2 Flashcards
what are the main components of the financial system? (5)
- Money
- Financial instruments
- Financial markets
- Financial institutions
- Central banks
3 main functions of money
Median of exchange (action of buying and selling, makes transactions easy)
unit of account (provides a standards way to measure and compare values of goods)
store value (money holds value overtime allowing people to save without it losing too much purchasing power)
what do financial instruments do
transfer resources from savers (lenders) to investors (borrowers) and to transfer risk to those best equipped to bear it.
what are financial markets
a place to Buy and sell financial instruments
what are financial institutions
Provide access to financial markets, collect information, and provide services
what do central banks do (3)
Monitor financial institutions
stabilize the economy
conduct policy.
4 key principles of money and banking
- Time has value.
Time affects the value and return of financial instruments. - Risk requires compensation.
In a world of uncertainty, individuals will accept risk only if they are compensated in some way. - Information is the basis for decisions.
The collection and processing of information stand at the foundation of the financial system. - Markets determine prices and the allocation of resources.
The “places” where buyers and sellers “meet” are the core of the economic system.
3 functions of financial markets
Connecting Savers and Borrowers – Financial markets help move money from people or institutions with extra funds (savers) to those who need funds for investment (businesses, governments, or individuals)
Promote economic efficiency by producing an efficient allocation of capital, increasing production.
Better Financial Planning for Consumers – Financial markets allow people to save, invest, or borrow, helping them manage spending and plan for future needs, such as buying a home or retirement.
what is direct finance
borrowers borrow funds directly from lenders in financial markets by selling them securities.
what is indirect finance
financial intermediary stands between lenders and borrowers.
what is an asset
something of value that is owned.
what is liability
something of value that is owed.
what is debt and equity markets
markets where financial claims are bought and sold e.g. bonds and stocks, for immediate cash payment
what are debt instruments
Debt instruments are contractual agreements where borrowers make regular payments to the holders (both principal and interest) until the debt reaches its maturity date.
what is equity in financial markets?
claims to share in the net income (dividends) and assets of a business.
what are derivative markets
Derivatives markets involve financial claims based on underlying assets. These financial instruments are bought and sold for payment at a future date, often used for hedging or speculative purposes.
what are primary markets
trade in newly issued securities
example: Investment Banks underwrite securities
what are secondary markets
trade in existing securities
example:
NYSE, LSE, NASDAQ;
Foreign exchange markets, futures markets, options markets.
what are brokers
agents matching buyers with sellers of securities (buy/sell for their clients)
what are dealers
link buyers and sellers by buying/selling securities at stated prices (buy/sell on their own account).
which market do brokers and dealers work in?
secondary market
what is a centralised exchange
Physical location where trading takes place.
e.g. NYSE.
what are Over-the-Counter (OTC) markets
Network of dealers connected electronically. Set price.
Foreign exchange, Federal funds
what are money markets and capital markets
Money markets: deal in short-term (<1 year) debt and equity.
Capital markets: deal in longer-term (>1 year) debt and equity.
examples of money market instruments
Government bonds (Treasury bills)
Bank certificates of deposit
Commercial paper
Repurchase agreements (Repo)
Eurodollars
Banker’s acceptances
examples of capital market instruments
Government securities and bonds (long-term)
Corporate stocks
Corporate bonds
Mortgages and mortgage-backed securities
Bank commercial loans
What is the store of value function in financial market instruments?
The store of value function refers to instruments that preserve value over time, such as stocks, bonds, loans, mortgages, and asset-backed securities.
What does transfer of risk mean in the context of financial market instruments?
Transfer of risk refers to the use of instruments like insurance contracts and derivatives (e.g., futures contracts and options) to transfer financial risk from one party to another.
How do financial intermediaries lower transaction costs? (2)
Financial intermediaries lower transaction costs through economies of scale, where the cost per transaction decreases as the size of transactions increases, making financing more affordable for corporations
Liquidity services allow individuals and firms to easily convert assets into cash, such as offering liquid savings accounts or short-term investments.
How do financial intermediaries reduce risk? (2)
Financial intermediaries reduce risk through risk sharing (asset transformation), where they pool funds from many investors and diversify investments, thereby spreading risk across various assets.
Diversification refers to the practice of spreading investments across various assets to reduce the overall risk to investors by avoiding concentration in one investment.
How do financial intermediaries reduce information costs?
Financial intermediaries reduce information costs by screening and monitoring borrowers, addressing problems of asymmetric information where one party has more information than the other.
What is Adverse Selection in financial markets?
Adverse selection occurs before the transaction, where financial intermediaries are more likely to select borrowers with higher risks due to limited information about the borrower’s true risk level.
What is Moral Hazard in financial markets?
Moral hazard occurs after the transaction, where a borrower may be less likely to repay the loan or act responsibly, knowing that the lender is bearing the risk.
types of financial intermediaries (3)
Depositary institutions e.g. commercial banks
Investment intermediaries e.g. finance companies
Contractual savings institutions e.g. life insurance companies
Internationalisation of financial markets (5)
- Foreign Bonds
- Eurobond
- Eurocurrencies
- Eurodollars
- World Stock Markets
what are foreign bonds
Foreign bonds are bonds that are sold in a foreign country and are denominated in that country’s currency. For example, a U.S. company issuing bonds in Japan denominated in yen.
what are eurobonds
A Eurobond is a bond that is denominated in a currency other than that of the country in which it is sold. For example, a bond issued in London but denominated in U.S. dollars.
what are eurocurrencies
Eurocurrencies refer to foreign currencies that are deposited in banks outside the home country. For example, Japanese yen deposited in a bank in London.
what are eurodollars
Eurodollars are U.S. dollars that are deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks. These deposits are used in international finance.
What are World Stock Markets?
World Stock Markets refer to stock exchanges and financial markets around the globe where stocks, bonds, and other financial instruments are bought and sold. They facilitate international investment and capital flow.
why do we need to regulate the financial systems
To increase the information available to investors
To ensure the soundness of financial intermediaries
why do we need to increase the information available to investors
- reduce adverse selection
- reduce moral hazards
- reduce insider trade
why do we need to ensure the soundness of financial intermediaries (6)
Restrictions on entry (chartering process) - governments ensure only reliable firms enter the market.
Disclosure of information - regularly report their financial status and risk exposure to regulators and the public.
Restrictions on assets and activities (control holding of risky assets). - prevent excessive risk taking
Deposit Insurance (avoid bank runs) - to protect depositors’ money and prevent panic-driven bank runs.
Limits on competition (in the past) - prevent reckless lending and instability
Restrictions on interest rates - to control inflation and ensure financial stability
Principal regulatory agencies in the UK (2)
- Bank of England
- Financial conduct authority (FCA)
Principal regulatory agencies in the USA (7)
- Securities and Exchange Commission (SEC)
- Commodities Futures Trading Commission (CFTC)
- Office of the Comptroller of the Currency
- National Credit Union Administration (NCUA)
- State banking and insurance commissions
- Federal Deposit Insurance Corporation (FDIC)
- Federal Reserve System
