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Financial Markets & Institutions > Week 1: Overview Of Financial System > Flashcards

Week 1: Overview Of Financial System Flashcards

1
Q

5 parts of financial system

A

Money
Financial instruments
Financial markets
Financial institutions
Central banks

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2
Q

5 principles of financial system

A

Time has value
Risk requires compensation
Information is the basis for decisions
Markets determine prices and allocate resources
Stability improves welfare

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3
Q

Flow of funds through the financial system

A

Lenders either provide indirect through financial intermediaries

or direct finance through financial markets.

These providers will then provide funds for borrowers/spenders.

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4
Q

What is direct finance, and who does it?

A

Borrowers sell securities directly to lenders in financial markets. (NOT FINANCIAL INTERMEDIARIES WHICH ARE INDIRECT FINANCE)

Direct financing usually for governments and corporations

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5
Q

Indirect finance

A

An third party facilitates a transaction between the lender and borrower.

E.g loan from a bank to buy a car.

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6
Q

Who are the users of the financial system? (2)

A

Ultimate lenders - agents whose excess income creates a surplus they are willing to lend (e.g bank depositors)
Ultimate borrowers - agents excess expenditure creates a deficit they wish to meet by borrowing. (those seeking loans from the bank)

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7
Q

4 preferences of borrowers and lenders

A

They have conflicting preferences
Borrowers:
Low liquidity (do not want to make frequent payments)
Minimum cost
Minimum risk
Minimum transaction costs

Lenders:
High liquidity (want faster repayments as lower risk, and can also re-lend funds to maximise profits)
Maximum return
Minimum risk
Minimum transaction costs

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8
Q

3 functions of money

A

Unit of account (prices expressed as money)
Store of value (transfer purchasing power into future)
Medium of exchange/means of payment

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9
Q

Liquidity

A

Ease of which an asset can be converted into cash.

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10
Q

2 types of liquidity

A

Market liquidity - ability to sell assets
Funding liquidity - ability to borrow money

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11
Q

How did the liquidity spiral link to the finanical crisis

A

Market liquidity (ability to sell assets fell) due to the uncertainty, so price of securities fell, and the falling asset prices further reduced confidence and funding liquidity (ability to borrow) fell.

This continued, causing a cycle called the liquidity spiral.

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12
Q

Primary cause of inflation

A

Too much money in circulation

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13
Q

Money types

A

M1 - narrow money
M2 - intermediate money
M3 - broad money

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14
Q

M1 narrow money is made of 2 components

A

Money in circulation
Overnight deposits

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15
Q

M2 intermediate money - 3 components

A

M1 (money circulating+overnight deposits)
Short term time deposits
Deposits redeemable at notice of 3 months max.

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16
Q

M3 broad money (2 components)

A

Sum of M2 and long term deposits

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17
Q

Composition of money aggregates in EU, UK and US

A

EU only goes up to M3

UK goes up to M4

US up to M2

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18
Q

CPI

A

FIXED EXPENDITURE WEIGHT INDEX - measuring changes in purchasing power

19
Q

CPI formula

A

Cost of basket current
/
Cost of basket in base year

x 100 for percentage form

20
Q

Financial instruments

A

The written legal obligation of one party to transfer something of value to another party at a future date.

21
Q

2 classes of financial instruments

A

Underlying instruments
Derivative instruments

22
Q

3 functions of financial assets

A

Means of payment - stock options as payment
Store of value - financial instruments can be held
Transfers risk from one person to another

(So not a unit of account unlike money)

23
Q

Which financial instruments are used primarily as a store of value (4)

A

Bank loans
Bonds
Mortgages
Stocks

24
Q

Which financial instruments are used primarily to transfer risk? (3)

A

Insurance contracts
Futures contracts
Options

25
Q

Role of financial markets

A

Where finanical instruments are bought and sold.

26
Q

3 functions of financial markets

A

Market liquidity - ensure can buy and sell easily
Information sharing
Risk sharing - provide place to buy and sell risk

27
Q

5 classifications of financial markets

A

Nature of claims

Maturity of claims

Seasoning of claims

Delivery time

Organisational structure

28
Q

Types of financial intermediaries (provide examples)

A

Deposit takers (banks)

Non deposit takers (insurance companies, pension funds, securities firms etc)

29
Q

Role of financial intermediaries (5)

A

Pool resources of small savers

Provide safekeeping and accounting services

Supply liquidity by converting savers balances directly into a means of payment whenever needed

Diversify risk

Collect and process info to reduce information costs.

30
Q

Pooling savings: what must they do to do this? (2)

A

Must attract a substantial number of savers (since deposits are small)

Must convince potential depositors of the institutions soundness (to be willing to put money in)

31
Q

Why are financial intermediaries beneficial, and how?

A

They provide a reliable and inexpensive payments system, helping economy function efficiently.

How? They have E.O.S

32
Q

Providing liquidity: what must intermediaries be able to do?

A

Must be able to handle sudden withdrawals by holding enough funds in short term.

E.g through ATMS can be used.

33
Q

Diversifying risk: how?

A

Banks use the deposits and make loans with them. So each depositor has a small stake in each one of the loans.

34
Q

Why do banks collect and process information?

A

Borrowers have more information lenders to not have. Lenders do not know whether the borrowers are trustworthy, this is asymmetric information.

By collecting and processing information, we can reduce problems of asymmetric information e.g knowing credit scores etc.

35
Q

What do markets require to work well, and what can halt this?

A

Sophisticated information.

If the cost of information is too high, markets cease to function.

36
Q

Results of asymmetric information (2)

A

Adverse selection arises before transaction occurs - asymmetric info means one makes an undesirable decision (e.g decision to make loan)

Moral hazard occurs after the transaction - when the borrower gets the money, the burden of risk on is the lender. Which can influence the way they use the money (may not use as they claim!)

37
Q

What does adverse selection imply the need for

A

To distinguish between bad and good credit risks.

38
Q

When does moral hazard arise?

A

When we can’t observe people’s actions

39
Q

What does moral hazard affect?

A

Equity and bond financing

40
Q

Moral hazard in equity finance

A

How do you know the share capital will be used in away to increase value for you (THE SHAREHOLDER)?

Could go to dividends etc.

41
Q

What is this problem known as

A

Principle agent problem (manager making decisions may be different from principle i.e shareholders)

42
Q

Moral hazard in debt finance - why does it exist

A

Debt finance allow owners to keep all profits since no shareholders like equity, encouraging greater risk taking. Only have to pay of their loan, doesn’t change proportionate to their success!

They receive the full benefit of the payoff, while the downside is limited to their collateral.

43
Q

Solutions to adverse selection (4)

A

Government required information disclosure.

Private collection of info

Pledging collateral to insure lenders against borrowers default.

Requiring borrowers to invest substantial resources of their own

44
Q

Solutions to moral hazard (3)

A

Required managers to report to owners (solve principle agent problem)

Requiring managers to invest substantial resources of their own

Covenants (agreements) that restrict what borrowers can do with borrowed funds

Financial Markets & Institutions (18 decks)

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