CECN506 - Chapter 2

Topics: Bond, Debt, Stock market Pages: 12 (1841 words) Published: February 26, 2014
Chapter 2: The Financial System

Financial system
Matching those who have savings with those who want to borrow With or without the use of financial intermediaries
The securities, intermediaries, and markets that exist to match savers and borrowers Essential part of a well- functioning economy

The Financial System

Financial Securities

Financial security
A contract in which a borrower
Who seeks to obtain money from someone
Promises to compensate the lender in the future
Debt security
Equity security [stock]
Investor
Owner of a financial security
Debt security
A contract that promises to pay
A given amount of money to the owner of the security
At specific dates in the future
Equity security [stock]
A contract that makes the owner of a security a part owner of the company that issued the security

U.S. Debt and Equity Securities – Fourth Quarter 2010

Financial Securities

Who borrows using debt and equity?
Debt: households, business firms, foreigners, governments, and financial intermediaries Equity: domestic and foreign business firms and financial intermediaries

Debt and Equity, by Issuer, Fourth Quarter 2010

Financial Securities

Households
Mortgage debt
To buy homes
Consumer credit
Credit cards
Loans for large purchases
Business firms (domestic and foreign)
Borrow using both debt and equity
Financial intermediaries
Borrow using both debt and equity
Governments
Borrow substantial amounts by issuing debt securities
Who owns these securities?
Households, business firms
Foreigners
Governments, and financial intermediaries

Debt and Equity, by Investor, Fourth Quarter 2010

Financial Securities

Differences between debt and equity
Maturity
Type of periodic payment being made
In case of bankruptcy
Maturity
The time until borrowed funds are repaid
Debt security - specifies a particular maturity date
Equity security – no maturity
Types of periodic payments
Debt securities - pay a specific amount of interest
Periodically until the debt matures
Equity securities – pay dividends
Not specified by the equity security
Higher when earnings are high
Lower in bad times
Principal
The original amount invested in a security
Interest
A payment (or series of payments)
Made by the borrower to the investor in a debt security
In addition to repayment of the principal
Dividend
The periodic payment made on an equity
In case of bankruptcy
Employees are paid any wages they are owed
Other companies to which the bankrupt firm owed money also are paid off Debt owners are paid off
If anything is left, it goes to the equity owners

Characteristics of Financial Securities
Matching Borrowers with Lenders

Financial system
Match borrowers who issue debt and equity securities
With savers who are willing to lend
Matches are facilitated through
Direct finance
Indirect finance
Direct finance
Savers buy securities directly from borrowers
Indirect finance
Savers invest through financial intermediaries, which buy securities from borrowers Financial intermediary
Company that transfers funds from savers to borrowers
By receiving funds from savers
And investing in securities issued by borrowers

Direct and Indirect Finance

Matching Borrowers with Lenders

Direct versus indirect finance
Both use financial securities
Both types of transactions are conducted in financial markets Young financial system – indirect finance
Over time, larger economy – direct finance
Financial intermediaries
Issue and own a large percentage of all the securities in the United States Are major participants in the financial system
Commercial banks, savings institutions
Credit unions, life insurance companies
Mutual funds, pension funds
Finance companies
Functions of financial intermediaries
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