🛒principles of microeconomics review
17.2 How Households Supply Financial Capital
Last Updated on June 25, 2024
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
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Banks As Financial Intermediaries | Introduction to Business View original
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- 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
Key Terms to Review (29)
Liquidity: Liquidity refers to the ease and speed with which an asset can be converted into cash without significant loss in value. It is a crucial concept in the context of financial markets and capital allocation decisions made by both businesses and households.
Borrowers: Borrowers are individuals or entities who obtain funds from lenders, typically in the form of loans, with the intention of using those funds for various purposes such as purchasing a home, financing a business, or financing personal expenditures. Borrowers are a crucial component in the demand and supply dynamics of financial markets, as well as in the way households supply financial capital.
Market Efficiency: Market efficiency refers to the degree to which asset prices fully reflect all available information. In an efficient market, prices adjust rapidly to new information, and it is not possible to consistently achieve returns in excess of average market returns on a risk-adjusted basis.
Bonds: Bonds are a type of debt security that represents a loan made by an investor to a borrower, typically a company or government. They are a financial instrument that allows the issuer to raise capital by promising to repay the loan with interest over a specified period of time.
Intermediaries: Intermediaries are entities that facilitate transactions or interactions between two or more parties, acting as a bridge or go-between. They play a crucial role in the financial system by connecting households that supply financial capital with those who demand it.
Savers: Savers are individuals or households that allocate a portion of their income towards savings rather than spending it on consumption. They forgo current consumption in order to accumulate financial assets for future use or investment.
Direct Finance: Direct finance refers to the process by which households supply financial capital directly to borrowers, without the involvement of financial intermediaries. It is a method of raising funds or investing that bypasses traditional financial institutions like banks or investment firms.
Mutual Funds: Mutual funds are investment vehicles that pool money from multiple investors and invest in a diversified portfolio of securities, such as stocks, bonds, or other assets. They offer a convenient way for individuals to access professional investment management and achieve diversification, which can help mitigate risk.
Financial Markets: Financial markets are the platforms where various financial instruments, such as stocks, bonds, currencies, and derivatives, are traded. They facilitate the efficient allocation of capital by connecting those who have excess funds (investors) with those who require funds (borrowers) to finance their activities or investments.
Indirect Finance: Indirect finance refers to the process of obtaining financial capital or funding through intermediaries, such as financial institutions, rather than directly from the original source of the funds. It involves the channeling of funds from savers or investors to borrowers or entities in need of capital through the services of financial intermediaries.
Current Yield: Current yield is a measure of the annual income generated by a bond or other fixed-income investment, expressed as a percentage of the investment's current market price. It represents the return an investor would receive if they held the bond or investment until maturity, assuming no change in the market price.
Bond Yields: Bond yields refer to the effective interest rate paid on a bond. It is the return an investor receives by holding a bond to maturity and is a crucial factor in households' decisions to supply financial capital.
Coupon Rate: The coupon rate is the stated interest rate on a bond that the issuer promises to pay the bond holder. It represents the amount of annual interest the bond will earn, typically expressed as a percentage of the bond's face value or par value.
Flow of Funds: The flow of funds refers to the movement and circulation of financial resources, such as savings and investments, within an economy. It describes how households, businesses, governments, and other economic agents borrow, lend, and allocate financial capital.
Yield to Maturity: Yield to maturity (YTM) is the total return expected on a bond if the bond is held until it matures. It represents the annual rate of return earned by an investor who buys a bond at the current market price and holds it until the bond's maturity date. YTM is a key concept for households when supplying financial capital through bond investments.
Risk-Return Tradeoff: The risk-return tradeoff is a fundamental concept in finance that describes the relationship between the level of risk an investor is willing to accept and the potential return they can expect on their investment. It suggests that higher-risk investments generally offer the potential for greater returns, while lower-risk investments typically have lower expected returns.
Real Estate Investment Trusts: Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-producing real estate properties. They allow individual investors to access and invest in a diversified portfolio of real estate assets, providing exposure to the real estate market without the typical challenges of direct property ownership.
Derivatives: Derivatives are financial instruments whose value is derived from the value of an underlying asset, such as a stock, bond, commodity, or currency. They are used to manage risk, speculate on price movements, or take advantage of arbitrage opportunities.
Portfolio Allocation: Portfolio allocation refers to the process of distributing an individual's or household's financial assets, such as stocks, bonds, and cash, across different investment options to achieve a desired risk-return profile. It is a crucial component of how households supply financial capital to the economy.
Asset Allocation: Asset allocation is the process of dividing an investment portfolio among different asset classes, such as stocks, bonds, and cash, to optimize the risk-return profile of the overall portfolio. It is a fundamental concept in personal finance and wealth management.
Unsystematic Risk: Unsystematic risk, also known as diversifiable risk or unique risk, is the risk specific to an individual asset or investment that can be mitigated through diversification. It is the risk associated with a particular company or industry that is independent of the overall market movements.
Diversification: Diversification is the process of investing in a variety of assets or activities in order to reduce the overall risk of a portfolio or investment strategy. It involves spreading out investments across different asset classes, industries, or geographical regions to minimize the impact of any single investment's performance on the overall portfolio.
Capital Markets: Capital markets are financial systems that facilitate the exchange and trading of various financial instruments, such as stocks, bonds, and other securities. They serve as a platform for individuals and institutions to invest their surplus funds and for businesses to raise capital for expansion and growth.
Stocks: Stocks, also known as equities, represent ownership shares in a publicly traded company. They are financial instruments that allow individuals and institutions to invest in and own a portion of a business, with the potential to generate returns through capital appreciation and dividend payments.
Risk Tolerance: Risk tolerance refers to an individual's willingness and ability to accept the possibility of financial loss or other negative outcomes in pursuit of potential gains. It is a crucial factor that influences how households supply financial capital and accumulate personal wealth.
Commodities: Commodities are basic, interchangeable goods or raw materials that are bought and sold in large quantities on the global market. They are the fundamental building blocks of the economy, serving as inputs for various industries and products.
Systematic Risk: Systematic risk, also known as market risk or undiversifiable risk, is the risk inherent to the entire market or market segment. It is the risk that cannot be mitigated or eliminated through diversification, as it is caused by factors that affect all assets in the market or a particular industry. This type of risk is a key consideration for households when they supply financial capital.
Compound Interest: Compound interest refers to the interest earned on interest, where the interest generated from an initial principal amount is added back to the principal, allowing for further interest to be earned on the growing total. This concept is central to how households can effectively supply financial capital and accumulate personal wealth over time.
Time Value of Money: The time value of money is the concept that money available at the present time is worth more than the same amount of money available in the future, due to its potential to earn interest. This principle is fundamental to understanding the true value of financial decisions and is crucial in the context of how households supply financial capital.