[Basic Finance] Market Organization & Structure #1
The Main Function of the Financial System
The three main functions of the financial system are to:
- Allow entities to save and borrow money, raise equity capital, manage risks, trade assets currently or in the future, and trade based on their estimates of asset values.
- Determine the returns(i.e., interest rates) that equate the total supply of savings with the total demand for borrowing.
- Allocate capital to ints most efficient uses.
Th financial system allows the transfer of assets and risks from one entity to another as well as across time. Entities who utilize the financial system include individuals, firms, governments, charities, and others.
Achievement of Purposes in the Financial System
The financial system allows entities to save, borrow, issue equity capital, manage risks, exchange assets, and to utilize information. The financial system is best at fulfilling these roles when the markets are liquid, transactions costs are low, information is readily available, and when regulation ensures the execution of contracts.
Savings. Individuals will save(e.g., for retirement) and expect a return that compensates them for risk and the use of their money. Firms save a portion of their sales to fund future expenditures. Vehicles used for saving include stocks, bonds, certificates of deposit, real assets, and other assets.
Borrowing. Individuals may borrow in order to buy a house, fund a college education or for other purposes. A firm may borrow in order to finance capital expenditures and for other activities. Governments may issue debt to fund their expenditures. Lenders can require collateral to protect them in the event of borrower defaults, take an equity position, or investigate the credit risk of the borrower.
Issuing equity. Another method of raising capital is to issue equity, where the capital providers will share in any future profits. Investment banks help with issuance, analysts value the equity, and regulators and accountants encourage the dissemination of information.
Risk management. Entities face risks from changing interest rates, currency values, commodities values, and defaults on debt, among other things. For example, a firm that owes a foreign currency in 90 days can lock in the price of this foreign currency in domestic currency units by entering into a forward contract. Future delivery of the foreign currency is guaranteed at a domestic-currency price set an inception of the contract. In this transaction, the form would be referred to as a hedger. This hedging allows the firm to enter a market that it would otherwise be reluctant to enter by reducing the risk of the transaction. Hedging instrument are available from exchanges, investment backs, insurance firms, and other institutions.
Exchanging assets. The financial system also allows entities to exchange assets. For example, Proctor and Gamble may sell soap in Europe but have costs denominated in U.S dollars.Proctor and Gamble can exchange their euros from soap sales for dollars in the currency markets.
Utilizing information. Investors with information expect to earn a return on that information in addition to their usual return. Investors who can identify assets that are currently undervalued or overvalued in the market can earn extra returns from investing based on their information(when their analysis is correct).
The financial system also provides a mechanism to determine the rate of return that equates the amount of borrowing with the amount of lending(saving) in an economy. Low rates of return increase borrowing but reduce saving(increase current consumption). High rates of return increase saving but reduce borrowing. The equilibrium interest rate is the rate at which the amount individuals, businesses, and governments desire to borrow is equal to the amount that individuals, businesses, and governments desire to lend. Equilibrium rates for different types of borrowing and lending will differ due to differences in risk, liquidity, and maturity.
Allocation of Capital
With limited availability of capital, one of the most important functions of a financial system is to allocate capital to its most efficient uses. Investors weigh the expected risks and returns of different investments to determine their most preferred investments. As long as investors are well informed regarding risk and return and markets function well, this results in an allocation to capital to its most valuable uses.
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