ECON 102 1st Edition Lecture 21 Outline of Last Lecture I Outline of Current Lecture II The Financial System a Terminology b Financial Fluctuations Current Lecture Financial System Terminology A household s wealth is the value of its accumulated savings Financial Asset A paper claim that entitles the buyer to future income from the seller Physical Asset A claim on a tangible object that gives the owner the right to dispose of the object as he or she wishes Liability A requirement to pay income in the future Transaction Costs The expenses of negotiating and executing a deal o Not just financial includes time and people running the deal etc Financial Risk Uncertainty about future outcomes that involve financial losses and gains Three Tasks of Financial System o Reducing transaction costs o Reducing financial risk To lower risk an individual can engage in diversification by investing in several different things so that the possible losses are independent events o Providing liquid assets assets that can be quickly converted into cash in contrast to illiquid assets which can t Four main types of financial assets o Loans o Bonds IOU with fixed interest maturity date o Stocks Share in the ownership of a firm o Bank Deposits In addition financial innovation has allowed the creation of a wide range of loan backed securities Loan A lending agreement between a particular lender and a particular borrower These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute Default This occurs when a borrower fails to make payments as specified by the loan or bond contract A financial intermediary is an institution that transforms the funds it gathers from many individuals into financial assets o Mutual Fund This creates a stock portfolio and the resells shares of this portfolio to individual investors Mutual Funds are not only about stock there are different types o Pension Fund A type of mutual fund that holds assets in order to provide retirement income to its members Life Insurance Company Sells policies that guarantee a payment to a policyholder s beneficiaries when the policyholder dies Financial Fluctuations Financial market fluctuations can be a source of macroeconomic instability Stock prices are determined by supply and demand as well as by the desirability of competing assets like bonds o When the interest rate rises stock prices generally fall and vice versa The value of a financial asset today depends on investors beliefs o EX If investors believe the asset will be worth less in the future they will demand lest today at any given price Consequently today s equilibrium price will fall Two Competing Principle Views o One view which comes from traditional economic analysis emphasizes the rational reasons why expectations should change o The other widely held by market participants and also supported by some economists emphasizes the irrationality of market participants Efficient Markets Hypothesis This holds that the prices of financial assets embody all publicly available information o It implies that fluctuations are inherently unpredictable the random walk
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