Financial markets reduce transaction costs by maldng it easier and less costly to match borrowers andlenders. They can be used to reduce the risk taken by individual lenders and borrowers by allowingdiversification (investing in several different assets). And they can be used as a way to provide liquidity(access to cash). Financial intermediaries (e.g., banks and mutual funds) are institutions that transformfunds they gather into financial assets.A financial asset is a paper claim that entitles its buyer to fdture income from the seller. There are fourimportant types of financial assets: loans, stocks, bonds, and bank deposits. A loan is an agreement torepay, with interest. A bond is an IOU issued by the borrower that represents a promise to pay fixed interestpayments at regular intervals and repay the principal on a specified date. A stock is a share in the ownershipof a company. A mutual fund is a financial intermediary that creates a portfolio (collection of financialassets) made up of different stocks and resells shares of it to individual investors. A mutual fund allowssmall investors to diversify their portfolio. Bank deposits are claims on a bank that oblige it to give fundsback to a depositor on demand. ,:li:].:r"!I, h'.- i?:!',• ,t'::ii•:iii},!i ,6: i'1 ;':iii:.!'L'p'IIJ"i :
Time Value of MoneyA dollar you receive today is worth more than a dollar you may receive a year from today! Money hasa time value because interest rates are positive. For example, if you earn 5'percent per year on yoursavings account, one dollar will grow to one dollar plus five cents after one year. Since the presentvalue of $1.05 to be received one year from nowi(if interest rates are 5%) is $1.00, then the presentvalue of $1.00 to be received one year from now (again if interest rates are 5%) must be some valueless than $1.00. In fact, the present value can be calculated using the formula!PV = IÿV / (1 + r)nwherePV is present valueFV is future valuer is the rate of interest per periodn is the number of compounding perio& (per year).