FM W1 Flashcards
5 core principles of the financial system
- time has value
- risk requires compensation
- information is the basis for decisions
4.market determines prices and allocates resources - stability improves welfare
what is direct finance
lenders sell securities directly to borrowers in the financial market
what is indirect finance
an institution stands between a lender and a borrower
what is an asset
something of value you own
what is a liability
something you owe
what are ultimate lenders
Agents whose excess of income over expenditure creates a
financial surplus which they are willing to lend
what are ultimate borrowers
Agents whose excess of expenditure over income creates
a financial deficit which they wish to meet by borrowing
what are the functions of money
- Means of payment
- unit of account
- store of value
what is liquidity
the ease at which an asset can be turned into a means of payment
what are the types of money
M1 - Narrow money (sum of currency in circulation)
M2 - Intermediate money (M1 + short-term time deposits + deposits redeemable of up to 3 months)
M3 - Broad money (M2 + long-term time deposits)
how to work out CPI
CPI = cost of current basket/cost of base year basket x100
what are financial instruments
The written legal obligation of one party to transfer something of value,
usually money, to another party at some future date, under certain
conditions
3 principal economic functions of financial assets
- Acts as a means of payment
- Act as a store of value (stocks)
- Allow for the transfer of risk (insurance)
3 economic functions of financial markets
- Market liquidity - ensures owners of financial instruments can buy and sell easily
- Information - communicate info about the seller
- Risk sharing - allows individuals to buy and sell risk
classification of financial markets
- By nature of claims
- By maturity of claims
- By seasoning of claims
- By delivery time
- By organisational structure
what are the 5 roles of financial intermediaries
- Pooling the resources of small savers
- Providing safekeeping and accounting services
- Supplying liquidity
- Providing ways to diversify risk
- Collecting and processing information
Pooling the resources of small savers
By accepting many small deposits, banks empower themselves to make large loans
Providing safekeeping and accounting services
Provides a reliable and inexpensive payment system. Helps us to manage our finances, bookkeeping and take advantage of economies of scale
Supplying liquidity
Eg: ATMs. They offer both individuals and businesses lines of credit, which
provides customers with access to liquidity
Diversifying 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. Diversifying investments
Collecting and processing info
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
what is adverse selection
Occurs before the transaction. Unable to distinguish between good and bad companies/bonds.
what is moral hazard
Occurs after the transaction. Arises when we cannot observe people’s actions. Equity finance. Debt finance
solutions to adverse selection
- government-required information disclosure
- private collection of info
solutions to moral hazard
- requiring managers to report to owners
- requiring managers to invest significant amount themselves
What is Future Value
FV is the value on some future date of an investment made today.
FV = PV x (1 + i)
Use compound interest for > 1 year
what is Present Value
PV is the value today of a payment planned for the future.
PV = FV / (1+i)^n
what is a bond
a promise to make a series of payments on specific future dates
the price of a bond depends on what characteristics
- Zero-coupon or discount bonds
- Fixed-payment loans
- Coupon bonds
- Consol or perpetuity
zero-coupon bonds
Pay a certain amount on a fixed future date.
= Face Value / (1+i)^n, where n=years
fixed-payment loans
Sequence of fixed payments like a mortgage. Sum of present values.
= Fixed payment / (1+i) + … Fixed payment / (1+i)^n
coupon bonds
Periodic interest payments + principal repayment at maturity.
= Coupon payment / (1+i) + …. Coupon payment / (1+i)^n + …. Face Value / (1+i)^n
perpetuity or consol bonds
The owner promises to make series of periodic investment payments forever.
= Yearly Coupon Payment / i
explain the 3 types of bond yields
- Nominal yield = the stated rate of the bond
- Yield to maturity = the yield bondholders receive if they hold the bond to its maturity when the final principal payment is made.
- Current yield = interest rate of the bond given its current price = Yearly Coupon Rate / Price Paid
explain price-yield relationship
the price of the bond changes in the opposite direction to the change in the required yield.
As bond price increases, the yield to maturity decreases.
what is a par bond
Bond Price = Face value (par value): Coupon rate = Current yield =
Yield to maturity
what is a discount bond
Bond price < Face value (par value): Coupon rate < Current yield<
Yield to maturity
what is a premium bond
Bond price > Face value (par value): Coupon rate > Current yield >
Yield to maturity
what is the fisher equation
nominal interest rate = real interest rate + expected inflation
