The financial system Flashcards
What is the financial system?
=The group of institutions in the economy which help match one person’s savings with another’s investment
- It is how the economy coordinates savings and investment by balancing the supply and demand for funds
- Moves the economies scarce resources from savers to borrowers
- 2 categories of institutions; Financial markets and financial intermediaries
What are financial markets?
= Institutions through which a person who wants to save can supply funds to a person who wants to borrow
- 2 types: bond market + stock market
What is a bond?
= A bond is an ‘IOU’ issued by large corp’s and gov’t’s which has a date of maturity and rate of interest (coupon) to be paid periodically
Key features of the bond market
- Bonds can be held until maturity or sold to someone else
- High credit risk and long-term bonds are riskier so they offer a higher rate of interest
- Inverse relationship between a bond’s price and it’s coupon
- National gov’t issued bonds to fund public spending are known as “sovereign debt”
What is a stock?
= A claim in partial ownership of a firm which denotes a claim to a share of the future profits the firm makes
- The selling of stocks is known as ‘equity finance’
Key features of the stock market
- Stocks are traded amongst stockholders on organized stock exchanges
- Corporation itself receives no money when the stock changes hands
- Prices are determined by supply and demand
- Demand reflects people’s perceptions of the company’s future profitability (optimism = high demand = higher price)
- Stock indices are used to monitor overall level of stock prices for a particular market eg. FTSE 100
What are financial intermediaries?
= Financial institutions through which savers can indirectly provide funds to borrowers
2 types: Banks + Investment funds
What do banks do as financial intermediaries?
= Take in loans from people who want to save and make loans to people who want to borrow
- Common for small businesses as they struggle to raise funds on the stock market
- Banks also create a ‘special asset’ which people can use as a medium of exchange eg. debit cards, cheques and this allows for easy access to deposits
What do investment funds do as financial intermediaries?
= Sell shares to the public + use the proceeds to buy a portfolio of various types of shares and bonds
- Shareholders of the investment fund accept all risk and return with the portfolio
- Allow people with minimal funds to diversify, spreads risk and gives access to money managers
What are Credit Default Swaps?
= A means by which borrowers can insure themselves against default (swap risk for a price)
- Are paid to another bank or hedge fund who in the case of default will compensate the lender
- Seller must have some form of collateral to cover itself in case of default
What are collateralized debt obligations?
= The funding of mortgages through bonds based on their level of risk (tranches)
- Those who buy bonds in the high risk ‘tranches’ benefit from high interest but also could lose out significantly
- ‘3rd wave structures’ of CDO emerged where tranches of debt would be mixed with other types of debt and sold to investors as fairly secure loans with high interest rates
What was the sub-prime market?
= The sub-prime market was enabled by CDO and offered mortgages to those who would otherwise be unable to get them
- Was very risky and many defaulted, holders of this debt had to write off a huge amount of assets
