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Level 11

Introduction to Financial Systems


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what is the financial system
the system put in place to manage money
securities
financial contracts (like shares) that can be traded in a financial market
settle commercial transactions
functions of the financial system:
Deficit units
The users of funds supplied by surplus units
Surplus units
The suppliers of funds to the financial system
Credit risk
possibility that borrower will not meet the scheduled repayments and default on their loan
Market risk:
possibility of unexpected movement in the market - change in interest rates, exchange rates, security prices (when the value of your securities move in a way you didn't expect due to market forces)
Operational risk
failure of process or controls-possibility that something goes wrong and don't have the money to function
shocks
eg GFC, stock market crash
risk management alternatives
avoidance- give up the opportunity
moral hazard
the risk that one party to a transaction will engage in behavior that is undesirable from the other party's point of view
information asymmetry
Parties do not have equal access to information
agency problems
Arise when an agent acts in its own interest, rather than those of the principals (eg wolf of wall street)
pooling of funds
An arrangement that consolidates small amounts of funds to satisfy the demands for large amounts
return
interest or similar
Debt
Obligation to repay
Equity
Stake of Ownership
maturity date
the day the loan is to be repaid
risk premium
the component of a return that compensates for risk (credit risk premium compensates for borrower's risk)
fixed rate
the interest rate that applies over the whole period of the loan
Primary Market
financial market where issues of a security are sold to initial buyers by the borrower
secondary markets
subsequent trading of existing securities- provide liquidity, price discovery, and develop the supply of investment funds
transaction
the time and money spent trying to exchange financial assets, goods, or services
settlement
when the value and title transfer
risk transfer function
Objectives of markets are to match risk appetites of participants in the financial system