chapter 15: the financial sector

5 functions of a bank

1. banks pool savings from many savers

2. banks spread the risk of lending money across many borrowers

3. banks solve information problems

4. banks provide payment services

5. banks create long term loans from short term deposits

maturity transformation

using short term loans to make long term loans

bank run

when many bank customers try to withdraw their savings at the same time

effects of bank runs

1. bank runs can cause a bank to collapse

2. a bank run is likely when people believe that a bank run is likely to happen

3. bank runs can be contagious

deposit insurance

a guarantee that you won’t lose the money you deposit in the bank

shadow bank

financial firms that act like banks but since they are not actually banks, they do not have to follow the same rules as banks

cons of a shadow bank

1. they are susceptible to bank runs

2. fire sales can cause shadow bank runs to spread

3. shadow banks are opaque

bond

IOU, a promise to pay back a loan with interest

functions of a bond market

1. the bond market channels funds from savers to borrowers

2. the bond market funds government debt

3. the bond market spreads risk

4. the bond market creates liquidity

evaluating risks in bonds

1. default risk is the risk of not getting paid

2. term risk arises when there’s uncertainty about future interest rates

3. liquidity risk arises when your bond will be hard to sell

default risk

the risk that your loan won’t be repaid

term risk

interest when there is uncertainty about future interest rates

liquidity risk

the risk that if you need to sell an asset quickly, you may not be able to get a good price for it

dividends

a share of profits that a company pays to its shareholders

retained earnings

the profits that a company chooses not to give as dividends to its stockholders

initial public offering

when a company first sells its stocks directly to the public

functions of stocks

1. channel funds from savers to investors

2. spread risk

3. reallocate control

stock market

the market where people buy and sell existing stocks

differences between stocks and bonds

1. bonds pay certain annual interest payments while stocks pay uncertain dividends

2. bondholders get paid before stockholders if a company declares bankruptcy

3. stockholders help control how a company is run

fundamental analysis

a framework for assessing an asset’s fundamental value

fundamental value

the present value of the future profits tha a company will earn

4 step process of assessing fundamental value

1. forecast future profits

2. discount profits

3. add up the sum of discounted future profits

4. divide the company’s fundamental value by the total amount of shares

relative valuation

an assessment of the value of an asset by comparing it to similar assets

2 kinds of analysis

1. fundamental value is the present value of future profits

2. relative valuation relies on comparable businesses

efficient markets hypothesis

theory that at any point in time, stock prices reflects all publicly available information

speculative bubble

when the price of an asset rises above what appears to be its fundamental value

“greater fool” theory

the idea that people buy an investment because they expect pother people to buy it from them at a higher price

even if it is a bubble it may not burst because

1. it can be hard to spot a speculative bubble

2. even if you spot the bubble. it can be hard to bet against it

3. you dont know when the bubble will burst

lessons in personal finance

1. harness the power of compound interest

2. don’t pick individual stocks

3. diversify your portfolio to reduce risk

4. past performances is no guarantee of future performance

5. minimize paying fees

6. follow all five rules with low cost index funds

overall the financial sector

1. reallocates resources from savers to borrowers

2. it shifts resources through time

3. it reallocates, spreads, and reduces risk

4. it creates liquidity

the risk in the financial sector is that

it creates interdependence

price to book ratio

price/ book value

price to earnings ratio

price/ earnings