Commercial Banks and other Financial Intermediaries Part 1

There are two main difficulties associated with direct arrangements between borrowers and savers, such as high search costs for bilateral loans and differences between the _____ needs of borrowers and savers. These difficulties can be overcome through financial intermediation.

Maturity. One of the big difficulties is agreeing on a maturity date. Most savers want to lend money for short time periods, whereas borrowers usually want to borrow for longer periods. Use of a financial intermediary, such as a commercial bank, can overcome this problem to meet the needs of both groups.

Until the late 1980s, mutual savings banks, savings and loan associations, and credit unions were commonly known as _______.

Thrifts. This term was coined to denote financial institutions whose mainstay was lending for residential mortgages. Nowadays, most savings institutions have failed, but credit unions still remain.

A money market is a market where securities and equities with an initial maturity period of less than _____ months are traded.

Twelve. This is the market for short-term securities--for example, Treasury Bills.

A bankers' ____________ is a type of bank draft. How it works is, a firm requests that an agent (usually a bank) pay the owner of the draft a particular amount at a specified time.

Acceptance. This instrument is used normally by importers and exporters. For example, if Company A in the US wants to buy clothes from Company B in Singapore, then instead of taking out a loan to buy $2m worth of clothes, it asks Company B to take out a banker's acceptance for $2.05m, maturing in 30 days. What this means is, Company B presents the bank with a draft for $2.05 million, and this draft is called a "bankers' acceptance" once the bank adds its irrevocable undertaking to pay the amount of the draft to the beneficiary (company B). In other words, the bank is promising to pay Company B on behalf of its client (Company A). Company A imports the clothes, sells them and remits $2.05m plus a fee to the bank. The bank then pays the owners of the bank acceptance (Company B) after 30 days. The whole point of a bankers' acceptance is that it allows the buyer to defer payment. Company A may not want to pay for the clothes right now--they want to pay for them in 30 days after they've had a chance to sell them. Company B may not be willing to take this risk of giving $2m worth of clothes without getting payment--what if Company A doesn't sell the clothes and doesn't have the money to pay? By using a bankers' acceptance, Company B is guaranteed that they will receive the money from a big, reputable bank. In essence, the bank is substituting its credit for that of Company A.

A financial instrument can also be called a financial claim, a security, or a financial ______.

Asset. This is one of the interchangeable terms used to describe a financial instrument.

Consumer finance companies make loans to individuals, business finance companies make loans to businesses, and sales finance companies make loans to consumers to ______ _________ goods.

Buy specific. For example, the GM Acceptance Corporation was set up specifically to give loans to people buying GM vehicles.

A bond is a debt security, traded on the __________ market, entitling the holder to coupon payments at specific times, as well as the face value of the bond at maturity.

Capital. Bonds are securities with maturity dates exceeding 1 year. These types of intermediate to long-term debt are traded on the capital market. A corporate bond is similar to a bond except that it is issued by a corporation.

_________ gain is the difference between the price of an asset when sold as compared to when it was purchased.

Capital. Capital gain tells you what you made or lost on an asset. It can be expressed in the positive, where an asset has increased in value or the negative, where an asset has reduced in value.

Insurance companies can be classified as either life insurance companies or property and _________ companies.

Casualty. Property and casualty companies accept premiums in exchange for coverage on property damage and financial consequences resulting from injury or death. As premiums are collected before insured losses occur, the company can invest these monies and hence act as financial intermediaries.

Commercial banks are the most popular financial institution in the US, and they mainly raise funds through savings and __________ deposits while investing in government securities and mortgages.

Checking. The checking account is essential for most people and used to make regular payments such as grocery and utilities bills.

A ________ is a bond with an infinite maturity date, promising to pay interest at specified periods, but not guaranteeing the payment of the face value.

Consul.

Credit unions are like mutual savings banks in that they are owned by their depositors, but in addition they invest mainly in ___________ loans.

Consumer. This is the main purpose of a credit union, with the income gained divided amongst the members in proportion to their deposits.

The _________ yield is the measure of interest gained per dollar invested.

Current.

Securities brokers charge clients a fee to buy and sell securities for them whereas securities __________ buy and sell securities from their own inventory of securities.

Dealers. This is what dealers do. They earn their commission in the difference in the bid price (the price they're willing to buy at) and the ask price (the price they're willing to sell at). For instance, in the retail market, the investor will buy securities from the dealer at the ask price, and sell at the bid price.

A mortgage is an example of a ______ security, where the principal borrowed is returned over the duration of the loan period along with payments of interest.

Debt. Remember, we had stated that there were securities that indicated ownership, and securities that indicated debt. A mortgage is an example of a debt security.

The ______ risk describes the risk that the issuer of a financial instrument will fail to make coupon payments or pay the face value.

Default. Default risk (the risk someone will default on their payment) is also known as credit risk. Obviously, instruments issued by the government carry a small risk, whereas those issued by small companies carry a much higher risk.

The advantages of saving money with a depository institution such as a bank is that there is no market risk, transactional costs are low, the _____ risk is minimal due to government agency backed insurance, and they offer a wide range of products.

Default. Remember, market risk refers to the risk that the price of an asset will fall as interest rates rise. This isn't a risk when saving money with a bank (versus saving money in bonds); the bank is committed to returning all of your deposits whenever you ask. You also have minimal default risk, which is the risk of losing your savings due to the bank collapsing financially. Banks are insured by a government agency (usually the FDIC), so you don't have to worry about the bank defaulting on your deposit.

Certificates of _________ are marketable certificates for funds deposited in a bank that promise to pay the holder the original amount deposited plus a specified interest rate.

Deposit. Certificates of Deposit are commonly just referred to as CD's.

Mutual savings banks are similar to savings and loans associations except that they are owned by the __________.

Depositors. The name 'mutual' implies that ownership lies with the savers themselves.

If Tina Williams sells her bond with a face value of $10,000 at $9900, then she has sold it at a _________.

Discount. This means that the security was sold at an amount less than the face value.

Mutual funds are an attractive option for savers because they are professionally managed, highly liquid, provide rates of return comparable to direct investments, have low transactional costs and can be ___________, thereby reducing risk.

Diversified. Diversification reduces the risk level experienced by the investor. The advantage of mutual funds over savings deposits is that the invested sum can be spread over various different types of investment, such as property and equities, thereby reducing exposure while providing better returns.

An ___________, which trades securities from a single main location, is a secondary market which trades securities.

Exchange. This is the definition of an exchange. An example is the New York Stock Exchange.

The _____ value of a security is the amount the holder can expect when a bond matures, or the nominal price of that bond stated on the security.

Face. Face value is also called par value.

Business finance companies purchase the accounts receivable of a company at a discount, thereby allowing the business to gain immediate funds in a process called __________.

Factoring. The accounts receivable of a company refers to whatever outstanding debts the company is waiting to collect on (i.e. money owed to the company by customers or other businesses). Companies will sometimes sell their outstanding debts to business finance companies at a discount because they need money right now, and the business finance companies make money by collecting the full value of those outstanding balances.

When one US bank instructs the Federal Reserve (FED) to transfer funds from its FED account to the FED account of another US bank, this type of loan is called _________ ______.

Federal funds. This loan is preferable to banks that need money quickly as the funds are available immediately upon transfer. The principal (amount borrowed) is returned with interest added when the loan period expires.

The present value (PV) refers to the current value of an asset whereas the ________ value refers to the value at a later date assuming the asset has been earning a particular rate of return.

Future. Future value is often referred to as FV.

Finance companies do not offer deposits, but instead specialize in making loans to ______-_______ individuals and businesses.

High-risk. This is the mainstay business of finance companies. They offer such loans to persons and companies that would normally be rejected by commercial banks.

The __________ ________ yield defines the rate of return obtained over the period the security is actually held.

Holding period.

A Treasury Bill is a security issued by the US Treasury which is sold at a discount so that the _______ from the bill equals the difference between the purchase price and face value.

Income. The Treasury Bill pays out income to the holder. So, for example, I buy a Treasury Bill maturing in 90 days with a face value of $20,000, but I only paid $19,000 for it. This means that I can expect income of $1000 over 90 days.

The drawbacks of saving in a depository institution are that there is little protection from ___________ and returns in the longer term may be poorer than in a direct investment.

Inflation. Inflation refers to the fall of purchasing power of money over time. For example, back in 1980, $1.35 could buy you a gallon of gas, whereas it now takes $2.00 or more to buy the same amount of gas. The value of cash savings usually do not keep up with inflation. So, over time, the value of the money in the bank, sometimes even with interest payments, declines

The equity market trades in securities with ownership rights, whereas the debt market trades securities with promises to pay the loaned amounts with _______.

Interest. "Securities" are documents that indicate either ownership or creditorship; i.e. stocks indicate ownership of a company, whereas bonds indicate an obligation to pay back a certain amount of money plus interest. Since there are two types of securities, it makes sense that there are two types of markets: equity markets and debt markets.

The coupon payments from a bond are a type of ________ payment.

Interest. This is another way of describing the coupon payment.

The market for savings deposits of commercial banks is an example of the financial ___________ market.

Intermediaries. Commercial banks act as financial intermediaries because they accept the savings deposits of customers, and then lend out these funds to borrowers. This activity is called financial intermediation or indirect finance.

An ___________ banker is a specialist agent that obtains new security issues and sells them on to investors.

Investment. This is one of the main jobs of an investment banker.

Treasury Bills are an example of a highly ______ asset because they can be readily sold at close to their full value.

Liquid. Liquidity refers to the speed that an asset can be converted to cash.

_______ market funds are mutual funds that invest in highly liquid investments such as Treasury Bills and other short-term money market instruments, whereas equity and bond funds invest in less liquid instruments such as bonds and equities.

Money. Money-market funds (MMF) are a special type of mutual fund. They invest in short-term (e.g., 30-day) securities from companies or governments that are highly liquid and low risk. The goal of MMFs are to minimize risk--they try to preserve principal while yielding a modest return. Basically, the companies try to make these feel like a high-yield bank account.

_________ funds are a combination of financial instruments, called 'shares', wrapped in a fund managed by investment companies who charge fees for their services to shareholders.

Mutual. A mutual fund is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund.

A primary market sells _____ securities to first purchasers, whereas a secondary market deals in secondhand securities.

New.

A Treasury Note differs from a Treasury Bond in that the former has an original maturity date between ___ and five yeas whereas the latter has an original maturity date exceeding five years.

One. Bonds in general have maturity dates exceeding one year, but Treasury Bonds have a maturity date exceeding five years.

Mutual funds may be open-ended, which means they can be repurchased by the shareholder at any time, or closed-ended, so that only a limited number of shares are issued and they can only be sold to ______ __________.

Other investors. Most mutual funds are open-ended, which means that the fund sells as many shares as investors want. The fund grows as more money comes in. When investors sell, the number of outstanding shares drops. Occasionally, open-end funds are closed to new investors when they become too large and difficult to manage. Conversely, a closed-end fund raises money only once, offers a fixed number of shares, and these shares are traded on exchanges.

When John Jones asks his stockbroker to buy shares in a particular company, then this secondary market is called an _____-____-_________ market.

Over-the-counter. These securities are traded from the dealer's inventories at prices given by the dealer at different locations.

The four types of non-depository financial institutions are insurance companies, __________ funds, mutual funds, and finance companies.

Pension. Pension funds collect contributions from members. Those contributions are invested on their behalf until the members reach retirement age, when they receive retirement benefit payouts.

When Sara Sims sold her General Motors bond for $2000 more than the face value, she sold it at a _________.

Premium. This term describes the sale of a security at a price above its face value.

Short-term, unsecured promissory notes sold at a discount by large corporations with good credit ranking are called _______ paper.

Prime. It can also be called commercial paper. It is a quick and easy way for companies to raise finances without involving financial institutions.

The key function of the money and capital markets is to facilitate the __________ of funds from economic agents that have surplus money, and to do it at a reasonable cost.

Raising. These markets provide governments, companies, and individuals with an effective means to raise funds as borrowers with the most productive funds use can bid for savings.

The yield on a financial instrument is the rate of ________ on a security.

Return (or interest).

The market risk refers to the risk that the price of an asset will fall as interest rates _______.

Rise. For example, as interest rates rise, bond prices tend to fall; this is market risk.

When the bond price falls, the yield _____.

Rises. Prices are inversely related to yield because the dollar amount of the interest paid on the bond is fixed. In other words, the amount in dollars that a bond pays in interest doesn't change, so if the price of the bond rises, then it would take a lower interest rate (or yield) to pay the same interest. So as prices increase, bond yields decrease and vice versa.

A financial market can be categorized as either a ________ market or a financial intermediaries market.

Securities. A securities market is one where agents trade debt and equity claims of the final borrowers. So, shares of Microsoft are bought and sold in securities markets.

Corporate _______ is an equity security issued by the corporation that entitles the holder to a proportion of dividends.

Stock. Remember, there are two general types of securities: there are equity securities, which indicate ownership, and debt securities. Corporate stock is a type of equity security.