Financial system - a group of instutiuons that bring savers , brorrowers nad investors toegther
Finanical markets and financial intermedaries
Help people manage both money and risk
Financial Markets- Institutions through which savers can directly provide funds to borrowers
Bond market
A bond is a certifcate of indebtness
Stock Market
Stocks are claims to partial ownership in a firm
Financial Intermediaries- Institution through which savers can indirectly provide funds to borrowers
Banks
Mutual Funds
Roles
Intermediation: helps match one person's savings with another person investment
Saving and investment are key to long-term growth
Provide liquidity: The ease at which an asset can be converted to cash
Diversify Risk: Risk sharing across assets or people
It fulfills its roles by creating financial assets that can be bought and sold
Major Financial Assets
Debt- A loan to a borrower in exchange for the future repayment of the loan amount plus periodic interest
Bonds- Certificates of indebtedness in which the buyer lends money in return for Regular interest payments over a period of time and the future repayment of the money borrowwed
The higher the interest rate, the higher the borrowers credit risk
Equity
A claim to partial ownership of a firm, with voting rights and its assets and profits
Compared to bonds, stocks offer higher risk and higher returns in the form of dividends and capital gains
Stock prices reflect expected profitability
Stock indexes are watched closely as indicators of future sconomics conditions
Derivatives
Financial assets based on the value of some other asset.
The buyer agrees to pay the seller based on the future price of some asset
Allows sellers to transfer risk relating to future prices to the contact partner
Major Payers in the financial system
Savers- people and governments who make funds available.
Entreprenuers and businesses
Speculators
People who buy and sell assets purely for fiancal gain
Examples of Financial Intermediaries
Commercial banks and trust companies
Pay depositors interest and charge browwoers higher interest on loans
Act as a medium of exchange
Investment banks
Do not accept deposits and do not make typical loans
Instead they assit companies in issuing stocks and bonds by acting as market makers
They match buyers with sellers
Mutual Funds
Sell shares in the fund to the public and use the proceeds to buy portfolios of stocks and bonds of other companies
Provide asset diversifcation and access to professional money managers who make decisions on behalf of cilents for a fee
Pension Funds
A professionally managed portfolios that provides income to retirees
2 types: defined benefit and defined contribution
Insurance Companies
Provide financial protection agnaist possible future losses in exchange for premiums
Valuing Assets
Basic tradeo-off
Expected risk in fiancial assets is correlated with expected return
Money Market: short term debt products such as money market mutual funds, treasury bills or money markets bank accounts
Fixed income: Bonds
Both are low risk and low reward Assets in developing countries carry more risk and reward
2 ways to classify risk
Market risk- Risk that is broadly shared by the entire market or economy
Idiosyncratic Risk - risk that is unique to the particular company or asset
Standards devication measures how spread out a set of numbers is relative to a bunch mark. Expected value
It is most commonly used to measure of risk in fiancial markets
A low Sd incidates that the data points tend to be close to the expected value
Appraoches ti choosing stocks
Savers decide on which assets to purchase based on the asset valuation principle : Any financial Asset's value is the present value of its expected future cash flows
There are 3 basic appraches used to pick stocks that are most likely to increase in value
Fundamental analysis
Conduct research on an indivual company to predict future profits.
Net present value is a measure of the current value of a stream of expected future cash flows
Technical Analysis
Computer Analysis of movements in stock prices to predict future movements
The effcient market hypothesis
The EMH states that market prices always incorpoates all available information, representing stock value as correctly as possible
FUND and Tech analysis only work if the current price differs from the ocrrect price
Principle: Markets often organize economic activity to maximize economic
well-being.
• Financial markets:
→ Are markets in which people trade financial assets.
→ Are governed by the forces of supply and demand.
■ Sellers/savers/lenders are the people with spare funds.
■ Buyers/investors/borrowers are those have productive ways to spend those
funds.
→ Match buyers and sellers who can both gain from trade.
■ Investors want to spend on productive inputs such as factories, machinery and
equipment.
■ Savers let investors borrow funds for a price.
→ Allow funding to flow to the places where it is most highly valued and so help
allocate the economy’s scarce resources to their most efficient uses.
GDP is both the total income in an economy and the total expe on the ecnomy's output of goods and services
National accounting identity for an open economy
In a closed economy net exports and imports are 0.
So gdp = c+i+g
Private saving- the portion of household's income that is not used for consumption or paying taxes
Y+TR-TA-C=Y-T-C=YD-C
Where yd- y-t is dispoable income
Public saving: net tex revenue minus government purchases
(Y-C-T)+(T-G) = Y-T-G
This portion of national incom that is not used for consumption or government purchases
Term: Long-term bonds are riskier than short term bonds because holders of long term bonds have to wait longer for repayment of principal.
Credit Risk: when bonds buyers perceive that the probability of default is high, they demand higher interest rate as compensation for that risk
Tax treatment : When provincial and local governments issue bonds, the bond owners are not equired to pay deferal income tax on the interest inceome.
Sprivate = Y-T-C is the amount of income (y) that households have left after paying the their taxes (t) and paying for consumption (c )
C= Y-T- Sprivate
= 800 billion- 150 -50
=600 bill
Public saving is the amoount of tax revenue that the government has left after paying for its spending. In order to solve for government
National Saving
S=Y-C-G
S is national saving
T is the national income
C is the total consumption
G is the total government expenfiture
S=Sprivate+Spublic
Since SPrivate Private = Y – T – C, then SPrivate Private = 10 000 – 1500 – 6000 = 2500.
Since SPublic Public = T – G, then SPublic Public = 1500 – 1700 = –200.
Since S = national saving = SPrivate Private + SPublic Public = 2500 + (–200) = 2300.
Finally, since I = investment = S, then 3300 – 100r = 2300 so that after rearranging, r = 10.
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