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Financial Systems III


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Indirect finance is....
... where borrowers borrow funds from the financial market through indirect means, such as through a financial intermediary
Financial Intermediaries
Business that specialize in borrowing funds from people who have saved and lending to people who want to borrow
Asymmetric Information
situation when one party doesn't know enough about the other party to make accurate decisions. This creates two kinds of problems:
Mutual Savings banks
Similar to savings and loans associations
Credit Unions
very small institutions which acquire funds from deposits and primarily make consumer loans
Insurance companies
Insure people against risks like theft, fire and automobile accidents
Pension Funds
These acquire funds by periodic contributions from employers or
Investment banks
These help corporations raise money, usually through issuing
Finance companies
These also help corporations raise money, but also make loans to individuals.
Mutual Funds
These are companies or divisions of an investment bank that sell shares of itself to investors and then use the proceeds to invest in different company stocks
Money market mutual funds
These are like mutual funds, but they invest in different money market instruments like treasury bills and bankers acceptances instead of investing in company stock.
Two Sources of finance:
Indirect finance- through a intermediary, like a bank
Outline the evidence for the importance of financial intermediaries:
better financial systems ease external financing constraints, countries with better banks and markets grow faster (the degree to which is it is bank based or market based does not matter).
Outline importance of the GFC
Showed serious flaws in financial system such as too large, too powerful politically, too inefficient, and too risky.
Financial system
The system that allows the transfer of money between savers and borrowers
Role of financial system
Transfer resources from savers to borrowers, increases economic efficiently
Financial intermediation: surplus and deficits agents
Savers/Lenders (Investors): households, companies, government... > save or invest current income for future consumption
Basic services FI provide
Denomination Divisibility: pool savings of many small Surplus Spending Units (SSU) into large investment
Financial Securities
Contract between borrower and lender where the lender owns the securities and each security specifies future compensation and consequences if borrower doesn't pay
Debt and Equity
Debt: an obligation or liability to pay or render something to someone else
Direct financing
Funds flow directly through financial markets (Interbank, Stock exchange, Money market, Bond arket, Foreign Exchange..)
Market
A virtual place (sometimes physical) where there are trades.
Primary and secondary markets
Primary market: a market that issues new securities on an exchange
Types of financial markets
Capital market: the part of a financial system concerned with raising capital by dealing in shares, bonds, and other long-term investments
over the counter (OTC) market
a secondary market in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities to anyone who comes to them and is willing to accept their prices
economies of scale
the reduction in transaction costs per dollar of transaction as the scale of transactions increases
Eurodollars
U.S dollar deposited in foreign banks outside the United States or in foreign branches of U.S banks
underwriting
guaranteeing prices on securities to corporations and then selling the securities to the public
adverse selections
the problem created by asymmetric information before a transaction occurs when the people who are most undesirable from the other party's point of view are the ones who are most likely to want to engage in the financial transaction
diversification
investing in a portfolio whose returns do not always move together with the result that overall risk is lower than for individual assets ( You shouldn't put all your eggs in one basket)
capital market
a financial market in which longer term debt and equity instruments are traded. (generally those with maturity of one year or greater)
financial intermediation
the process of indirect finance whereby financial intermediaries link lender savers and borrower spenders
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
equities
claims to share in the net income and assets of a corporation, such as common stock
transaction
the time and money spent trying to exchange financial assets, goods, or services
federal funds rate
the interest rate banks charge other banks on overnight loans
economies of scope
the ability to use one resource to provide many different products and services
asset transformation
turning risky assets into safer assets
portfolio
a collection or group of assets
financial panic
a widespread collapse of financial markets and intermediaries
capital
wealth that is used to produce more wealth
thrift institutions (thrifts)
savings and loans, mutual savings banks and credit unions
default
occurs when an institution is unable to make interest payments or pay off the amount owed on a debt instruments at maturity
conflicts of interest
can arise when a financial institution provides multiple services, leading to misleading or multiple services, leading to misleading or concealing of some information
risk sharing
occurs when firms create and sell assets that are less risky and use proceeds to buy riskier assets
brokers
agents for investors who help match buyers and sellers
liquid
easily converted into cash
dealers
those who buy and sell securities at a specifies price for buyers and sellers
currency
paper money or coins