Chapter 1 The Financial System The purpose of the financial system is to move money between lenders and borrowers Financial assets for discussion Debt securities bonds Equity securities stocks Securitized loans mortgage backed securities Financial Markets Financial Intermediaries Banks commercial savings loans credit unions Nonbank financial institutions Investment Banks Firms Mutual Funds Pension Funds Hedge Funds Insurance Firms System participants Individuals households retail investors Businesses corporations firms Government federal state local Key services provided by the financial system Risk sharing is the spread or transfer of risk Diversification Insurance Hedging Liquidity Speed ease with which an asset can be converted to cash At a reasonable value A characteristic of an asset Liquidity is a relative term Information is the collection and communication of facts about Borrowers Expected returns Main government regulators Federal Reserve The Fed Central bank of the United States Lender of last resort Conductor of monetary policy as opposed to fiscal policy Securities Exchange Commission SEC Regulates the financial markets Federal Deposit Insurance Corporation FDIC Insures deposits in commercial banks Terminology and usage Direct versus indirect investing Securitization Inflation Risk Opportunity cost Insurance premium Debt versus equity Borrowers versus lenders savers investors Liability Asset Q A Chapter 1 Questions 1 Briefly define equity securities debt securities and securitized loans Equity securities are securities that represent residual ownership in a firm Stock is the most common type of equity security Is it possible for a saver to consider something a financial asset while a borrower considers it to be a financial liability Debt securities are financial securities issued by firms and governments to borrow money In exchange for purchasing debt securities purchasers have a legal rights to principal and interest Government Treasuries and corporate bonds are common types of debt securities Securitized loans are loans that are tradable can be bought and sold in financial markets Yes it is possible that a saver s asset could be a borrower s liability A bond issued by a corporation is a liability to the corporation because it represents a loan that the firm is legally obliged to pay back From the point of view of the saver who buys the bond however the bond is an asset because it represents a financial claim on the corporation that issued the bond The saver investor expects to be repaid his principal and interest at some future date 2 What s the difference between direct and indirect finance Which involves financial intermediaries and which involves financial markets With direct finance one party lends directly to the other party Buying the stock of a firm s IPO is direct financing Direct financing requires financial markets Indirect finance involves three parties the borrower the lender and the financial intermediary who accepts the savings of Party 1 and independently lends those savings to Party 2 A bank exemplifies indirect finance because it accepts deposits from savers and lends the funds to borrowers Indirect finance involves financial intermediaries 3 Briefly explain why the financial system is one of the most highly regulated sectors of the economy The financial system is highly regulated because when left largely alone the financial system has experienced periods of instability that have led to economic recessions 4 What is the Federal Reserve What are its current responsibilities How do these compare to those of the U S Treasury Department The Federal Reserve is the central bank of the United States The president appoints the members of the Board of Governors with the consent of the Senate The Federal Reserve s initial responsibility was to act as a lender of last resort As the financial system and banking system have evolved the Fed s role has expanded from being a lender of last resort to include the conduct of monetary policy to manage inflation unemployment and the stability of the financial system The U S Treasury is concerned with fiscal policy This involves taxing budgeting and spending It is the Treasury that physically prints currency 5 Briefly describe the 3 key services that the financial system provides to savers 1 Risk sharing allows investors to diversify spread and transfer their risk The ability to do this makes savers more willing to invest 2 Liquidity the speed and ease with which an asset can be converted into cash at a reasonable amount 3 Information includes data collection and communication about borrowers and return expectations on financial assets 6 What do economists mean by a bubble A bubble is an unsustainable increase in the price of a class of assets Many economists believe there was a housing bubble in the U S between 2000 and 2005 7 By the 2000 s what significant changes had taken place in the mortgage market Mortgages were regularly packaged together into mortgage back securities MBS and sold to investors through financial markets Additionally mortgage lenders greatly loosened their lending standards for obtaining a mortgage 8 What problems did the decline in housing prices that begun in 2006 cause for the financial system Declining housing prices caused mortgage backed securities to lose value This caused losses for the investment institutions that owned them Application Problems 1 When I pay insurance premiums I don t get any of my money back When I deposit money in the bank I can always withdraw it Therefore the bank is a financial intermediary but the insurance company is not Do agree with this statement Why No Insurance companies specialize in contracts to protect their policy holders from the risk of financial loss They invest the insurance premiums collected in stocks bonds and mortgages Since they channel funds from savers to borrowers insurance companies are financial intermediaries 2 Ultimately in this country we rise and fall together banks and small businesses consumers and large corporations Why are banks singled out from among other types of businesses such as grocery stores and computer firms for greater regulation Banks are singled out because of their importance as financial intermediaries in the economy They provide credit to households and businesses Without bank loans to pay for inventories help meet payrolls and fund long term capital projects many businesses would have to cut back on operations or
View Full Document
Unlocking...