Chapter 2 - Learning Objectives

Page 1

Chapter 2 - Learning Objectives

Describe the role of the financial system in the economy and the two basic ways in which money flows through the system

The role of the financial system is to gather money from people, businesses, and governments with surplus funds to invest (lender-savers) and channel that money to businesses and consumers who need to borrow money (borrower-spenders). If the financial system works properly, only investment projects with high rates of return and good credit are financed and all other projects are rejected. Money flows through the financial system in two basic ways: (1) directly, through financial markets, or (2) indirectly, through financial institutions

Discuss direct financing and the important role that investment banks play in this process

Direct markets are wholesale markets where lender-savers and borrower-spenders deal directly with one another. For example, corporations sell securities, such as stocks and bonds, directly to investors in exchange for money, which they use to invest in their businesses. Investment banks are important in the direct markets because they help borrower-spenders sell their new security issues. The services provided by investment bankers include origination, underwriting, and distribution.

Describe the primary, secondary, and money markets, explaining the special importance of secondary and money markets to business organisations

Primary markets are markets in which new securities are sold for the first time. Secondary markets are markets for securities that were previously issued. Not all securities have secondary markets. Secondary markets are important because they enable investors to convert securities easily into cash. Business firms whose securities are traded in secondary markets are able to issue new securities at a lower t than they otherwise could because investors are willing to pay a higher price for securities that have secondary markets.

Large corporations use money markets to adjust their liquidity because cash inflows and outflows are rarely perfectly synchronised. Thus, on one hand, if cash expenditures exceed cash receipts, a firm can borrow short-term in the money markets. If that firm holds a portfolio of money market instruments, it can sell some of these securities for cash, On the other hand, if cash receipts exceed expenditures, the firm can temporarily invest the funds in short-term money market instruments. Businesses are willing to invest large amounts of idle cash in money market instruments because of the liquidity and their low default risk.

Explain what an efficient market is and why market efficiency is important to financial managers

An efficient market is a market where security prices reflect eh knowledge and expectations of all investors. Public markets, for example, are more efficient than private markets because issuers of public securities are required to disclose a great deal of information about those securities to investors and investors are constantly evaluating the prospects for these securities and acting on the conclusion from their analyses by trading them. Market effciency is important to investors because it assures them that the securities they buy are prices close to their true value.

Explain how financial institutions serve the needs of consumers and small businesses

One problem with direct financing is that it takes place in a wholesale market. Most consumers and small businesses do not have the skills, financing requirements, or money to transact in this market. In contrast, a large portion of the indirect market focuses on providing financial services to consumers and small businesses. For example, commercial banks collect money from consumers in small dollar amounts by selling them checking accounts, savings accounts, and consumer CDs. They then aggregate the funds and make loans in larger amounts to consumers and businesses. The financial services bought or sold by financial institutions are tailor-make to fit the needs of the markets they serve

Compute the nominal and real rates of interest, differentiating between them

The fisher equations is used to compute the nominal (real) rate of interest when you have the real (nominal) rate and the inflation rate. The real rate of interest is the interest rate that would exist in the absence of inflation. It is determined by the interaction of (1) the rate of return that businesses can expect to earn on capital projects and (2) individuals' time preference for consumption. The interest rate we observe int he marketplace is called the nominal rate of interest. The nominal rate of interest is composted of two parts: (1) the real rate of interest and (2) the expected rate of inflation.