Financial markets reduce transaction costs by maldng

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Financial markets reduce transaction costs by maldng it easier and less costly to match borrowers and lenders. They can be used to reduce the risk taken by individual lenders and borrowers by allowing diversification (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 transform funds they gather into financial assets. A financial asset is a paper claim that entitles its buyer to fdture income from the seller. There are four important types of financial assets: loans, stocks, bonds, and bank deposits. A loan is an agreement to repay, with interest. A bond is an IOU issued by the borrower that represents a promise to pay fixed interest payments at regular intervals and repay the principal on a specified date. A stock is a share in the ownership of a company. A mutual fund is a financial intermediary that creates a portfolio (collection of financial assets) made up of different stocks and resells shares of it to individual investors. A mutual fund allows small investors to diversify their portfolio. Bank deposits are claims on a bank that oblige it to give funds back to a depositor on demand. , :li: ].: r" ! I , h'. - i? :!', • ,t':: ii •:ii i},! i , 6: i '1 ;': iii:. !'L' p' II J"i :
11. In each of the following scenarios, identify the financial asset (loan, stock, bond, bank deposit) and what important function of financial markets is being served (reduce transaction costs, reduce risk, provide liquidity). Explain how the asset is serving the function(s) you identify. Scenario Financial asset Function(s) iI 'i !!: (A) The cost of building a new factory is financed by selling shares iÿ the company. .." (B) Funds from many small savers are combined and provided to an individual to buy a house. (C) The $1,000 in your savings account at your local bank pays you 3 percent ' interest. (D) A firm borrows money by promising to pay a fixed sum of interest each year for 10 years and then pay back the amount borrowed at the end of 10 years. I! i i!:I !, i' I 128 Advanced Placement Economies iviacroeconomics: Student Resource Manual © Council. for Economic Education New York, N,Y, t I
Time Value of Money A dollar you receive today is worth more than a dollar you may receive a year from today! Money has a time value because interest rates are positive. For example, if you earn 5'percent per year on your savings account, one dollar will grow to one dollar plus five cents after one year. Since the present value of $1.05 to be received one year from nowi(if interest rates are 5%) is $1.00, then the present value of $1.00 to be received one year from now (again if interest rates are 5%) must be some value less than $1.00. In fact, the present value can be calculated using the formula ! PV = IÿV / (1 + r)n where PV is present value FV is future value r is the rate of interest per period n is the number of compounding perio& (per year).

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