Chapter 14 Flashcards
What is traded in a financial market
People trade future claims on funds or goods.
Who are the buyers in a financial market
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
Who are the sellers in a financial market
Individuals, corporations, and government entities willing to forgo some spending in return for repayment
What is adverse selection
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
What are the problems with adverse selection
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
What is a moral hazard
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
What are the consequences of a moral hazard
Sometimes they make financial transactions impossible
What is an information asymmetry
A condition in which one participant in a transaction knows more than another participant
What are the three main functions of financial markets
- Intermediaries: channel funds from people who have them to people who want them
- Provide benefits of liquidity: having cash easily available when you want it
- They help savers diversify risk by providing funds to borrowers
Intermediaries, liquidity, diversify
Describe the market for loanable funds
A hypothetical marketplace that brings together everyone looking to lend money and everyone looking to borrow money
What is the price of loanable funds
The market clears at a price where supply and demand meet. This price is the interest rate
Differentiate between savings and investment
Savings is the portion of income that is not immediately spend on consumption
Investment is spending on productive inputs
List the factors that affect the supply and demand of loanable funds
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
What is crowding out
Reduction in private borrowing that is caused by an increase in government borrowing
What are two factors that drive differences in interest rates
Length of time and degree of risk
Why do lenders generally want a higher interest rate
To compensate for the added opportunity cost when the loans stretch over a long period and for taking on additional risk
What is the interest rate one would lend if there is no risk involved
A risk-free rate
What does intermediation in financial systems do
Reduces transaction costs by centralizing information about prices and providing a broad and dynamic marketplace for transactions
What are financial intermediaries
Institutions that channel funds from people who have them to people who want them
What does the financial system offer savers and borrowers
A wide set of interconnected markets in which to find financial intermediaries
What is liquidity
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
What are market makers
They make a market by always being ready to buy or sell
Why is liquidity important
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
What is diversification
The process by which risks are shared across many different assets or people, reducing the impact of any particular risk on any one individual
What is the difference between debt and equity and define a bond
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
What is a derivative
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
What are the main institutions in financial markets
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)
What are mutual funds, pension funds and life insurance policies
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
Explain the trade off between risk and return
The riskier the investment, the higher its potential return
Ex. Stocks
The investments with the lowest risk and lowest returns are government bonds
What are the two different types of risk for financial assets
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
What is the efficient market hypothesis
Holds that all markets are efficient- that market prices incorporate all available information and as a result they represent stock value correctly as possible
What do supporters of efficient-market hypothesis think
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
What do those who argue against efficient market hypothesis say
That some people simply have better information than others or a better ability to put all the complex pieces together to predict stock price
Why do savings equal investment in a closed economy and what the relationship is called
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
Define default
The failure of a borrower to pay back a loan according to the agreed upon terms
What is a dividend
A payment made periodically, typically quarterly or annually, to all shareholders of a company
What is net present value (NPV)
A measure of the current value of a stream of cash flows expected in the future
What is arbitrage
The process of taking advantage of market inefficiencies to earn profits
What is public savings
The difference between government tax revenue and government spending
What is national savings
The sum of private savings of individuals and corporations plus the public savings of the government
What is a closed economy
An economy that does not interest with other countries economies
What is an open economy
An economy that interacts with other countries economies
What is net capital outflow
The net flow of funds invested outside of a country
