Subject 1. The Functions of the Financial System

Helping People Achieve Their Purposes Using the Financial System

The financial system helps people:

  • Save money for the future. Saving here means buying notes, CDs, bonds, stocks, mutual funds, or real estate assets.
  • Borrow money for current use. This is the opposite of the first purpose (above). Individuals, companies, and governments may need money to spend now (consumption, investment, paying taxes, expenses, etc).
  • Raise equity capital. Companies can sell ownership rights to raise the equity capital they need.
  • Manage risks. People can use financial contracts to offset risks.
  • Exchange assets for immediate (in spot markets) and future (in futures markets) deliveries.
  • Trade on information. Information-motivated traders can (or they believe they can) use the financial system to earn a return in excess of the fair rate of return because they have information whose value declines over time (as it becomes recognized by other market participants).

Determining Rate of Return

The price in the financial system is the rate of return. It is the result of interaction of the broad forces of supply and demand.

There are as many different prices (rates of return) as there are different types of assets in the financial system. For example, equities have higher rates of return than T-bills. All of the rates are determined in the financial system.

Prices rapidly adjust to new information. The prevailing price is fair because it reflects all available information regarding the asset.

Capital Allocation Efficiency

In the financial markets investors distinguish good firms from bad firms. This lets the market channel capital to good firms and away from problem firms.

Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Such information facilitates the rapid flow of capital to its highest value uses.

User Contributed Comments 1

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Shaan23: I've finished this section. And some of the questions people had were easily answered if they read the Derivatives sections first(Unit 17).

This section is a joke. and honestly Unit 17 was the best read and the most difficult. I would not do it at the end.