Financial Markets Week 1 Introduction

Financial markets transfer funds from lender-savers to borrower-spenders, allowing lenders to earn interest on surplus funds and enhancing economic welfare through efficient interactions.

Debt markets encompass short-term (maturity < 1 year), long-term (maturity > 10 years), and intermediate-term (maturity in between) debt securities. In 2009, the total value of debt securities was $52.4 trillion. If a company defaults on its debt, investors can recover up to 20% of its assets following bankruptcy.

<p>The Primary market is where new securities, such as stocks and bonds, are initially sold to investors. Investment banks typically underwrite these offerings, providing liquidity and making these securities more attractive for companies to issue.</p> Signup and view all the answers

<p>The Secondary Market, where previously issued securities are bought and sold, provides liquidity, allowing investors to quickly sell their holdings when needed. Major examples include the New York Stock Exchange (NYSE) and Nasdaq.</p> Signup and view all the answers

<p>Brokers act as intermediaries, facilitating trades between buyers and sellers without holding any inventory themselves. They execute buy and sell orders on behalf of clients, connecting them within the market.</p> Signup and view all the answers

<p>Dealers directly buy and sell securities from their own inventory, providing liquidity and helping to stabilize prices for investors. They are a key factor in maintaining a smooth and efficient market.</p> Signup and view all the answers

<p>Exchange markets, like the New York Stock Exchange (NYSE) and Chicago Board of Trade (CBOT), have a centralized location where trades are conducted. In contrast, Over-the-Counter (OTC) markets are decentralized, with dealers and brokers at different locations facilitating trades.</p> Signup and view all the answers

<p>False</p> Signup and view all the answers

<p>Financial markets classify securities based on their maturity into Money Markets and Capital Markets. Money Markets focus on short-term instruments (maturity less than one year) and include equities, while Capital Markets cover longer-term securities (maturity exceeding one year) such as stocks and bonds.</p> Signup and view all the answers

<p>Foreign bonds are denominated in a foreign currency and targeted at a foreign market. Eurobonds are also denominated in one currency, but are sold in a market different from the currency's origin. They may be issued in US dollars and sold in London, for example.</p> Signup and view all the answers

<p>The Eurocurrency market is a global market for foreign currency deposits outside of their home countries. A prominent example is Eurodollars—U.S. dollars deposited in banks outside of the U.S., often in London. This market provides an alternative source of funding for U.S. borrowers.</p> Signup and view all the answers

<p>Issuing bonds in foreign currency like US dollars can attract a broader range of investors, potentially increasing demand and lowering borrowing costs for emerging market countries. However, this strategy also exposes them to exchange rate risk. If their local currency depreciates against the foreign currency, it becomes more expensive to repay the debt, increasing the risk of default and financial instability.</p> Signup and view all the answers

<p>Direct finance involves borrowers accessing funds from lenders directly in financial markets by selling financial instruments, such as bonds or equity, which represent claims on their future income or assets.</p> Signup and view all the answers

<p>Indirect finance involves borrowers accessing funds from lenders indirectly through financial intermediaries, such as banks, who act as go-betweens. Borrowers sell financial instruments to these intermediaries, who in turn issue their own financial instruments (like deposits) to lenders.</p> Signup and view all the answers

<p>Financial intermediation is the process by which financial institutions facilitate the flow of funds from savers to borrowers. It involves the creation of financial instruments and markets that enable borrowers to access capital efficiently.</p> Signup and view all the answers

<p>Financial intermediaries achieve low transaction costs through economics of scale. They utilize a standardized contract for numerous transactions, significantly reducing the costs associated with individual transactions.</p> Signup and view all the answers

<p>Indirect finance provides key advantages: liquidity services, allowing savers to readily access their funds while also enabling borrowers to obtain long-term financing; risk sharing, reducing the impact of potential losses for individual investors by spreading risk across a diversified portfolio; and asset transformation, transforming illiquid, risky, or long-term assets into more liquid, lower-risk, or shorter-term assets suitable for investors' needs.</p> Signup and view all the answers

<p>Risk sharing involves financial intermediaries distributing and managing risk among different participants, ensuring that no individual bears an excessive risk burden. This process creates a more stable and balanced financial system.</p> Signup and view all the answers

<p>Asset transformation is the process by which financial intermediaries convert illiquid, high-risk, or long-term assets, like mortgages, into more liquid, low-risk, or short-term assets, like savings deposits. This transformation makes it easier for savers to access their funds while also providing borrowers with access to long-term financing.</p> Signup and view all the answers

<p>Banks generate profits through what is often called the 'riding the yield curve' business model. They gather deposits from customers at relatively low interest rates and then leverage these funds to lend to borrowers or purchase longer-term securities with higher interest rates, generating a spread between the two sides.</p> Signup and view all the answers

<p>Financial intermediaries pool funds from multiple investors and invest in a diversified range of assets across different sectors and industries. This diversification reduces the risk of a single investment performing poorly, lowering individual investors' overall risk exposure.</p> Signup and view all the answers

<p>Moral Hazard</p> Signup and view all the answers

<p>Adverse selection is an asymmetric information problem that occurs before a transaction. It arises because those most likely to benefit from a transaction are also the most likely to seek it out, creating a situation where the party with less information faces a higher risk.</p> Signup and view all the answers

<p>Moral hazard is an asymmetric information problem that occurs after a transaction. It occurs when one party to a transaction changes their behavior in a way that is harmful to the other party, knowing that they are protected by the transaction.</p> Signup and view all the answers

<p>The Diamond-Dybvig Model is a theoretical model that explains how banks and financial institutions can create social welfare by resolving liquidity issues and mitigating moral hazard concerns.</p> Signup and view all the answers

<p>Long-term investment return tomorrow = R &gt; 1</p> Signup and view all the answers

<p>Investment Intermediaries</p> Signup and view all the answers

<p>Commercial Banks</p> Signup and view all the answers

<p>Depository institutions accept deposits from individuals and businesses and then use these funds to make loans to other individuals and businesses.</p> Signup and view all the answers

<p>Fire and Casualty Insurance Companies</p> Signup and view all the answers

<p>Contractual savings institutions collect funds from clients on a regular basis, based on contracts that specify future payouts. This allows them to invest in longer-term assets and guarantee payouts to their policyholders or beneficiaries.</p> Signup and view all the answers

<p>Mutual Funds</p> Signup and view all the answers

<p>Commercial banks are the largest financial intermediaries and hold the most diversified portfolios of assets, making them essential players in the financial system.</p> Signup and view all the answers

<p>Thrifts are a collective term for savings and loan associations, mutual savings banks, and credit unions.</p> Signup and view all the answers

<p>Unlike commercial banks, Mutual Savings Banks and Credit Unions issue deposits as shares owned by their depositors. This means depositors have a stake in the institution and can vote on decisions relating to its operation. Credit unions are often further restricted by their member base, usually people associated with specific groups.</p> Signup and view all the answers

<p>Life insurance companies can invest in less liquid assets due to their predictable payouts based on actuarial analysis, which estimates the timing and magnitude of future claims based on the probability of death among their policyholders.</p> Signup and view all the answers

<p>Fire and casualty insurance companies face a higher degree of uncertainty regarding the timing and magnitude of their future payouts. They need liquid assets to quickly meet obligations when unforeseen events occur.</p> Signup and view all the answers

<p>Finance companies raise funds through the issuance of commercial paper, bonds, and stocks. They then use these funds to provide loans to consumers for durable goods purchases and to small businesses for operational financing.</p> Signup and view all the answers

<p>Mutual funds pool money from individual investors, primarily through retirement accounts. They then use these funds to construct a large, diversified portfolio of stocks and bonds, aiming to generate a return for their investors.</p> Signup and view all the answers

<p>Hedge funds are similar to mutual funds but have fewer regulations and typically take on greater risk. They often have higher minimum investment amounts (e.g., $100,000) and are only accessible to high-net-worth individuals or institutions.</p> Signup and view all the answers

<p>Money market mutual funds are restricted to investing in highly liquid, short-term debt assets. This limits their risk exposure and is designed to make them relatively safe investment options.</p> Signup and view all the answers

<p>Increase information to investors</p> Signup and view all the answers

<p>Federal Reserve System (Fed)</p> Signup and view all the answers

<p>The SEC regulates organized exchanges and financial markets in the US. Its objectives include promoting transparency through information disclosure, preventing insider trading, and protecting investors from fraud.</p> Signup and view all the answers

<p>The OCC charters and examines the books of federally chartered commercial banks and thrift institutions. It imposes restrictions on the assets they can hold and ensures their adherence to regulatory standards.</p> Signup and view all the answers

<p>The FDIC provides insurance of up to $250,000 for each depositor at an insured bank. It also examines the books of insured institutions and imposes restrictions on their asset holdings, working to maintain financial stability.</p> Signup and view all the answers

<p>The Fed regulates all depository institutions, including commercial banks. It examines the books of commercial banks that are members of the system, sets reserve requirements, and plays a central role in monetary policy.</p> Signup and view all the answers

<p>Restrictions on Entry</p> Signup and view all the answers

<p>Empirical evidence suggests that bank lending often decreases during financial crises, particularly impacting financially constrained firms. These firms are disproportionately affected by a crisis, as banks often tighten lending standards, leading to a decrease in credit supply.</p> Signup and view all the answers