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Chapter 3 Overview of the Financial System

Chapter 3 Overview of the Financial System Purpose of the Financial System Transfer funds from savers to borrowers Savers (lenders) supply the funds, obtaining assets that pay future returns. Borrowers demand the funds, issuing liabilities that require future returns.

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Chapter 3 Overview of the Financial System

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  1. Chapter 3Overview of the Financial System

  2. Purpose of the Financial System • Transfer funds from savers to borrowers • Savers (lenders) supply the funds, obtaining assets that pay future returns. • Borrowers demand the funds, issuing liabilities that require future returns.

  3. Two Parts of Financial System • Financial markets directly transfer funds from savers to borrowers. • Financial intermediaries indirectly transfer the funds by acting as go-betweens: • The ultimate savers lend to financial intermediaries, which then lend the funds to the ultimate borrowers.

  4. Key Services of Financial System • Risk-sharing • Liquidity • Information about borrowers and returns on financial assets

  5. Risk-Sharing • Risky assets have uncertain returns due to • Default • Fluctuating asset prices • Risk can be reduced by holding a portfolio of assets; i.e. by diversification. • Financial system enables risk to be shifted from those less willing to bear it to those more willing.

  6. Liquidity • Liquid assets — easily, quickly bought or sold at almost equal prices and at little cost • Examples of liquid assets: currency, deposits, Treasury bills, stocks of large companies • Example of an illiquid asset: houses

  7. Information • Financial system collects and communicates information. • It is costly for many individual savers and borrowers to do so themselves.

  8. Financial Markets • Newly issued claims are sold to initial buyers in primary markets. • Previously issued claims are resold in secondary markets. • Active secondary markets engender liquidity.

  9. Types of Secondary Markets • Format • Auction markets; e.g. NYSE • Over-the-counter markets: e.g. NASDAQ • Settlement • Cash markets; e.g. stocks, bonds • Derivative markets; e.g. futures, options

  10. Two Types of Claims • Debt • Equity

  11. Debt • Principal and interest • Maturity date • Term to maturity • Short-term:  1 year; money market • Intermediate-term: >1, < 10 years • Long-term:  10 years • Default

  12. Equity • Claim to a given share of profits and assets • Managers have discretion over how much to distribute. • Dividend — the amount distributed • Default: debt vs. equity • Risk-sharing: debt and equity • Capital market: equity plus intermediate- and long-term bonds

  13. Financial Intermediaries • Collect funds from many savers and transfer the funds to many borrowers • Provide risk-sharing, liquidity and information services

  14. Financial Evolution • Strong competition • Financial innovation • Financial integration in US • Globalization • Recent years • Before 1914

  15. Reasons for Financial Regulation • Prevention of fraud • Financial stability • Monetary control (silly) • Willie Sutton effect

  16. Facts for 2006 • 40% of assets were direct debt and equity instruments • 60% were liabilities of financial intermediaries of which about • 27% in bank deposits • 49% in pension reserves • 19% in mutual funds • 5% in insurance reserves

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