Finance is all about getting the proper return for the level of risk you re willing to take because no one knows the future FIN3244 Chapter 1 3 with absolute certainty Chapter One The Financial System The purpose of the financial system is to move money between lenders and borrowers if money sits it becomes in risk of inflation furthermore losing value It is highly regulated because when left largely alone the financial system has experienced periods of instability that have led to economic recessions o Financial Assets Asset anything of value owned by a person or firm Financial Asset an asset that represents a claim on someone else for a payment i e money Security a financial asset that can be bought and sold in a financial market something that is tradable in the market place Money moves through financial markets and financial intermediaries o Financial Markets a place or channel for buying or selling stocks bonds and other securities i e New York Stock Exchange Invest trade directly one party lends directly to the other party requires financial markets Incurs more risk less liquidity and more information costs Primary vs Secondary Market Primary a financial market in which stocks bonds and other securities are sold for the first time Secondary a financial market in which investors buy and sell already existing securities Stock market Bond market Stock financial securities that represent residual ownership of a firm also called equities hence equity securities Shareholders help increase the funds available financial capital to the firm firms keep some of the profits in retained earnings and pay the remaining in the form of dividends Houses tend to have more savings in stocks rather than bonds because while stocks may be more risky they also tend to have a higher rate of return in the longer run Bond a financial security issued by a corporation or a government that represents a promise to borrow a fixed amount of money they re debt securities short vs long term bonds o Examples include government treasuries and corporate bonds Interest rate the cost of borrowing funds or the payment for lending funds usually expressed as a percentage of the amount borrowed o High interest rates represent the risk involved in lending money to people with poor credit I E people borrow from pawnshops because they don t have access to this credit o Imposing a ceiling of certain rates can help people by preventing high interest rates from trapping them in a cycle of debt but at the same time they don t have access to high risk loans loans that are tradable can be bought sold in financial markets Securitization the process of converting loans and other financial assets that are not tradable into securities Mortgage backed security new basis of security in which bank granted mortgages are bundled together with similar mortgages granted by other banks o Makes renegotiating loans more difficult because they are owned by multiple investors as opposed to a single owner like the bank Expensive reduces the liquidity of the MBS o A marketplace for mortgages allows banks to transfer the risk of holding the loans to others when the mortgages are sold banks can offer lower interest rates than if they held them themselves Securitized Loans Other markets derivatives commodities foreign exchange currency market futures option o Financial Intermediaries entities between the buyer and the seller Trade indirectly 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 involves financial intermediaries Commercial banks bank savings loans credit unions Banks provide credit to households and businesses Putting money in the bank 1 increases liquidity 2 decreases risk 3 decreases information costs because it allows you to withdraw your money when needed transfers the risk of default to the bank and eliminates your need to evaluate loans 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 shutdown would damage economic growth and the number of jobs available to individuals Bad Lending refers to lending to borrowers with flawed credit histories or otherwise have difficulty repaying loans lending to borrowers with an unacceptable risk of loan default Can obtain credit from credit cars borrowing from family members or pawnshops and receiving microloans Investment banks No FIDC if something goes wrong you re on your own Does not take deposits Mutual funds obtains money by selling shares to investors which are then invested in a portfolio of financial assets i e stocks and bonds typically charging a small management fee for its services Pension funds invest contributions from works and firms in stocks bonds and mortgages to earn the money necessary to pay pension benefit payments during workers retirements Hedge funds accept money from investors and use the funds to buy a portfolio of assets typically has no more than 99 investors Riskier investments As the stock market goes up so does money Insurance companies Get money through premiums which they invest to obtain the funds necessary to pay claims to policyholders and cover their other costs channel funds from savers to borrowers Small Intermediaries o System Participants Individuals households retail investors main provider into system Businesses corporations firms Large corporations tend to have more access to bond and credit markets and greater cash on hand than smaller businesses Government federal state local receive money from tax payers Key Services provided by the financial system that increase the willingness of individual business and governments to lend and borrow money o Risk Sharing the spread or transfer of risk everything is a tradeoff helps share risk with others as savers are more willing to invest Money continuously flowing Investor risk the likelihood that you won t receive your expected future return on investment aka uncertainty With greater risk comes greater reward money higher return Would you buy a stock if you didn t have an intention of reselling it Capital gains the difference between what you paid for a security and what you sell it for The risk return trade off i e lottery ticket example everything depends on circumstance Lets investors choose the level of risk they re willing to accept Diversification splitting wealth among may different
View Full Document
Unlocking...