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FIN 3244 Study Guide Chapter 1 The purpose of the financial system is to move money between lenders anyone who provides money and borrowers 3 financial assets Debt securities bonds borrowing Equity securities stocks ownership in a company Securitized loans mortgage backed securities TRADEABLE o Securitized loans were one of the main issues that led to the economic crisis of 2007 Financial markets trade directly buying share of stock DIRECT INVESTING Financial intermediaries intermediary in between never know what the bank intermediary does with your money banks invest do other stuff with your money when you deposit because they have to make money as well all take money in to move money from savers to borrowers INDIRECT INVESTING Banks Mutual funds pool funds from individuals and use those funds to invest Pension funds intended for retirement Hedge funds privately traded funds limited to no more than 99 investors larger sums of money use money to invest in other things Insurance firms use premiums we pay to invest in whatever they want so they make money and also to pay claims Investment banks don t take deposits Equity what you could get back for an asset what you owe to the bank Who participates in the financial system Individuals the primary source of funds government businesses Individuals both borrow and lend Don t need to know but Derivative markets are the right to buy sell something in the future for a price established today Key services Risk sharing spreading or transferring risk through o Insurance have the insurance company take on a portion of our risk the more we risk we have the bigger premium we are going to pay o Diversification investing in more than one stock hoping for a better return in case one doesn t go as planned o Hedging reduces risk ex playing roulette you think it will land on red so you put a lot on red but in case it doesn t hit red you put a little bit on black to make sure you don t lose a lot if your premonition of red is incorrect Liquidity speed and ease with which an asset can be converted to cash relative term this is a characteristic of an asset needs a reference point must be at a reasonable price you could easily sell any house for 5 Information the collection and communication of facts about borrowers and expected returns makes lenders more willing to lend funds and borrowers more willing to borrow them Main government regulators Federal Reserve the fed MONETARY POLICY NOT FISCAL POLICY o The central bank of the US o Lender of last resort o Conductor of monetary policy manages money supply and interest rates less money higher price of money higher interest rates more money lower price of money lower interest rates o She won t ask the details of what makes up the FED o Does not deal with individuals the interface between the government and the individual banks banks can go to the FED in problems of illiquidity ex if all depositors want their money back at the same time o Has a tricky balancing act o Non political it is there to help the US economy remain stable and reliable o Doesn t deal with fiscal policy that is the treasury they assist with setting the budget and collecting taxes the FED has nothing to do with that Securities and exchange commission SEC regulates the financial markets make all the rules that try to keep the markets running efficiently and effectively FDIC insures deposits in commercial banks only other financial intermediaries don t have insurance Terminology and Usage Direct versus indirect investing direct investing is giving money to a company or stock directly bond stock derivative markets indirect is giving money to a bank or hedge mutual pension funds and they invest your money so they can make money themselves Securitization Inflation increase in prices and fall in the purchasing power of money Risk the chance that returns will be other than expected happens in finance as well as everything we do ex stock return risk and crossing the street not in a crosswalk risk return has a lot to do with the individual Opportunity cost potential returns from other possible investments Debt versus equity debt is borrowing money with interest equity is buying Insurance premium price you pay to have them insure you Borrowers versus lenders borrowers borrow money lenders provide ownership stock money Liability Asset Proprietary owner of something Interest the cost of money Can vary with Chapter 2 o Inflation cost of something rises without any improvement in the product itself o Money supply remember this is controlled by the FED o Economic and political stability uncertainty o Potential returns from other investments possible opportunity cost o Economic environment o Default risk of person receiving loan person might not return or pay back loan o How much the loan is secured o Length of loan Time Value of Money money received today is worth more than money received in the future o Ex 100 today or 100 one year from now You would take it today because there is no opportunity cost at the moment because you have it and can spend it now no default risk and no concern about inflation You would need a larger amount in the future Present value of money o PV FV 1 interest rate raised to the number of years Future value of money the value of an investment made today is expected to increase in the future as a result of o Interest earned on the investment o FV PV 1 interest rate raised to the number of years Compounding occurs when interest is earned on interest o Ex Invest 1000 8 annually for 2 years Year 1 1000 08 80 interest earned the first year Year 2 1080 08 86 40 interest earned the 2nd year 6 40 compounded interest earned in 2nd year off the 80 earned off interest in the first year Basically it is the extra money you receive based on the interest you receive the year prior o Can always just do 1000 1 08 raised to the year you are looking for o Compounding is an exponential function o More frequent compounding increases the interest earned o Ex Compounding 100 8 annually versus semiannualy versus quarterly Annually 100 1 08 108 Return 108 100 8 100 8 return Semiannully Quarterly 100 1 04 104 1st 6 months 104 1 04 108 16 2nd 6 months Return 108 16 100 8 16 100 8 16 Return 100 1 02 102 1st quarter 102 1 02 104 04 2nd quarter 104 04 1 02 106 12 3rd quarter 106 12 1 02 108 24 4th quarter Return 108 24 100 8 24 100 8 24 return Discounting the opposite of compounding starting with a future value to find the present value in terms of


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FSU FIN 3244 - Study Guide

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