Week 1: Overview of Financial Markets & Institutions Flashcards
Why are financial markets important?
a) Provision of savings accounts with interest
b) Efficient allocation of Capital
c) Allows consumers to time purchases better
What is the main function of financial markets?
Channel funds from individuals/firms without investment opportunities to those who have them.
What are the different types of markets, and under which categories can they fall?
Debt and Equity markets
Primary and Secondary markets
Exchanges and Over-the-counter
Money and Capital Markets
What is the difference between securities in debt and equity markets?
Securities in equity market represent ownership claim in firm.
Often pay dividends
What is the difference between Exchange and Over-the-counter Markets?
Exchange: Trades conducted in central location
Over-the-counter: Dealers in different locations
What are foreign bonds called?
What are they?
Eurobonds: denominated in one currency, but sold in a different market
E.g. US bond denominated in USD but sold in the British Exchange
What is the Eurocurrency market?
Currencies deposited outside their home country
E.g. USD deposited in Madrid
Why is the Eurocurrency market useful?
It provides individuals with an alternative source for the currency.
E.g. USD deposited and earning interest in Madrid
What is direct finance?
Borrow directly from lenders in financial markets by selling claims on the borrower’s future income/assets
What is indirect finance?
Borrow via financial intermediaries by selling claims on the borrower’s future income/assets
Why is financial intermediation needed?
i) Transaction costs
ii) Risk sharing
iii) Information Asymmetry
What are liquidity services offered by financial intermediaries?
Provision of checking accounts which can earn interest whilst offering the ability to convert them into goods/services at any point.
How is risk sharing solved through financial intermediation?
Allowed by the low transaction costs (economies of scale).
Asset transformation
What is asset transformation?
Pooling assets and diversifying.
Intermediary sells low risk assets to one party and uses proceeds to buy high risk assets from another.
What are 2 problems that arise from information asymmetry?
a) Before transaction: Adverse selection
Individual who has higher risk of producing adverse outcome is more likely to seek out a loan
b) After Transaction: Moral hazard
Individual who has obtained a loan is likely to pursue undesirable actions that would increase default risk.
What leads to risk of bank runs according to the Diamond-Dybvig model?
Banks need to convert short-term deposits into long-term loans.
What are the 3 types of financial intermediaries?
a) Banks (Depository institutions)
b) Contractual Savings Institutions (CSI)
c) Finance Companies
What type of financial intermediaries are Hedge funds? What do they do?
Finance companies.
Hedge funds sell shares to individual investors (pool investments) and use the proceeds to construct a diversified portfolio.
What are the main objectives of regulation in financial markets?
a) decrease information asymmetry
b) ensure soundness of financial intermediaries
In what ways does regulation in financial markets happen?
1) Restrictions to entry
2) Disclosure
3) Restrictions on Interest Rates
4) Deposit insurance
5) Limits on competition
