MODULE 7 Flashcards
What are the functions of the financial markets?
Financial Market: in a financial market, people trade future claims on funds or goods. These can be in the form of insurance premiums, stock in a company or loans paid to the bank
Adverse selection
It refers to the situation in which buyers and sellers have different information about the QUALITY of a good or the riskiness of a situation, and this information asymmetry results in failure to complete transactions that might have otherwise been completed (if both sides possessed the same information)
Moral hazard
Moral hazard: refers to the tendency for people to behave in RISKIER ways or to RENEGE on a CONTRACT when they do not meet the full CONSEQUENCES of their ACTIONS. It’s an asymmetric information problem that arises once a transaction takes place
Main three functions of banks
Intermediate between borrowers and savers, provide liquidity and offer diversity for risk
What are savings?
Savings: is the portion of income that is not IMMEDIATELY spent on the consumption of goods and services
When people purchase STOCKS or put money into an RRSP account for retirement, they often say they are “investing” the money. But to an economist, these are examples of savings, not investment
NET BORROWER VS NET LENDER
Canada’s loanable funds market participates in the global market through net exports (NX). If Canada’s NX increases then Canada has acquired foreign assets; therefore, it has become a net lender and the quantity of loanable funds in Canada is lower than the national savings. On the other hand, if Canada’s NX decreases, then Canada owes foreign assets and has become a net borrower; thus the quantity of loanable funds would be greater than national savings
How does a recession affect savings rates comparing future and current income levels?
In the present, if future expectations do not change, then the savings rate will go down with a recession.
Expectations can affect the savings rate; if people expect their income to be lower in the future, then they will likely save more money now to ensure they have enough down the road
When the economy is performing well and has a strong future outlook, how are savings rates affected?
When the economy is performing well and has a strong future outlook, then people will be less likely to save because they expect higher incomes in the coming years. As a result, savings rates will drop which shifts the supply left, moves the equilibrium to a higher point on the demand curve and subsequently raises the interest rate
Would the length of a long term loan have a higher or lower interest rate than a short term loan?
A long term loan would have a higher interest rate because there is greater opportunity cost
How do derivatives transfer risk?
In general, derivatives are meant to transfer risk to people who are more willing to bear it
Defined benefit vs. contribution plan
Defined-benefit plan: guarantees a fixed payout to employees who have met specific requirements, such as working for a company for x years
Defined-contribution plan: does not guarantee retirees a defined level of pension. Employees pay in a certain (defined) amount per year and their employers may match some portion of that contribution. The fund provides payouts that depend on how the stock market performs. Most defined-contribution plans allow contributions to grow tax-deferred until they are withdrawn
What’s market risk?
Market risk: risk that is shared by the entire market. This risk is harder to diversify out of. One example is unexpected inflation, a method of diversifying out of this risk is by buying inflation protected bonds that have a variable interest rate.
What is idiosyncratic risk?
Risk that is unique to a particular stock or industry
What is the efficient market hypothesis
states that the market always prices in all information available about a stock and therefore represent the true value correctly
What is the savings investment identity?
Altogether, the savings investment identity tells us that savings equals investment in an economy with no government and no trade
