Chapter 2: An overview of the Financial system

Default

A situation in which the party issuing the debt instrument (the federal government, in this case) is unable to make interest payments or pay off the amount owed when the instrument matures.

Financial intermediaries fall into 3 categories. What are the categories?

- Depository institutions (banks) - Contractual savings institutions - Investment intermediaries

6 types of government regulations on Financial intermediaries

- Restrictions on entity - Disclosure - Restrictions on Assets and Activities - Deposit insurance - Limits on competition - Restrictions on interest rates

Eurobond

A bond denominated in a currency other than that of the country in which it is sold—for example, a bond denominated in U.S. dollars sold in London. (A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro).

Negotiable Bank Certificates of Deposit

A certificate of deposit (CD) is a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price.

Adverse selection

Adverse selection is the problem created by asymmetric information before the transaction occurs. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected.

Commercial Paper

Commercial paper is a short-term debt instrument issued by large banks and well-known corporations, such as Microsoft and General Motors.

Contractual savings institutions

Contractual savings institutions, such as insurance companies and pension funds, are financial intermediaries that acquire funds at periodic intervals on a contractual basis. Because they can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years, they do not have to worry as much as depository institutions about losing funds quickly. As a result, the liquidity of assets is not as important a consideration for them as it is for depository institutions, and they tend to invest their funds primarily in long-term securities such as corporate bonds, stocks, and mortgages.

Depository institutions

Depository institutions (banks) are financial intermediaries that accept deposits from individuals and institutions and make loans. These institutions include commercial banks and the so-called thrift institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions.

Eurocurrencies

Foreign currencies deposited in banks outside the home country. The most important of the Eurocurrencies are Eurodollars, which are U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. banks.

Asymmetric information

In financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information.

Moral hazard

Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender's point of view, because they make it less likely that the loan will be paid back.

Mortgage

Mortgages are loans to households or firms to purchase land, housing, or other real structures, in which the structure or land itself serves as collateral for the loans. The mortgage market is the largest debt market in the United States

Repurchase Agreements

Repurchase agreements (repos) are effectively short-term loans (usually with a maturity term of less than two weeks) for which Treasury bills serve as collateral, an asset that the lender receives if the borrower does not pay back the loan.

State and Local Government Bonds (Municipal bonds)

State and local bonds, also called municipal bonds, are long-term debt instruments issued by state and local governments to finance expenditures on schools, roads, and other large programs. An important feature of these bonds is that their interest payments are exempt from federal income tax and generally from state taxes in the issuing state.

Financial intermediation

The process of indirect financing using financial intermediaries

Economies of scale

The reduction in transaction costs per dollar of transactions as the size (scale) of transactions increases

Transaction costs

The time and money spent in carrying out financial transactions.

Foreign bonds

The traditional instruments in the international bond market are known as foreign bonds. Foreign bonds are sold in a foreign country and are denominated in that country's currency.

Commercial Banks

These financial intermediaries raise funds primarily by issuing checkable deposits (deposits on which checks can be written), savings deposits (deposits that are payable on demand but do not allow their owners to write checks), and time deposits (deposits with fixed terms to maturity). They then use these funds to make commercial, consumer, and mortgage loans and to buy U.S. government securities and municipal bonds. They are the largest financial intermediary and have the most diversified portfolios (collections) of assets.

Federal (Fed) Funds

These instruments are typically overnight loans between banks of their deposits at the Federal Reserve. The federal funds designation is somewhat confusing because these loans are not made by the federal government or by the Federal Reserve but rather by banks to other banks. One reason why a bank might borrow in the federal funds market is that it might find it does not have enough funds in its deposit accounts at the Fed to meet the amount required by regulators. It can then borrow these funds from another bank, which transfers them to the borrowing bank using the Fed's wire transfer system.

Corporate Bonds

These long-term bonds are issued by corporations with very strong credit ratings. The typical corporate bond sends the holder an interest payment twice a year and pays off the face value when the bond matures. Some corporate bonds, called convertible bonds, have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date.

U.S. Government Securities

These long-term debt instruments are issued by the U.S. Treasury to finance the deficits of the federal government. Because they are the most widely traded bonds in the United States (the volume of transactions on average exceeds $500 billion daily), they are the most liquid security traded in the capital market. They are held by the Federal Reserve, banks, households, and foreigners.

U.S. Treasury Bills

These short-term debt instruments of the U.S. government are issued in one-, three-, and six-month maturities to finance the federal government. They pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount—that is, at a price lower than the set amount paid at maturity. For instance, in May 2016, you might buy a six-month Treasury bill for $9,000 that can be redeemed in November 2016 for $10,000. U.S. Treasury bills are the most liquid of all money market instruments because they are the most actively traded. They are also the safest money market instrument because there is a low probability of default

Investment Intermediaries

This category of financial intermediary includes finance companies, mutual funds, money market mutual funds, and hedge funds.