Fin 320- Overview Of The Financial System

Front 1

What is a financial market?

Back 1

Market in which financial assets are traded.

Front 2

Financial Asset

Back 2

-Claim on future income (cash flow) generated by a real asset
-Stock, bond, commercial paper, etc.

aka financial security, financial instrument, asset, or security

Front 3

Real Asset

Back 3

-Asset used to produce goods and services and thereby generate cash flow
-Examples: Factories, equipment, land/real estate, commodities, buildings, knowledge

Front 4

Function of a financial market

Back 4

Transfer of funds from surplus units to deficit units

Front 5

Surplus unit

Back 5

Household, business, government agency or foreigners with excess funds.

Front 6

Deficit Unit

Back 6

Household, business, government agency or foreigners in need of funds.

Front 7

Financial Asset & Fund Transfer [Now]

Back 7

-Deficit unit sells/issues financial asset to surplus unit to obtain cash
-Surplus unit pays for the financial asset with cash. (See financial asset as investment.)

Front 8

Financial Asset & Fund Transfer [Future]

Back 8

-Deficit unit pays cash to surplus unit as specified by financial asset
-Surplus unit receives cash as return on investment

Front 9

Why are financial markets important?

Back 9

Because by channeling funds from surplus to deficit units, financial markets promote economic efficiency (i.e. makes everyone better off)

Front 10

Why do surplus units benefit in financial markets?

Back 10

In financial markets, ____ benefits because it earns a return on funds it otherwise would earn nothing on.

Front 11

Why do deficit units benefit in financial markets?

Back 11

In financial markets, ____ benefits because it gets to:
-Invest funds to generate greater output and wealth (e.g., a business with investmen opportunity) OR
- Consumer (e.g., use borrowed funds to buy a house)

Front 12

What are four structures of financial markets?

Back 12

1. Debt/ Equity
2. Primary/ Secondary
3. Exchange/ Over-the-counter
4. Money/ Capital

Front 13

Debt Security

Back 13

Contract whereby the issuer (borrower) promise to make specified payments over a period of time to the investor (lender)
- Has maturity date, i.e., will expire in the future.
-Short-term (<1 yr), long term (≥10 yrs), intermediate (b/w 1 and 10 yrs)
-43.6 trillion at end of 2006

Front 14

Equity Market

Back 14

Common Stock securities
-Represents an ownership claim in the firm
-Potential returns: dividends, capital gains
-No maturity date, considered long-term security
-Holder has the right to vote on issues important to the firm and elect directors
-$19.3 trillion at end of 2006

Front 15

Primary Market

Back 15

-Security is sold/ issued to investors for the first time
-Deficit unit gets cash by selling securities to investors
-Investment banks assist by underwriting securities
-Ex: Initial Public Offerings (IPO) of common stock

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Secondary Market

Back 16

-Trading of previously issued securities
-Liquidity: investor can sell security to raise cash
-Price disovery: determine how much security is worth
-Examples: New York Stock Exchange (NYSE) NASDAQ

Front 17

Exchanges

Back 17

Buyers and sellers meet in one central location to trade
-Ex: NYSE, American Stock Exchange (AMEX), Chicago Mercantile Exchange

Front 18

Over-the-Counter markets (OTC)

Back 18

-Dealers at different locations tand ready to buy and sell securities at posted prices
-Trading is done over a telecommunications network
-Examples: NASDAQ (stocks), US government bonds, most corporate and municipal bonds, currencies, credit default swaps

Front 19

Money markets

Back 19

-Short-term debt securities (maturity ≤ 1 yr)
-Good liquidity, low risk, low expected return
-Ex: Treasury bills, commercial paper

Front 20

Capital markets

Back 20

-Debt securities with maturities > 1 yr
-Equity securities (common stock)
-Securities differ in terms of liquidity, expected return and risk

Front 21

Financial Institution

Back 21

An entity that channels funds from surplus to deficit funds

Front 22

How does a Financial Institution (FI) channel funds to surplus to deficit units?

Back 22

-Issuing securities to suprlus units in exchange for funds
-Providing those funds to deficit units in exchange for securities
-aka, financial intermediary
-Method known as transferring funds known as "financial intermediation" or "indirect finance"

Front 23

Why do Financial Institutions exist in financial markets?

Back 23

Frictions in financial markets impede the flow of funds from surplus to deficit units

Front 24

Role of Financial institutions

Back 24

To facilitate the flow of funds from surplus to deficit units by overcoming frictions

Front 25

What are "frictions" in the financial market?

Back 25

-Transaction costs
-Asymmetric information

Front 26

Transaction costs

Back 26

Time and money spent in carrying out financial transactions

Front 27

How do transaction costs affect individual investors?

Back 27

______ can easily outweigh return from lending funds.

Front 28

What do FIs special in?

Back 28

______ specialize in conducting financial transactions.

Front 29

What does specialization allow FIs to do?

Back 29

-Develop expertise in cost reduction
-Reduce cost through large volume transactions (economies of scale)

Front 30

Asymmetric Information

Back 30

One party does not know enough about the other party to make accurate decisions

Front 31

What does asymmetric information impede?

Back 31

______ impedes the flow of funds because if you don't know the other party well, you refuse to provide funds.

Ex: A borrower who needs money for an investment project usually has better info about the returns and risk associated with the project than the lender.

Front 32

In which two ways does asymmetric information impede fund flows?

Back 32

1. Adverse selection
2. Moral Hazard

Front 33

Adverse Selection

Back 33

Problem created by asymmetric information BEFORE the transaction occurs.
-Occurs when potential borrowers who are most likely to produce an undesirable (adverse) outcome - bad credit risks- are the ones who most actively seek out a loan and thus most likely to be selected

Front 34

Because adverse selection makes it more likely that loans will be made to bad borrowers, lenders may decide __________________.

Back 34

____ may decide not to lend any money, even though there are good borrowers in a situation involving adverse selection.

Front 35

Moral Hazard

Back 35

Problem created by asymmetric info AFTER the transaction occurs. It is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender's point of view, because they will reduce the likelihood of loan repayment

Front 36

Lenders may decide not to make a loan because moral hazard _______ the likelihood of repayment.

Back 36

Reduces

Front 37

Moral hazard leads to _______ between parties involved in a financial transaction.

Back 37

Conflicts of Interest

Front 38

How FIs Overcome Asymmetric Information Problems

Back 38

-FIs better are better equipped to screen out bad credit risks from good ones
-FIs develop expertise in monitoring borrowers
-Individual investors can provide funds to the financial markets by ledning lthese funds to FIs, which in turn use the funds for making loans or buying securities.

These descriptions describe _____.

Front 39

FI's screen out bad credit risks from good ones by..

Back 39

-Lending money only to good credit risks
-Reducing losses from adverse selection

Front 40

FIs develop expertise in monitoring borrowers by..

Back 40

-Preventing borrowers from engaging in activities that reduce probability of repayment
-Reduce losses from moral hazard

Front 41

3 Types of Financial Institutions

Back 41

1. Depository Institutions
2.Contractual savings institutions
3. Investment intermediaries (everything else)

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Responsibilities of Depository Institutions

Back 42

Accept DEPOSITS from surplus nits and provides funds to deficit units through loans and purchases of securities.

Front 43

Responsibilities of Contractual savings Institutions

Back 43

Acquire funds from surplus units at periodic intervals. Make payments to designated beneficiaries under specified conditions (e.g. death, theft, fire, retirement, etc.)

Front 44

Describe Commercial banks In Depository Institutions

Back 44

- The dominant type of depository institution
-Offer a wide variety of deposit accounts (checking, savings, time)
-Use deposited funds to make loans (consumer, commercial, mortgage) and purchase debt securities (US Treasuries, municipal bonds)

In Depository Institutions, These functions describe what _____ do.

Front 45

Describe a Savings Institutions in Depository Institutions

aka, Savings and loan associations (S&Ls), and mutual savings banks

Back 45

-Mostly owned by depositors (mutual)
-Historically concentrated on residential mortgage loans.

Front 46

Credit Unions in Depository Institutions

Back 46

-Tend to be smaller than other depository institutions
-Organize around particular group union members, employees of a firm, etc.
-Restrict their loans to credit union members
-Primarily make consumer loans

Front 47

2 Types of Contractual savings Institutions

Back 47

1. Insurance companies
2. Pension funds

Front 48

Insurance Companies

Back 48

-Insure against financial hazards following someone's death; sell annuities for retirement
-Fire and casualty insurance: Insure against loss from theft, fire and accidents
-Acquire funds from premiums paid by policy holders
-Invest premiums in range of securities including US government bonds, municipal bonds, corporate bonds, and mortgages and stocks

Front 49

Pension Funds

Back 49

-Vehicles to help employees save or retirement
-Receive contributions from employees and employers
-Invest contributions in portfolio of bonds and stocks. Manage retirement portfolio until retiree withdraw funds.

Front 50

Finance companies

Back 50

-Raise funds by issuing commercial paper, bonds and stock
-Use funds to make loans to consumers and small businesses

Front 51

Mutual funds

Back 51

-Sell shares to surplus units
-Use funds to purchase a portfolio of securities
-Allow small investors to invest in a diversified portfolio with a relatively small amount of money

Front 52

Investment Banks-- Investment Intermediaries

Back 52

Help corporations issue securities:
-Help corporations issue securities
-Adice clients on M&A and other forms of corporate restructuring
-Broker
-Dealer

Front 53

How do investment banks help corporations issue securities?

Back 53

-Advise firms on which type of securities (stocks/ bonds) to issue
-Underwrite newly issued securities

Front 54

Broker

Back 54

Executes securities transactions between two paties

Front 55

Dealer

Back 55

Has an inventory of securities. Stands ready to buy securities from or sell securities to clients.

Front 56

2 reason to why regulate the financial system?

Back 56

1) Increases information available to investors
2) Ensure soundness of financial system

Front 57

How does increasing information available to investors regulate the financial system?

Back 57

-Reduce adverse selection and moral hazard problems
-Significant ex: 1. Securites Act of 1933 2. Securities Exchange Act of 1934 3. Sarbanes-Oaxley Act of 2002

Front 58

How does ensuring soundness of the financial system explain why it should be regulated?

Back 58

-Asymmetric information can lead to widespread collapse of financial intermediaries (financial panic)
-To avoid these negative consequences, government regulation ensures FIs are financially viable and unsound FI's closed down

Front 59

Ch. 1 Summary

Back 59

Financial markets and institutions facilitate transfer of funds from surplus to deficit units.
-Financial markets enable people to trade financial assets and promote economic efficiency.
-Frictions such as transaction costs and asymmetric information problems impede the flow of funds
-Financial institutions exist because they reduce transaction costs and asymmetric information problems
-There are different types of financial markets and institutions
-Financial markets and institutions are regulated.