Functions of Financial System Flashcards
What is the Secondary Market
The Secondary Market is where previously issued shares are traded amongst investors
Why is the Secondary Market important?
Because it provides LIQUIDITY and INFORMATION to investors
What is an Order-Driven Market?
Centralized, book contains all bids and asks of participants for different securities. Best for stocks and standardized securities.
(typical stock exchanges)
What is a Price-Driven Market?
Not centralized, network of dealers providing bids and ask prices they are willing to trade at. Best for bonds and customized securities.
(OTC Markets)
Advantage of Order-Driven Markets
Less costly, because system is centralized, fully integrated, and settlement is automatic once the trade is done.
Advantages of Price-Driven Markets
Offers more liquidity: dealers act as market makers, trading large quantities.
Describe Function 1: Channeling of Funds
Investment Channel - creating investment opportunities for savers to lenders
Consumption Channel - Smooths consumption over time
Describe Function 2: Managing Asymmetric Information
Lenders have less information than Borrowers and this can hinder channeling of funds. Financial Systems must find ways to manage this.
Describe Function 3: Transfer of Risk
Through Capital Markets and Financial Institutions, investors can transfer risk (1) across time and (2) across uncertain parts of the world
Describe Function 4: Pooling Individual Resources
Investment projects require large resources, investors want to minimize risks (diversifying): financial systems allow pooling of resources
Describe Function 5: Providing Liquidity
Secondary Markets - allows participants to cover (un)expected liquidity needs by exchanging between securities and cash
Describe Function 6: Providing Information
Secondary Markets - Investors can observe daily quotations for prices, interest rates, which bankers, politicians, and managers can use to improve the real economy
Define Capital Markets
Markets where the demand and supply of financial securities meet
Define Financial Institutions
Companies that produce financial products and services (banks, insurance companies etc.)
‘Blank’ offer a promise of interest payments for specified periods
Debt Securities
‘Blank’ provide an uncertain stream of dividends and an ownership claim in the company
Corporate Stocks
Largest financial institution in the US is:
- Mutual Funds
- Commercial Banks
- Pension Funds
- Commercial Banks ( $17,352B in 2019)
What is the most important function of the financial system?
Channeling of funds
A good financial system channels funds from _____ to ______.
from Savers to Borrowers
What is the most important source of external financing, Capital Markets or Financial Institutions?
Financial Institutions
What are the two problems of asymmetric information?
Adverse selection, and moral hazard
Describe the adverse selection problem
Investors propose an average price or rate.
Good borrowers may refuse to issue securities if prices drop too low.
Investors will refuse to lend because only bad borrowers are left in the market.
Result: inefficient market
Describe the Moral Hazard problem
Describes a situation where there is incentive for engaging in risky activity.
Example: Banks take more risks, the government bails them out because it cannot let them fail, banks take more risks because they know they will be bailed out.
What are the 3 functions of money?
- Medium of exchange (vs barter economy)
- Unit of account (comparing prices)
- Store of value (financial asset)
What are the two jobs of the central bank?
- Monetary Policy: setting the right quantity of money (impacts inflation and economic output)
- Lender of Last Resort (lends to financial institutions in times of crisis)
What is Quantitative Easing?
In Quantitative Easing, the central bank purchases longer-term securities to affect long-term interest rates.
Why perform Quantitative Easing?
Lower long-term interest rates, decrease borrowing costs for firms, reduce new and refinanced mortgages, and improve banks financial health.
How is monetary policy conducted today?
The size of reserves has increased, and the Fed has agreed to pay interest on these reserves. Higher interests means banks are less likely to lend and more likely to keep the reserves; Lower interests means banks are more likely to lend and less likely to sit on the reserves.
