Financial Markets Exam 1 (Ch 1-5, little bit of 6)

Financial System

Composed of money, financial instruments, financial markets, financial institutions, government regulatory agencies, and central banks

Money

Used for purchases and wealth storage

Financial Instruments

Transfer resources and risk, e.g. stocks, mortgages, insurance policies

Financial Markets

Enable quick and cheap buying and selling of financial instruments

Financial Institutions

Provide services and access to financial markets, e.g. banks, securities firms, insurance companies

Mutual Funds

Pool savings of many investors

Gross Domestic Product (GDP)

Market value of final goods and services produced in a country during a year

Payments System

Arrangements for exchanging goods, services, and assets among different people

Automated Clearinghouse (ACH) Transaction

Used for recurring payments like paychecks and utility bills

Monetary Aggregates

Measures of money supply, e.g. M1 and M2

Circumstances (Value of a financial instruments)

Payments made when needed most are more valuable

Stocks

Ownership shares in a company

Over-the-Counter Markets

Decentralized secondary markets where dealers trade electronically

Principal, Face Value, Par Value

Final payment of a bond and initial amount lent

Store of Value

Money retains its value from day to day

M2

Includes M1 plus assets that are difficult to turn into currency quickly

Financial Instruments

Legal obligations to transfer value, e.g. stocks, bonds, mortgages

Financial Institutions

Intermediaries that reduce transaction costs in financial markets

Pension Funds

Invest contributions to provide payments to retired workers

Finance Companies

Raise funds in financial markets to make loans

Coupon Rate

Annual amount of bond coupon payments

What is the formula to calculate the price of a $100 face value zero-coupon bond?

= $100 / (1+i)^n

What are fixed-payment loans?

Loans that promise a fixed number of equal payments at regular intervals. Conventional mortgages and car loans

Consol Bonds

Bonds that make periodic interest payments forever, never repaying the principal

Effect of falling yield to maturity on price

If the yield to maturity falls, the price rises

Government Regulatory Agencies

Ensure safe and reliable operation of financial system

Central Banks

Monitor and stabilize the economy, e.g. Federal Reserve System

Dodd-Frank Act

Largest US regulatory change since the 1930s, adopted in 2010

Basel III

Major update for internationally active banks, adopted in 2010

Core Principle 1: Time Has Value

Time affects the value of financial transactions

Core Principle 2: Risk Requires Compensation

Higher risk requires higher payment

Core Principle 3: Information is the Basis for Decisions

Collect information before making decisions

Core Principle 4: Markets Determine Prices and Allocate Resources

Markets are essential to the economy, determine prices and allocate resources

Core Principle 5: Stability Improves Welfare

Stability is desirable, reducing volatility reduces risk

Real GDP

GDP adjusted for changes in prices

Nominal GDP

GDP measured in current-dollar terms

GDP Deflator

Measure of prices in the economy

Inflation Rate

Rate at which the GDP Deflator changes

Consumer Price Index (CPI)

Most commonly used price index

Money

Asset accepted as payment or repayment of debt

Means of Payment

Primary use of money

Unit of Account

Money is the unit of account. Money is used to quote prices and record debts

Liquidity

Measure of ease of turning an asset into money

Market Liquidity

The ability to sell assets for money

Funding Liquidity

The ability to borrow money to buy securities or make loans

Commodity Monies

First means of payment with intrinsic value (silk in china or butter in Norway)

Fiat Money

Value comes from government decree

Check

Instruction to transfer funds from an account to another

Debit Card

Transfers funds directly from cardholder's account to a merchant's account

Credit Card

Bank lends money to the cardholder for purchases

Electronic Funds Transfers (EFTs)

Direct movement of funds between accounts

Inflation

Increase in general prices over time

Inflation Rate

Measure of the rate of inflation

M1

Narrowest definition of money, includes currency and deposit accounts

Direct Finance

Borrower sells security directly to a lender

Indirect Finance

Financial institution stands between lender and borrower

Uses of Financial Instruments

1. means of payment

2. store of value

3. transfer of risk

Means of Payment (Uses of financial instruments)

Function of financial instruments for purchase of goods or services

Store of Value (Uses of financial instruments)

Function of financial instruments for transferring purchasing power into the future

Transfer of Risk (Uses of financial instruments)

Function of financial instruments for transferring risk from one party to another

Standardization

Homogeneity of financial instruments

Counterparty

Person or institution on the other side of a contract

Underlying Instruments

Used to transfer resources directly between savers and investors. Sometimes called primitive securities

Derivative Instruments

Value derived from behavior of underlying instruments

Four fundamental characteristics that influence the value of a financial instrument

1: Size

2: Timing

3: Likelihood

4: Circumstances

Size (Value of a financial instrument)

Larger payments are more valuable

Timing (Value of a financial instrument)

Payments made sooner are more valuable

Likelihood (Value of a financial instrument)

More likely payments are more valuable

Financial Instruments Used Primarily as Stores of Value

1: Banks Loans

2: Bonds

3: Home Mortgages

4: Stocks

5: Asset-backed securities

Bonds

Promise to make payments on specific future dates

Home Mortgages

Loans for purchasing homes

Collateral

Assets pledged to protect lender's interests in case of nonpayment

Asset-backed Securities (ABS)

Shares in returns or payments from specific assets

Mortgage-backed Securities (MBS)

ABS that bundles mortgages into a pool and sells shares

Financial Instruments Used Primarily to Transfer Risk

1: Insurance Contracts

2: Futures Contracts

3: Options

4: Swaps

Insurance Contracts

Contracts for transferring risk to an insurance company

Futures Contracts

Contracts for buying or selling assets at a future date

Options

Contracts that give the holder the right to buy or sell assets

Swaps

Contracts for exchanging cash flows

Financial Markets

Places where financial instruments are bought and sold

Primary Markets

Markets where newly issued securities are sold

Secondary Markets

Markets where existing securities are traded

Centralized Exchanges

Secondary markets where dealers meet in a central location

Electronic Communication Networks

Electronic systems for buyers and sellers to trade without brokers

Trading Algorithm

A rule-based program for automatically executing hundreds or thousands of trades

Debt and Equity Markets

Markets for buying and selling financial claims for immediate cash

Derivatives Markets

Markets for trading claims based on underlying assets paid at a later date

Debt Markets

Markets for loans, mortgages, and bonds

Equity Markets

Markets for stocks

Characteristics of a Well-Run Financial Market

1: Must be designed to keep transaction costs low

2: The information the market pools and communicates must be both accurate and widely available

3: Borrowers' promises to pay lenders must be credible

Depository Institutions

Take deposits and make loans, e.g. banks

Insurance Companies

Accept premiums and invest in securities and real estate

Securities Firms

Include brokers, investment banks, asset management firms, etc.

GSEs (Government-sponsored Enterprises)

Federal credit agencies providing loans for farmers and home mortgagors

Future Value

Value of an investment on a future date

Future Value Formula

=PV x (1+i)

Compound Interest

Interest on interest

Future Value Formula with Compound Interest

=PV x (1+i)^n

Present Value

Value today of a payment promised in the future

Present Value Formula

=FV / (1+i)^n