Functions of the Financial System
The __financial system__ broadly includes participants such as individual investors or corporations, intermediaries that act on their behalves, and the markets where they transact. The financial system impacts pretty much everyone in the world, so it is of huge importance and fills many purposes.
How often do you think you utilize the financial system?
Correct.
One of the primary purposes of the financial system is to create a market to _trade assets for immediate and future delivery_. It is hard to imagine a day going by that you don't utilize the financial system for this purpose.
That's probably not true.
In fact, one of the primary purposes of the financial system is to create a market to _trade assets for immediate and future delivery_. It is hard to imagine a day going by that you don't utilize the financial system for this purpose.
Beyond allowing investors to grow their savings, the financial system allows investors to _speculate on information_. For example, think about the process of deciding which company to invest in. You likely did research and chose a firm you thought was undervalued.
Why do you think this process is so critical?
Correct.
By providing a venue to trade on the information you have collected, financial markets create an incentive for you to discover information and trade on that information. As people trade on newly discovered information, prices change, so trading on information likely leads to higher price volatility, not lower.
Incorrect.
As people trade on newly discovered information, prices change, so trading on information likely leads to higher not lower price volatility. By providing a venue to trade on the information you have collected, financial markets create an incentive for you to discover information and trade on that information.
Another function of the financial system is to _mitigate risk_. For example, imagine you are the manager of a firm and you have _borrowed money_ (another function of the financial system) to go to Alaska to build a gold mine. This is a risk proposition, but some risks are under your control and others aren't. Which risks to your venture do you think can be mitigated via the financial system?
Correct.
Financial risks such as future gold prices or future exchange rates via derivatives can be managed via the financial system. Management risk, such as worker availability, equipment failures, or the quality of the gold in the mine, cannot be managed via the financial system.
Incorrect.
Management risk, such as worker availability, equipment failures, or the quality of the gold in the mine, cannot be managed via the financial system. The financial system can be used to manage financial risks such as future gold prices or future exchange rates via derivatives.
A well-functioning financial system aggregates buyers and sellers of financial instruments, creating economies of scale and minimizing transaction costs. By creating incentives for investors to discover and invest on new information, the financial system also helps to ensure that financial instruments are accurately priced. In turn, savers and borrowers get fair rates and money is allocated to its best use in the economy.
To summarize:
[[summary]]
Most people utilize the financial system by _investing and growing savings_. For example, when you buy shares issued by a firm, you hope to grow your savings when the shares go up in value. The firm benefits by raising capital to invest in their operations, and you benefit from the expected return.
Utilize the financial system daily
Utilize the financial system maybe once a week or a couple of times a month
Trading on information enhances price informativeness
Trading on information decreases price volatility
The risk that gold prices will drop
The risk that you will not be able to find sufficient workers
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