Lecture 2 Overview Of The Financial System Flashcards
Function of the financial system
Channel funds from those who have excess money to those who want to invest and don’t have any money
Indirect finance
Savers such as households, business firms and government put their money into financial intermediaries such as banks. Financial intermediaries allocate funds to borrowers such as businesses, government and households.
Direct finance
Borrowers borrow funds from lenders through financial markets. The borrowers issue and sell securities.
Ie a bond.
Bond is an asset for the buyer and a liability to the company issuing.
Assets
A resource which produces future economic cash. Wealth can be held.
Liability
Something that is owed to another party.
An obligation which is expected to be an outflow of cash.
How do financial markets promote economic efficiency?
1) If desired consumption is more than current income.
Borrow money
Become better off
Lender is better off as they earn interest on which would have been unproductive funds.
2) If current income is more than desired consumption
Lend money
Lender is better off because it earns interest
Borrow is better off because they can invest in capital and increase productivity.
What would happened without markets?
Stuck with the status quo.
Consumers would be forced to consume less. Consumer can’t spread consumption optimally over time.
Businesses would produce less because it would be hard to finance investment.
Society would be worse off
What is a Debt market?
Debt securities are issued and traded such as, bonds.
A debt security is a contractual agreement where the borrower has to make payments and intervals with interest to the lender who holds the bond.
Maturity of the debt is the length of time until the contract expires.
What is an equity market?
Where shares of stock are issued and traded.
A stock = a residual claim on the net income and assets of a
corporation.
What is a Primary Market?
Where new issues of a security are sold to initial buyers.
• The selling often takes place behind closed doors through investment
banks, which underwrite securities
– (i.e. guarantee a certain price for a company’s securities and then sell
these securities to the public).
• Corporations use primary markets to raise funds
What is a Secondary Market?
Where securities previously issued are bought and sold by the public.
• Trading in the secondary market does not yield new funds for the
company.
• However, they make securities more liquid, and therefore more
attractive in the primary market
What are organized markets?
Buyers and sellers (or their agents) meet in
one central location to conduct trades.
• Examples: NYSE, London SE, Frankfurt SE
What are over the counter markets?
Dealers at different locations stand ready to buy/sell “over the
counter” to anyone who’s willing to accept their prices (bid-ask).
• Dealers are in computer contact and know the prices set by one
another (strong competition).
• Examples: Nasdaq, foreign exchange market, bond markets
What are Treasury Bills?
Short/term debt instruments issued by the government
No interest payments
High degree of liquidity, high trading volume
Very low chance of default
What are Certificates of Deposits?
Short/term (1 to 5 years) debt instruments sold by banks to depositors
Interest payments
What is a Commercial Paper?
Short/term (2 to 30 days) debt instrument issued by large banks and
corporations
No interest payments
What are repurchase agreements?
Party A sells some securities to party B and promises to buy them back at
a higher price
The securities act as collateral, and the effect is that B lends money to A
What are commercial bonds?
Long/term debt instruments issued by corporations
Interest payments
Medium degree of liquidity
Default risk varies considerably across issuers
What are Government Bonds?
Long/term debt instruments issued by governments
Interest payments High degree of liquidity, high trading volume
Default risk varies considerably across countries
Risk that borrower will not be able/willing to meet its obligations
Why is Indirect Finance so Important?
Financial intermediation addresses 3 major issues that
may reduce the effectiveness of financial markets:
1. It reduces transaction costs
2. It reduces risk exposure through risk sharing
3. It mitigates asymmetric information problems
– Adverse selection
– Moral hazard
How have transaction costs made intermediaries?
Existence of financial intermediaries may be explained by
the existence of transaction costs.
– Example: you have some savings (£100)
– you want to find a productive use for them
– you need to find someone willing to pay to “rent” your funds
– Problems:
• This amount is too small to be interesting/relevant for businesses
• Need time and money to carry out this financial transaction!
Example of Transaction Costs
Assume that by sheer luck you’ve found a potential
borrower (lend £100, interest = £10)
• Now you have to hire a lawyer to write up the
loan contract! (cost=£500)
Lending your funds would be unprofitable!
(the transaction will not take place!)
How do banks reduce transaction cost?
A bank, instead, could reduce transaction costs through
economies of scale:
–Bank hires a lawyer to write a standard loan contract that can be used 1000
times
–Unit cost of loan contract = £500/1,000 = £0.5
–If you lend your funds to the bank and then the bank lends these funds to the
borrower transaction will take place everyone will benefit!
What is risk sharing?
Intermediaries can create and sell to the public assets with
low risk characteristics then use the funds to invest in
much riskier assets (asset transformation).
Intermediaries can help people reduce exposure to risk
through diversification.
– Financial institutions typically hold large and well
diversified portfolios
– Idea: you shouldn’t put all your eggs in one basket.
– Without intermediaries, it would be very difficult for small savers to
spread risk across many investments.
