Financial Systems Test 1

Six Parts of the Financial System

Money, Financial Instruments, Financial Markets, Financial Institutions, Regulatory Agencies, Central Banks

Money

Pay for purchases and store wealth.

Financial Instruments

Transfers resources from savers to investors and to transfer risk to those best equipped to bear it.

Financial Markets

Buy and sells financial instruments

Financial Institutions

Provide access to financial markets, collect information & provide services

Regulatory Agencies

Provide oversight for the financial system

Central Banks

Monitors financial instutions and stabilize the economy

What do financial markets help sell?

Financial instruments

What do financial institutions provide access to?

Financial markets and gathering information

When were government regulatory agencies introduced?

After the Great Depression

Five core priniples of money and banking

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

Time has value

Time affects the value of financial instruments. (Interest)

Risk Requires Compensation

Individuals will only accept risk if they are compensated. The higher the rish, the bigger the payment expected

Information is the basis for decisions

We gather more information if the decision is bigger

Markets determine prices and allocate resources

Markets channel resources and minimize the cost of gathering information and making transactions

Stability Improves Welfare

A stable economy reduces risk and improves everyone’s welfare

Income

A flow of earnings over time

Wealth

The value of assets minus liabilities

Three characteristics of money

Means of payment, unit of account, store of value

Market Liquidity

The ability to sell assets for money

Funding Liquidity

The ability to borrow money to buy securities or make loans

Payments System

A web of arrangements that allow for the exchange of goods and services

Possible Methods of Payment

Commodity and Fiat monies, Checks, Electronic Payments

Commodity monies

Things with intrinsic value (silk and salt)

Fiat money

Today’s paper money. Named that because its value comes from a government decree

Check

Instruction to the bank to take funds from your account and transfer them to another

Electronic Payments

Take the form of credit and debit cards, electronic funds transfers, e-money

Debit Cards

Works like a check in the form of a card

Credit Cards

A promise by a bank to lend the cardholder money to make a purchase

Electronic funds transfers

Movement of funds directly from one account to another

What is the most common form of an electronic fund transfer?

Automated Clearinghouse Transaction (ACH). Used for recurring payments

Inflation

The process of prices rising

Inflation rate

The measurement of the process of inflation

What are the safest and most liquid insturment?

US Treasury Securities

Central Counterparty

An entity that is the buyer to all sellers and the seller to all buyers

M2

The most commonly quoted monetary aggregate in the US

How useful is M2 in tracking inflation?

When the quantity of money grows quickly, it produces high inflation

CPI Formula

(Cost in Current Year / Cost in Base Year) x 100

Direct Finance

Borrowers sell securities directly to lenders in the financial markets

Indirect Finance

An institution stands between and lender and borrower

Asset

Something of value that you own

Liability

Something you owe

Three functions of financial instruments

Act as a means of payment, act as stores of value, allow for the transfer of risk

Leverage

The use of borrowing to finance part of an investment

What does leverage increase?

The risk that an adverse surprise will lead to bankruptcy

Characteristics of financial instruments

Very complex, costly, communicate information

Characteristic that influence of a financial instrument

Size of the payment, timing of the payment, likelihood that payment is made, conditions under with payment is made.

Which instruments are used as a store of value

Bank loans, bonds, home mortgages, stocks, asset-backed securities

Mortgage-backed securities

Bundle a large number of mortgages together into a pool in which shares are sold

Financial intruments used to transfer risk

Insurance contracts, futures contracts, options, swaps

Role of financial markets

Market liquidity, information, risk sharing

Primary Financial Market

A borrower obtains funds from a lender by selling newly issued securities

Secondary financial markets

People can buy and sell existing securities

Centraliezed exhanges

Buyers and sellers meet in a central, physical location

Over-the-counter markets

Decentralized markets where dealers stand ready to buy and sell securities electronically

Trading Algorithm

A rule-based program for automatically executing multiple trades

High frequency traders

Can purchase or sell thousands of stocks in seconds

Debt markets

Markets for loans, mortgages and bonds

Equity markets

markets for stocks

Derivative markets

Markets where investotrs trade instruments like futures

Depository Institutions

Take deposits and make loans

Nondepository institutions

Include insurance companies, securities firms, mutual fund companies

Future value

The value on some future date of an investment made today

Future Value Formula

FV = PV + PV (i)

Future Value and Compound Interest

FVn = PV (1+i)^n

Present Value Formula

PV = FV / (1+i)

Bond

Promise to make a series of payments on specific future dates

Coupon Bond

Most common type of bond

Present value of the bond principal

PBP = F/(1+i)^n

Nominal interest rates

The interest rate expressed in current-dollar terms

Real Interest Rates

The inflation adjusted interest rate