Week 1: overview of the financial system Flashcards
Describe financial system
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Financial system main function
Financial system is about flow of funds:
* Assets: Something of value that you own (you have a claim against someone).
* Liabilities: Something you owe (sometimes labeled as “IOU”)
* The role of the financial system is to facilitate production, employment, and consumption:
Resources are funneled through the system so (ideally) resources flow to their most efficient
uses.
Direct vs Indirect finance
*Direct Finance:
Borrowers sell securities directly to lenders in the financial markets.
* Direct finance provides financing for governments and corporations without intermediation (only brokers may in between).
* “Market-based” system: direct claims b/w lenders and borrowers
*Indirect Finance:
An institution stands between lender and borrower.
* Households get a loan from a commercial bank to buy a car.
* Process of intermediation: “Bank-based” system → e.g., deposits of savers are channeled to borrowers; both have a claim resp. liability against banking system, but no direct financial relation to each other.
6 parts of financial system
- Money
To pay for purchases and store wealth. - Financial Instruments
To transfer resources from savers to investors and to transfer risk to those best equipped to bear it. - Financial Markets
To buy and sell (i.e., trading financial instruments. - Financial Institutions
To provide access to financial markets, collect information & provide services. - Regulatory Agencies
To provide oversight for financial system and safeguard stablity. - Central Banks
To monitor financial institutions and stabilize the economy through their usage of monetary policy
instruments
5 core principles of money and banking
- Time has value.
* Time affects the value of financial instruments.
* Interest is paid to compensate the lenders for the time the borrowers have their money. - Risk requires compensation.
* In a world of uncertainty, individuals will accept risk only if they are compensated.
* In the financial world, compensation comes in the form of explicit payments: the higher the risk the bigger the payment. - Information is the basis for decisions.
* The more important the decision, the more information we gather.
* Collection and processing of information is the foundation of the financial system. - Markets determine prices and allocate resources.
* Markets are the core of the economic system.
* Markets channel resources and minimize the cost of gathering information and making transactions.
* In general, the better developed the financial markets, the faster the country will grow. - Stability improves welfare.
* A stable economy reduces risk and improves everyone’s welfare.
* Financial instability in the autumn of 2008 triggered the worst global downturn since the Great Depression.
* A stable economy grows faster than an unstable one.
* One of the main roles of central banks is stabilizing the economy.
Money and its characteristics
Money is an asset that is generally accepted as payment for goods and services or repayment of debt.
Money has three characteristics:
1. It is a means of payment (used in exchange for goods and services)
2. It is a unit of account (used to quote prices), and
3. It is a store of value (used to transfer payments into the future)
→ here the idea of liquidity is important
Not to confuse with:
* Income is a flow of earnings over time.
* Wealth is the value of assets minus liabilities (i.e., a stock variable)
→ money is one of those assets
→ Other forms of wealth are also a store of value: stocks, bonds, houses, etc.
Money and Liquidity (name 2 concepts of liquidity)
Although other stores of value are sometimes better than money, we hold money because it is (most) liquid.
- Liquidity is a measure of the ease with which an asset can be turned into a means of payment.
- The more costly it is to convert an asset into money, the less liquid it is.
- Two concepts of liquidity:
Market liquidity - the ability to sell assets for money.
Funding liquidity - ability to borrow money to buy securities or make loans.
Financial instruments- characteristics
The written legal obligation of one party to transfer something of value, usually money, to another party [both are so-called counterparties to each other] at some future date, under specified conditions.
* The enforceability of the obligation is important.
* Financial instruments obligate one party (person, company, or government) to transfer something to another party.
* Financial instruments specify payment(s) which will be made at some future date.
* Financial instruments specify conditions under which a payment will be made.
* Financial instruments also communicate information, summarizing certain details about the issuer.
Two forms/classes of financial instruments
- Underlying (or, primary) instruments (like stocks and bonds)
- Derivative instruments: their value is “derived” from the behavior of underlying instruments (likes options and futures)
3 functions of financial instruments
- Financial instruments act as a MEANS OF PAYMENT (like money).
–>Employees take stock options as payment for working. - Financial instruments act as STORES OF VALUE (like money).
–>Financial instruments can be used to transfer purchasing power into the future. - Financial instruments allow for the TRANSFER OF RISK (unlike money).
–> Options, futures, insurance contract etc. allow one person to transfer risk to another.
Financial contracts can be very complex.
* This complexity is costly, and people do not want to bear these costs.
* Standardization of financial instruments overcomes potential costs of complexity.
Four fundamental characteristics influencing the value of any financial instrument
- Size of the payment: Larger promised payment → more valuable.
- Timing of payment: Payment is sooner → more valuable.
- Likelihood that payment is made: More likely to be made → more valuable.
- Conditions (circumstances) under with payment is made: if payments are made when we need them → more valuable.
2 usages of financial instruments
- Primarily used as stores of value: bank loans (incl. mortgages), bonds, stocks, and asset-backed securities.
- Primarily to transfer risk:
insurance contracts, futures contracts, options, and swaps.
Main characteristics of financial markets
- Market liquidity:
* Ensure owners can buy and sell financial instruments cheaply.
* Keeps transactions costs low. - Informational efficiency:
* Pool and communication information about issuers of financial instruments. - Risk sharing:
* Provide individuals a place to buy and sell risk, sharing them with others.
Types of financial markets
- A primary financial market-
is one in which a borrower obtains funds from a lender by selling newly
issued securities. - Secondary financial markets-
are those where people can buy and sell existing securities.
Historically there were:
* Centralized exchanges:
buyers and sellers meet in a central, physical location (NYSE etc.).
* Over-the-counter markets (OTC’s): decentralized markets where dealers stand ready to buy and
sell securities electronically.
- More recently, there are electronic communication networks:
- Electronic system bringing buyers and sellers together without the use of a broker or dealer.
Debt vs Equity markets
- Debt markets are markets for loans, mortgages, and bonds.
Debt instruments categorized by the loan’s maturity.
Repaid in less than a year - traded in money markets.
Maturity of more than a year - traded in bond markets (sometimes also labelled capital markets). - Equity markets are the markets for stocks (define ownership in a firm).
Like in the debt markets, in equity markets, actual claims are bought and sold for immediate cash payments. (not so much covered in this course)
+Derivative markets
