The Financial System

Financial Intermediaries

• Banks: Lend to individuals/businesses using deposits from savers, with interest
  • Profit from rate charged for loans - rate paid for deposits
• Investment Banks: Help organizations raise capital by selling securities to public
  • Profit from charge from investor - price paid to security issuer
• Funds: Invest in private businesses on behalf of individual savers
  • Profit from management fees charge from savers
• Insurance Companies: Premiums from individuals/businesses for insurance
  • Premium is invested prior to paying out claims
  • Revenue from premium + investment - claims

Security: General term for a tradable financial asset (e.g. stock, bond)

Stock: Ownership in an incorporated company

Bond: Debt issued by govmt/corps with maturity > 1 year

• Basically a loan where the govmt is the borrower and you are the bank
• Prime example of fixed income security
• Face Value (lump sum) paid at maturity
  • Coupons paid out periodically
    • PMT = percentage (coupon rate) of face value
  • Coupon rate or nominal yield = annual payments / face value
  • Current yield = annual payments / market value of bond

Money Markets: For fixed income securities bonds with maturity < 1 years; no coupons

• Short-term; highly liquid (easy to sell); large face values (because no coupons)
• Low-cost source of temporary funds

Capital Markets: Long-term securities

• Long-term investments for large projects (e.g. factories, highways)
• Only accessible by corporations

Primary Markets: First issuance of securities, IPOs

• IPO: Firm firsts offers shares to the public and becomes a public company

Secondary Markets: Trades securities after issuance - "glorified casinos"

• Auction Market: NYSE, RuneScape GE
  • Sellers ask & buyers bid
  • Direct trading between buyers and sellers
• Dealer/Over-the-Counter Market: NASDAQ
  • Dealer/"Market Maker" sells and buys - either as a broker or as an individual on their own behalf
  • Dealers list their own buy (bid) and sell (ask) prices
  • Incentivize entities to buy and sell securities by making it easier
    • Faster to find a "match" (buyer to seller)
    • Dealer's Revenue **=** Spread **=** Bid Price - Ask Price

Liquidity: Market with lots of trading activity (the goal of Market Makers in Dealer Markets)

• Trades: Means that it is possible to buy/sell whenever you want
• Traders: ****More traders = competitive market; no monopoly power
• Depth: # of available shares to be traded; encompasses Trades

Management: "The goal of a manager is to maximize shareholder wealth."

• Principal-Agent Problem: When managers put their own interests before those of the stockholders.
• Agency Cost: Money that must be spent to monitor managers to insure the P-A Problem doesn't occur

The Financial System

The Money Market

The Capital Market

Dealer Markets

Types of Business Entities