FIN3244 Exam 1 - Summary Financial Markets, Institutions, and International Finance Systems PDF

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Study Guide for Peterson's FIN3244 exam 1 - FSU...

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FIN3244 Exam 1 Chapter 1 The Financial System  Purpose of the financial system: to move money from those with excess funds to those with a use for them o Those with excess funds are called: lenders, investors, speculators, etc. o Those we a use for the funds are called: borrowers or sellers  There are 2 ways by which money is moved: o Financial markets: move money directly (buyers know exactly when they are purchasing and sellers knows exactly what they are selling)  Financial market where assets are bought and sold  Stock market  Bond market  Other markets: derivatives, commodities, foreign exchange o Financial intermediaries: move money indirectly (buyers don’t know exactly where their money is going but they have a general idea)  Someone else decides where your money will go or be invested  Includes mutual funds, pension funds, hedge funds  Includes commercial and investment banks and insurance companies  Smaller intermediaries: pawn brokers, payday loan businesses, mortgage brokers  At their core, all intermediaries move money around the financial system  Interest: the cost of the money that was borrowed  Participants in the financial system: o Households & individuals: both borrowers and lenders o Businesses: both borrowers & lenders  Frequently money borrowers, but also contribute some funds to the financial system  Create jobs and provide funds to employees; philanthropy o The government: both borrowers & lenders  One of the main sources of government funds are taxes: pay for the military, the courts, and many public services  Issues treasury bonds to raise funds  Bonds are borrowing instruments o Overall, the government and businesses are the net users of funds while individuals are the suppliers of funds to the financial system o All three categories typically borrow and lend at the same time o These groups can overlap depending on the circumstances at a certain point in time  Financial markets themselves are businesses

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Small businesses: get funding for different sources; subject to different financial pressures and regulations Risk & Liquidity  The financial system evolved to provide services that both borrowers and savers needed  Investor risk: the likelihood that you won’t receive your expected future return on an investment o The borrower does not return what was promised o In the case of purchasing equity: the corporation does not provide the anticipated profits or capital gains in the time period expected  Capital gains: the difference between what you paid for a security and what you sell it for  The more risk you take, the higher the potential return, but the less chance of getting it o The riskier you are as a receiver of money, the higher the return you’ll have to offer to get someone to invest in you  Risk: the chance that returns will be other than expected  The risk-return trade off: the more risk you take, the higher the potential return, but the less chance of getting it o Your answer depends on the circumstances at the time o The lower the risk, the more likely you’ll get the expected return, but expectations should be lower  Finance is about getting the proper return for the level of risk you are taking  Risk-sharing: the spread or transfer of risk o Diversification:  Investing in 2+ firms, some riskier than others and some safe, in order to receive an average return  Not putting your eggs all in the same basket o Insurance:  Typically do not know what they invest in  Transfer of risk; insurance company assumes the responsibility of risk and damage o Hedging: ‘diversifying your bet’; high-risk, high-stakes  Originally intended to be a risk reduction tool  Hedge funds are generally considered risky  Take actions that can have a much higher return that typical if successful, but also a much greater than typical loss if unsuccessful  Solvent: the ability of a firm to meet all of their financial obligations  The more something deviates from the norm, the more uncertain and risky  Finance always involves the future  Liquidity: the speed and ease with which an asset can be converted to cash o Must be at a reasonable price o Measured on a spectrum  From very liquid to not liquid:

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Cash, mutual funds/stocks, art supplies/instruments/specialty tools, real estate, part ownership in a business or artist co-op o Cash is the most liquid of all assets and the most common unit of economic exchange  Makes for efficient exchange  Liquidity refers to an asset class, not a specific asset; the “average”  Liquidity reduces uncertainty and risk, and allows for flexibility o Investors will usually choose the more liquid asset because they can access their funds quickly if they need to  Typically, the higher the liquidity, the lower the return  Financial assets are divided by time: o Money market assets: short term – maturities of one year or less  Always debt instruments  Typically low risk, high liquidity, low return  Liquid by nature o Capital market assets: long term – maturities of at least one year  Typically riskier than money market assets  Can be debt or equity (stock)  May or may not be liquid  Time is an assets characteristic: o Whether the asset is in the money markets or capital markets o The lifespan of the asset  Investor’s time horizon: how long an investor holds an asset before selling or trading Information and Risk & Return  Key services of the financial system: o Risk sharing o Liquidity o Information: what to buy, what to sell, what to hold  Without the financial system, investing would be even riskier  Information: the collection and communication of facts about— o Borrowers o Investments o Expected returns  Information itself has become a business  Credit score: a tool to assess how likely you are to repay a loan/debt  Information in the financial system make us more confident in taking on risk; it increases the willingness of individuals, businesses, and governments to lend and borrow money  Investors invest to get the highest possible return; this involves risk-sharing, liquidity, and information o Risk-return tradeoff: higher risk for higher reward, lower risk for lower reward  Risk tolerances: individuals are willing to accept different amounts of risk at different reward levels before they’ll refuse to bet it all

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Risk, liquidity, and information all combine to help determine at what level an individual is willing to invest and the amount of return he/she will demand  Different assets have different risk levels o The same type of assets may have different risk levels o Specifics depend on circumstances The Government  The government is both a borrower and a lender  As a borrower: o Debt: treasuries (bills, notes, bonds) o Other debt instruments (US savings bonds, etc.)  Primary source of income comes from taxes  As a lender: o Social and economic appropriations o Employee salaries, military, interest and global activities  The government is not intended to be a profit-gaining entity  The Federal Reserve (the Fed) o Manages amount of money in the economy o Central bank of the US o Lender of last resort  Will make loans to illiquid commercial banks (add liquidity) o Conducting monetary policy (FOMC—Federal Open Market Committee)  Money supply and the demand for money  Raising the interest rate represents a tightening of monetary policy (inflation too high)  To achieve higher interest rates: decrease the money supply which reduces liquidity in the economy o Less liquidity means borrowers must pay more, thus, the interest rates rise  Lowering the interest rate represents an easing of the monetary policy (inflation too low)  To achieve lower interest rates: increase the money supply which increases liquidity  More liquidity means the borrower pays less, thus, interest rates lower o Promotes maximum employment at stable prices o Targets short term interest rates  Determined by collected data from numerous sources and interprets what actions are needed to meet congressional mandate o It is transparent: communicates predictions and anticipated actions  Most movement in the market is caused by newly released information that changes expectations, resulting is price changes o Price changes also convey information

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 Securities & Exchange Commission (SEC): regulates the financial markets  Federal Deposit Insurance Corporation (FDIC): insures deposits in commercial banks Debt & Equity  Ways to obtain money: borrow or sell ownership of something o Jobs: sell yourself and your labor o Borrow—take on debt  Ex.:  Loan: a promise of borrowed money plus interest in the future (not tradeable on the market)  Debt securities: treasury and corporate bonds (tradeable on the market) o Sell ownership—sell equity  Ex.:  Stock: partial ownership in a firm  Home ownership  Car ownership  Capital Market: where long term financial instruments are bought and sold o Long term: more than a year o Ex.: treasury/corporate bonds, stocks  Money Markets: where short term financial instruments are bought and sold o Short term: less than a year o Ex.: t-bills, commercial paper, repurchase agreements  Bonds: long term debts sold in the capital markets  The longer the maturity of an asset, the riskier it tends to be  Time to maturity: the longer the length to maturity, the riskier the asset o Less liquid  Securitization: the process of bundling (pooling) loans together, making them tradeable in the financial markets o Makes non-tradeable loans tradeable in the financial markets  Individual loans aren’t tradeable—ex.: a single mortgage  A bundle of mortgages that form one security is tradeable on the market  More diversified as compared to a single loan and more liquid  Debt is generally considered less risky than equity—you know exactly what you owe and there are no questions o Fixed rate, held to maturity  Equity, or ownership, is considered risky because there is no set value and an uncertain return o Ownership, partial ownership o Changes with market o Equity is synonymous with stock  Stock share: partial ownership of a firm o Limited liability: investors can’t lose more than total investment plus transaction costs (cost of stock + commissions)

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Firms are assumed to exist in perpetuity (forever) o All stock trades in the capital markets All returns from stocks come from: o Capital gains: difference between buy and sell prices o Dividends, if paid by firm: partial return of profits by firm The Financial Crisis of 2007-2009 o AKA: The Crisis of Credit—money flow stopped Chapter 2

Interest Rates & Rates of Return  Interest: the cost of money; it compensates for: o Opportunity cost o Default risk o Inflation: the loss of purchasing power (the cost rises/the value of money decreases)  Time value of money: money received today is worth more than money received in the future  Compounding: the process of earning interest on both the interest and the principal of an investment (interest earned on interest) o = (principal) * (1 + interest rate) ^(number of times compounded) n  ¿ p ( 1+r ) o Exponential increase in value o The future value: the value of an investment made today is expected to increase in the future as a result of interest earned on the investment  Interest rates are the link between the financial present and future o Interest rates account for inflation o The value of $100 today is more than $100 in the future; interest rates make up the value to increase it numerically but hold the same value throughout time Compounding & Discounting  Compounding: interest earned on interest o If you compound more frequently, the future value increases o Same with a higher interest rate and longer lending periods o Shorter intervals between compounding increase FV  Discounting: basically the reverse of compounding o Start with the future value of money and discount it by the percentage we think we will get through time to get the present value  Present value is worth less than future value o FV =PV x ( 1+i )n FV PV =  (1+i )n o Use expected returns to calculate the investment’s present value Chapter 3 6

Transaction Costs & Asymmetric Information  Financial intermediaries naturally evolved to solve some problems we have: o Provide services to individuals, business, and other intermediaries o Product innovation to help solve problems; gives options in securities, etc. o Technology has led to many changes sprung by financial intermediaries  Many individuals use technology for their banking  There are obstacles to conducting transactions, which is why financial intermediaries developed: o Individual lenders don’t have to seek out individual borrowers, and vice versa  Financial intermediaries find qualified individuals and reduce risk and stress of finding individuals on your own o Transactions cost: cost associated with making direct financial transactions  Individual to individual, you know what you’re buying and selling o Asymmetric information: situation in which one party to a transaction has better info than the other  Prefix “a-” before a word makes it negative; uneven information in this case  Starting a business: o Raise capital  Own savings; friends; family  What if not enough?  What if they don’t want to lend to us?  What if they don’t think you have the right skills or ability?  These are all risks  Transaction costs account for risks—the higher the cost of making a transaction, the less likely the transaction will occur o Flat fee: a set rate for the transaction; high for small investment amounts o Insufficient money for high-dollar investments o Insufficient money to diversify  Intermediaries mitigate transaction costs for individuals and small-medium sized firms: o Economies of scale: reduction in average unit cost with increased volume of goods or service; producing in bulk makes costs cheaper  Mutual funds/ pensions—diversification o Technology: ATMs/computers o Standardization: intermediaries are accustomed to performing a process and that makes it easier and more efficient o Specialization: intermediaries are good at financial transactions; they are experts who know what they are doing as compared to other professions  Information costs: cost of not knowing things o Asymmetric information: one party to a transaction has better information than the other  Typically, the borrower knows more than the lender

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Adverse selection: a problem investors face when distinguishing low-risk borrowers from high-risk borrowers before lending or investing  Financial intermediaries reduce adverse selection by collection information about individuals and their financial habits over time  To reduce adverse selection: o Borrowers use collateral/reputation o Firms use net worth o Investors use credit rationing  Moral hazard: the risk that borrowers could engage in actions after a transaction that are harmful to the lender o Best way to mitigate asymmetric information:  Investors: gather more information  Private information-gathering firms; can be costly Adverse Selection  The Lemons Problem: analyzed by George Akerlof o Refers to an adverse selection problem arising from asymmetric information o Potential investors have difficulty in distinguishing good borrowers from bad borrowers, so they offer good borrowers terms they are reluctant to accept o Ex.: selling & buying a used car—  The seller of a used car has more information than the buyer of a used car  Problem: the buyer cannot tell the difference between a good car and a ‘lemon’ car  The buyer will pay the expected value of the car, not knowing that it is a ‘lemon’ and there are problems with it that reduce its value  ¿ probability ( price if good car ) + probability( price if lemon)  If it’s a good car, the buyer is offering too little  If it’s a lemon, the buyer is offering too much  Result: overall quality of good used cars decreases  Intermediary: used car dealership—reduces asymmetric information  Dealers price cars closer to their true value  Dealer’s reputation is on the line, making them more likely to be honest about the quality of the car  Government regulations require these businesses to be more honest and disclose problems it has  Adverse selection problem in debt markets: investors can’t tell low-risk borrowers from high-risk borrowers  Adverse selection problem in equity markets: investors can’t tell good firms from bad firms  Adverse selection problem in insurance: those most likely to buy insurance are most likely to file claims o Those who buy insurance are more likely to need it  Private information-gathering firms have a free-rider problem o People get the benefit of a service without having to pay for it

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Mitigating adverse selection problems: o Financial intermediaries:  Banks: ration loans rather than make them at very high interest rates  High interest rate borrowers are more likely to default  Requires collateral/high net worth o Pawnshops/market capitalization  Specialize in gathering borrower’s default-risk information  Detailed application requiring lots of information about your financial situation  Credit score check  Relationship banking: the ability of banks to assess credit risks on the basis of private information about borrowers  Banks have a unique ability to gather information about a borrower’s creditworthy-ness  Banks have a relationship with the borrower and can check their worthiness by looking at their transactions and deposits  Can reduce free-riding problem: receivers of bank loans are not publicly known; bank loans to people are not public knowledge o Financial markets:  Small-medium sized firms: need external funds  Not enough history and background to determine worthiness  More risky  Large firms: can use internal funds  Can sell securities publicly because they’re known and public information about the firm determines worthiness  Security & Exchange Commission (SEC): publicly traded firms must disclose financial and other material information to stockholders/the public; requires transparency  Material information: information that could affect stock price  Costly to become publicly traded  Exchange listing requirements and fees  Transparency reduces adverse selection  Even with a good selection, you still have to monitor have funds are being used Moral Hazard  Moral hazard is an asymmetric information problem  Moral hazard: the risk that after entering into a transaction, the borrower takes actions that could harm the lender  Behavioral changed, after capital is received, that increase the investor’s risks o Funds are used in a way that was not intended by the investor  Moral hazard problems in the equity markets tend to be greater than in the bonds markets o Bonds have fewer moral hazards

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o A firm must be in serious financial trouble before bondholders aren’t paid the interest owed to them o Debt obligations are fixed and paid before shareholders receive dividends or see the price of their stock rise o Equity, partial ownership of a firm, raises more risks because you are directly affected by the ways your money is used and the return you receive Mitigating Moral Hazard  Principal-agent problem: possibility that managers might pursue objectives different than their shareholders o Principals: shareholders are the firm’s owners o Agents: top management employed by shareholders to carry out their wishes  Separation between management who runs the firm and the shareholders who own it creates conflicts of interest  Firm managers are hired to maximize shareholder wealth, but it’s very hard to tell if they’re doing it  In equity markets, ways to reduce the principal-agent problem: o Board of directors: owners who have a significant amount of stock  Don’t meet often  Use information supplied by the manager  Not always independent of the management o Incentive contracts: align the goal of managers with that of the shareholders (executive compensation)  Financial intermediaries mitigate moral hazard: o Restrictive covenants: place limits on the use of funds that borrowers receive  May req...