FIN3244

FIN3244

Test #1

Chapter 3

Overview of the Financial System

Key Purpose of Financial System?

Net Borrowers- have ideas, need funds, willing to pay for it

Net Savers- People with a lot of money that are not sure what to do with money, Want return on their money

“Cost of money” – having money and not doing anything with it. Therefore, they lose possible return on your money.

The key purpose of the financial system is to match these people up

The borrowers pay the money back with interest

Stocks and bonds are indicators of companies wanting to borrow money

Net savers Net Borrowers

Household buys stock household go to bank

Business invest business issue stocks

Pay more in taxes than the government needs- Clinton Administration

Most tax paying Americans would like to see the government run a small deficit, to make sure we’re not paying more taxes than we need to.

This is achieved through Markets and Intermediaries.

Financial Regulation

The government can change the rules of the game. Why does the government feel that it needs to come in and set up new rules?

1) The government feels that it is very important that both sides of the transaction need to have equal and access to information.

2) Maintain Financial Stability- ever since the Great Depression, the government has been very willing to make sure that it never happens again

3) Advancement of policy objectives- for example, tax deductions are given to those who give money to charities because then the government doesn’t have to spend the money on the poor.

a. Property Taxes give a deduction because the government wants to encourage home ownership; renters usually use more of the public service, like calling the police, which is money spent.

i. Homeowners take a vested interest in their neighborhoods.

b. Having children gives you tax exemptions because buying things for your kids propels the economy.

c. Also, Social Security is needed. For every retired person, there are 4-6 workers to pay for the social security.

What are the main regulatory bodies in the US?

SEC (Securities and Exchange Commission)

Chapter 11

Transaction and Information Costs

Obstacles to matching Savers and Borrowers

2 major obstacles

1. Transaction costs- any cost associated with buying or selling an asset

a. ATMs- pull out $20 and get charged $4.50, 22-23%

a. Buying stocks, transaction costs

b. Paying tuition, online convenience fee

c. Marriage? Ring, wedding, honeymoon

1. So we obviously want to get around them, but how?

i. Financial intermediaries help reduce transaction costs because they are based on economies of scale. As volume (quantity) increase, the cost per unit decreases.

1. Example- 10 people are each going to buy 10 shares of Google. Lets assume they are going to charge each person 10$ worth of transaction costs. Instead, the same 10 people can pool their money in intermediaries and instead of each paying 10$ of transaction costs the group of 10 people can just pay $10.

a. Information costs and information asymmetry- This is when one party has more information than the other. There are two types of information asymmetry:

a. Adverse Selection

b. Adverse Selection: this happens before the transaction occurs.

c. The lemons problem: When you are going to look at the car, who knows better? The seller has an advantage because they know everything that has been done to the car. So the buyer goes into the market and has set that if they can’t find out how good the car is then they will just pay the average. But what if the seller knows that they have an above average car and won’t take a below average price. Now the owner of the above average withdraws themselves from the market. Now there are only average and lemons on the market and the buy re-sets their standards for average.

d. Adverse selection happens before the transaction

e. Adverse selection- one party knows more than the other before the transaction

c. Moral Hazard

a. Moral Hazard- after the transaction… afterwards you get screwed

b. Moral Hazard is after the transaction

c. Insurance- Kathy Bates gets insurance and then slams her car into another

d. Banking- go to the bank, ask for a loan, great credit and collateral, say they have an awesome idea, then do whatever with the money

e. Equity Markets- issue bonds to Tyco, and the owner uses the stock money to throw a birthday party for his wife costing a million dollars

f. Relationships- get married and then someone in the relationships goes to whack… women doing methamphetamines after they have kids

g. How do you stop moral hazard?

i. Insurance- co-pay, deductibles, co-insurance, restrictions on coverage such as life insurance doesn’t get paid if suicide occurs, skydiving

ii. Banking- restricted covenants, if you do something other than what you say your going to do you owe the money; money that you get lent doesn’t go through your hands, straight from the bank to the seller if you’re buying a house… collateral… align incentives, if you screw the bank, they will screw you

iii. Equity markets- investors give money to companies and managers will squander the cash, how do you align the incentives? Give them stock. You could give them options, but that doesn’t perfectly align the incentives… there would be know downside to being a manager.



	FIN3244 FIN3244 Test #1 Chapter 3 Overview of the Financial System Key Purpose of Financial System? Net Borrowers- have ideas, need funds, willing to pay for it Net Savers- People with a lot of money that are not sure what to do with money, Want return on their money “Cost of money” – having money and not doing anything with it. Therefore, they lose possible return on your money. The key purpose of the financial system is to match these people up The borrowers pay the money back with interest Stocks and bonds are indicators of companies wanting to borrow money Net savers Net Borrowers Household buys stock household go to bank Business invest business issue stocks Pay more in taxes than the government needs- Clinton Administration Most tax paying Americans would like to see the government run a small deficit, to make sure we’re not paying more taxes than we need to. This is achieved through Markets and Intermediaries. Financial Regulation The government can change the rules of the game. Why does the government feel that it needs to come in and set up new rules? 1) The government feels that it is very important that both sides of the transaction need to have equal and access to information. 2) Maintain Financial Stability- ever since the Great Depression, the government has been very willing to make sure that it never happens again 3) Advancement of policy objectives- for example, tax deductions are given to those who give money to charities because then the government doesn’t have to spend the money on the poor. a. Property Taxes give a deduction because the government wants to encourage home ownership; renters usually use more of the public service, like calling the police, which is money spent. i. Homeowners take a vested interest in their neighborhoods. b. Having children gives you tax exemptions because buying things for your kids propels the economy. c. Also, Social Security is needed. For every retired person, there are 4-6 workers to pay for the social security. What are the main regulatory bodies in the US? SEC (Securities and Exchange Commission) Chapter 11 Transaction and Information Costs Obstacles to matching Savers and Borrowers 2 major obstacles 1. Transaction costs- any cost associated with buying or selling an asset a. ATMs- pull out $20 and get charged $4.50, 22-23% a. Buying stocks, transaction costs b. Paying tuition, online convenience fee c. Marriage? Ring, wedding, honeymoon 1. So we obviously want to get around them, but how? i. Financial intermediaries help reduce transaction costs because they are based on economies of scale. As volume (quantity) increase, the cost per unit decreases. 1. Example- 10 people are each going to buy 10 shares of Google. Lets assume they are going to charge each person 10$ worth of transaction costs. Instead, the same 10 people can pool their money in intermediaries and instead of each paying 10$ of transaction costs the group of 10 people can just pay $10. a. Information costs and information asymmetry- This is when one party has more information than the other. There are two types of information asymmetry: a. Adverse Selection b. Adverse Selection: this happens before the transaction occurs. c. The lemons problem: When you are going to look at the car, who knows better? The seller has an advantage because they know everything that has been done to the car. So the buyer goes into the market and has set that if they can’t find out how good the car is then they will just pay the average. But what if the seller knows that they have an above average car and won’t take a below average price. Now the owner of the above average withdraws themselves from the market. Now there are only average and lemons on the market and the buy re-sets their standards for average. d. Adverse selection happens before the transaction e. Adverse selection- one party knows more than the other before the transaction c. Moral Hazard a. Moral Hazard- after the transaction… afterwards you get screwed b. Moral Hazard is after the transaction c. Insurance- Kathy Bates gets insurance and then slams her car into another d. Banking- go to the bank, ask for a loan, great credit and collateral, say they have an awesome idea, then do whatever with the money e. Equity Markets- issue bonds to Tyco, and the owner uses the stock money to throw a birthday party for his wife costing a million dollars f. Relationships- get married and then someone in the relationships goes to whack… women doing methamphetamines after they have kids g. How do you stop moral hazard? i. Insurance- co-pay, deductibles, co-insurance, restrictions on coverage such as life insurance doesn’t get paid if suicide occurs, skydiving ii. Banking- restricted covenants, if you do something other than what you say your going to do you owe the money; money that you get lent doesn’t go through your hands, straight from the bank to the seller if you’re buying a house… collateral… align incentives, if you screw the bank, they will screw you iii. Equity markets- investors give money to companies and managers will squander the cash, how do you align the incentives? Give them stock. You could give them options, but that doesn’t perfectly align the incentives… there would be know downside to being a manager.