Chapter 1 The Financial System the purpose of the financial system is to move money between lenders and borrowers Financial assets o Debt securities bonds o Equity securities stocks o Securitized loans mortgage back securities Financial Markets trade directly o Stock market o Bond market o Other markets Derivatives Commodities Foreign exchange Financial Intermediaries trade indirectly o Banks commercial savings and loans credit unions o Nonbank financial institutions o Financial institutions Commercial banks Investment banks Mutual funds Pension funds Hedge funds Insurance companies o Smaller intermediaries System participants o Individuals households retail investors o Businesses corporations firms o Government federal state local The Risk Return Trade off The more risk you take the higher the potential return but the less chance of getting it The lower the risk the more likely you ll get the expected return but the lower should be your expectations Risk sharing the spread or transfer of risk o Diversification o Insurance o Hedging Some Definitions Investor risk the likelihood that you won t receive your expected future return on an investment Capital gains the difference between what you paid for a security and what you sell it for o If you sell something for less than you paid for it you have a negative capital gain commonly called a capital Insolvent owing more than you re worth Default failure to pay legal financial obligations Key services of the financial system risk sharing liquidity information They increase the willingness of individuals businesses and governments to lend and borrow money Various financial products provide different levels of service which in turn impacts their level of risk and the potential returns offered Different investors have different expectations and investment goals and desires Key Services of the financial system risk is the chance that returns will be other than expected Risk sharing is the spread and or transfer of risk o Diversification o Insurance o Hedging Liquidity is the speed and ease with which an asset can be converted to cash at a reasonable value characteristic of asset judge by comparison need reference pt spectrum o Liquidity is a relative measure o All things being equal Assets with greater liquidity increase investor s willingness to invest trade Liquidity has value Typically have lower returns than illiquid assets Very liquid cash then mutual funds and stocks Medium art supplies instruments specialty tools then real estates Totally not liquid part ownership in a business or artist co op Information is the collection and communication of facts about borrowers and about expected returns o Borrowers o Investments o Expected returns Main Government Regulators The federal reserves the fed o Central bank of the United States o Lender of last resort o Conducts monetary policy Securities and exchange commission SEC o Regulates the financial markets Federal deposit insurance corporation FDIC o Insures deposits in commercial banks o Terminology and usage Direct versus indirect investing Securitization Inflation Risk Opportunity cost Insurance premium Debt versus equity Borrowers versus lenders savers investors Liability Asset
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