Introduction to Finance and the Financial System

Comprehensive vocabulary flashcards covering the financial system, bond and stock markets, exchange rates, the Federal Reserve, banking operations, the 2008 financial crisis, and insurance/pension instruments.

Indirect financing transactions

Transactions involving a financial intermediary between the lender-saver and the borrower-spender, which represent the majority of financial activities.

Two goals of financial market regulation

1. Providing better information for investors and 2. Ensuring the soundness of financial institutions and intermediaries.

Yield to maturity (YTM)

The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today, typically equal to the return only if the bond is held to maturity.

Bond return

Equal to the yield to maturity and the coupon rate only when the bond is held for a period equal to its maturity.

Fisher effect

The relationship where the expected inflation rate affects interest rates; when expected inflation rises, the demand for bonds decreases and the supply of bonds increases, leading to a drop in bond prices and an increase in interest rates.

Flight to quality

A financial phenomenon where investors move their capital out of risky assets (like corporate bonds) and into safe-haven assets (like Treasuries) during a credit crisis, causing credit spreads to widen.

Expectations theory

A theory of term structure stating that long-term interest rates are the summation of expected future short-term rates.

Liquidity premium

An extra return added to the expectations theory formula to account for the risk of holding longer-term bonds, explaining why yield curves are typically upward sloping.

Money market funds

Financial instruments characterized as low risk, low return, short duration, and generally highly liquid.

Callable bond

A bond that gives the issuer the right to buy back the bond before its scheduled maturity date under specific conditions.

Convertible bond

A bond that can be converted into a specified number of shares of common stock at the option of the holder.

Gordon Growth Model

A simplified version of the dividend discount model that assumes dividends grow at a constant rate indefinitely.

Mutual fund's Net Asset Value (NAV)

Calculated by taking the total net assets of the fund and dividing it by the total number of shares outstanding.

Spot rates

Exchange rates for the immediate exchange of currencies.

Forward rates

Exchange rates for the exchange of currencies at a specified future date.

Law of One Price

The economic concept that if two countries produce an identical good, the price of the good should be the same throughout the world regardless of which country produces it.

Purchasing Power Parity (PPP)

The theory that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries.

Capital adequacy

A risk management area for banks focused on ensuring they have enough owner's equity to absorb fluctuations in the balance sheet and prevent insolvency.

Return on Equity (ROE)

A financial metric calculated as profits divided by capital; bank owners prefer lower capital to maximize this ratio, while regulators prefer higher capital for safety.

Securitization

The process of pooling various types of contractual debt (such as mortgages) and selling their related cash flows to third-party investors.

Ginnie Mae

A government-backed entity that facilitates pass-through mortgages that are insured and considered safe.

Freddie Mac

A government-sponsored entity (GSE) that introduced more complex mortgage-backed products like Collateralized Mortgage Obligations (CMOs).

Collateralized Debt Obligation (CDO)

A structured financial product that pools mortgage securities and slices cash flows into different tranches based on risk and duration.

Tranche

A specific portion or slice of a pool of securities (like a CDO) categorized by risk, duration, or other characteristics to appeal to different investors.

Ninja loan

A 'no doc' loan often associated with subprime mortgages where the borrower has 'No Income, No Job, and no Assets' verified.

Board of Governors

The central governing body of the Federal Reserve System that, along with Federal Reserve Banks, makes up the FOMC.

Federal Open Market Committee (FOMC)

The body within the Federal Reserve that meets eight times a year to set and implement monetary policy.

Interest on Reserve Balances (IORB)

The primary tool used by the Fed in an ample reserves regime to set and manage the federal funds rate.

The Dual Mandate

The Federal Reserve's statutory objectives to promote price stability and maximum employment.

Greenspan Doctrine

The policy stance that central banks should not try to pop asset bubbles because they are hard to identify, though credit-driven bubbles are considered more dangerous.

Asymmetric information

A situation where one party in a transaction has more or better information than the other, often leading to adverse selection or moral hazard.

Debt deflation

A process where a substantial decline in the price level leads to a further deterioration in firms' net worth because of the increased burden of indebtedness, often seen in the Great Depression.

Credit spreads

The difference between interest rates on loans with different levels of risk; these gap out or widen during times of financial crisis.

FDIC Insurance

Government-provided insurance for bank deposits intended to alleviate bank panics, though it can increase moral hazard by creating a safety net for risky behavior.

CAMELS

An acronym used by bank examiners to evaluate the health of a bank: Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk.

Value at Risk (VaR)

The industry standard for assessing a bank's risk by calculating the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval.

Sarbanes-Oxley Act of 2002

Legislation passed to improve the quality of financial statements and disclosure in response to corporate accounting scandals.

Dodd-Frank Reform

A broad piece of financial legislation passed after the 2008 financial crisis to address systemic risk and improve financial stability.

Volcker Rule

A component of Dodd-Frank that limits the types of risky speculative activities, such as proprietary trading, that banks can engage in.

Insurable risk

A risk that meet specific principles enabling an insurer to underwrite it, including having an insurable interest in the object or person insured.

Term life insurance

Life insurance that provides coverage for a specific period (terminates) and offers only insurance protection with no cash value.

Whole life insurance

Permanent life insurance that lasts for the insured's entire life, featuring higher premiums that build a cash value account.

Annuities

Financial products designed as 'longevity insurance' that provide a guaranteed income stream for the life of the insured in exchange for premiums paid now.

Defined Benefit pension

A pension plan where the employer guarantees a specific benefit to the employee at retirement, placing the investment risk on the employer.

Defined Contribution pension

A pension plan where a specific amount is contributed to the employee's account, and the employee bears the investment risk on those funds.