CHAPTER 1 Introducing Money and the Financial System I Key Components of the Financial System a Financial Assets i Asset Anything of value owned by a person or a firm ii Financial asset a financial claim 1 Security is tradable and can be bought and sold in a financial market 2 Non security not tradable b Financial Institutions c The Federal Reserve and other financial regulators Financial Assets a Money anything that people are willing to accept in payment for goods and services or to pay II off debts markets i The money supply is the total quantity of money in the economy b Stocks Equities represent partial ownership of a corporation and can be sold in financial i As an owner of a share of stock in a corporation you have a legal claim to a share of the corporation s assets and to a share of its profits ii Dividend payments corporations typically make every quarter c Bonds a financial security issued by a corporation or government that represents a promise to repay a fixed amount of money and can be sold in financial markets i Interest rate the cost of borrowing funds or the payment for lending funds expressed as a percentage of the amount borrowed 1 Coupons fixed dollar amount interest payments on bonds ii Short term bond matures in a year or less iii Long term bond matures in more than one year d Foreign exchange units of foreign currency i Most important buyers and sellers of foreign exchange are large banks e Securitized loans loans that banks can sell in financial markets i Mortgage backed security a bundle of mortgages that function like a bond ii Securitization the process of converting loans and other financial assets that are not tradable into securities III Financial Institutions a The financial system matches savers and borrowers through two channels i Banks ii Other financial institutions b These two channels are distinguished by how funds flow from savers or lenders to borrowers and by the financial institutions involved i Direct finance funds flow directly from savers lenders to borrowers ii Indirect finance funds flow indirectly from savers lenders to borrowers by means of financial intermediaries such as a bank c Financial Intermediaries i Commercial banks are the most important financial intermediary 1 They are a financial firm that takes in deposits from savers and lends them to borrowers via loans 2 Commercial and industrial loans banks make these types of loans to small businesses for fairly short periods of time a To bridge the gap between when firms must make payments to employees and suppliers and when they receive revenue from selling their products 3 Real estate loans banks make these loans to allow firms to construct or purchase office buildings factories and shopping malls 4 Nonbank financial intermediaries are legally distinct from banks but operate in a similar way by taking in deposits and making loans a Insurance companies collect premiums from policyholders which companies then invest to obtain the funds necessary to pay claims to policyholders and to cover their other costs b Pension funds invest contributions from workers and firms in stocks bonds and mortgages to earn the money necessary to pay pension benefit payments during workers c Mutual funds obtains money by selling shares to investors invests the money in a portfolio of financial assets i Portfolio a collection of assets such as stocks and bonds d Hedge funds i Similar to mutual funds but usually has no more than 99 investors all of whom are wealthy individuals ii Typically make riskier investments and charge much higher fees than mutual funds e Investment banks concentrate on providing advice to firms issuing stocks and bonds or considering mergers with other firms i Underwriting guaranteeing a price of a stock to a firm issuing stocks or bonds and the make a profit by selling the stocks or bonds at a higher price ii Proprietary trading occurs when a trader trades stocks bonds currencies commodities their derivatives or other financial instruments with the firm s own money as opposed to depositor s money so as to make a profit for itself d Financial Markets are places or channels for buying and selling stocks bonds and other securities and can be physical or virtual places i Primary market a financial market in which stocks bonds and other securities are sold for the first time 1 Initial public offering IPO the first time a firm sells its shares to the public ii Secondary market a financial market in which investors buy and sell existing securities e The Federal Reserve and Other Financial Regulators i The Securities and Exchange Commission SEC regulates financial markets ii The Federal Deposit Insurance Corporation FDIC insures deposits in banks iii The Office of the Comptroller of the Currency regulates federally chartered banks iv The Federal Reserve System the central bank of the United States 1 The lender of last resort 2 Monetary Policy the actions of the Federal Reserve takes to manage supply and interest rates to pursue macroeconomic policy objectives a Federal Funds Rate the interest rate that banks charge each other on 3 Federal Open Market Committee FOMC the main policymaking body of the short term loans Fed a Consists of seven members and they meet 8 times a year to decide on what the federal funds rate will be IV What Does the Financial System Do a Three key services the financial system provides to savers and borrowers i Risk Sharing you expect 1 Risk the chance that the value of financial assets will change relative to what 2 Diversification the splitting of wealth into many assets 3 The financial system provides risk sharing by allowing savers to hold many ii Liquidity the ease with which an asset can be exchanged for money 1 Assets created by the market such as stocks bonds or checking accounts 2 The process of securitization has made it possible to buy and sell securities assets based on loans iii Information facts about borrowers and expectations of returns on financial assets 1 Financial markets convey information to both savers and borrowers by determining the prices of stocks bonds and other securities V The Housing Bubble a Freddie Mae and Freddy Mac sell bonds to investors and use the funds to purchase mortgages from banks b By the 2000 s important changes had taken place i Investment banks became significant participants in the secondary market for mortgages ii By the height of the housing bubble 2005 2006 lenders had greatly loosened the standards for
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