ECON10003 Chapter Notes - Chapter 7: Bank Reserves, Credit Risk, Risk Premium
25 May 2018
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The financial system provides information to savers about which of the many possible uses of
their funds are likely to prove most productive and pay the highest return --> helps to direct
saving to its best uses
1.
Financial markets help savers to share the risks of individual investment projects --> protects
individual savers from bearing excessive risk and making it possible to direct saving to projects
that are risky but potentially very productive
2.
A well-functioning financial system improves the allocation of saving in two ways:
Eg. banks
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Financial intermediaries are firms that extend credit to borrowers using funds raised from savers
Expertise in performing the information-gathering activities necessary for profitable lending
(checking out the borrower's background, determining whether the borrower's business plans
make sense and monitoring the borrower's activities during the life of the loan
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Banks can evaluate potential borrowers at a much lower cost and with better results than
individual savers
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Intermediaries develop a comparative advantage in evaluating the quality of borrowers
Banks reduce the costs of gathering information about potential borrowers by pooling the saving of
many individuals to make large loans, which only need to be evaluated once, rather than separately
Banks help savers by eliminating their need to gather information and directing their saving towards
higher return, more-productive investments
Banks help borrowers by providing access to credit that might otherwise not be available
Banks can bring together small savers looking for good uses for their funds and small borrowers with
worthwhile investment projects
People also hold bank deposits to make it easier to make payments
A large firm has alternative ways of raising funds (besides going to the bank)
The principal amount (the amount originally lent) is paid at the maturation date
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The owner of the bond (the bondholder) receives coupon payments until the bond's
maturation date
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The coupon rate is the interest rate at which coupon payments are paid
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Corporation and governments often raise funds by issuing bonds and selling them to savers
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Credit risk is the risk that the borrower will go bankrupt and not repay the loan
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A higher coupon rate is required for riskier bonds
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Bond owners are free to sell their bonds in the bond market
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A bond is a legal promise to repay a debt
Shareholders receive a regular payment (dividend) for each share of stock they own
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Shareholders receive returns (capital gains) when the price of their stock increases
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Increase in interest rates tend to depress stock prices
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The risk premium is the difference between the required rate of return to hold risky assets and
the rate of return on safe assets
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A share of stock (equity) is a claim to partial ownership of a firm
The financial system and the allocation of saving to
productive uses
Monday, 28 August 2017
12:05 PM
Intro Macro Page 1
A corporation can issue new bonds or shares to finance its capital investment
Many highly promising investment projects are quite risky
Bond and stocks markets help reduce risk by giving savers a means to diversify their financial
investments
Allows risky projects to obtain funding
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Diversification is the practice of spreading one's wealth over a variety of different financial
investments to reduce overall risk
Bond markets, stock markets and the allocation of saving
Monday, 28 August 2017
12:05 PM
Intro Macro Page 2
Document Summary
The financial system and the allocation of saving to productive uses. A well-functioning financial system improves the allocation of saving in two ways: The financial system provides information to savers about which of the many possible uses of their funds are likely to prove most productive and pay the highest return --> helps to direct saving to its best uses. Financial markets help savers to share the risks of individual investment projects --> protects individual savers from bearing excessive risk and making it possible to direct saving to projects that are risky but potentially very productive. Financial intermediaries are firms that extend credit to borrowers using funds raised from savers. Intermediaries develop a comparative advantage in evaluating the quality of borrowers. Expertise in performing the information-gathering activities necessary for profitable lending (checking out the borrower"s background, determining whether the borrower"s business plans make sense and monitoring the borrower"s activities during the life of the loan.
