Introduction to Finance and the Financial System

finance

the study of how people allocate scarce resources over time - costs and benefits are spread out over time and usually unknown in advance

finance comes down to 4 different kinds of decisions

1. consumption vs savings

2. investment

3. financing

4. risk management

financial system is made up of

individuals, corporations, banks, insurance companies, intermediaries, governments, super-sovereigns, asset managers

functions of financial system

flow of funds, manages risk, provides clearing, pooling and subdivision of resources, price information, deals with incentive problems

flow of funds

efficient transfer of funds from those with a surplus to those with a deficit through time, across borders, and among industries

manages risk

pooling and subdivision of risks/expertise

provides clearing

credit cards, bond receipts, stock settlement

pooling and subdivision of resources

mutual funds, IPOs

price information

useful/necessary for decision making, “signaling effect”, eliminates arbitrage/provides systemic equilibrium

deals with incentive problems

when one party has information that the other does not, or when one party is an agent who makes decisions for another, moral hazard, adverse selection, principal agent problems

moral hazard

when having insurance causes us to take greater risk

adverse selection

those who buy insurance are more likely to be at risk than the general population

principal agent problems

when critical tasks are delegated to others. When risk-takers (principals) have different objectives than those making decisions (agents)

Conclusions

lots of choices, incredible complexity, interdependence, interconnectivity

financial systems reflect the complexity of the economies they serve, everyone wants to be paid a return for taking risk, people will squeeze out inefficiencies