FIN 344 (Ch 1-3) Review:

Six Parts of the Financial System: 1) Money To pay for purchases & store wealth. 2) Financial Instruments (bonds, stocks
& other securities) to transfer resources from savers to investors & to transfer risk to those best equipped to bear it. The written legal
obligation of one party to transfer something of value, usually money, to another party at some future date, under specified
conditions {subject to government enforcement/obligates one party (person, company, or government) to transfer something to
another party/specify PMT will be made at some future date/Specify conditions under whch a PMT will be made. 3) Financial Mrkts
the places where financial instruments are bought & sold. 4) Financial Institutions (Also known as financial intermediaries)
provide access to financial mrkts, collect information & provide services EX: Examples: banks, insurance companies, securities firms,
& pension funds. 5) Regulatory Agencies to provide oversight for financial system. 6) Central Banks to monitor financial
Institutions & stabilize the economy.
Five Core Principles of Money & Banking: 1) Time has value - Interest is paid to compensate the lenders for the time the
borrowers have their money.
2) Risk requires compensation - individuals will accept risk only if they are compensated/the higher the risk the bigger the PMT. 3)
Information is the basis for decisions/foundation of the financial system. 4) Markets determine prices and allocation
resources/core of the economic system/minimize the cost of gathering info. 5) Stability improves welfare/reduces risk/main roles
of central banks is stabilizing the economy.
Money is an asset that is generally accepted as payment for goods & services or repayment of debt. It has three characteristics: 1) It
is a means of payment (most important) Money is easier & finalizes payments so there is no further claim on buyers & sellers. 2)
It is a unit of account Money is used to quote prices & record debts -it is a standard of value/Prices provide the information
needed to ensure resources are allocated to their best uses/Using dollars makes relative price comparisons easier. 3) It is a store of
value A means of payment has to be durable and capable of transferring purchasing power from one day to the next/ accepted at
face value in transactions/Other forms of wealth are also a store of value: stocks, bonds, houses, bank loans,

asset-backed securities//Money is more liquid.

Uses of Financial Instruments Three functions: 1) a means of PMT (like money) EX: Employees take stock options as PMT for
working. 2) Stores of value (like money) EX: Financial instruments can be used to transfer purchasing power into the future. 3) allow
for the transfer of risk (unlike money) EX: Futures & insurance contracts allows one person to transfer risk to another.
Four fundamental characteristics influence the value of a financial instrument: 1) Size of the payment: Larger PMT-more
valuable. 2) Timing of PMT: PMT is sooner- more valuable. 3) Likelihood PMT is made: More likely to be made-more valuable. 4)
Conditions under whch PMT is made: Made whn we need them-more valuable.
Liquidity is a measure of the ease w/ whch an asset can be turned into a means of PMT. Liquidity is a highly valuable resource that
can disappear when most needed.
Leverage is the use of borrowing to finance part of an investment. The more leverage, the greater the risk that an adverse surprise
will lead to bankruptcy.

Payments system: is a web of arrangements that allow for the exchange of goods and services, as well as assets. The possible
methods of payment are:
Commodity Monies are things with intrinsic value//to be successful, a commodity money must be: Usable by most people, Can
be made into standardized quantities, Durable, Easily transportable, & Divisible into smaller units. Fiat Monies Todays paper
money, its value comes from government
decree//must be limited in volume of
circulation to be credible. Check is an
instruction to the bank to take funds from
your account and transfer them to another
acct (not a final PMT as currency is - it sets in
motion a series of transactions//Checks are
legal proof of payment. Electronic
Payments * Debit Cards: Works like a
check - tells the bank to transfer funds from
your account to another. * Credit Cards: A
promise by a bank to lend the cardholder
money to make a purchase (They do not
represent money). * Electronic funds
transfers - Movements of funds directly from
one account to another. Most common is the
automated clearinghouse transaction
(ACH).Used for recurring PMTS like paychecks
or
utility bills. Banks use electronic transfers for
bank to bank transactions (thru Fedwire). *
Stored-value card - transfer money to the
card, then use the card at a merchant //Limited in what can be purchased with them. * E-money - Can be used to pay for purchases
on the Internet or by mobile phone//Really a form of private money, so not guaranteed by the government.

The Role of Financial Markets 1) Market liquidity: Ensure owners can buy and sell financial instruments cheaply. Keeps
transactions costs low.
2) Information: Pool & communication info about issuers of financial instruments. 3) Risk sharing: Provide individuals a place to
buy & sell risk.
Shadow banks (EX: Brokerages, insurers, hedge funds, etc.) Provide services that compete with banks but do not accept deposits.
Take on more risk than traditional banks and are less transparent-less subject to government regulations. Highly leveraged.
Non-depository institutions Include insurance companies, securities firms, mutual fund companies, hedge funds, private equity
or venture capital firms, finance companies, & pension funds.
Inflation the process of prices rising. With inflation, you need
more money to buy the same basket of goods. The primary cause
of
inflation is too much money.
Inflation rate the measurement of the process.
Money aggregates (definitions of money based upon degree of
liquidity): M1: Narrowest definition only the most liquid
assets. // M2: Broader definition
Includes assets not used as means of PMT.
Consumer Price Index (CPI)

CPI

Cost of Basket in Current Year

*100
Cost of Basket in Base Year

Inflation Rate 2015

CPI 2015 CPI 2014

*100
CPI 2014

Indirect Finance An institution stands between lender and borrower (EX: We get a loan from a bank or finance company to buy a
car).
Direct Finance Borrowers sell securities directly to lenders in
the financial markets (EX: Direct finance provides financing for
governments and corporations).
Underlying instruments are used by savers/lenders to
transfer resources directly to investors/borrowers (EX: stcks &
bonds)
Derivative instruments are those where their value and
payoffs are derived from the behavior of the underlying
instruments (EX: futures, options, swaps).
Instruments Used to Transfer Risk 1) Insurance
contracts: assure tht PMTs will be made under particular, &
often rare, circumstances. 2) Futures contracts: An agreement
between two parties to exchange a fixed quantity of a commodity
or an asset at a fixed price on a set future date. 3) Options: Give
the holder the right, not obligation, to buy or sell a fixed quantity
of the asset at a pre-determined price on either a specific date or
at any time during a specified period. 4) Swaps: Agreements to exchange two specific cash flows at certain times in the future.
The Structure of the Financial Industry Depository institutions take deposits and make loans. Insurance companies
accept premiums, which they invest, in return for promising compensation to policy holders under certain events. Pension funds
invest individual and company contributions in stocks, bonds, and real estate in order to provide payments to retired workers.
Securities firms include brokers, investment banks, underwriters, mutual fund companies, private equity firms, & venture capital
firms. * Brokers and investment banks issue stocks and bonds to corporate customers, trade them, and advise customers. * Mutualfund companies pool the resources of individuals and companies and invest them in portfolios - passive investing. * Hedge funds do
the same for small groups of wealthy investors. *Private equity and venture capital firms also serve wealthy investors by acquiring
controlling stakes in a few firms and manage them actively. Finance companies raise funds directly in the financial markets in order
to make loans to individuals and firms. Finance companies tend to specialize in particular types of loans, such as mortgage,
automobile, or business equipment. Government-sponsored enterprises (GSEs) are federal credit agencies that provide loans
directly for farmers and home mortgagors. Guarantee programs that insure loans made by private lenders. Provides retirement
income and medical care through Social Security and Medicare.

Ch 1-3 Q&As

Assuming no interest is paid on chcking accts, wht would you expect to see happen to the relative growth rates of M1 & M2 if IR rose significantly? Whn IR
rise, you would expect tht people would shift funds from chcking accts into savings accts, as the opportunity cost of holding funds in a non-interest bearing
acct has risen. Chcking accts are a component of M1 while both checking & some savings accts are included in M2. Therefore, any shift from chcking to
savings accts would depress growth in M1 to a greater degree thn growth in M2, leading to a relative increase in the M2 growth rate.
Consider again the tropical island described in Problem 12. Under what circumstances would you recommend the issue of a paper currency by the
government of the island? Wht advantages might this strategy have over the use of oranges as money? Islanders must have enough confidence in their
government to accept notesbacked only by a government decree that have no intrinsic value themselves, will act as final PMT, & government will not

print too much. Advantages: paper money easier to carry, longer lasting and more divisible, government that would control the supply.
Consider an economy tht only produces & consumes 2 goods: food & apparel. Suppose inflation rate based on consumer price index is higher during the
year thn tht based on the GDP deflator. Assuming underlying tastes & preferences in the economy stay the same, wht can you say about food & apparel
price movements during the year? Since the 2 price indices yield different inflation rates w/ preferences remaining constant, the relative price of the 2 goods
must have changed. In other words, the price of one of the goods must have gone up by a greater % thn the other. For example, suppose the price of food
went up by 10% while the price of apparel went up by 20%. This would induce consumers to substitute away from apparel to food. As a fixed weight index,
the CPI would not take this substitution into acct while the GDP deflator would, as it is calculated on the basis of what is actually purchased. Therefore, the
CPI inflation rate would be higher thn the rate calculated from the GDP deflator.
Core Principle 1 states that time has value by receiving the $1000 today, you can immediately put the money to use.
Could the dollar still function as the unit of account in a totally cashless society? Yes. Using dollars & cents to quote prices & to record debts--Dollars &
cents may still serve as the standard measurement of value even if they are not themselves exchanged.
Despite the efforts of the US Treasury & Secret Service, someone discovers a cheap way to counterfeit $100 bills. Wht will be the impact of this discovery
on the economy? People unwilling to accept $100 bills-it will require PMT via chck, cc, debit, or electronic, all of whch are more costly. Theoretically,
inflation could result if supply of money was increased by a large enough amount.
During the financial crisis of 2007-2009, some financial instruments tht received high ratings in terms of their safety turned out to be much riskier thn those
ratings indicated. Expln why mrkts for other financial instruments might have been adversely affected by tht development. Core Principle 3 states that
information is the basis for decisions. Ratings are an important source of info for investors in assessing many financial instruments, so when confidence in
tht info is undermined, they are more reluctant to lend.
Financial markets are those for stocks and for bonds. In the stock markets, equities or ownership shares in companies are bought and sold. In the bond
market, debt issues of government units or companies are traded.
Give four examples of ACH transactions: 1) Paycheck electronically transferred to bank acct 2) auto scheduled monthly electric bill payment 3) Prescheduled payments on credit card from your bank acct each month 4) Arranging car payment deducted from checking account on the same day/each month.
If 2% growth is your break-even point for an investment prjct, would you be more inclined to go ahead with the investment: (1) A forecast for economic
growth tht ranges from 0-4% or (2) a forecast of 2% growth for sure? What Core Principle does this illustrate? You would be more inclined to invest in prjct
if you knew for sure tht growth would be 2%. Uncertainty about the future makes investment less attractive. This illustrates core principle 5 stability
improves welfare.
If money growth is related to inflation, wht would you expect to happen to the inflation rates of countries tht join a monetary union & adopt a common
currency such as the euro? Once countries join a monetary union, they effectively share a common money supply. Given the link between money growth &
inflation, you would expect the inflation rates of these countries to converge.
If time has value, why are financial institutions willing to extend 30yr mortgage @ a lower IR thn they would charge for a 1yr loan? The house purchased
acts as collateral for the loan. In the event you default, the bank can sell the house & recoup its funds. The existence of collateral reduces the risk associated
w/ the loan.
If U.S. Securities & Exchange Commission eliminated its requirement for public companies to disclose info about their finances, wht would you expect to
happen to the stck prices for these companies? Expect the stock prices to fall. Gathering sufficient information would become much more costly.
Loan application questions are aimed at figuring out how likely you are to repay the loan. They are standardized to reduce the cost of making the loan.
M2 includes money market mutual fund shares, money market deposit accounts, small-denomination time deposits, checking accounts, and travelers checks
in addition to currency in the hands of the public. It also includes holdings by businesses, in addition to households.
Many people believe tht, despite ongoing financial innovations, cash will always be w/ us to some degree as a form of money. What Core Principle could
justify this view? Core Principle 3 information is the basis for decisions. Whn cash it is a final payment, not some form of a promise to pay. (Anonymityif desired)
Nominal GDP is the product of real GDP & the GDP deflator. Alternatively, real GDP is nominal GDP divided by the deflator. In simple terms, if Y is
nominal GDP, P is the deflator, and Q is real GDP, then Y = PQ or equivalently Q = Y / P.
Over a nine-year period in the 16th century, King Henry VIII reduced the silver content of the British pound to one-sixth its initial value. Why do you think
he did so? What do you think happened to the use of pounds as a means of payment? If you held both the old and new pounds, which would you use first,

and why? To pay for wars. The use of pounds as PMT declined bcz people could not be sure how much silver each coin contained. People spent the new
coins first since old coins had a higher intrinsic value.
Suppose a significant fall the price of certain stocks caused the mrkt makers in those stocks to experience difficulties w/ their funding liquidity. Under wht
circumstances might tht development lead to liquidity prblms in mrkts for other assets? Faced w/ difficulties in borrowing money, mrkt makers in the stcks
may decide to hold more cash--to meet clients demands. This, in turn, reduces loans available for other mrkt participants potentially causing them to alter
their behavior & could lead to funding liquidity prblms throughout the financial system. Moreover, to fund itself, the mrkt maker might try to sell other
assets, depressing their prices & spreading the disruption.
Suppose financial institutions didnt exist but you urgently needed a loan. Where would you most likely get this loan? Using Core Principles, identify an
advantage and a disadvantage this arrangement might have over borrowing from a financial institution: Family/friends. Advantage Core Principle 3, they
have more info about your reliability to pay them back- Disadvantage would be the necessity of finding family/friend to have funds available to lend to you
at tht point in time. Financial institutions help bring potential borrowers and lenders in the financial market together to allocate available resources (Core
principle 4).
Suppose medical research confirms earlier speculation tht red wine is good for you. Why would banks be willing to lend to vineyards tht produce red wine
@ a lower IR thn bfr? Future prospects for vineyards have improved, reducing risk involved in lending to them. The banks require less compensation thn
bfr.
Under what circumstances might money in the form of currency be the best option as a store of value? If there were deflation in the economy, then paper
currency would increase in value. Whn deflation occurs, overall prices in the economy are falling, so the currency you hold has more purchasing power.
During periods of falling prices of goods & services, prices of assets often fall too, so currency might be an attractive option as a store of value.
Under wht circumstances might you expect barter to reemerge in an economy tht has fiat money as a means of PMT? Can you think of an example of a
country where this has happened recently? You might expect an economy to revert to barter whn the public loses confidence in the fiat money issued by the
government, perhaps bcz of over-use of the printing presses. (Or high inflation)
W/O money, people have to barter to exchange goods & services. This requires a double coincidence of wants, whch makes it difficult to specialize. Whn
money is used, people are free to specialize in areas in whch they have a comparative advantage, increasing production of society as a whole, & improving
everyones standard of living.
What factors should you take into acct whn considering using the following assets as stores of value? Gold potential for price of gold to rise, ability to
buy & sell gold easily & any costs associated w/ storage & security. Real estate the rate @ whch real estate is appreciating & is likely to appreciate in

the future; how easy or difficult it is to sell real estate; the housing services you could receive from holding the real estate. Stocks the potential
appreciation in nominal value of the stck; the historical volatility of the stck price; the volume of the stock being traded on the secondary market to gauge its

liquidity. Government bonds the ROR on the bonds including any potential capital gain as well as interest PMTS. *When assessing an asset as a store
of value, the primary things to consider are the risk & return of the asset & its liquidity.
Wht are the advantages of a common currency for someone who is traveling through Europe? Each country has the same unit of account, making it easier
for a traveler to compare prices in different countries. The traveler also saves the costs of exchanging currencies.
Why are lrg, publicly listed companies much more likely thn small businesses to sell financial instruments such as bonds directly to the mrkt, while small
businesses get their financing from financial institutions such as banks? Info costs associated with small businesses are higher thn those for lrg, publicly
listed companies. Banks are skilled at gathering info, evaluating risks associated with loans - they are more likely to be willing to lend to smaller businesses.
Why might each of the following commodities not serve well as money? Tomatoes perishable & would not serve as a store of value. Bricks heavy,
bulky, will break easily, not easily divisible into usable units. Cattle are not standardized in terms of weight & other characteristics.
You receive a chck drawn on another bank & deposit it into your chcking acct. Even though this is a demand deposit the funds are not immediately
available. Why? Would your answer change if chck is drawn on the acct of another customer of your own bank? Funds drawn on another bank are not
immediately available until funds are transferred through the check-clearing process. If chck is drawn on an acct @ your bank, thn funds are internally
transferred, so funds may be available almost immediately.

You visit a tropical island that has only 4 goods in its economy: oranges, pineapples, coconuts & bananas. There is no money in this economy. a) Draw a
grid showing all the prices for this economy. (You should check your

answer using the [n*(n - 1)]/2 formula where n is the number of goods.)
There would be 6 prices total. b) An islander suggests designating oranges as
the means of PMT & unit of account for the economy. How many prices

would there be if her suggestion were followed? 3 prices:

pineapples/oranges, coconuts/oranges & banana/oranges. c) Do you think the change suggested in part b is worth implementing? Only a small gain by using
oranges as a unit of account. The gains would be significantly bigger in an economy with more goods. Drawback, would be the danger tht more people
would grow oranges, due to their special status, thus pushing up the prices of the other fruits in terms of oranges.