Introduction to

FINANCE
Markets, investments, and
Financial Management

STUDY GUIDE
 Chapter 1: The Financial Environment
Three areas of finance Policy makers
 Institutions and markets  President
 Investments  Congress
 Financial management  U.s. Treasury
 Federal reserve board
Why should you study finance?
 Make informed economic/financial Monetary system
decisions  Federal reserve (central bank)
 Make informed personal and business  Commercial banking system
decision
 Make informed career decisions Financial institutions
based on a basic understanding of  Depository institutions
business finance  Contractual savings organizations
 Securities firms
Financial environment  Finance firms
1. Financial system
2. Financial markets Financial markets
3. Financial institutions or intermediaries  Debt securities markets
4. Business firms  Equity securities markets
5. Individuals  Derivative securities markets
6. Global interactions  Foreign exchange markets

Financial markets Policy makers

-physical locations or electronic
 Financial institutions/intermediaries
 Transfer funds from savers and
investors
 Individuals, businesses, and
governments
Financial markets
-investments
 Sale of securities, analysis of securities,
and management of investment risk
Financial markets
 Financial management
 Financial planning, asset
management, and fund-raising
decisions designed to increase the
value of the business
6 principles of finance
1. Time value of money
2. Risk v. Return
3. Diversification of risk
4. Efficient markets
5. Management v. Owner's objective
6. Reputation (ethical behavior)
 Congress and president pass laws
 Congress & president set fiscal policy
through taxing and spending
decisions. Treasury implements these
decisions
 Federal reserve board sets monetary
policy. Treasury works with the federal
reserve
Monetary system
Federal reserve (central bank), commercial
banking system
 Federal reserve can create money
 Federal reserve works with the
commercial banking system to transfer
money
Financial institutions
Depository institutions, contractual savings
organizations, securities firms, financial firms
 Accumulate savings
 Lend and invest savings
Financial markets Debt securities markets
Debt securities markets, equity securities Obligation to repay borrowed funds
markets, derivative securities markets, foreign
exchange markets Bond markets
 -market financial assets Longer-term maturities
 Transfer financial assets
Mortgage markets
Characteristics: Loans to purchase real estate
 -money markets
 -capital markets Equity securities markets
 -primary markets Ownership rights are sold and traded
 -secondary markets  Common stock
 Preferred stock
Money markets
Debt security with maturity less than 1 year Derivative securities markets
Value from underlying debt or equity
Capital markets securities
Debt security with maturity more than 1 year  Forward contracts
and stocks  Future contract
 Options: puts and calls
Primary markets
Initial offering of securities Foreign exchange markets
Buy and sell currencies from different
Secondary markets countries
Securities are sold/traded after initial offering

Types of financial markets

 Debt securities markets
 Bond markets
 Mortgage markets
 Equity securities markets
 Derivative securities markets
 Foreign exchange markets
 Chapter 2: Banks and Other Financial Intermediaries
Financial intermediation
Process by which individual savings are
accumulated in depository institutions and,
in turn, lent or invested
 Depository institutions
Accept deposits from individuals and
then lend these pooled savings to
businesses, governments, and
individuals
 Contractual savings organizations
Collect premiums on insurance
policies and employee/employer
contributions from participants and
provide retirement benefits and
insurance against
Major financial losses
 Securities firms
Accept and invest individual savings
and also facilitate the sale and
transfer of securities between
investors
 Finance firms
Provide loans directly to consumers
and businesses as well as help
borrowers obtain mortgage loans on
real property
Depository institutions
1. Commercial banks
Depository institutions that accept
deposits, issue check-writing accounts,
and make loans to businesses and
individuals
2. Thrift institutions
Noncommercial bank depository
institutions referred to as savings and
loan associations, savings banks, and
credit unions that accumulate
individual savings and lend primarily to
other individuals
3. Savings banks
Accept the savings of individuals and
lend pooled savings to individuals
primarily in the form of mortgage loans
4. Savings and loan associations (S&Ls)
Accept individual savings and lend
pooled savings to individuals, primarily
in the form of mortgage loans, and to
businesses
5. Credit unions
Cooperative nonprofit organizations
that exist primarily to provide member
depositors with consumer credit
Contractual savings
1. Insurance companies
Provide financial protection to
individuals and businesses for
life, property, liability, and
health uncertainties
2. Pension funds
Receive contributions from employees
and/or their employers and invest the
proceeds on behalf of the employees
Securities firms
1. Investment companies
Sell shares in their firms to individuals
and others and invest the pooled
proceeds in corporate and
government securities
2. Mutual funds
Open-end investment companies that
can issue an unlimited number of their
shares to their investors and use the
pooled proceeds to purchase
corporate and government securities
3. Investment banking firms
Sell or market new securities issued by
businesses to individual and
institutional investors
4. Brokerage firms
Assist individuals who want to
purchase new or existing securities
issues or who want to sell previously
purchased securities
Finance firms
1. Finance companies
Provide loans directly to consumers
and businesses or aid individuals in
obtaining financing
2. Mortgage banking firms
Help individuals obtain mortgage
loans by bringing together borrowers
and institutional investors
Investment bank
Helps businesses sell their new debt and
equity Securities to raise financial capital
Universal bank
Bank that engages in commercial banking
and investment banking
Banking system
Commercial banks, S&Ls, savings banks, and
credit unions.
1. Accept deposits
2. Issuing checkable deposit accounts
3. Granting loans
4. Clearing checks
5. Creating deposit money
6. Raising financial capital for businesses
(investment banking)
Dual banking system
Allows commercial banks to obtain charters
from the Federal government or a state
government
Unit banking
Exists when a bank can have only one full-
service office
Limited branch banking
Allows additional banking offices within a
geographically
Defined distance of a bank's main office
Statewide branch banking
Allows banks to operate offices throughout a
state
One-bank holding companies (OBHCs)
Permits a firm to own and control one bank
Multibank holding companies (MBHCs)
Permits a firm to own and control two or more
banks
Federal reserve system
1. Members banks
2. Federal reserve district banks
3. Board of governors
4. Federal open market committee
5. Advisory committees
 Chapter 3: Savings and the Investment Process
Capital formation
Process of constructing real property,
manufacturing producers' durable
equipment and increasing business
inventories
Personal consumption expenditures
Expenditures by individuals for durable goods
and services
Government expenditures
Expenditures for goods and services plus
gross investment by federal, state and local
governments
Gross private domestic investment
Measures fixed investment in residential and
nonresidential structures, producers' durable
equipment and changes in business
inventories
Net exports
Exports of goods and services minus imports
Budgetary deficit
When tax and other general expenditures fail
to meet expenditures
Federal statutory debt limit
Limits on federal debt set by congress
Savings
Occur when all of an economic units income
is not consumed and are represented by the
accumulation of cash and other financial
assets
Savings surplus
Occurs when an economic unit, such as
individuals taken as a group, has current
income that exceeds its direct investment in
real assets
Undistributed profits
Profits remaining after taxes and, in the case
of corporations, after the cash dividends are
paid to stockholders
Savings deficit
A situation in which it becomes necessary to
acquire funds from a savings surplus unit
Personal savings
Savings of individuals equal to personal
income less personal current taxes less
personal outlays
Voluntary savings
Savings in the form of financial assets held or
set aside for use in the future
Contractual savings
Savings accumulated on a regular schedule
for a specific length of time by prior
agreement
Capital consumption adjustment
The estimate of the "using up" of plant and
equipment assets for business purposes
Dissave
Spend accumulated savings rather than
further reduce consumption spending
Capital market securities
Debt securities with maturities longer than
one year and corporate stocks
Mortgage
Loan backed by real property in the form of
buildings and houses
Treasury bond
A debt instrument or security issued by the us
fed gov't with a typical maturity ranging from
5 to 20 years
Municipal bond
Debt instrument issued by a state or local
gov't
Corporate bond
Debt instrument issued by a corporation to
raise long-term funds
Common stock
Ownership interest in a corporation
Derivative security
Financial contract the derives its value from
the value of another asset, such as a bond or
stock
Mortgage markets
Markets in which mortgage loans are
created to purchase buildings and houses
and are originated in primary markets and
traded in secondary markets
Fixed-rate mortgage
Fixed interest rate with constant monthly
payments over the life of the loan, which is
typically 15-30 years
Adjustable rate mortgage
Has an interest rate that changes or varies
over time with market-determined interest
rates on a us treasury bill or other debt
security
Securitization
Process of pooling and packing mortgage
loans into debt securities
Mortgage-backed security
A debt security created by pooling together
a group of mortgage loans whose periodic
payments belong to the holders of the
security
Credit rating
Indicates the expected likelihood that a
borrower will miss interest or principal
payments and possibly default on the debt
obligation in the form of a loan, mortgage or
bond
Credit score
A number that indicates an individual’s
creditworthiness of likelihood that a debt will
be paid according to the terms that were
initially agreed to
Prime mortgage
A home loan to a borrower with relatively
high creditworthiness indicating a relatively
high likelihood that mortgage payments will
be paid when due
Subprime mortgage
Home loan made to a borrower with a
relatively low credit score indicating a higher
likelihood that the borrower will miss
mortgage payments when due
Budget surplus
Receipts-expenditures > 0
Budget deficit
Receipt-expenditures < 0
Continuing resolution
Legislating in the form of a joint resolution
enacted by congress when the new fiscal
year is about to begin or has begun to
provide budget authority for federal
agencies and programs to continue in
operation until the regular appropriations
acts are enacted
Mandatory spending
A legal obligation on the federal gov't to
make payments to a person, business, or unit
of gov't that meets the criteria set in law
Discretionary spending
Spending controlled in annual appropriations
acts
National debt
Total debt owned by a gov't accumulated
over many years as a result of annual budget
deficits
Pass through
Interest and principal payments go to the
owners of the securities
Strips
Issuer separates the interest and principal
payment streams into separate securities
Stimulate fiscal policy
Increased gov't spending and tax cuts in
2002
Ease monetary policy
The fed maintains liquidity in the financial
sector and continued to lower interest rates