Financial Intermediaries and Markets – Flashcards
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Types of financial markets
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Bond, Stock, Foreign Exchange
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Purpose of Financial Markets
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To channel funds from net savers to net demanders
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Security
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financial instrument that represents a claim on an issuers future income or assets
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Bond
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A security that promises to make payments of interest and principal over some specific time horizon
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Where are interest rate determined
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Bond Markets
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What are the implications of an increase in interest rates?
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More costly to borrow money, but can increase income from assets
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Stock
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a security that represents a claim on the earnings and assets of a corporation
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Primary Market
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where companies initially sell stock
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Secondary market
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where subsequent trades among investors occur
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Which market receives the most attention of all active markets?
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Stock Markets
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Foreign Exchange Market
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Where international currencies trade and exchange rates are set. Daily volume=$3 trillion
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What are the implications of the value of the US dollar on demand for foreign goods?
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When the US dollar is strong, foreign demand for US goods is weak. When the US dollar is weak, foreign demand for US goods is strong
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Effects of the value of the US dollar on a US tourist traveling abroad
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International travel is more expensive when the US dollar is weak
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Who operates the so-called "marketplace", and what role do they play?
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Financial institutions, such as corporations, organizations, and networks operate the marketplace, and they play a crucial role in improving the efficiency of the economy
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What are financial intermediaries? Give 3 examples
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Institutions that borrow funds from people who have saved and in turn make loans to others. Commercial banks, Insurance companies, finance corporations
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Primary purpose of a bank
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to accept deposits, and then use the resulting funds to make loans
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What are financial crises
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Financial crises represent major disruptions in financial markets, characterized by sharp declines in asset prices and the failure of many financial and non-financial firms
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Monetary Policy
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Involves the management of interest rates and the quantity of money (Money Supply)
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Federal Reserve System
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The government agency that is primarily responsible for US monetary policy
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Function of financial markets
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to channel funds from persons or businesses without investment opportunities to those who have them
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Examples of lender-savers
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Households, businesses, government, foreigners
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Examples of borrower-spenders
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Households, businesses, government, foreigners
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Direct Finance
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Borrowers borrow directly from lenders in financial markets
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Example of direct finance
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Individual borrows directly from another individual
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Indirect Finance
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Borrowers borrow indirectly from lenders via financial intermediaries
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Example of indirect finance
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An individual borrows from a bank
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Debt Markets
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Short term (maturity shorter than one year), long term (maturity longer than ten years), and intermediate term (maturity in between)
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Equity markets
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Pays dividends, in theory forever. Represents ownership claim in the firm; considered an asset to the holder of the stock and a liability to the issuer
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Aspects of Debt (refer to table, pg 7)
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A creditor interest in the firm, typically no voting rights, priority claim on income and assets, interest payments are tax deductible, failure to make required payments may result in bankruptcy
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Aspects of Equity (refer to table, pg 7)
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An ownership interest in the firm, common equity typically has voting rights, residual claim on income and assets, dividend payments are not tax deductible, no obligation to pay dividends unless declared by Board
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Primary Markets
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Net Security Issues sold to initial buyers; typically involves an investment bank who underwrites the offering
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Secondary Market
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Securities previously issued are bought and sold; involves both brokers and dealers
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How is the secondary market important
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Although firms get money from the primary market, the secondary is important because it provides liquidity, and it establishes a price for the securities
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Brokers
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Agents of investors that match buyers with sellers of securities
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Dealers
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Link buyers and sellers by buying and selling securities at stated prices
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Money Market
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Short term (maturity of less than 1 year)
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Capital Market
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Long term (maturity of greater than 10 years)
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Foreign Bonds
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Bonds that are sold in a foreign country and are denominated in that country's currency
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Eurobonds
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Bonds that are sold in a foreign country and are denominated in a currency other than that of the country in which they are sold
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Eurocurrency
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A foreign currency that is deposited in banks outside the home country
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Eurodollars
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US dollars deposited in foreign banks outside the US or in foreign branches of the US
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Financial Intermediation
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The primary means of moving funds from lenders to borrowers
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Benefits of financial intermediaries
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Reduces transactions costs, and reduces asymmetric information
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Asymmetric information
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Occurs when one party lacks crucial information about another party, impacting decision making
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Features of adverse selection
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Occurs before the transaction occurs. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek a loan
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Features of Moral Hazard
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After a transaction occurs. It is a hazard that borrower has incentives to engage in undesirable activities making it more likely that he will not pay the loan back
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Primary Liabilities and Primary Assets of commercial banks
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Liabilities: Deposits Assets: Business and consumer loans, mortgages, US government securities, and municipal bonds
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Primary Liabilities and Primary Assets of savings and loan associations
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Liabilities: Deposits Assets: Mortgages
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Primary Liabilities and Primary Assets of life insurance companies
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Liabilities: Premiums from policies Assets: Corporate bonds and mortgages
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Primary Liabilities and Primary Assets of pension funds, government retirement funds
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Liabilities: Employer and employee contributions Assets: Corporate bonds and stock
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Primary Liabilities and Primary Assets of Finance companies
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Liabilities: Commercial paper, stocks, bonds Assets: Consumers and business loans
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Primary Liabilities and Primary Assets of mutual funds
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Liabilities: shares Assets: Stocks, bonds
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Primary Liabilities and Primary Assets of money market mutual funds
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Liabilities: Shares Assets: money market instruments
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What are the two types of depository institutions
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Commercial banks and savings and loan associations
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Commercial banks
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Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer, and mortgage loans
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Savings and Loan associations
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similar to commercial banks
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What are the two types of contractual savings institutions and what do they do
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Life insurance companies and pension funds. They acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements
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Life insurance companies
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Receive policy premiums
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Pension funds
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Receive employee and employer payroll contributions
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Finance companies
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Acquire funds by selling commercial paper and issuing bonds and stocks. They use the funds to make loans to consumers and small businesses
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Mutual Funds
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Acquire funds by selling shares to individual investors and they use those funds to purchase large, diversified portfolios of stocks and bonds
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Money Market mutual funds
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Acquire funds by selling checkable deposit-like shares to individual investors, and they use those funds to purchase highly liquid and safe short term money market instruments
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What do investment banks do
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They advise companies on securities to issue, underwrite security offerings, offer assistance in mergers and acquisitions, and act as dealers in security markets
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Reasons for regulation of the financial system
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Increase information to investors and ensure the soundness of financial intermediaries
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What does the value of a debt security depend on?
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The amount of cash flow it generates, the timing of the cash flows, and risk
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Present Value
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Current value of future cash flows discounted at the appropriate discount rate, where discounting is the inverse of compounding
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Present value interest factor
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PVIF=1/(1+i)^n
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Loan principal
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The amount of funds the lender provides the borrower
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Maturity date
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The date the loan must be repaid
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Interest payment
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the cash amount that the borrower must pay the lender for the use of the loan principal
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Simple Interest rate
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The interest payment divided by the loan principal; the percentage of the principal that must be paid as interest to the lender
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What is the relationship between the discount rate and the PV when the future value and n are constant?
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The discount rate and the PV are inversely related
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Four basic types of Credit instruments
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Simple loan, fixed payment loan, coupon bond, discount bond
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Yield to maturity
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Interest rate that equates today's value with present value of all future payments
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Simple loans
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Require payment of one amount which equals the loan principal plus the interest
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Fixed payment loans
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Loans where the loan principal and interest are repaid in several payments, often monthly, in equal dollar amounts over the loan term. Also called fully amortized loans, where a portion of each payment goes towards reducing loan principal and a portion towards interest
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Coupon Bonds
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Pay the owner a fixed interest payment every year until maturity date, when a specified final amount is paid
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Discount Bonds
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Purchased at a price below face value. Face value is repaid at maturity date. This type of bond does not make any interest payments. Also known as a zero coupon bond
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Perpetuity
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Perpetual bond with no maturity date and no repayment of principal. Also known as a consol
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Default Risk
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The risk that a loan customer may fail to repay a loan as promised
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Interest rate risk
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the possible reduction in returns that is associated with changes in interest rates
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Reinvestment risk
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the interest rate risk associated with the fact that the proceeds of short term investments must be reinvested at a future interest rate that is uncertain
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Inflation risk
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risk that interest rates will rise because of unanticipated inflation
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Currency risk
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risk that the currency in which a bond investment is denominated will decline versus your home currency
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Lack of marketability or liquidity risk
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risk that you cant sell a bond prior to its maturity easily.
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What is Duration?
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The weighted average of the maturities of the cash payments
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What happens to duration when interest rates rise?
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Duration of a coupon bond falls
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What happens to duration when the coupon rate is higher?
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Duration of the bond is shorter
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Securities and Exchange Commission
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Regulates organized exchanges and financial markets
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Commodity Futures Trading Commission
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Regulates Future market exchanges
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Office of the Comptroller of the Currency
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Regulates federally chartered commercial banks
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National Credit Union Administration
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Regulates federally chartered credit unions
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State banking and insurance commissions
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Regulate state chartered depository institutions
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Federal Deposit Insurance Corporation (FDIC)
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Regulates commercial banks, mutual savings banks, savings and loan associations
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Federal Reserve Bank
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Regulates all depository institutions
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Office of Thrift Supervision
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Regulates savings and loan associations
