Exam 1 Flashcards
What does capital mean in accounting and finance terms?
Money
Who are the four major players in the economy?
Households, Firms, Government, Foreign Sector
What does capital mean in economics terms?
Goods used as inputs to produceother goods and services.
What is the formula to determine total output in an economy and what does each part represent?
Z = C + I + G + (x-m)
Where Z means total output C means consumer spending I means investment (firms investment) G means government spending X means exports M means imports
x-m represents trade surplus or deficit
What is a market?
Any MECHANISM which brings BUYERS and SELLERS together with a purpose to transact in agreementa
Buyer
Economic agent willing and able to buy
Seller
Economic agent willing and able to sell
Market price
Price at which market clears (transaction occurs)
Financial market
Any mechanism which facilitates issuing (origination) and/or trading (repurchasing and reselling) of financial securities with a purpose of TRANSFERRING FUNDS
Financial security
A transferable claim on the future income or on the assets of the economic agent who issued that financial security
- Financial security is an asset to the security holder (buyer) and a liability to the security issuer (who is not always the seller)
What essential function do the financial markets perform?
Channel funds (not money) from economic agents with surplus funds but do not have productive use or desire to consume to economic agents who have a shortage of funds but have productive use or desire to consume
Other functions of financial markets
Promote economic growth by stimulating increase in production due to efficient allocation of funds.
Improve consumer well-being by allowing time preference of consumption
8 classifications of financial markets
Debt vs. Equity Money vs. Capital Markets Primary vs. Secondary -Secondary markets are classified as -Centralized Exchanges vs. Over the Counter
Debt contracts
Buyer of debt instrument = creditor
issuer of debt instument = borrower
has a maturity day
principal and interest must be repaid
Equity contracts
ownership stake in enterprise
no maturity day
proportionate claims on future income
residual claims on assets… means that in dissolution or insolvency of business, debt contracts are paid first, and if there is any leftover, it goes to equity holders
Primary market
Company issues securities and funds flow to issuers.
Public offering
- Registered with SEC
- Initial Public Offering (IPO) - first time securities issued
- Seasoned - subsequent issue
- -Investment bank via Firm Commitment or Best Efforts
- -Auction - issue acquired by dealer
Private Placement (not registered with SEC) -Investment bank assists in locating buyers and negotiating for a fee (broker)
Secondary market
Investors trade (repurchase and resell) securities Funds flow to sellers not original issuers
Exchanges
Centralized trading floor (like New York Stock Exchange NYSE)
Buyers and sellers submit orders to a central location and orders are matched by a specialist
Over the Counter (OTC)
Decentralized computer and phone network of dealers
Individual dealers provide liquidity for investors by buying and selling securities out of their own inventory
Example: NASDAQ, National Association of Securities Dealers Automated Quotation System
Money market
Only short term - 1 year or less Only debt instruments Generally highly liquid Have nearly non-existent price fluctuations, guaranteed rate of return Maturity dates
Capital markets
Longer term debt (above 1 year) Equity instruments (No maturity)
Money Market Instrument examples
US Treasury Bills
Certificates of Deposit (CDs)
Commercial paper
Federal funds and security repurchase agreements
Capital Market Instruments
Corporate stocks Residential mortgages Corporate bonds US government securities (long term) US govt. agency securities State and local government bonds Bank commercial loans Consumer loans Commercial and farm mortgages
Direct finance
Funds are transferred directly from the fund suppliers to the fund users
-a fund provider receives a financial security (claim) and a fund user receives funds
Indirect finance
Funds move from suppliers to users indirectly via financial intermediaries (banks, mutual funds, investment banks, pension funds, etc.)
Where do financial intermediaries operate in terms of direct vs. indirect finance
Indirect
Financial intermediaries
Financial institutions which CHANNEL FUNDS from those who have a surplus and no productive use to those who have a shortage but also a productive use
Depository institutions (banks): accept deposits and make loans
Mutual funds: transform assets and offer diversification
Pension funds: offer savings plans for retirement
Insurance companies: protect from adverse events
Finance companies: make loans but do not accept deposits
Functions of financial intermediaries
Lower transaction costs
Provide liquidity services
Reduce risk exposure
How to financial intermediaries lower transaction costs?
Their expertise in locating and evaluating investments
Economies of scale: reduction in transaction cost per unit as number of transactions increase
How do financial intermediaries reduce risk?
Asset transformation: combine risky assets with less risky assets to offer risk-return combinations acceptable to small investors
Offer investment diversification (portfolio instead of individual assets)
Asymmetric Information
Unevenly distributed knowledge between counterparts in a transaction
Adverse selection
Before transaction
Financial intermediaries reduce risk of selecting most risky borrowers by gathering information about potential borrower
Moral hazard
After transaction
Ensure borrower won’t engage in activities preventing him/her to repay the loan
Why regulate the financial system
To increase information available to investors:
- reduce adverse selection and moral hazard problems
- reduce insider trading (SEC)
To ensure the soundness of financial intermediaries
- Restrictions on entry (chartering)
- Disclosure of information
- Restrictions on Assets and Activities (control holding of risky assets)
- Deposit Insurance (avoid bank runs)
What can be described as direct finance?
You borrow $2,500 from a friend
Are debt and equity contracts both short term? Why or why not?
No because although debt contracts can be short term, equity is a perpetual claim against future income. It never expires
Liquid financial security
Short notice
Predictable price
Low transaction cost
U.S. Treasury bills pay no interest but are sold at a ______. That is, you pay a lower purchase price at the time of the purchase than the amount you receive at maturity.
Discount
Income
the flow of earnings per unit of time
Wealth
total collection of the property owned.
in addition to money, wealth includes:
Value storing or income producing REAL assets
Income producing Financial Assets
Income Producing Intangible Assets
Value Storing or Income Producing Real Assets
Art (paintings, sculptures, antiques, precious metals, jewelry) Real estate (land, houses, offices, apartments, storage space) Means of production (factories, equipment, tools, warehouse, trucks)
Income producing Financial Assets
Stocks - paying cash dividends
Bonds and notes - paying fixed or floating interest income
Income Producing Intangible Assets
Copyrights
Patents
Money
Anything universally accepted as a payment for goods and services and in repayment of debts.
Defined as stock
Expressed as quantity at a point in time
Functions of money
Medium of exchange
Store of value
Unit of account
Benefit of money as a medium of exchange
Money promotes economic efficiency by reducing transaction costs associated with double coincidence of wants
Double coincidence of wants
Like in barter: example:
I have diamonds willing to trade and I want chocolate. I must find someone who wants diamonds but has chocolate.
Barter
Exchanging goods and services for other goods and services without using money
What can function as money
Any commodity can as long as it is:
Universally accepted as payment Easily standardized Divisible "to make change" Easy to carry Not deteriorate too quickly
How does money store value?
It is used to save purchasing power over time. Value storing refers to the time period from when we received money in exchange for goods or services to the time period we want to use it to pay for other goods and services.
- Money is not unique value-storing asset
- Money isn’t a perfect store of value. Inflation slowly erodes purchasing power.
- Gold, real estate, art, jewelry and art store value better.
How is money a unit of account
the value of all of the goods and services can be expressed in a singular term… the quantity of money it takes to purchase something.
instead of
in the barter system, there would be several terms.
Ex. 1 gallon of milk = $5 instead of 1 gal of milk = 1/3 haircut, or 4 pounds of salt, or 1/25 of a chair.
Payments system
Method of conducting transactions in the economy. System of payments has been evolving over centuries and so has the form of money
Commodity money
Valuable, easily standardized and divisible commodities
Precious metals, tobacco or cigarettes
Fiat money
Paper money, which used to carry a guarantee that it would be converted to precious metal on demand. Lighter than commodity but still heavy in large amounts
Checks
An instruction to your bank to transfer money from your account to someone else’s account when he or she deposited your check
Electronic payment
Ex. online bill pay. Saves costs on stamps and envelopes. Payment is faster and recurring payments make life easier
E-money
Debit card - enables consumer to pay for goods and services by electronic transfer or funds from own account to merchant’s account
Stored value card - prepaid card
Smart card - rechargeable card
E-cash
Bitcoin
World’s first decentralized digital currency
M1 (most liquid assets)
Currency (paper money and coins held in the hands of nonbank public)
Traveler’s checks
Demand deposits
Other checkable deposits
M2
M1 small denomination time deposits savings deposits money market deposit accounts money market mutual fund shares
Does it matter which measure of money is considered?
Yes because M1 and M2 can move in different directions in the short run
What is investment in terms of finance?
What we do with our savings to make them grow over time.
Commitment of your savings for a period of time in order to derive future payments, which will compensate you for:
- The time your funds were committed
- Inflation or lost purchasing power
- Any sources of uncertainty of collecting what is promies
Calculate savings
Income (Y) - Tax (T) - Consumption (C) = Savings (S)
Also referred to as
Income - Tax = Disposable income
So then, Disposable Income - Consumption = Savings, or
Disposable Income = Savings + Consumption
Two things that can be done with disposable income
Consumed or saved
Why is it true that the only way to persuade people to defer their consumption and let others use their savings is to promise them a higher payback in the future than the original loan they make today?
Most people are rational and act in their own self-interest
What is the source of interest rates?
Time Value of Money (Savings)
Interest rate
Rate that a creditor charges a borrower for using creditor’s savings.
Typically expressed as a fee amount of dollars divided by the original loan amount
Time Value Analysis formula
Future Value at maturity = Present Value x (1+ interest rate) ^number of periods
or
FV at n = PV x (1 + i)^n
Time Value Analysis
Process of converting dollar values over time
Compounding
Process of finding future values
Discounting
Process of finding present values
Four types of credit market instuments
Simple Loan (Commercial loans, CDs)
Fully Amortized Loan (installment loan)
Coupon Bonds (T-notes, T-bonds, Corp-bonds)
- finite maturity (most common)
-Infinite maturity (perpetuities or consoles)
Discount bond (Zero coupon bonds like T-Bills)
Coupon rate
“Promised” rate of interest paid in form of coupon. *Constant and printed on the bond contract.
*except for floating rate bonds.
Coupon payment
Expressed at a percentage of the instrument’s face value (AKA Future Value)
Yield to Maturity (YTM)
Prevailing market interest rate, which investors expect to earn when buying bonds with certain risk characteristics. Fluctuates continuously.
Relationship between coupon rate, YTM, and price of bond
when coupon rate = YTM, then PV = FV
coupon rate < YTM, then PV < FV
coupon rate > YTM, then PV >FV
Perpetuity formula
Yield to maturity = Yearly Interest Payment / Price
or
i at c = C / P at c
One year discount bond formula
i = (F-P) / P
Nominal interest rate
Makes no allowance for inflation
Real interest rate
adjusted for changes in price level so it more accurately reflects the cost of borrowing
ex ante: real interest rate is adjusted for expected changes
ex post: adjusted for actual changes
Fisher equation
Nominal interest rate = real interest rate + expected inflation rate
When real interest rate is low, better to borrow than to lend
How to calculate interest rate
(FV/PV)^(1/n) - 1 = i
Calculate the number of time periods
ln(FV/PV) / ln (1 + i) = N
Calculate coupon bonds
Calculate coupon payments which = i or YTM x FV
The use
Payment / (1 + i)^N for each period and add all periods together.
