Financial Markets and Institutions 1: Overview of the financial system Flashcards
1 Money 2 Financial instruments 3 Financial markets 4 Financial institutions 5 Central banks
What are the 5 parts of the financial system
1 Money
2 Financial instruments
3 Financial markets
4 Financial institutions
5 Central banks
What are the 5 core principles of the financial system
1 Time has value.
2 Risk requires compensation
3 Information is the basis for decisions
4 Markets determine prices and allocate resources
5 Stability improves welfare
Describe, including a flow chart, the flow of funds through the financial system
- Direct Finance: Borrowers sell securities directly to lenders in the financial
markets.
▶ Direct finance provides financing for governments and corporations. - Indirect Finance: An institution stands between lender and borrower.
▶ We get a loan from a bank or from a finance company to buy a car. - Asset: Something of value that you own.
- Liability: Something you owe
Describe the users of the financial system
- Ultimate lenders: Agents whose excess of income over expenditure creates a
financial surplus which they are willing to lend. - Ultimate borrowers: Agents whose excess of expenditure over income creates
a financial deficit which they wish to meet by borrowing.
- Borrowers and lenders have conflicting preferences:
▶ Borrowers
⋆ low liquidity
⋆ minimum cost
⋆ minimum risk
⋆ minimum transaction costs
▶ Lenders
⋆ high liquidity
⋆ maximum return
⋆ minimum risk
⋆ minimum transaction costs
Describe money and its function
Money is an asset that is generally accepted as payment for goods and
services or repayment of debt.
Money has three functions:
1 It is a means of payment: used in exchange for goods and services.
2 It is an unit of account: used to quote prices.
3 It is a store of value: used to transfer purchasing power into the future
Describe ‘liquidity’
Liquidity is a measure of the ease with which an asset can be turned into a
means of payment:
▶ Market liquidity is the ability to sell assets.
▶ Funding liquidity is the ability to borrow money.
Describe the 2 types of liquidity
Describe, in a flow chart, the liquidity spiral in the 2007-2009 financial crisis
Describe the importance of measuring money
Changes in the quantity of money are related to inflation:
▶ Inflation is the process of prices rising.
▶ Inflation rate is the measurement of the process.
With inflation, you need more money to buy the same basket of goods.
The primary cause of inflation is too much money.
▶ We therefore must be able to measure how much is circulating.
▶ Defining money means defining liquidity.
Describe ‘money aggregates’
M1–Narrow Money
▶ is the sum of currency in circulation and overnight deposits.
M2–Intermediate Money
▶ is the sum of M1, short-term time deposits (i.e. with an agreed
maturity of up to 2-year) and deposits redeemable at notice of up to 3
months.
M3– Broad Money
▶ is the sum of M2 and long-term time deposits.
Show the compositions of monetary aggregates in the eurozone, UK
and US
Describe the Consumer Price Index (CPI) to measure inflation
CPI measures “How much more would it cost for people to purchase today
the same basket of goods and services that they actually bought at some
fixed time in the past”
▶ Survey people to see what they bought.
▶ Figure out what it would cost to buy the same basket of goods and
services today.
▶ Compute the percentage change in the cost of the basket of goods:
CPI = Cost of the basket in current year / Cost of the basket in base year ∗ 100
Inflation Rate = ((CPI for current year - CPI for base year) / CPI for base year) * 100
Describe & explain ‘financial instruments’
Describe the 2 types of assets
They are the written legal obligation of one party to transfer something of value,
usually money, to another party at some future date, under certain conditions.
▶ Tangible Assets
⋆ Value is based on physical properties (e.g. buildings, land, machinery).
▶ Intangible Assets
⋆ Claim to future income generated (ultimately) by tangible asset(s).
There are two fundamental classes of financial instruments:
1 Underlying instruments.
2 Derivative instruments.
Financial assets have three principal economic functions:
1 Act as a means of payment
▶ Employees take stock options as payment for working.
2 Act as a store of value
▶ Financial instruments generate increases in wealth that are larger than
from holding money.
3 Allow for the transfer or risk
▶ Futures and insurance contracts allow one person to transfer risk to
another
Classification of financial instruments by their use:
Used primarily as store of value -
▶ Bank loans
▶ Bonds
▶ Home mortgages
▶ Stocks
Used primarily to transfer risk -
▶ Insurance contracts
▶ Futures contracts
▶ Options
Describe & explain ‘financial markets’
Financial markets are the places where financial instruments are bought and sold.
Financial markets provide three economic functions:
1 Market liquidity:
▶ Ensure that owners of financial instruments can buy and sell them
cheaply and easily.
2 Information:
▶ Pool and communicate information about the issuer of a financial
instrument.
3 Risk sharing:
▶ Provide individuals a place to buy and sell risk.
Classification of financial markets:
1 By nature of claims:
▶ Debt Market
▶ Equity Market
2 By maturity of claims:
▶ Money Market
▶ Capital Market
3 By seasoning of claims:
▶ Primary Market
▶ Secondary Market
4 By delivery time:
▶ Spot Market
▶ Derivative Market
5 By organisational structure
▶ Auction Market
▶ Over-the-counter Market
▶ Intermediate/Dealer Market
Describe & explain ‘financial intermediaries’
In their role as financial intermediaries, financial institutions perform five
functions:
1 Pooling the resources of small savers.
2 Providing safekeeping and accounting services, as well as access to payments
system.
3 Supplying liquidity by converting savers’ balances directly into a means of
payment whenever needed.
4 Providing ways to diversify risk.
5 Collecting and processing information in ways that reduce information costs
Types of financial intermediaries
- Deposit-takers
▶ Retail banks
▶ Commercial banks - Non-deposit takers
▶ Insurance companies
▶ Pension funds
▶ Securities firms (brokers, investment banks, mutual funds, private
equity and venture capital firms)
▶ Finance companies
Describe financial institutions’ function for pooling small savers’ resources
- By accepting many small deposits, banks empower themselves to make large
loans. - In order to do this, the intermediary:
▶ Must attract substantial numbers of savers.
▶ Must convince potential depositors of the institution’s soundness
Describe financial institutions’ function for providing safekeeping and accounting services, as well as access to payments
system
Financial intermediaries, by providing us with a reliable and inexpensive
payments system, help our economy to function more efficiently.
Financial intermediaries also help us to manage our finances.
▶ They provide us with bookkeeping and accounting services.
▶ These force financial intermediaries to write legal contracts - but one
can be written and used over and over again - reducing the cost of
each.
▶ Much of what financial intermediaries do takes advantage of economies
of scale
Describe financial institutions’ function for providing liquidity
Liquidity is a measure of the ease and cost with which an asset can be
turned into a means of payment.
Financial intermediaries offer us the ability to transform assets into money at
relatively low cost - ATMs, for example.
Banks can structure their assets accordingly, keeping enough funds in
short-term, liquid financial instruments to satisfy the few people who will
need them and lending out the rest.
By collecting funds from a large number of small investors, the bank can
reduce the cost of their combined investment, offering each individual
investor both liquidity and high rates of return.
Intermediaries offer both individuals and businesses lines of credit, which
provides customers with access to liquidity
Describe financial institutions’ function for diversifying risk
Financial institutions enable us to diversify our investments and reduce risk.
Banks take deposits from thousands of individuals and make thousands of
loans with them. Thus, each depositor has a very small stake in each one of
the loans.
All financial intermediaries provide a low-cost way for individuals to diversify
their investments
Describe financial institutions’ function for collecting and processing information
The fact that the borrower knows whether he or she is trustworthy, while the
lender faces substantial costs to obtain that information, results in an
information asymmetry.
Borrowers have information that lenders do not have.
By collecting and processing standardized information, financial
intermediaries reduce the problems that information asymmetries create.
