Chapter 13 - Role of Finance Flashcards
Definition of a Financial market
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
Various forms of claims
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)
Characteristic of a well functioning market
market matches buyers and sellers;
buyers want to spend funds on something valuable
sellers let others borrow funds for a price
Fundamental level of financial markets
Start with a bank, savers, and borrowers
Characteristics of Banks
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;
Definition of The Market for Loanable Funds
Moreover, what are loanable funds? and what dictates the price of them?
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
Where does the supply of loanable funds come from?
What is investment?
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
Where does the demand for loanable funds come from?
Investment
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?
The price people receive to supply these funds
The price people pay for the funds - so interest
Definition of Interest Rate
The price of borrowing money for a specific period of time;
expressed as a percentage per dollar borrowed per unit of time.
Characteristics of the Market for Loanable Funds Diagram
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
List of Determinants of Savings
Culture Social welfare policies wealth current economic conditions expectations about future economic conditions
Trends of determinants of savings in Canada
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%
Determinants of investment:
Investment decisions are based on…
the trade offs between the potential profits and the costs of borrowing.
Determinants of investment:
trade off between potential profits and costs of borrowing;
expectations about future profitability
Crowding out
Definition of ‘crowding out’
The reduction in private borrowing by an increase in government borrowing
2 basic factors driving differences in interest rates
the loan term
the riskiness of the transaction
the loan term
the opportunity cost
the riskiness of the transaction
a default occurs when a borrower fails to pay back the loan according to the loan terms
credit risk
the risk of a borrower defaulting on a loan;
is measured against risk free rate
risk free rate
is the interest rate that would prevail if there was no risk of default
approximated by the interest on government debt
risk premium
the difference between the risk free rate and the interest rate an investor must pay
A financial system
represents the markets where financial products are traded
brings together savers, borrowers, investors, and insurers;
help manage both money and risk
financial intermediaries
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
how do mutual funds reduce costs and what part of financial system function are they under?
mutual funds reduce costs by centralizing information about share prices and providing a marketplace for transactions
are under intermediation
providing liquidity
a measure of how easily a particular asset can be converted quickly to cash without much loss of value
diversification of risk
the process by which risks are shared among many different assets or people
equity describes
things that can be bought and sold that are apart of larger companies
stocks - partial ownership
dividend - annual payments
demonstrates diversification
why do companies issue stock?
raising capital without borrowing
3 major financial assets
equity, debt, and derivatives
equity - things that can be bought and sold that are apart of larger companies (stocks ÷nds)
debt - loans, bonds/ fixed income securities
derivates – financial assets based on the value ofsome other asset
debt: what is a loan?
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
debt: what is a bond?
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
4 key players in a financial system
- banks and other intermediaries
- savers and their proxies
- entrepreneurs and business
- speculators
2 types of banks
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.
2 different kinds of funds that savers and proxies have
Savers don’t operate with the financial system directly; savers operate through a proxy.
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
entrepreneurs and businesses
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
speculators
anyone who buys and sells financial assets purely for financial gain
What kind of risk do assets such as cash and fixed income bonds carry?
Very low risk and reward
Financial assets in emerging countries carry what kind of risk?
A high risk, high return
Definition of ‘Market (systemic) risk?
Risk that is broadly shared by the entire market for economy
Definition of ‘Idiosyncratic risk’
Risk that is unique to a particular company or asset
Definition of ‘Standard Deviation’
a measure of how spread out a set of numbers are
What is the principle of asset valuation?
helps savers decide on which assets to purchase
3 basic approaches used to pick stocks that are most likely to increase in value
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)
Definition of ‘Efficient Market Hypothesis’
states that market prices always incorporate all available information, and therefore represent stock value as correctly as possible
Definition of Arbitrage
the process of taking advantage of market inefficiencies to earn a profit
What is the ‘savings - investment identity’
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
Difference between government budget surplus and deficit
Surplus = form of saving
Deficit = form of dissaving (spending more than it makes
and national savings are less than private savings
If you subtract government spenditure from government revenue, what do you get/
public savings = taxes - government spending
What is national savings?
private savings + public savings
investment = national savings
this identity is called the savings investment identity
The identity between national savings and investment holds only in a..
closed economy; an economy that does not interact with other economies
an open economy is when an economy interacts with other countries’ economies
In open economies there is a movement of money across borders; What are these movements called?
capital outflow
or
capital inflow
What is the difference between capital inflow and capital outflow called?
net capital flow
What are the major types of financial assets?
debt and equity
According to the efficient market hypothesis, why is it impossible to accurately predict stock return?
the efficient market hypothesis states that market prices incorporate ALL available information
