BAFI 341 - Money and Banking Chapters 1-2

Financial markets

Markets that channel funds from savers to investors, promoting economic efficiency. Their activity affects personal wealth, business firms, and the overall economy.

Debt markets

Markets that allow governments, corporations, and individuals to borrow money.

Bond

A security issued by a borrower that offers interest and principal payments over time.

Interest rate

The cost of borrowing money.

Stock market

The market where common stock (or just "stock") is traded.

Foreign exchange market

The market where international currencies are traded and exchange rates are set; has a daily volume of around $5 trillion.

The Great Recession (2007-2009)

The worst financial crisis since the Great Depression, discussed as a key event in the study of financial institutions.

Lender-Savers

Individuals or entities without productive investment opportunities who supply funds to the financial system (e.g., households, business firms, government, foreigners).

Borrower-Spenders

Individuals or entities with productive investment opportunities who obtain funds from the financial system (e.g., business firms, government, households, foreigners).

Direct finance

Borrowers borrow directly from lenders in financial markets by selling financial instruments that are claims on the borrower's future income or assets.

Indirect finance

Borrowers borrow indirectly from lenders via financial intermediaries, which source funds from savers and lend them to borrowers, by issuing financial instruments that are claims on the borrower's future income or assets.

Debt market maturities

Debt markets are classified by maturity: short-term (under 1 year), intermediate-term (in between), and long-term (over 10 years).

Equity market

A market for securities that represent an ownership claim in a firm and typically pay dividends indefinitely.

Primary market

The market where new security issues are sold to initial buyers to raise money, typically underwritten by an investment bank.

Secondary market

The market where previously issued securities are bought and sold (e.g., NYSE, Nasdaq); provides liquidity and establishes a price for securities, though firms don't receive money from these sales.

Exchanges

A type of secondary market where trades are conducted in central locations (e.g., NYSE, CBT).

Over-the-counter (OTC) market

A type of secondary market where dealers at different locations buy and sell securities; the Treasury securities market is a key example.

Money market

A financial market that trades only short-term debt instruments (maturity under 1 year).

Capital market

A financial market that trades longer-term debt instruments (maturity over 1 year) and equities, which have no maturity.

Foreign bonds

Bonds denominated in a foreign currency and targeted at a foreign market.

Eurobonds

Bonds denominated in one currency but sold in a market other than that currency's home country; now larger than the U.S. corporate bond market, making up over 80% of new bonds.

Eurocurrency market

A market for foreign currency deposited outside its home country (e.g., Eurodollars, which are U.S. dollars deposited outside the U.S., such as in London).

Financial intermediation

The process by which financial intermediaries move funds from lenders to borrowers; the primary means of moving funds through the financial system, more important than securities markets.

Transactions costs

The time and money spent carrying out financial transactions; financial intermediaries reduce these costs through expertise and economies of scale.

Liquidity services

Services provided by financial intermediaries, made possible by low transaction costs, that make it easier for customers to conduct transactions (e.g., checking accounts).

Risk sharing

The process by which financial intermediaries create and sell low-risk assets to one party in order to buy higher-risk assets from another, reducing investors' exposure to risk.

Asset transformation

The process of turning risky assets into safer assets for investors, which is how financial intermediaries accomplish risk sharing.

Diversification (via financial intermediaries)

Financial intermediaries use their low transaction costs to buy a range of assets, pool them, and sell rights to the diversified pool to individuals, allowing investors to diversify their holdings.

Asymmetric information

A situation where one party in a financial transaction lacks crucial information about the other party, impacting decision-making; discussed via adverse selection and moral hazard.

Adverse selection

An asymmetric information problem that occurs before a transaction: potential borrowers most likely to produce an undesirable (adverse) outcome are the ones most likely to seek a loan.

Moral hazard

An asymmetric information problem that occurs after a transaction: the borrower has an incentive to engage in undesirable activities that make it less likely the loan will be repaid.

Economies of scope

The lowering of information production costs achieved by financial intermediaries using the same information to provide multiple services (e.g., accounts, loans, insurance).

Depository institutions

Financial intermediaries (such as commercial banks and thrifts) that accept deposits and make loans.

Commercial banks

Depository institutions that raise funds primarily through checkable, savings, and time deposits to make commercial, consumer, and mortgage loans; the largest type of financial intermediary with the most diversified asset portfolios.

Thrifts

Savings and loan associations, mutual savings banks, and credit unions; raise funds primarily through deposits, mostly for mortgage and consumer loans.

Contractual savings institutions (CSIs)

Financial intermediaries (such as insurance companies and pension funds) that acquire funds from clients at periodic intervals on a contractual basis and have predictable future payout requirements.

Finance companies

Financial intermediaries that raise funds by selling commercial paper and issuing bonds and stocks, then lend to consumers and small businesses.

Mutual funds

Financial intermediaries that acquire funds by selling shares to investors and use the proceeds to purchase diversified portfolios of stocks and bonds.

Money market mutual funds

Financial intermediaries that sell checkable deposit-like shares to investors and use the proceeds to purchase safe, highly liquid short-term money market instruments.

Hedge funds

A type of mutual fund requiring large investments (often $100,000+), long holding periods, and subject to few regulations; can invest across almost all asset classes.

Investment banks

Financial institutions that advise companies on securities to issue, underwrite security offerings, provide M&A assistance, and act as dealers in security markets.

Securities and Exchange Commission (SEC)

Regulates organized exchanges and financial markets by requiring information disclosure and restricting insider trading.

Commodities Futures Trading Commission (CFTC)

Regulates procedures for trading in futures market exchanges.

Office of the Comptroller of the Currency

Charters and examines federally chartered commercial banks and thrift institutions, and imposes restrictions on the assets they can hold.

National Credit Union Administration (NCUA)

Charters and examines federally chartered credit unions and imposes restrictions on the assets they can hold.

Federal Deposit Insurance Corporation (FDIC)

Provides deposit insurance up to $250,000 per depositor at a bank; examines the books of insured banks and imposes restrictions on their assets.

Federal Reserve System

Examines the books of member commercial banks and sets reserve requirements for all depository institutions.

Reasons for financial market regulation

The two main reasons for regulating financial markets are to increase information available to investors and to ensure the soundness of financial intermediaries.

Six types of financial intermediary regulation

Restrictions on entry, disclosure requirements, restrictions on assets and activities, deposit insurance, limits on competition, and restrictions on interest rates.

Reserve requirements

Regulations requiring depository institutions to keep a certain fraction of their deposits in accounts with the Federal Reserve, helping the Fed control the money supply.

Financial panic

A situation where depositors, unable to assess the soundness of financial intermediaries, withdraw funds from both sound and unsound institutions, causing large public losses and economic damage.