Notes

Overview of the Financial System

Chapter 1

Finance 327

Definition of a Financial System

* Financial System

* Network of financial markets and financial institutions

* Brings savers and investors together

* Key financial services of the system

* Risk Sharing

* Provision of liquidity

* Information services

Purpose of the Financial System

* Transfer funds from savers to borrowers

* Savers are suppliers of funds

* Borrowers are investors, demanders of funds

* Financial markets issue claims on borrowers

* Financial intermediaries act as go-betweens

Key Services Provided by the Financial System

* Risk Sharing

* Savers can hold many assets (diversification)

* Liquidity

* Ease of converting assets to cash (without slashing price)

* Information

* Provide information to investors

* Help solve information asymmetry problems (more on this in Chapter 9)

Financial Markets

* Primary Markets

* Newly issued claims (e.g., bonds, loans or stock)

* Sold to initial buyers

* Province of investment bankers

* Secondary Markets

* Previously issued claims are resold (traded)

* Province of Brokers and Exchanges (e.g., NYSE)

* Secondary Markets provide risk sharing, liquidity, and information services

Types of Secondary Markets

* Maturity

* Money Markets < 1 year

Major Components of the Money Market

* Capital Markets > 1 year

* Market for debt and equity securities with maturities over 1 year

Relative new addition to the capital markets: Mortgage Backed Securities

* Developed in the 1970s to help liquidity of financial institutions

* Proportional ownership of a pool or a specified obligation secured by a pool

(“MBS pass through”)

* Market has experienced very high rates of growth

Mortgage-backed Securities Outstanding, 1979-2007

Trading places

* Auction...