Chapter 13 - Role of Finance

Question 1

Definition of a Financial market

Answer 1

a market in which people trade future claims on funds or goods

People with spare funds don’t always have the most valuable way to spend them so financial markets allow funding to flow to the places where it is most highly valued

Question 2

Various forms of claims

Answer 2

Receiving a loan from a bank (gives you money now in return for repayment in the future)

Buying a company stock today gives you a right to a share of profits in the future

Purchasing insurance (paying premiums for a submission of a claim later)

Question 3

Characteristic of a well functioning market

Answer 3

market matches buyers and sellers;
buyers want to spend funds on something valuable
sellers let others borrow funds for a price

Question 4

Fundamental level of financial markets

Answer 4

Start with a bank, savers, and borrowers

Question 5

Characteristics of Banks

Answer 5

banks act as an intermediary between savers and borrowers;

make cash more readily accessible when and where you want it;

let people enjoy the benefits of liquidity;

diversify risk;

Question 6

Definition of The Market for Loanable Funds

Moreover, what are loanable funds? and what dictates the price of them?

Answer 6

A market in which savers supply funds to those who want to borrow;

Loanable funds are the dollars that are available between lenders and borrowers. Made up of savings and investment
The price for loanable funds is the interest rate

Question 7

Where does the supply of loanable funds come from?

What is investment?

Answer 7

Savings; ie the portion of income that is not immediately spent on consumption of goods and services

Investment is spending on productive inputs (ie spending on factories, machinery, inventories)- creates the need for loanable funds

Question 8

Where does the demand for loanable funds come from?

Answer 8

Investment

Question 9

What does the quantity of savings that people are willing to supply depend on?

What does the quantity of investment funding that people demand depend on?

Answer 9

The price people receive to supply these funds

The price people pay for the funds - so interest

Question 10

Definition of Interest Rate

Answer 10

The price of borrowing money for a specific period of time;

expressed as a percentage per dollar borrowed per unit of time.

Question 11

Characteristics of the Market for Loanable Funds Diagram

Answer 11

Quantity of dollars = x axis
Interest Rate = y axis

Savings = up ward sloping ; meaning suppliers provide additional funds at higher interest rates

Investment = downward sloping; ie - demanders are willing to borrow less at higher interest rates

Equilibrium is where savings intersects investment. This establishes the equilibrium interest rate and the amount of money that is traded in the market

Question 12

List of Determinants of Savings

Answer 12

Culture 
Social welfare policies
wealth 
current economic conditions 
expectations about future economic conditions

Question 13

Trends of determinants of savings in Canada

Answer 13

the early 1980s - savings rate in Canada was 11- 18%
Decreased rate of 2-3% until to mid 2000s
After recession in 2009 - the savings rate jumped to 5%

Question 14

Determinants of investment:

Investment decisions are based on…

Answer 14

the trade offs between the potential profits and the costs of borrowing.

Question 15

Determinants of investment:

Answer 15

trade off between potential profits and costs of borrowing;

expectations about future profitability

Crowding out

Question 16

Definition of ‘crowding out’

Answer 16

The reduction in private borrowing by an increase in government borrowing

Question 17

2 basic factors driving differences in interest rates

Answer 17

the loan term

the riskiness of the transaction

Question 18

the loan term

Answer 18

the opportunity cost

Question 19

the riskiness of the transaction

Answer 19

a default occurs when a borrower fails to pay back the loan according to the loan terms

Question 20

credit risk

Answer 20

the risk of a borrower defaulting on a loan;

is measured against risk free rate

Question 21

risk free rate

Answer 21

is the interest rate that would prevail if there was no risk of default
approximated by the interest on government debt

Question 22

risk premium

Answer 22

the difference between the risk free rate and the interest rate an investor must pay

Question 23

A financial system

Answer 23

represents the markets where financial products are traded
brings together savers, borrowers, investors, and insurers;
help manage both money and risk

Question 24

financial intermediaries

Answer 24

bringing together buyers and sellers; lower transaction costs of this process with bank;
channel funds from other people;
mutual funds are made witch match people with small amounts of money who want to buy a portfolio of various companies

Question 25

how do mutual funds reduce costs and what part of financial system function are they under?

Answer 25

mutual funds reduce costs by centralizing information about share prices and providing a marketplace for transactions

are under intermediation

Question 26

providing liquidity

Answer 26

a measure of how easily a particular asset can be converted quickly to cash without much loss of value

Question 27

diversification of risk

Answer 27

the process by which risks are shared among many different assets or people

Question 28

equity describes

Answer 28

things that can be bought and sold that are apart of larger companies

stocks - partial ownership
dividend - annual payments

demonstrates diversification

Question 29

why do companies issue stock?

Answer 29

raising capital without borrowing

Question 30

3 major financial assets

Answer 30

equity, debt, and derivatives
equity - things that can be bought and sold that are apart of larger companies (stocks &dividends)
debt - loans, bonds/ fixed income securities
derivates – financial assets based on the value ofsome other asset

Question 31

debt: what is a loan?

Answer 31

a loan is issued when a lender provides funds to a borrower in exchange for future repayment of the amount loaned plus interest

• less risky and less rewarding
• no matter how successful company is, the lender will never receive more than the amount specified in original terms
• loans can be bought and sold

Question 32

debt: what is a bond?

Answer 32

a form of debt where the bond issuer promises to repay the loan plus scheduled interest payments (called coupon payments) every 3-6 months + final payment called the face value
also known as fixed income securities

Question 33

4 key players in a financial system

Answer 33

1. banks and other intermediaries
2. savers and their proxies
3. entrepreneurs and business
4. speculators

Question 34

2 types of banks

Answer 34

commercial banks - banks for regular people

investment banks - these banks don’t take deposits and they don’t make loans in the traditional sense; they provide liquidity to financial markets themselves by acting as market makers.
They help issue stocks and bonds by guaranteeing to buy any that remain unsold.

Question 35

2 different kinds of funds that savers and proxies have

Savers don’t operate with the financial system directly; savers operate through a proxy.

Answer 35

mutual funds - a portfolio of stocks and other assets managed by a professional who makes decisions on behalf of clients

pension fund - a professionally managed portfolio intended to provide income to retires

index fund - buy all stocks with goal of mirroring the same return as the market on average

Question 36

entrepreneurs and businesses

Answer 36

engage in economic investment often with the advice of specialized investment banks that channel saver’s money to them. Without these borrowers, much of the financial system would simply cease
they’re looking to borrow money to finance their latest ventures

Question 37

speculators

Answer 37

anyone who buys and sells financial assets purely for financial gain

Question 38

What kind of risk do assets such as cash and fixed income bonds carry?

Answer 38

Very low risk and reward

Question 39

Financial assets in emerging countries carry what kind of risk?

Answer 39

A high risk, high return

Question 40

Definition of ‘Market (systemic) risk?

Answer 40

Risk that is broadly shared by the entire market for economy

Question 41

Definition of ‘Idiosyncratic risk’

Answer 41

Risk that is unique to a particular company or asset

Question 42

Definition of ‘Standard Deviation’

Answer 42

a measure of how spread out a set of numbers are

Question 43

What is the principle of asset valuation?

Answer 43

helps savers decide on which assets to purchase

Question 44

3 basic approaches used to pick stocks that are most likely to increase in value

Answer 44

Fundamental analysis: estimate how much money a company will earn in the future. This is done using NPV (Net present value -the measure of the current value expected in future cash flows) - only works if the current price differs from the correct price

Technical analysis: analyze movements in a stock’s prices to predict future movements. - only works if the current price differs from the correct price

throw a dart: make a list of all stocks, pin it to a wall, and throw a dart at it. (or efficient market hypothesis)

Question 45

Definition of ‘Efficient Market Hypothesis’

Answer 45

states that market prices always incorporate all available information, and therefore represent stock value as correctly as possible

Question 46

Definition of Arbitrage

Answer 46

the process of taking advantage of market inefficiencies to earn a profit

Question 47

What is the ‘savings - investment identity’

Answer 47

tells us that savings always equals investment in an economy without government or trade

private savings refer to the savings of individuals or firms within a country: they’re income = consumption + savings
Individuals earn money when people buy g/s
income = consumption + investment

ie) savings = investment

Question 48

Difference between government budget surplus and deficit

Answer 48

Surplus = form of saving
Deficit = form of dissaving (spending more than it makes
and national savings are less than private savings

Question 49

If you subtract government spenditure from government revenue, what do you get/

Answer 49

public savings = taxes - government spending

Question 50

What is national savings?

Answer 50

private savings + public savings

investment = national savings
this identity is called the savings investment identity

Question 51

The identity between national savings and investment holds only in a..

Answer 51

closed economy; an economy that does not interact with other economies

an open economy is when an economy interacts with other countries’ economies

Question 52

In open economies there is a movement of money across borders; What are these movements called?

Answer 52

capital outflow

or

capital inflow

Question 53

What is the difference between capital inflow and capital outflow called?

Answer 53

net capital flow

Question 54

What are the major types of financial assets?

Answer 54

debt and equity

Question 55

According to the efficient market hypothesis, why is it impossible to accurately predict stock return?

Answer 55

the efficient market hypothesis states that market prices incorporate ALL available information