Week One Flashcards
What is direct finance
- Raising funds directly from financial markets rather than from intermediaries like banks. This can involve issuing stocks or bonds directly to investors. It’s a method for companies or governments to obtain funding without going through traditional lending channels.
What is indirect finance
An institution stands between lender and borrower.
- We get a loan from a bank or from a finance company to buy a car
What is an asset
Something of value you own
What is a liability
Something you owe
Who are the users of the financial system (2)
- ultimate lenders
- ultimate borrowers
What is an ultimate lender
Agents whose excess of income over expenditure creates a
financial surplus which they are willing to lend
What is an ultimate borrower
Agents whose excess of expenditure over income creates
a financial deficit which they wish to meet by borrowing
Why do borrowers and lenders have conflicting preferences
- borrowers :
Low liquidity
Minimum cost
Minimum risk
Minimum transaction costs
lenders:
- high liquidity
- maximum return
- minimum risk
- minimum transaction costs
What are the functions of money (3)
- means of payment : used in exchange for goods and servives
- It is a unit of account: used to quote prices.
- It is a store of value: used to transfer purchasing power into the future
What is liquidity
a measure of the ease with which an asset can be turned into a means of payment
What are the different types of liquidity (2)
- market liquidity : is the ability to sell assets
- funding liquidity: is the ability to borrow money
What is the inflation and inflation rate
The process of rising prices and inflation rate is the measurement of the process
How does inflation link to the basket of goods
If inflation rises you need more money to buy the same basket of goods
What is M1
Narrow money - the sum of currency in circulation and overnight deposits.
What is M2
Intermediate money - the sum of M1, short-term time deposits (i.e. with an agreed
maturity of up to 2-year) and deposits redeemable at notice of up to 3
months.
What is m3
Broad money - is the sum of M2 and long-term time deposits.
What is CPI
How much more would it cost for people to purchase today
the same basket of goods and services that they actually bought at some fixed time in the past
How to calculate cpi
X
- survey to see what’s they bought
- Figure out what it would cost to buy the same basket of goods and
services today
- Compute the percentage change in the cost of the basket of goods:
CPI =
Cost of the basket in current year /
Cost of the basket in base year ∗ 100
What are financial instruments
Assets that can be traded such as stocks, bonds, derivatives, commodities, currencies, and mutual funds. They represent a claim to future cash flows or a right to receive something of valu
What are the different types of assets (2)
Tangible assets - value based on physical properties
Intangible assets - Claim to future income generated (ultimately) by tangible asset(s)
What are two fundamental classes of financial instruments
Underlying and derivative instruments
What are the three principle economic functions of financial assets
- act as mean of payment - employees take stock options as payment for working
- act as a store of value - Claim to future income generated (ultimately) by tangible asset(s)
- allow for the transfer of risk - Futures and insurance contracts allow one person to transfer risk to
another
What financial instruments are a store of value
Bank loans
Bonds
Home morgatges
Stocks
What financial instruments are used to transfer risk
Insurance contracts
Future contracts
Options
What are financial markets
Places where financial instruments are bought and sold
What are the economic functions of financial markets
Market liquidity + ensure that owners of financial instruments can buy and sell them cheaply and easily.
Information - Pool and communicate information about the issuer of a financial instrument
Risk sharing - Provide individuals a place to buy and sell risk
What are different types of financial intermediaries (2)
Deposit takers
- retail bank
- commercial bank
Non deposit taker
- insurance companies
- pension funds
- Securities firms (brokers, investment banks, mutual funds, private equity and venture capital firms)
- Finance companies
What are the role of financial intermediaries (5)
- Pooling the resources of small savers.
-Providing safekeeping and accounting services, as well as access to payments system - Supplying liquidity by converting savers’ balances directly into a means of payment whenever needed
- providing ways to diversify risk
- Collecting and processing information in ways that reduce information costs
How do banks pool savings
By accepting many small deposits banks empower themselves to more large loans
- must attract substantial numbers of savers
- must convince potential depositors of the institutions soundness
How do banks provide safekeeping payment systems access and accounting
- provide reliable and inexpensive payments systems
- manage our finances
- provide us with bookkeeping and accounting service
- These force financial intermediaries to write legal contracts - but one can be written and used over and over again - reducing the cost of
each
Take advantage of economies of scales
What does providing liquidity look like for banks (6)
- Liquidity is a measure of the ease and cost with which an asset can be
turned into a means of payment. - Financial intermediaries offer us the ability to transform assets into money at relatively low cost - ATMs, for example.
- Banks can structure their assets accordingly, keeping enough funds in short-term, liquid financial instruments to satisfy the few people who will
need them and lending out the rest. - By collecting funds from a large number of small investors, the bank can reduce the cost of their combined investment, offering each individual
investor both liquidity and high rates of return. - Intermediaries offer both individuals and businesses lines of credit, which
provides customers with access to liquidity. - A financial intermediary must specialise in liquidity management, designing its balance sheet to sustain sudden withdrawals.
What does diversifying risk look like
-Financial institutions enable us to diversify our investments and reduce risk
- Banks take deposits from thousands of individuals and make thousands of loans with them. Thus, each depositor has a very small stake in each one of the loans
- All financial intermediaries provide a low-cost way for individuals to diversify
their investments.
How do banks collect and process information
-The fact that the borrower knows whether he or she is trustworthy, while the
lender faces substantial costs to obtain that information, results in an information asymmetry.
- Borrowers have information that lenders do not have
-By collecting and processing standardized information, financial intermediaries reduce the problems that information asymmetries create
What is information asymmetries
- Information plays a central role in the structure of financial markets and financial institutions
- markets require a sophisticated information to work well
- if the cost of information is too high the markets cease to function
- Issuers of financial instruments know more about their business prospects and willingness to work than potential lenders/investors
What is asymmetric information (2)
One party lacks crucial information about
another party, impacting decision-making
- adverse selection - before transactions
- moral hazard - after transactions
What are solutions for adverse selection
- goverment require information disclosure
- private collection of info
- Pledging of collateral to insure lenders against the borrower’s default
- Requiring borrowers to invest substantial resources of their ow
What are thr solutions of moral hazard
Requires mangers to report to owners
Requiring mangers to invest substantial resources of their own
- covenants that restrict what borrowers can do with borrowed funds
