The financial system Chapter 1 The purpose of the system is to move money from those with excess funds to those with a use for them Entities with excess funds are investors speculators etc Ones with the use are borrowers sellers etc Money can move through The financial markets Financial intermediaries o Move money directly Buyers and sellers know exactly what they are buying and selling Financial markets are where financial assets are bought and sold Common examples include the stock markets and the bond market but there are also markets for derivatives commodities and foreign exchange o Indirectly They do more than facilitate trade they decide where the money will be invested The investor gives up a degree of control over their investment because they don t know exactly which stocks are bought and sold Sometimes you don t even realize your money is being invested such as depositing in a bank or premiums from an insurance policy They have to invest to make money to pay their business expenses Financial institutions include commercial banks investment banks mutual funds pension funds hedge funds and insurance companies Smaller ones include pawn brokers too They move money around the financial system Interest is the cost of using the money Participants in the financial system who is putting the money in or taking it out include households or individuals businesses and the government Households contribute by depositing in banks savings account etc They borrow through student loans and mortgages Businesses frequently borrow money to expand repurchase shares buy other businesses etc but they also create jobs providing funds to employees and contribute to charities which add to the system The government receives most funds through taxes which pay for all of the government s expenses But it also issues treasury bonds which is a type of borrowing Overall government and businesses are net users of funds while households and individuals are net suppliers of funds These sources are often supplying funds in one aspect while borrowing funds in a different aspect These groups can overlap The financial markets themselves are also businesses that borrow and supply money There is considerable amount of exchange between the financial markets and financial intermediaries Risk and liquidity The financial system evolved to provide services that both borrowers and savers lenders or investors needed Investor risk the likelihood that you won t receive your expected future return on an investment The borrower does not return what was promised or with equity when ownership is purchased the corporation doesn t provide the anticipated capital gains Capital gains the difference between what you paid for a security and what you sell it for When you take more risk the potential return is higher but there is less change of getting it On the other hand if you are the borrower and are perceived to be more risky you will have to offer a higher return for someone to invest The risk return tradeoff is the fact that taking on more risk gives a higher potential return but a smaller chance of actually getting it An example of this is the lottery because there is a huge risk of losing that dollar you spent on the lottery ticket but there could be a huge return if you actually win it Consequently a lower risk would make the expected return more likely but your expectations would have to be lower An example of this is putting money in the bank because you know it s gonna stay in there but you will only get a little bit of interest Finance is all about uncertainty because it s about future events Finance is about getting the proper return for the level of risk you are taking Risk sharing the spread or transfer of risk diversification This includes putting some money in stocks and some in the bank or putting your money in different kinds of stocks etc Not putting all of your eggs in one basket Risk sharing is one of the key services the financial system has to offer By investing in firms that have different levels of risk the amount of risk our investment has will average out We won t get the highest amount of return this way but we ll get something better than a low return The average will be higher than the return on one stock but lower than the return on another Mutual funds contain numerous assets so buying one share of a mutual fund will give you the overall risk and return of all of their investments This is also the case for pensions hedge funds etc Most people don t even know what insurance companies are investing in but it doesn t matter if they are still able to meet all of their financial obligations remaining solvent We are paying them to assume some level of risk in our lives Hedging risk reducing scenario An example if you are betting on red and black You think the ball will land on red so you put most of your money on red but you put some on black If what you expect to happen happens you lose that little bit of money but you still have the rest If what you don t expect to happen happens you lose most of the money but not all of it Liquidity if you sell something for cash quickly and it doesn t lose value when you sell it it s liquid Cash is the most liquid money in savings then most stocks bonds and mutual funds Things like houses and obscure stocks aren t liquid Sometimes things are so rare or expensive that buyers are hard to find or it s complicated like a family business Sometimes there is a buyer but they don t want to pay what you think is fair Liquidity is a characteristic of an asset that describes the speed and ease with which an asset can be converted to cash at a reasonable value This characteristic is not specific to one transaction but all similar assets Liquidity is a relative measure the spectrum ranges from cash in hand cash at bank notes receivable debtors inventory office equipment plant and machinery building and land Assets with greater liquidity increase investors willingness to invest trade Liquidity has value and typically liquid assets have lower returns than illiquid assets Information and government regulators While risk sharing lets an investor choose the level of risk he s willing to accept and liquidity increases the likelihood an investor can exchange his investment at a fair price for cash when he wants to information provided by the financial system is the basis of which investors form their future investment expectations about what to buy what to sell and what to hold
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