week 1 Flashcards
Function of financial market
Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them. Financial markets also improve the well-being of consumers, allowing them to time their purchases better
Debt market
When you need funds you can issue a debt instrument, such as a bond or a mortgage, this is a contractual
agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals
(interest and principal payments) until a specified date (the maturity date), when a final payment is made.
Equity market
Second method of raising funds is by issuing equities, such as common stock, which are claims to share in the net income and the assets of a business. Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. Also you will receive voting rights.
Interest Rates on Selected Bonds
- interest rate is higher on long term bonds because people require higher returns due to risk increasing over time
- three month treasury bills are much more volatile because this takes the average of three months and the long term takes the average return of one year.
Primary market
On the primary market there is typically an investment bank involved who underwrites the offering. This means that they determine the starting share price and quantity.
Also they take part of the risk in the sense that, when not all of the shares introduced to the market are sold, the investment bank will buy up all excess shares.
Secondary market
refers to the financial market where securities (such as stocks, bonds, and other financial instruments) are bought and sold after they have been issued in the primary market
Securities brokers and dealers are crucial to a well-functioning
secondary market.
Brokers
agents of investors who match buyers with sellers of securities, they do not own the securities or assets that they trade.
Dealers
Trades securities for their own account, link buyers and sellers by buying and selling securities at stated prices.
Function of secondary market
- They make it easier and quicker to sell financial instruments and raise cash, they make financial
instruments liquid - They determine the price of the security that the issuing firm sells in the primary market
Two types of secondary market
- Exchanges: buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. For example The New York and American Stock Exchanges.
- Over-the-Counter (OTC) market: in which dealers at different location who have an inventory of
securities stand ready to buy and sell securities “over-the-counter” to anyone who comes to them
and is willing to accept their prices. Over-the-counter dealers are in contact via computers.
Distinguish money and capital markets
Another way of distinguishing between markets is on the basis of the maturity of the securities traded in each market.
- Money Market: Short Term (maturity < 1 year)
- Capital Market: Long Term (maturity > 1 year) plus equities
Foreign bonds
are sold in a foreign country and are denominated in that country’s currency
German automaker Porsche sells a bond in the US denominated in US dollars
Eurobonds
a bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies
which are foreign currencies deposited in banks outside the home country
Eurodollars
which are US dollars deposited in foreign banks outside the US
Direct finance
Borrowers borrow directly from lenders in financial markets by selling securities (financial instruments) which are claims on the borrower’s future income or assets.
Indirect finance
refers to the process by which borrowers obtain funds through financial intermediaries, such as banks, insurance companies, pension funds, and mutual funds. These intermediaries act as middlemen between those who have surplus funds (lenders) and those who need funds (borrowers).
What leads to lower transaction costs and why it is important?
A financial intermediary can substantially lower transaction costs, because they have developed expertise in lowering them and because their large size allows them to take advantage of economies of scale.
Lower transaction costs can provide customers with liquidity services:
- Banks provide depositors with checking accounts that enable them to pay their bills
- Depositor can earn interest on checking/saving accounts and convert them into g&s
Another benefit of low transaction costs
- It reduces the exposure of investor to risks
Asset transformation
Financial intermediaries create and sell assets with lesser risk to one party in order to buy assets with greater risk from another
party
Adverse selection
Problem created by asymmetric information before transaction occurs.
Potential borrowers
most likely to produce adverse outcome are ones most likely to seek a loan.
Moral Hazard
Problem created by asymmetric information after transaction occurs
Hazard that borrower has
incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back
List of depository institutions
- Commericial banks
- Savings and loan associations
- Mutual savings banks
- Credit unions
List of Contractual savings institutions
- Life insurance companies
- Fire and casualty insurance companies
- Pension funds, government retirement funds
List of investment intermediaries
- Finance companies
- Mutual funds
- Money market mutual funds
Depository institutions (banks)
Financial intermediary that accept deposits from individuals and institutions and make loans
Commercial banks
Raise funds primarily by issuing checkable, savings, and time deposits which are used to
make commercial, consumer, and mortgage loans.
S&Ls & Mutual Savings Banks and Credit Unions
Savings and Loan Associations are financial institutions that primarily focus on accepting savings deposits and making home mortgage loans.
Mutual Savings Banks are similar to savings and loan associations, but they have a slightly different organizational structure and focus.
Credit Unions are nonprofit financial cooperatives owned by their members. Credit unions provide many of the same services as commercial banks, but they operate under a cooperative model and focus on providing benefits to their members rather than generating profits.
Contractual Savings Institutions (CSIs)
All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements.
Finance Companies
sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations
Mutual Funds
acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds.
Money Market Mutual Funds
acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments.
Main reason of having regulation on the financial system
to increase the information available to investors and to ensure the soundness of the financial system
