Chapter 1 The Financial System Purpose of fin system move money between lenders borrowers Lenders put money into the system savers Borrowers use excess money that lenders have and put it to a purpose the will create additional money necessary because that s the cost for borrowing the money Lends it to make investment The three major components of the financial system financial assets financial institutions the Reserve and other financial regulators Asset anything of value owned by a person or a firm Financial assets a financial claim which means that if you own a financial asset you have a claim on someone else to pay you money Five key categories of assets 1 Money anything that people are willing to accept in payment for goods and services or to pay off debts corporation a Money supply total quantity of money in the economy 2 Stocks also called equities financial securities that represent partial ownership of a a When you buy a stock you become a shareholder of that stock b Selling ownership of the company increases its financial capital c Dividend a payment that a corporation makes to its shareholders 3 Bonds financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money a Bonds can be bought and sold so they are securities b Interest rate the cost of borrowing funds or the payment for lending the funds usually expressed as a percentage of the amount borrowed c Bonds that mature in a year are short term bonds d Bonds that mature in more than one year are long term bond 4 Foreign exchange units of foreign currency a Most important buyer sellers are large banks b To buy or sell product from or to a foreign country you must first exchange the U S dollars for the other currency 5 Securitized loans the process of converting loans and other financial assets that are not tradable into securities a Loans are financial assets not securities b Loans that banks could sell financial markets became securities so the process of converting loans into securities is known as securitization c What a saver views as a financial asset a borrower views as a financial liability a financial claim owed by a person or firm i Ex Car loan loan is an asset from the viewpoint of the bank but a liability to you o Debt securities bonds most typical type of financial debt we have borrowing If you are borrowing the money the debt is not an asset it is a liability For the investor who lends the money to the borrower it is an asset because they are expecting the flow of money to come to them over time Principle interest Whether it is an asset or liability depends on which side of the o Equity securities stocks ownership spectrum you are on Ex What you could get for the house if you sold it today minus what you need to pay back for the house If you paid off your mortgage loan then your house is totally yours and you have 100 of the equity in it The value of the house is going to fluctuate over time When we talk about finance we are ALWAYS talking about the future time and expected returns o Securitized loans mortgage backed securities tradeable Financial system matches savers and borrowers through two channels 1 banks and other financial intermediaries 2 and financial markets Financial Markets different markets where financial instruments stocks bonds and other securities can be sold Can buy directly o Example New York Stock Exchange o Primary market financial market in which securities are sold for the first time which is called an initial public offering IPO o Secondary market investors buy and sell already existing securities Debt market where debt instruments are sold Equity markets stock market Financial Intermediaries a financial firm such as a bank that borrows funds from savers and lends them to borrowers Part of the investment process take money and invest it o Funds flow from lenders to borrowers indirectly o Banks commercial savings loans credit unions Commercial banks are the most important financial intermediaries a commercial bank is a financial firm that serves as financial intermediary by taking in deposits and using them to make loans o Nonbank financial institutions Investment banks pensions mutual funds hedge funds insurance company Investment Banks Firms ex Goldman Sachs and Morgan Stanley o Differ from commercial banks because they don t take deposits and rarely lend directly to households o More concentrated in providing advice to firms issuing stocks and bonds o Also engage in underwriting guarantee a price to a firm and then make a profit by selling the stocks or bonds at higher price o Proprietary trading hope to profit by buying and selling securities Mutual Funds ex Fidelity Investment s Magellan Fund o Obtains money by selling shares to investors o The mutual funds then invests the money in a portfolio of financial assets such as stocks and bonds typically charging a small management fee for its services Pension Funds these funds take investment contributions from workers and firms and invest it in stocks bonds and mortgages to earn the money necessary to pay off pension benefits Hedge Funds ex Quantum Group o Similar to mutual funds but typically has no more than 99 investors all wealthy individuals or institutions o Typically make riskier investments Insurance Firms they collect premiums from policyholders which the companies then invest to obtain the funds necessary to pay claims to policyholders and cover their other costs o Specialize in writing contracts to protect policyholders from risk of financial losses from particular events such as car accidents or fires o Ex When you buy automobile insurance policy the insurance company may lend the premiums you pay to a hotel chain that needs funds to expand System participants o Individuals households retail investors o Businesses corporations firms o Government federal state local Key services provided by the financial system Risk sharing is the spread or transfer of risk a service that the financial system provides that allows savers to spread and transfer risk o Diversification Splitting wealth among many different assets to reduce risk o Insurance o Hedging Liquidity o Speed ease with which an asset can be converted to cash o At a reasonable value o A characteristic of an asset o Liquidity is a relative term Information is the collection and communication of facts about o Borrowers o Expected returns on financial assets Bubble an unsubstantial increase in the price of a class
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