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Ch 3 - Chapter 3 I Introduction The international financial...

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Chapter 3 I. Introduction The international financial system exists to facilitate the design, sale and exchange of a broad set of contracts with a very specific set of characteristics We obtain financial resources through this system o Directly from markets, o Indirectly through institutions Indirect finance : institution stands between lender and borrower o We got a loan from a bank or finance company to buy a car Direct Finance : borrowers sell securities directly to lenders in the financial markets o Financing for governments and corporations Asset : Something of value that you own Liability : something you owe Financial development is linked to economic growth The role of the financial system is to facilitate production, employment, and consumption Resources are funneled through the system so resources flow to their most efficient uses We will survey the financial system in three steps 1. Financial instruments or securities a. Stocks, bonds, loans and insurances 2. Financial Markets a. NY Stock Exchange, Nasdaq 3. Financial Institutions II. Financial Instruments a. The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions i. The enforceability of the obligation is important ii. Obligates one party (person, company, or government) to transfer something to another party iii. Specific payments will be made at some future date iv. Specific certain conditions under which a payment will be made b. Uses of Financial Instruments i. Three Uses: 1. Act as a means of payment (like money) a. Employees take stock options as payments for working 2. Act as stores of value (like money) a. Generate increases in wealth that are larger than from holding money b. Can be used to transfer purchasing power into the future 3. Allow for the transfer of risk (unlike money) a. Futures and insurance contracts… c. Leverage
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Chapter 3 i. The use of borrowing to finance part of an investment is called leverage 1. Leverage played a key role in the financial crisis of 2007- 2009 ii. How did this happen? 1. The more leverage, the greater the risk an adverse surprise will lead to bankruptcy a. The more highly leveraged, the less net worth 2. Some important financial institutions during the crisis, were leveraged at more than 30 times their net worth 3. When losses are experienced, firms try to deleverage to raise net worth a. Too many institutions deleveraged, prices fell… III. Characteristics of Financial Instruments a. Contracts are very complex b. Complexity is costly and people do not want to bear these costs c. Standardization of financial instruments overcomes potential costs of complexity i. Most mortgages feature a standard application with standardized terms d. Financial instruments also communicate information , summarizing certain details about the issuer i. Continuous monitoring of an issuer is costly and difficult e. Mechanisms exist to reduce the cost of monitoring the behavior of counterparties i.
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