AC 509 Chapter 2 The Role of Financial Markets and Financial Intermediaries

Note

A transfer of funds from one intermediary (savings and loan association) to another (money market mutual fund) can have an important impact on the supply of credit available to a particular sector of the economy.

Note

All commercial banks that are members of the Federal Reserve System must purchase insurance from FDIC.

1. when you start your own business and invest your savings in the operation 2. when securities are initially sold to investors in the "primary" market.

Direct Investment

1. Commercial Banks 2. Thrift Institution 3. Life Insurance Companies

Examples of financial intermediary

Saving accounts Money market accounts Certificate of deposists

Examples of interest bearing accounts

Time deposit - no requirement Checking account - 10%

Examples of reserves

1. saving and loans association 2. mutual saving banks 3. credit union

Examples of thrift institution

1. Safety of principal 2. Liquidity 3, Interest rates that exceed the rates paid by the bank

Three factors that explain the popularity of money market mutual fund

1. Positive relationship 2. Negative relationship (inverted yield curve) 3. Neutral relationship (relatively flat)

Three relationships found in the yield curve

1. Insurance 2. Saving plan (accumulated cash value)

Two elements contain by life insurance policy

1. to facilitate the transfer of funds from savers to firms, government, and individuals who use the funds. 2. to facilitate the transfer of existing securities from sellers to buyers

Two functions of financial markets

1. M-1 2. M-2

Two measures of money

1. cash in the vault 2. deposit with another bank

Two ways to hold reserves

shells, stones, metals, coins, and paper money

What do the words "anything" and "generally accepted" in money mean?

1. Intermediary's diversified portfolio 2. the insurance of deposits

What made financial intermediaries a haven for investors?

M-2

Which is preferable by economists and financial analysts?

Mortality tables

a life insurance company can predict with accuracy the volume of death benefits that the company will have to pay and can construct a portfolio of long-term assets that meets the forecast benefits.

Money

a medium of exchange; its value is related to what it will purchase

Repurchase agreement (repos)

a sale of security in which the seller agrees to buy back (repurchase) the security at a specified price at a specified date; repurchase price > initial sale price

Saving and loans association

a source of mortgage loans; self-liquidating

Pension plans

accumulate assets for workers so that they will have funds for retirement.

Deposit Institution Deregulation and Monetary Control Act of 1980 (Monetary Control Act of 1980)

all depository institutions became subject to the regulation of the Federal Reserve.

Commercial paper

an unsecured short-term note issued by a corporation as an alternative to borrowing funds from commercial banks; only those creditworthy can sell this type of security.

Money

anything that is generally accepted as a means of payment (for goods and services; retirement of debt)

Financial Intermediaries

borrow funds from one group and lend to another; a process that channels resources into productive investment

Federal Reserve System

central bank; has the power to control the supply of money and to oversee the commercial banking system; created by Congress.

Checking and savings account Time deposit

constitute almost 50% of the bank's source of finance.

Rate of interest

cost of credit is often expressed as a percentage.

Interest

cost of credit; the price paid for the use of someone else's money

Intermediate term

debt that matures in one to ten years.

Minimum amount of reserve

determined by the Federal Reserve

Mutual saving banks

developed in 1800s; owned by its depositors; but managed by a board of trustees; owners may readily withdraw their funds

Liquidity

ease of converting an asset into cash without a loss; depth of the financial market

Federal Deposit Insurance Corporation (FDIC)

established because of the large losses sustained by commercial banks; increases the general public's confidence in the banking system.

Investment bankers

facilitate initial sale

Broker and secondary markets

facilitate subsequent sales

Required reserves

funds that banks must hold against deposit liabilities

Power to create money

given by the Constitution to the FEDERAL GOVERNMENT.

Use of Interest

helps allocate scarce credit among competing uses for the fund.

Secondary reserves

high-quality, short-term marketable securities, such as U.S. government securities (Treasury bills) that may be readily sold.

Fully loaned up

if there is no excess reserves

Yield curve

illustrates the term structure of interest rates; graph relating interest rates and the term to maturity.

Schwab U.S. Treasury Money Fund

invest solely in U.S. government securities or securities that are collateralized by obligations of the federal government.

Money market mutual fund

investment company that invest SOLELY in short-term money market instruments (newly issued)

Mutual funds

invests on behalf of individuals; not financial intermediary

Time deposit (certificate of deposit or CDs)

issued by a bank with a specified interest rate and maturity

Tax anticipation notes

issued by states or municipalities to finance current operations before tax revenues are received; tax exempt

Eurodollar certificate of deposits (Eurodollar CDs)

issued either by branches of domestic banks located abroad or by foreign banks; denominated in U.S. Dollars; a secondary market exist

Negotiable CDs

issued in amounts of $100,000 or more whose terms are individually negotiated between the bank and the saver and for which there exists a secondary market

Main reason of having reserves

it's one of the tools of monetary control.

Correspondent bank

major bank which a smaller bank has a relationship to facilitate check clearing and to serve as depository for reserves.

Banks with national charter

must join the Federal Reserve and are subjected to its regulation as well as to examination by the Comptroller of the Currency

Money market mutual funds

offer individuals an alternative to the checking accounts, savings accounts, and saving certificates issued by banks and thrift institutions.

Federal government deposit insurance

one of the positive results of the Great Depressions of the 1930s

Usual time period for a debt

one year

Life insurance companies

perform the role of a financial intermediary because they receive the funds of savers, create claims on themselves, and lend the funds to borrowers.

Thrift insitution

place for savers to deposit funds

Teachers Insurance and Annuity Association (TIAA)

purchases an entirely different type of portfolio that stresses debt, especially mortgages; savers to borrowers; acts as a financial intermediary (pension plan)

College Retirement Equity Fund (CREF)

purchases existing corporate stock

Government regulations

purpose is to protect the bank's creditors, especially their depositors.

Banks with state charter

regulated by the individual banking state commission and are subject to regulation by the Federal Reserve.

Savings

represent a command over resources that are not in used.

Excess reserves

reserves held by a bank in excess of those it must hold to meet its reserve requirement

U.S. Treasury Bill (T-Bill)

safest short-term securities issued by the federal government

Short term and Long term

short term: refers to a year or less long term : refers to greater than a year

Banker's acceptances

short-term promissory notes guaranteed by a bank; supported by two parties: the firm on which the draft is drawn and the bank that accepts the draft.

depth of the financial market

the ability to sell an asset without affecting its price

Note

the amount of the reserve requirement varies with the type of account.

Second function of financial markets

the creation of markets in existing securities; transfer of ownership of securities among various investors

Comptroller of the Currency

the federal agency that grants national bank charters

Financial intermediary

the funds are initially lent to the intermediary and the intermediary subsequently lends the funds to the ultimate user

Note

the longer the term of the debt and the riskier (or less creditworthy) the debt instrument, the higher will be the rate of interest.

Money market

the market for low-risk, large-denomination debt instrument that matures within a year.

Capital market

the market for securities with a longer horizon

Financial markets

the mechanism to transfer these savings to productive uses

Commercial banks

the most important depository institution (in terms of size); prime source of funds to consumers; tends to stress loans that must be paid off (mature) quickly.

Commercial banks

the most important financial intermediary in terms of the amount of loan

Primary function of financial system

the process of transferring savings to investment

Term structure of interest rates

the relationship between interest rates(cost of credit) and the length of time to maturity(the term) for debt in a given risk class

M-1

the sum of coins and currency plus demand deposits (interest-bearing checking account and traveler's check)

M-2

the sum of coins and currency plus demand deposits, regular saving accounts and small certificate of deposit (less than $100,000)

Money supply

the total amount of money in circulation.

Role of financial intermediary

the transfer of purchasing power from saver to borrower by an intermediary that creates claims on itself

Crucial component of financial system

the transfer of savings through financial intermediaries -from individuals with funds to firms, government, and other individuals who need the funds.

Primary liability of commercial banks

their deposits: checking accounts(demand deposit), savings and time deposits

Competition for Funds

through yield and services offered.

Note

to obtain the funds, the financial intermediary create CLAIMS ON THEMSELVES.

Used of Money

to transfer purchasing power to the future; acts as a STORE OF VALUE from one time period to another.

Indirect investment

transfer through financial intermediaries.

Commercial banks and Life insurance companies

Commercial banks: short-term liquid loans Life insurance companies: mortality tables

1. inflation 2. action of the Federal Reserve to curb rising prices

Reasons of having negative relationship in yield curve

$250,000

Amount insured by FDIC; legal limit

Note

For a pension plan to serve as a financial intermediary, it must pass the funds directly to a borrower or invest them directly in a firm

Note

No financial market can exist without its sources of funds.

Investment bankers Brokers Secondary market

Not financial intermediary but acts as a middleman (facilitate the buying and selling of new and existing securities)

Stocks, bonds, saving accounts, saving bonds, real estate, gold and collectibles

Other store of value (nonmonetary assets)