A. Fin. Sys. (People, IS, Efficient Allocation); explain the main functions of the financial system; Flashcards
People and Entities
Save for tomorrow, Borrow for today, manage risk, efficiently allocate capital
“People use the financial system for six main purposes:
1 save for future 2 borrow for today 3 raise equity capital 4 manage risk 5 exchange assets for immediate and future delivery 6 trade on info
The Main Functions of the Financial System
1 the achievement of the purposes for which people use the financial system;
2 rates of return to equate aggregate savings with aggregate borrowings;
3 allocation of capital to the best uses.
Ex: Financing Capital Projects
“Financing Capital Projects
As a chief financial officer (CFO) of a large industrial firm, you need to raise cash within a few months to pay for a project to expand existing and acquire new manufacturing facilities. What are the primary options available to you?”
borrow the funds or to raise the funds by selling own- ership interests. If the company borrows the funds, you may have the company pledge some or all of the project as collateral to reduce the cost of borrowing.”
“2.1.5 Exchanging Assets for Immediate Delivery (Spot Market Trading)”
Spot market trading is for immediate delivery
“People and companies often trade one asset for another that they rate more highly or, equivalently, that is more useful to them.
■ Volkswagen pays its German workers in euros, but the company receives dollars when it sells cars in the United States. To convert money from dollars to euros, Volkswagen trades in the foreign exchange markets.
■ A Mexican investor who is worried about the prospects for peso inflation or a potential devaluation of the peso may buy gold in the spot gold market. (This transaction may hedge against the risk of devaluation of the peso because the value of gold may increase with inflation.)
■ A plastic producer must buy carbon credits to emit carbon dioxide when burning fuel to comply with environmental regulations. The carbon credit is a legal right that the producer must have to engage in activities that emit carbon dioxide.
“2.1.6 Information-Motivated Trading”
profit from information that they believe allows them to predict future prices.”
expect to earn a return on their information in addition to the normal return expected for bearing risk through time.”
Ex2: “Investing versus Information-Motivated Trading”
“The head of a large labor union with a pension fund asks you, a pension consul- tant, to distinguish between investing and information-motivated trading. You are expected to provide an explanation that addresses the financial problems that she faces. How would you respond?”
investing - move the union’s pension assets from the present to the future when they will be needed to pay. by buying stocks, bonds, and perhaps other assets. return should compensate for the risks that it bears and for the time that other people are using the fund’s money.
The object of information-motivated trading is to earn a return in excess of the fair rate of return. Information-motivated traders analyze information that they collect with the hope that their analyses will allow them to predict better than others where prices will be in the future. They then buy assets that they think will produce excess returns and sell those that they think will underperform. Active investment managers are information-motivated traders.
The characteristic that most distinguishes investors from information- motivated traders is the return that they expect. Although both types of traders hope to obtain extraordinary returns, investors rationally expect to receive only fair returns during the periods of their investments. In contrast, information- motivated traders expect to make returns in excess of required fair rates of return.
Summary
saving, borrowing, raising equity capital, managing risk, exchanging assets in spot markets, and information-motivated trading. The financial system best facilitates these uses when people can trade instruments that interest them in liquid markets, when institutions provide financial services at low cost, when information about assets and about credit risks is readily available, and when regulation helps ensure that everyone faithfully honors their contracts.”
Determining Rates of Return: Interest Rates: Ex 3
“For a presentation to private wealth clients by your firm’s chief economist, you are asked to prepare the audience by explaining the most fundamental facts concerning the role of interest rates in the economy. You agree. What main points should you try to convey?”
“Solution:
Savers have money now that they will want to use in the future. Borrowers want to use money now that they do not have, but they expect that they will have money in the future. Borrowers are loaned money by savers and promise to repay it in the future.
The interest rate is the return that lenders, the savers, expect to receive from borrowers for allowing borrowers to use the savers’ money. The interest rate is the price of using money.
Interest rates depend on the total amount of money that people want to borrow and the total amount of money that people are willing to lend. Interest rates are high when, in aggregate, people value having money now substantially more than they value having money in the future. In contrast, if many people with money want to use it in the future and few people presently need more money than they have, interest rates will be low.”
Capital Allocation Efficiency
+Ex 4: “Primary Market Capital Allocation
How can poor information about the value of a project result in poor capital allocation decisions?”
“Primary capital markets (primary markets) are the markets in which companies and governments raise capital (funds). Companies may raise funds by borrowing money or by issuing equity. Governments may raise funds by borrowing money.”
“EXAMPLE 4”
“Solution:
Projects should be undertaken only if their value is greater than their cost. If investors have poor information and overestimate the value of a project in which its true value is less than its cost, a wealth-diminishing project may be undertaken. Alternatively, if investors have poor information and underestimate the value of a project in which its true value is greater than its cost, a wealth-enhancing project may not be undertaken.”
