Financial intermediaries play a crucial role in our economy. They connect savers with borrowers, making it easier for money to flow where it's needed. Banks are a prime example, taking deposits and giving out loans.
Financial assets come in different flavors, each with its own risk-return profile. Bonds are generally safer but offer lower returns. Stocks can be riskier but potentially more rewarding. Mutual funds offer a mix of both.
Financial Intermediaries and Assets
Financial Intermediaries
- Financial intermediaries serve as middlemen between savers and borrowers facilitating the flow of funds from those with surplus money to those needing to borrow
- Savers deposit money in financial intermediaries which then lend that money to borrowers
- Banks are a common financial intermediary accepting deposits from savers, paying interest on those deposits, and making loans to borrowers while charging interest on the loans
- Financial intermediaries reduce transaction costs and risks by allowing savers to deposit money without having to search for individual borrowers and borrowers to obtain loans without searching for individual savers
- By lending to many different borrowers, financial intermediaries are able to diversify risk
Financial Assets
- Bonds: debt securities representing loans from investors to issuers
- Provide fixed interest payments and have a specified maturity date when the principal is repaid
- Generally have lower expected returns and risks compared to stocks
- Typically more liquid than stocks, easier to buy and sell in the market
- Stocks: equity securities representing ownership in a company
- Stockholders have a claim on the company's assets and earnings
- Provide variable dividends and have no specified maturity date
- Generally have higher expected returns and risks compared to bonds
- Mutual funds: investment vehicles pooling money from many investors
- Invest in a diversified portfolio of stocks, bonds, or a combination of both
- Offer benefits of professional management and diversification
- Returns and risks depend on the performance and volatility of the underlying investments
Return and Risk Tradeoffs
- Returns and risks are positively related for most investments - higher expected returns generally come with higher risks while lower expected returns come with lower risks
- Time horizon affects the tradeoff between returns and risks
- Longer time horizons provide more time for returns to compound and short-term losses to potentially recover
- Shorter time horizons may necessitate more conservative investments
- Risk tolerance varies among individual investors
- Risk-averse investors prefer lower returns coupled with lower risks
- Risk-neutral investors are indifferent between equivalent risk-return tradeoffs
- Risk-seeking investors prefer higher potential returns despite the accompanying higher risks