies oil and other commodities or houses The origins of the financial crisis of 2007 2009 lie in this housing bubble Because more people wanted to be homeowners mortgages were the first loans to be widely securitized By early 2006 lenders had greatly loosened the standards for obtaining a mortgage loan allowing people with flawed credit history to be issued mortgages and loans Basically people who had taken out mortgages and bought homes could no longer make the payments because the expected rise in the housing market and the lesser chance to default was completely false This led to the mortgage companies going under and loads of houses to be foreclosed on Chapter 2 Interests Rates and rates of return o Interest is the cost of money it compensates for inflation price rising default risk the chance that the borrower will not pay back the loan and opportunity costs which is the value of what you have to give up to engage in an activity The interest rate is important to all aspects of the financial system because of the following key fact Most financial transactions involve payments in the future o Time Value of Money The way that the value of a payment changes depending on when the payment is received A dollar today is worth more than a dollar received in the future Compounding the process of earning interest on interest as savings accumulate over time o Future value The value at some future time of investment made today Suppose that you deposit 1000 dollars in a bank certificate of deposit CD that pays an interest rate of 5 What will be the future value of this investment 1000 1000 x 05 1050 1000 X 1 05 1050 Principal x 1 i FV after 1 year o Compounding for more than one period Refer to same problem but you decide to Suppose you earned 25 interest the first year and 1 in the second and reinvest for another year 1000 x 1 05 2 1102 50 Principal x
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