CHAPTER 1 Financial System Parts 1 Money a Assets used to pay for purchases b Store of wealth c Medium of exchange 2 Financial Instruments a Used to transfer wealth from savers lenders to investors borrowers to transfer risk to those best equipped to bear it b Securities Stocks Bonds 3 Financial Markets a Allow us to buy sell financial instruments quickly and cheaply b Funds are transferred from people who have an excess of available funds to people who have a shortage of funds 4 Financial Institutions a Firms that provide access to financial markets b Commercial banks insurance companies finance companies pension funds mutual funds and investment banks 5 Central Banks a Monitor and stabilize the economy b Monitor financial institutions c Federal Reserve Benefits of A Well Functioning Financial System Promotes economic efficiency o Facilitates payments Commercial bank checking accounts o Channel funds from Savers Borrowers o Enable risk sharing insurance and forward markets Bond Market Interest Rates Bond debt instrument security that promises to make payments periodically for a specified period of time Security claim on issuer s future income assets FI Interest Rate cost of borrowing Price paid for the rental of funds expressed as a percentage Stock Market Common Stock represents a share of ownership in a corporation An equity security financial instrument is a claim on assets and earnings of the corporation Residual clam Firms can issue new shares to finance investment spending Financial Institutions Banking Financial Intermediaries institutions that borrow funds from people who save and then make loans to other people Commercial Banks accept deposits and make loans Others insurance companies finance companies pension funds mutual funds and investment banks Money Real Economic Activity Money plays an important role in generating business cycles Recessions expansions in economic activity Monetary theory ties changes in the money supply to changes in aggregate economic activity the price level Money Inflation Pt P t 1 Pt Aggregate Price Level the average price of goods and services in an economy Continual rise in the price level is inflation and affects all economic players Connection between growth in supply and the rate of inflation Money Interest Rates Before 1980 rate of money growth and the interest rate on long term Treasury bonds were closely tied Since then relationship is less clear but the rate of money growth is still an important determinant of interest rates Federal Reserve System FOMC Federal Open Market Committee Federal Funds Federal Funds Rate Discount Loan Discount Rate Open Market Operation OMO Quantitative Easing QE 1 2 and 3 Large Scale Asset Purchase MBS Money Market Capital Market Shadow Banking System The US central bank 1913 Board of governors with 12 regions Directs engage in open market operations Buy Sells US Government Bonds Banks can borrow for each other in federal funds market The interest rate on loans in federal funds market That are required to hold loan Loans given to banks from the federal reserve Interest rate given to banks from the federal reserve Buying and selling US government bonds and mortgage bonds MBS Current reserve policy to buying back bonds Capital Market Buying and selling LTB Formal name for quantitative easing Mortgage backed securities Bonds attached to mortgage payments Financial instrument that matures in less than a year debt traditionally federal reserve Any financial instrument that matures greater than a year debt equity Unregulated financial institutions that engage in banking activities Federal reserve CHAPTER 2 OVERVIEW OF THE FINANCIAL SYSTEM Function of Financial Markets Channels funds from economic players that have a surplus of funds savers to those that have a shortage of funds borrowers Improve the well being of consumers by allowing them to time purchases better Allow spending in excess of income now with a loan to be paid off out of future income Segments of Financial Markets Direct Finance borrowers borrow directly from lenders in financial markets by selling financial instruments claims on the borrower s future income assets Indirect Finance borrowers borrow indirectly from lenders via financial intermediaries established to source loanable funds and loan opportunities by issuing financial instruments claims on the borrower s future income assets Types of Financial Instruments Securities give the owner a claim on the issuer s assets of future payments Loans give borrowers funds today in return for future payments o Simple Contracts o Negotiable can re sell o Used in Direct Indirect Finance o Complicated Contracts o Non negotiable Collateral Covenants o Used in Indirect Finance World W O Financial Intermediaries Flow of funds from net savers net borrowers is likely to be low World W Financial Intermediaries Function of Financial Markets Indirect Finance Involves Asset Transformation Assets Something of value you own Left Side Liabilities Something of value you owe Right Side Net Worth Assets Liabilities Indirect Financial Institution Commercial Bank Asset Transformation banks issue liabilities and use the proceeds to purchase assets Money Transformation bank liabilities are short term Indirect Financial Institution Insurance Company Asset Transformation Insurance companies issue liabilities and use the proceeds to purchase assets Sell the liabilities and use the money they made to buy assets Direct Finance Activities IPO Stock Corporation selling bonds to public Corporation issuing commercial paper to public Bowie Bonds Structure of Financial Markets 1 Debt Markets 2009 52 4 Trillion a Short Term Mat 1 yr b Long Term Mat 10 yrs c Intermediate Term Mat 1yr X 10yrs 2 Equity Markets 2009 20 5 Trillion a Pay Dividends b Represent ownership claim of firm 1 Primary Markets 2 Secondary Markets a New security issues sold to initial buyers b Involves investment bank that underwrites offering a Exchanges trades conducted in central locations b OTC Markets Dealers at different locations that buy and sell Market for treasury securities c Functions Because buying selling doesn t make company money i Provides liquidity making it easy to buy and sell securities of a company ii Establishes a price for the security 1 Money Market Short term Maturity 1 yr 2 Capital Market Long term Maturity 1 yr Indirect Finance Lower Transaction Costs and sales costs o Most are fixed costs Provide Liquidity Services o Checking accounts o