Financial Economics

The Federal Reserve (known more informally as “the Fed”) is the central bank of the United States of America. It is made up of a network of 12 regional Federal Reserve banks, but the Fed’s power centers in its New York bank.

The Glass-Steagall Act (1933) separated depository institutions aka retail banks from investment banks and limited securities, activities, and affiliations within commercial banks and securities firms.

Commercial Banks are a type of financial institution that provides loans, accepts deposits, and offers financial products and services like savings accounts or a certificate of deposit to individuals and businesses.

A Monetary System is defined as a set of policies, frameworks, and institutions by which the government creates money in an economy. Such institutions include the mint, the central bank, treasury, and other financial institutions. There are three common types of monetary systems – commodity money, commodity-based money, and fiat money.

A stock market (also known as an equity market or share market), is a collection of buyers and sellers of stocks. These stocks represent ownership interests in companies. These may include publicly or privately traded securities. The New York Stock Exchange (NYSE) is an example of a share market.

A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that consolidates deposits and uses the funds to transform them into loans.

The United States has imposed has created banking regulations to prevent unnecessary damage to confidence and liquidity in the financial system. The regulations are meant to prevent things like bank runs, credit crunches, and financial crises.

The McFadden Act (1927 – 1994) was appealed by the Riegle-Neal Interstate Banking and Branching Efficiency Act. The Act made national banks competitive against state-chartered banks by letting national banks add more branches to the extent permitted by state law.

Risk is the uncertainty of an asset’s return over a given period of time. Risk perception is the individual judgment people make about the severity of a risk and may vary from person to person.

In financial markets, people trade financial securities, commodities, and instruments at prices that reflect supply and demand. There are two types of Financial Markets – the primary market and the secondary market. All well-developed markets have standardized financial instruments.

The Efficient Market Hypothesis (EMH) is an application of ‘Rational Expectations Theory’ where people who enter the market, use all available & relevant information to make decisions. The only caveat is that information is costly and difficult to get.

A bond is a type of financial instrument. Bonds are debt that firms and governments can issue to raise money and they earn interest.

A Yield Curve is a graph of the yields (interest rates) of bonds with different maturities. Short terms bonds generally have a lower yield because they are most liquid.

The intrinsic value approach or the fundamental analysis of stocks prices is equal to the dividend over the interest rate. This approach is based on predictions of future cash flows and profitability.

The interest rate risk structure for interest rates is called the Risk Premium or Risk Spread. It is the extra interest that a risky asset must pay relative to a risk-less asset since investors demand compensation for taking on higher risk.

The goal of Financial Institutions is to provide access to financial markets, a.k.a. financial intermediaries (they serve as middlemen) and indirect finance. Most financial institutions are regulated by the government.

The concept of Asymmetric Information centers around a situation in which there is unequal knowledge between each party to a transaction, that one party has better information than the other party. This type of asymmetry creates an imbalance in a transaction.

The Theory of Storage describes features observed in commodity markets. Here are some basic terminology that needs to be understood to understand the Theory of Storage.

The Money Supply (MS) is the total cash in circulation and bank account deposits. Changes in the supply of money affect the rate of inflation, the exchange rate, and the business cycle.

Financial Instruments are tradeable assets (claim) for people who hold them and liabilities (obligation) for the issuer. Securities such as bonds, stocks, bank loans are examples of financial instruments.

The Securities and Exchange Commission (SEC) in the United States financial system is a regulatory body that monitors the financial system, exchange, and securities market. Securities are types of financial instruments created in financial markets.

When borrowers borrow funds directly from the financial market without using a third-party service, such as a financial intermediary, it is called direct finance.

Money is anything that is generally accepted as payment. Ex: cash or checking account. A double coincidence of wants is necessary to facilitate the trade of goods and services.

A firm or individual’s decision for allocating its wealth amongst assets is known as the Theory of Asset Demand or Portfolio-Choice Theory.

Central banks oversee the banking system in their country. They play an important role in managing a state’s currency, money supply, and interest rates.