The Financial System : Money and banking

Vocabulary flashcards covering key terms and concepts from Chapter 2, Sections 2.2–2.7 on the Financial System.

Financial system

A densely interconnected network of financial intermediaries, facilitators, and markets that serves three major purposes: allocating capital, sharing risk, and facilitating intertemporal trade.

Three purposes of the financial system

1) Allocate capital to its most productive uses; 2) Share risk between hedgers and speculators; 3) Facilitate intertemporal trade (pay later, produce now).

Borrowers (spenders)

Entities such as entrepreneurs, inventors, households, governments, established businesses, and foreigners whose expenditures exceed revenues ($\text{Expenditures} > \text{revenues}$) and who hold positive-NPV project ideas but limited cash.

Lenders (savers)

Entities such as households, businesses, governments, and foreigners whose revenues exceed expenditures ($\text{Revenues} > \text{expenditures}$) and who supply the excess funds borrowers need.

Hedgers

Risk-averse market participants who use financial instruments to reduce risk, such as a farmer locking in a crop price.

Speculators

Risk-loving market participants who use financial instruments to increase risk exposure in pursuit of return.

Internal finance

Plowing profits back into the business, which requires having sufficient wealth (stock) and income (flow) already on hand.

External finance

Funding obtained from outside sources, needed by most people and firms because savings alone rarely cover blueprints, prototypes, space, staff, and licenses.

Minimum efficient scale

The operational volume a lending firm must reach to spread substantial fixed costs (underwriting, advertising, technology, office space) so that average costs drive toward insignificance and lending becomes profitable.

Asymmetric information

A condition that occurs when a seller (a borrower issuing securities) knows more about a deal than the buyer (a lender or investor) does.

Adverse selection

An asymmetric information problem occurring before a deal is signed, where the riskiest borrowers want loans the most, causing unaware lenders to attract a disproportionate share of bad risks.

Moral hazard

An asymmetric information problem occurring after a deal is signed, where borrowers change their behavior and act recklessly because they are gambling with someone else's money.

Principal-agent problem

A problem related to moral hazard that occurs when an agent acting for a principal has incentive structures that differ from the principal's, leading to post-contract exploitation.

Primary markets

Financial markets where newly issued instruments are sold for the first time, such as an initial public offering (IPO) or a new bond issue.

Secondary markets

Financial markets where existing, negotiable securities trade among investors, such as stock exchanges and bond markets.

Exchanges

Centralized trading locations for securities, such as the New York Stock Exchange (NYSE) or the Chicago Board of Trade (CBOT).

Over-the-counter (OTC) markets

Financial markets run by dealers connected electronically via telecommunications rather than through a centralized physical exchange location.

Derivatives

Financial instruments whose value is based on the price of an underlying asset, variable, or index—not a direct claim on the asset itself.

Brokers

Facilitators who link buyers to sellers in secondary markets for a fee or commission without taking positions themselves.

Dealers

Market participants who 'make a market' by continuously buying and selling securities, profiting from the spread between bid and ask prices.

Brokerages

Firms that operate as both brokers and dealers, usually adding advice and research for clients.

Investment banks

Financial institutions that underwrite primary-market stock and bond offerings (including IPOs) and sometimes broker, deal, or advise on M&A.

Foreign bonds

Bonds sold in a foreign country and denominated in that foreign country's currency (for example, Mexico selling dollar-denominated bonds in the U.S.).

Eurobonds

Bonds sold outside the home country but denominated in the home country's currency (for example, a U.S. firm selling dollar bonds in London).

Financial intermediaries

Institutions that link savers to borrowers indirectly by transforming assets—buying and selling instruments with different risk, return, and liquidity profiles.

Demand deposits

Low-risk, low-return, highly liquid liabilities that commercial banks sell to depositors.

Bank assets

Riskier, higher-return, illiquid assets—such as loans, mortgages, and bonds—that commercial banks purchase from borrowers.