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Econ 102 > Chapter 14 > Flashcards

Chapter 14 Flashcards

1
Q

What is traded in a financial market

A

People trade future claims on funds or goods.

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2
Q

Who are the buyers in a financial market

A

Families buying new houses, students paying tuition, corporations buildings new factories, entrepreneurs starting new ventures, and the government when it needs to finance public spending

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3
Q

Who are the sellers in a financial market

A

Individuals, corporations, and government entities willing to forgo some spending in return for repayment

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4
Q

What is adverse selection

A

Adverse selection refers to a state that occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation which results in failure to complete transactions that would have been possible

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5
Q

What are the problems with adverse selection

A

Without tight regulation on the provision of public information, adverse selection would lead to sharp decreases in the market prices of company stock and higher interest rates on bank loans

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6
Q

What is a moral hazard

A

The tendency for people to act riskier when they do not face the full consequences of their actions

Ex) when people have car insurance they are mor likely to speed or drive unsafe

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7
Q

What are the consequences of a moral hazard

A

Sometimes they make financial transactions impossible

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8
Q

What is an information asymmetry

A

A condition in which one participant in a transaction knows more than another participant

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9
Q

What are the three main functions of financial markets

A
  1. Intermediaries: channel funds from people who have them to people who want them
  2. Provide benefits of liquidity: having cash easily available when you want it
  3. They help savers diversify risk by providing funds to borrowers

Intermediaries, liquidity, diversify

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10
Q

Describe the market for loanable funds

A

A hypothetical marketplace that brings together everyone looking to lend money and everyone looking to borrow money

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11
Q

What is the price of loanable funds

A

The market clears at a price where supply and demand meet. This price is the interest rate

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12
Q

Differentiate between savings and investment

A

Savings is the portion of income that is not immediately spend on consumption

Investment is spending on productive inputs

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13
Q

List the factors that affect the supply and demand of loanable funds

A

Factors that determine how much people save:
Wealth, current, economic conditions, expectations about future economic conditions, borrowing constraints, social welfare policies, and culture

Factors that determine investment decisions:
Expectations about future profitability and future economic conditions, borrowing constraints, and crowding out

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14
Q

What is crowding out

A

Reduction in private borrowing that is caused by an increase in government borrowing

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15
Q

What are two factors that drive differences in interest rates

A

Length of time and degree of risk

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16
Q

Why do lenders generally want a higher interest rate

A

To compensate for the added opportunity cost when the loans stretch over a long period and for taking on additional risk

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17
Q

What is the interest rate one would lend if there is no risk involved

A

A risk-free rate

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18
Q

What does intermediation in financial systems do

A

Reduces transaction costs by centralizing information about prices and providing a broad and dynamic marketplace for transactions

19
Q

What are financial intermediaries

A

Institutions that channel funds from people who have them to people who want them

20
Q

What does the financial system offer savers and borrowers

A

A wide set of interconnected markets in which to find financial intermediaries

21
Q

What is liquidity

A

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

We say an asset is liquid if it can be sold for cash quickly without much loss of value

22
Q

What are market makers

A

They make a market by always being ready to buy or sell

23
Q

Why is liquidity important

A

It affects peoples willingness to save: if markets were not liquid, you would be extremely cautious about lending money out for investment which would reduce the supply of loanable funds, drive up interest rates, reducing the amount of investment and leading to slower growth

24
Q

What is diversification

A

The process by which risks are shared across many different assets or people, reducing the impact of any particular risk on any one individual

25
Q

What is the difference between debt and equity and define a bond

A

Equity is ownership in a company, the most common form being a stock
The most basic debt is a loan and a bond

A bond is a loan that has been standardized into a more easily tradable and liquid asset

26
Q

What is a derivative

A

A financial contract based on the value of some other asset call derivatives: An asset whose value is based one the value of another asset, such as a home loan, stock, bond or barrel of oil

The best example is a futures contract: the buyer of a futures contract agrees to pay the seller a set amount today based on the expected future price of some asset

27
Q

What are the main institutions in financial markets

A

Commercial and investment banks

When you make a deposit at a bank, or get a mortgage or student loan from a bank you are interacting with a commercial bank

Investment banks focus on providing liquidity to the financial markets themselves, by acting as market makes, helping companies to issue stocks and bonds (known as underwriting)

28
Q

What are mutual funds, pension funds and life insurance policies

A

Mutual funds: professionally managed portfolios of stocks and other assets

Pension funds: professionally administered portfolios of assets intended to provide income to retirees

Life insurance policies: where people pay premiums that pay out to dependants upon the death of the insured

29
Q

Explain the trade off between risk and return

A

The riskier the investment, the higher its potential return
Ex. Stocks

The investments with the lowest risk and lowest returns are government bonds

30
Q

What are the two different types of risk for financial assets

A

Market risk: a risk that is broadly shared by the entire market

Idiosyncratic risk: risk unique to a particular asset or company

In financial markets you use standard deviation to measure risks

31
Q

What is the efficient market hypothesis

A

Holds that all markets are efficient- that market prices incorporate all available information and as a result they represent stock value correctly as possible

32
Q

What do supporters of efficient-market hypothesis think

A

They describe the expected movements of a stock as a random walk- a term that describes any variable that moves in a completely unpredictable way from one moment to the next

33
Q

What do those who argue against efficient market hypothesis say

A

That some people simply have better information than others or a better ability to put all the complex pieces together to predict stock price

34
Q

Why do savings equal investment in a closed economy and what the relationship is called

A

In a closed economy with no international trade, citizens can consume or save. The amount of savings is equal to the amount of investment that can occur, therefore the are always equal which is called the savings-investment identity

35
Q

Define default

A

The failure of a borrower to pay back a loan according to the agreed upon terms

36
Q

What is a dividend

A

A payment made periodically, typically quarterly or annually, to all shareholders of a company

37
Q

What is net present value (NPV)

A

A measure of the current value of a stream of cash flows expected in the future

38
Q

What is arbitrage

A

The process of taking advantage of market inefficiencies to earn profits

39
Q

What is public savings

A

The difference between government tax revenue and government spending

40
Q

What is national savings

A

The sum of private savings of individuals and corporations plus the public savings of the government

41
Q

What is a closed economy

A

An economy that does not interest with other countries economies

42
Q

What is an open economy

A

An economy that interacts with other countries economies

43
Q

What is net capital outflow

A

The net flow of funds invested outside of a country

Econ 102 (11 decks)

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