Lecture 1 & 2 - Introduction and overview of the financial system Flashcards
(153 cards)
1
Q
What are financial markets?
A
Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage.
2
Q
What are financial markets crucial for?
A
Promoting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. They also help to produce efficient allocation of capital (wealth, either physical or financial) which contributes to higher production in the overall economy. Well functioning financial markets also directly improve the well being and economic welfare of consumers by allowing them to time their purchases better (e.g. young people).
3
Q
What do the activities in financial markets have direct effects on?
A
Personal wealth, behaviour of businesses and consumers, and the cyclical performance of the economy.
4
Q
What is a security (financial instrument) ?
A
A claim on the issuer’s future income or assets.
5
Q
What are assets?
A
Any financial claim or piece of property that is subject to ownership.
6
Q
What is a bond?
A
A debt security that promises to make payments periodically for a specified period of time.
7
Q
Why is the bond market especially important to economic activity?
A
It enables corporations and governments to borrow finance their activities and because it is where interest rates are determined.
8
Q
What is an interest rate?
A
It is the cost of borrowing or the price paid for the rental of funds.
9
Q
What and who do interest rates affect?
A
The overall health of the economy - governments, consumer’s willingness to spend or save and a businesses’ investment decisions.
10
Q
The interest rate on UK government bonds that have a maturity of 10 years follows the same pattern as long term government bonds that have no maturity date. What are these types of bonds referred to as?
A
Consols.
11
Q
When a firm issues a bond,
A
It is borrowing money that it will have to repay.
12
Q
If you buy a bond,
A
You are a lender who will be repaid with interest.
13
Q
A security is a liability (IOU or debt) for…
A
The agent that sells (issues) it.
14
Q
A security is an asset for…
A
The agent that buys it.
15
Q
What is the difference between bonds and stocks?
A
A bond entitles the owner to receive future payments that are “independent” of the firm’s performance, whereas, with stocks, the owner becomes part owner of the firm and future payments received depend on the firm’s performance.
16
Q
What does a stock represent?
A
A share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation.
17
Q
How do corporations raise funds to finance their activities?
A
They issue stock and sell it to the public.
18
Q
What is the stock market?
A
The market where shares of stock are traded
19
Q
Why is the stock market an important factor in business investment decisions?
A
The price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending.
20
Q
What is the foreign exchange market?
A
The market where one currency is bought and sold using another currency.
21
Q
What is the foreign exchange rate?
A
The price at which one currency is exchanged for another.
22
Q
Give some examples of financial intermediaries.
A
Banks, mutual funds, insurance companies, finance companies, and investment banks.
23
Q
What are financial intermediaries?
A
Institutions that borrow funds from people who have saved and in turn loan to others.
24
Q
Why might the same bond type have different interest rates in different countries?
A
Differences between the countries relating to inflation risk, default risk and political risk.
25
What are financial crises?
Major disruptions in financial markets that are characterised by sharp declines in asset prices and the failure of many financial and non financial firms.
26
What are banks?
Banks are financial institutions that accept deposits and make loans.
27
What is e-finance?
The delivery of financial services electronically.
28
Define money (money supply).
Anything that is generally accepted in payment for goods and services or in the repayment of debt.
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Why is money so important?
Changes in the money supply can directly affect business cycle fluctuations and are linked to changes in major macroeconomic variables.
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What is aggregate output?
The total production of goods and services.
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What is the unemployment rate?
The percentage of the available labour force unemployed.
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What is a business cycle?
The upward and downward movement of aggregate output produced in the economy.
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What are recessions?
Periods of declining aggregate output.
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What is monetary policy?
Refers to the management of money and short term interest rates by a Central Bank.
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What is the aggregate price level?
The average price of goods and services in an economy.
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What is inflation?
A continual increase in the price level.
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What explains inflation?
Money supply and price level tend to rise together.
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What is inflation rate?
The rate of change in price level, usually measured as a percentage per year.
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What is fiscal policy?
Involves decisions about government spending and taxation.
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What is a budget deficit?
The excess of government expenditures over tax revenues for a particular time period.
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What is a budget surplus?
Arises when tax revenues exceed government expenditures.
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A budget deficit leads to a...
Higher government debt burden.
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A budget surplus leads to a...
Lower government debt burden.
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What is Gross Domestic Product (GDP)?
The market value of all final goods and services produced in a country during the course of the year.
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Why does the change in the exchange rate have a direct effect on consumers?
It affects the cost of imports.
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A strong pound means...
Consumers can purchase foreign goods cheaply.
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A weak pound means...
Foreign goods are more expensive.
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What is aggregate income?
The total income of factors of production (land, labour and capital). It is thought of as being equal to aggregate output.
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What is nominal GDP?
GDP measured using current prices.
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What is real GDP?
GDP measured using constant fixed prices.
51
Define GDP deflator.
Nominal GDP divided by real GDP.
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Define Personal Consumption Expenditures (PCE) deflator?
Nominal PCE divided by real PCE.
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How is the Consumer Price Index (CPI) measured?
It is measured by pricing a 'basket' of goods and services bought by a typical urban household.
54
The CPI, PCE deflator and GDP deflator measures of the price level can be used to convert or deflate a nominal magnitude into a real magnitude. How is this accomplished?
By dividing the nominal magnitude by the price index.
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How is a growth rate defined?
As a percentage change in a variable.
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What happens in direct finance?
Borrowers borrow funds directly from lenders in financial markets by selling them securities., which are claims on the borrower's future income or assets.
57
What is a stock?
A security that entitles the owner to a share if the company's profits and assets.
58
Give an example of direct finance.
A company might issue bonds to raise funds. As a saver, when you buy one of these bonds your funds get transferred to the company and you receive an IOU (the bond).
59
Why is the channelling of funds from savers to spenders so important to the economy?
The people who save are frequently not the same people who have profitable investment opportunities available to them. Without financial markets, it is hard to transfer funds from a person who has no investment opportunities to on who has them.
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What would happen in the absence of financial markets?
Everyone would be stuck with the status quo. Consumers would be forced to consume less and the timing of their purchases would not be optimal. They would not be able to spread consumption optimally over time. Businesses would produce less because it would be more difficult to finance capital investment. They cannot achieve optimal investment pattern.
61
How does issuing a debt instrument, such as a bond or a mortgage, work?
There is a contractual agreement by the borrower to pay the holder of the instrument fixed amounts of money at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made.
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What is the maturity date of a debt instrument?
The number of years (term) until the instrument's expiration date.
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A debt instrument is short term if...
Its maturity is less than a year.
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A debt instrument is long term if...
Its maturity is longer than one year.
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What is another method of raising funds other than by issuing debt instruments?
Issuing equities, such as common stock, which are residual claims to share in the net income (income after expenses and taxes) and the assets of a business.
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Why are equities considered long term securities?
They have no maturity date and they often make periodic payments to their holders, dividends.
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What is the main disadvantage of owning a corporation's equities rather than its debt?
An equity holder is a residual claimant, that is, the corporation must pay all its debt holders before it pays its equity holders.
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What is an advantage of holding a corporation's equities?
Equity holders benefit directly from any increases in the corporation's profitability or asset value because equities confer ownership rights on the equity holders. Debt holders do not share in this benefit, because their payments are fixed.
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What is a primary market?
A financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds.
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What is a secondary market?
A financial market in which securities that have been previously issued can be resold.
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What important financial institution assists in the initial sale of securities in the primary market and how does it do this?
An investment bank does this by underwriting securities. It guarantees a price for corporation's securities and then sells them to the public.
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Give examples of secondary markets.
New York Stock Exchange, London Stock Exchange and Frankfurt Stock Exchange. Other examples include foreign exchange markets.
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What are brokers?
Agents of investors who match buyers with sellers of securities.
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What are dealers?
Dealers link buyers and sellers by buying and selling securities at stated prices.
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When does a corporation acquire new funds?
A corporation acquires new funds only when its securities are sold in the primary market. Trading in the secondary market does not yield new funds for the company.
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Secondary markets serve two functions. What are they?
Firstly, they make it easier and quicker to sell financial instruments to raise cash, that is, they make the financial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the primary market. Secondly, they determine the price of the security that the issuing firm sells in the primary market. The investors who buy securities in the primary market will pay the issuing corporation no more than the price they think the secondary market will set for the security.
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The higher the security's price in the secondary market...
The higher the price that the issuing firm will receive for a new security in the primary market, and hence the greater the amount of financial capital it can raise.
78
What are organised exchanges?
Where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. Examples include The London Stock Exchange for stocks and The London Metal Exchange for commodities.
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What is an over-the-counter (OTC) market?
Where dealers at different locations who have an inventory of securities stand ready to buy and sell securities 'over the counter' to anyone who comes to them and is willing to accept their prices. Examples include US government bond market.
80
Why is the OTC market very competitive and not very different from a market with an organised exchange?
OTC dealers are in computer contact and know the prices set by one another.
81
What is the money market?
A financial market in which only short term debt instruments (generally those with original maturity of less than one year) are traded.
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What is the capital market?
A financial market in which only long term debt instruments (generally those with original maturity of one year or greater) are traded.
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Why do money market securities tend to be more liquid?
Money market securities are usually more widely traded than longer term securities.
84
Why are short term securities safer investments than long term securities?
Short term securities have smaller fluctuations in prices than long term securities.
85
Short term securities tend to be safer investments. What does this mean for corporations and banks?
Corporations and banks can actively use the money market to earn interest on surplus funds that they expect to have only temporarily.
86
What are Treasury bills?
Short term debt instruments of the UK government which are issued in one, three and six month maturities to finance government spending. They pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount, that is, at a price lower than the set amount paid at maturity.
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Why are Treasury bills highly liquid?
They are the easiest to trade.
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Why are Treasury bills the safest of all money market instruments?
There is almost no possibility of default, a situation in which the party issuing the debt instrument is unable to make interest payments or pay off the amount owed when the instrument matures. HM government is always able to meet its debt obligations because it can raise taxes or issue currency (paper money or coins) to pay off its debts.
89
Who are Treasury bills held by?
Mainly by banks, although small amounts are held by households, corporations and other financial intermediaries.
90
What are Bank bills?
They are like Treasury bills and issued by banks and bought mostly by other banks. They have the same maturity as Treasury bills but they differ by being sold at a greater discount (higher yield implied).
91
What are certificates of deposit (CD)?
They are short term (1 to 5 years) debt instruments sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price.
92
What are negotiable CDs?
CDs that are sold in secondary markets, with the amount outstanding. They are an extremely important source of funds for commercial banks, from corporations, mutual funds, charitable institutions and government agencies.
93
What is commercial paper?
A short term (2 to 30 days) debt instrument issued by large banks and well known corporations. There are no interest payments.
94
What are interbank deposits?
They have varying maturities from overnight, seven days, one, three, six and twelve months.
95
What is the interbank market?
The market where surplus banks can lend to cash short banks sometimes substantial amounts.
96
What are gilt repurchase agreements (repos)?
They are effectively short term loans (usually with a maturity of less than two weeks) for which UK government gilt edged securities (bonds, Treasury bills) but also high grade commercial paper and certificate of deposits act as collateral.
97
What is the gilt repo market?
It is a market where a borrowing institution will sell a gilt edged security to a lending institution with a promise to buy it back at some predetermined maturity. It is also the market in which the Bank of England makes funds available to the banking system.
98
How does a repo work?
The Bank of England buys a security from a commercial bank, which agrees to repurchase it at a specified period at a slightly higher price. The effect of this agreement is that the Bank of England has made a loan to the commercial bank and holds an equivalent value of gilts until the bank repurchases them to pay off the loan.
99
What are capital market instruments?
They are debt and equity instruments with maturities greater than one year. They have far wider price fluctuations than money market instruments and are considered to be fairly risky investments.
100
What are stocks?
They are equity claims on the net income and assets of a corporation.
101
What are mortgages?
Loans to households or firms to purchase housing, land, or other real structures or land itself serves as collateral.
102
What are corporate bonds?
They are long term bonds issued by corporations with very strong credit ratings. The typical corporate bond sends the holder an interest payment twice a year and pays off the face value when the bond matures.
103
What are convertible bonds?
They have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date.
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What makes convertible bonds desirable to prospective purchasers?
It allows corporations to reduce interest payments because these bonds can increase in value if the price of the stock appreciates sufficiently.
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Why are non convertible and convertible bonds not as liquid as other UK securities such as UK government bonds?
The outstanding amount of both non convertible and convertible bonds for any given corporation is small. (Outstanding bonds are those bonds that have been purchased by an investor and have not yet been paid back by the company to the investor.)
106
What are UK government bonds?
These are long term debt instruments issued by the UK government Debt Management Office to finance the deficit of the government.
107
Why are UK government bonds highly liquid?
They have the highest rating (AAA).
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Who are UK government bonds held by?
The Bank of England, commercial banks, pensions funds, life insurance companies, households and foreigners.
109
What are long authority bonds?
These are long term bonds that are issued by various local authorities in the UK and were very popular as a means of financing capital projects in individual cities.
110
What are bank and building society bonds?
Banks and building societies issue long term bonds of typically fixed rates of 1 to 5 years maturity. However, some banks issue bonds based on investments in selected stocks and provide guaranteed minimum rate of return and therefore have some of the properties of equity rather than debt.
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What are bank and building society loans (excluding mortgages)?
These loans are principally made to businesses.
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What are the traditional instruments in the international bond market known as?
Foreign bonds.
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Foreign bonds are...
Sold in a foreign country and denominated in that country's currency.
114
What is the Eurobond?
A bond denominated in a currency other than that of the country in which it is sold, for example, a bond denominated in US dollars sold in London. A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro.
115
What are Eurocurrencies?
Foreign currencies deposited in banks outside the home country.
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What are eurodollars?
US dollars deposited in foreign banks outside the US or in foreign branches of US banks.
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How are eurodollars similar to short term Eurobonds?
The short term deposits earn interest.
118
Explain the role of eurodollars for American banks.
American banks borrow eurodollar deposits from other banks or from their own foreign branches, and eurodollars are now an important source of funds for American banks.
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What is indirect finance?
A financial intermediary stands in between lender-savers and borrower-spenders to help transfer funds from one to the other.
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What are transaction costs?
The time and money spent in carrying out financial transactions.
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How can financial intermediaries reduce transaction costs?
They have developed expertise in lowering them and their large size allows them to take advantage of economies of scale.
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What does reduce transactions costs mean?
Financial intermediaries cant provide its customers with liquidity services, which make it easier for them to conduct transactions.
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Another benefit of reduced transaction costs is...
That financial institutions can help to reduce the exposure of investors to risk, more specifically the uncertainty of the returns investors will earn on assets.
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This can be done through a process called risk sharing. Explain how it works.
Financial intermediaries will create and sell assets with risk characteristics that people are comfortable with, and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk. Low transaction costs allow financial intermediaries to share risk at a low cost, enabling them to earn a profit on the spread between returns they earn on risky assets and the payments they make on the assets they have sold.
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This process of risk sharing is also sometimes referred to as...
Asset transformation, because in a sense, risky assets are turned into safer assets for investors.
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How else do financial intermediaries promote risk sharing?
The help individuals to diversify and thereby lower the amount of risk to which they are exposed. Low transaction costs allow financial intermediaries to do this by pooling a collection of assets into a new asset and then selling it to individuals.
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What is diversification?
Entails investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets.
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What is asymmetric information?
One party often does not know enough about the other party to make accurate decisions.
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What is adverse selection?
It is the problem created by asymmetric information before the transaction occurs.
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When does adverse selection occur?
It occurs when the potential borrowers who are the most likely to produce an undesirable outcome are the ones who most actively seek out a loan and are thus most likely to be selected. As adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks in the marketplace.
131
What is moral hazard?
It is the problem created by asymmetric information after the transaction occurs. It is the risk that the borrower might engage in activities that are undesirable from the lender's point of view, because they make it less likely that the loan will be paid back. Moral hazard lowers the probability that the loan will be repaid, lenders may decided that they would rather not make a loan.
132
Why do successful financial intermediaries have higher earnings than small savers?
They are better equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection. Additionally, they have higher earnings because they develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard.
133
What are depository institutions?
They are financial intermediaries that accept deposits from individuals and institutions and make loans.
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What are commercial banks?
These financial intermediaries raise funds primarily by issuing sight deposits (deposits on which cheques can be written), savings deposits (deposits that are payable on demand by do not allow their owner to write cheques) and time deposits. They then use these funds to make commercial, consumer and mortgage loans and to buy government securities and commercial paper.
135
What are building societies?
Building societies are depository institutions owned by depositors. They obtain funds primarily through savings deposits (shares) and time and sight deposits.
136
What are credit unions?
These are typically very small cooperative lending institutions organised around a particular group: union members and employees of a particular firm etc.
137
What are contractual savings institutions?
Examples of these are insurance companies and pension funds. These financial intermediaries acquire funds at periodic intervals on a contractual basis. They can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years and so do not have to worry as much as depository institutions about losing funds quickly. As a result, the liquidity of assets is not as important a consideration for them and they tend to invest their funds primarily in long term securities such as corporate bonds, stocks and mortgages.
138
What are life insurance companies?
They insure people against financial hazards following death and sell annuities (annual income payments upon retirement). They acquire funds from the premiums that people pay to keep up their policies in force and use them mainly to buy government bonds, corporate bonds and stocks.
139
What are pension funds?
Private pension funds and government agency retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan. Funds are acquired by contributions from employers and from employees, who either have a contribution automatically deducted from their pay or contribute voluntarily.
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What are investment intermediaries?
Includes finance companies, mutual funds, money market mutual funds.
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What are finance companies?
Finance companies raise funds by selling commercial and by selling stocks and bonds. They lend these funds to customers.
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What are mutual funds?
These financial intermediaries acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds.
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What are the largest asset holdings for pension funds?
Corporate bonds and stocks.
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What do mutual funds allow?
They allow shareholders to pool their resources so that they can take advantage of lower transaction costs when buying large blocks of stocks or bonds. They also allow shareholders to hold more diversified portfolios than they otherwise would.
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Why can investments in mutual funds be risky?
Shareholders can sell shares at any time, but the value of these shares will be determined by the value of the mutual fund's holdings of securities. As these fluctuate greatly, the value of mutual fund shares will, too; therefore, investments in mutual funds can be risky.
146
What are money market mutual funds?
These financial intermediaries have the characteristics of a mutual fund but also function to some extent as a depository institution because they offer deposit type accounts. Like most mutual funds, they sell shares to acquire funds that are then used to buy money market instruments that are both safe and very liquid. The interest on these assets is paid out to the shareholders.
147
What do investment banks do?
They help a corporation issue securities. It first advises the corporation on which types of securities to issue (stocks or bonds); then it helps sell (underwrite) the securities by purchasing them from the corporation at a predetermined price and reselling them in the market. They also act as deal makers and earn fees by helping corporations acquire other companies through mergers or acquisitions.
148
Why are financial markets regulated?
To increase the information available to investors and to ensure the soundness of the financial system. Government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency. Asymmetric information can lead to the widespread collapse of financial intermediaries, referred to as financial panic, which causes large losses and serious damage to the economy.
149
What are restrictions on entry?
Individual regulatory agencies of Europe set regulations governing who is allowed to set up a financial intermediary. Individuals or groups that want to establish a financial intermediary, such as a bank or insurance company, must obtain an authorisation of 'fit and proper'.
150
What is disclosure?
There are stringent reporting requirements for financial intermediaries. Their bookkeeping must follow certain strict principles, their books are subject to periodic inspection, and they must make certain information available to the public.
151
What are restrictions on assets?
Restrictions on what financial intermediaries are allowed to do and what assets they can hold. In order to ensure that your funds are safe and that a financial intermediary will be able to meet its obligations to you, you can restrict it from engaging in certain risky activities. One way to limit risky behaviour is to restrict it from holding certain risky assets, or at least holding a greater quantity of these risky assets than is prudent. For example, commercial banks in the UK are not allowed to hold common stock because stock prices experience substantial fluctuations.
152
What is deposit insurance?
The government can insure people's deposits so that they do not suffer great financial loss if the financial intermediary that holds these deposits should fail.
153
What are limits on competition?
Idea that competition among financial intermediaries can promote failures that will harm the public. Individual European governments at times have imposed restrictions on the takeover of banks by other banks within Europe on grounds of national interest.
