The Main Functions of the Financial System

Achievement of Purposes

People use the financial system for various reasons, which can be broken down into six main purposes. However, regardless of the purpose, the financial system is more efficient when transactions are performed in liquid markets.

1. Saving

Both individuals and companies alike set aside money in the present to have more to spend in the future. Individuals typically save during their working years so they can withdraw money later on to fund their retirement. Corporations may save money collected from customers to repay suppliers or lenders, purchase new equipment, or acquire other companies. Money can be saved in a broad range of investment vehicles: from low-risk treasury bills to higher-risk corporate bonds and stocks. Investors that put money into riskier investments expect to be compensated with higher returns.

2. Borrowing

In contrast to saving, borrowing involves receiving money in the present that will be repaid in the future. People can borrow money through secured loans, like most car loans and mortgages; for example, the lender can sell the asset posted as collateral if the borrower defaults. On the other hand, student loans or credit card debt is typically unsecured. Since there is no collateral to be recovered if the borrower fails to pay, lenders will typically charge a higher interest rate on unsecured loans to compensate for the greater downside risk. In addition, companies oftentimes utilize both debt and equity to fund current and future investments. Finally, governments also borrow money to finance current spending by issuing bills, notes, and loans repaid with future taxes or revenue earned by government projects.

3. Raising Equity Capital

Companies use investment banks to assist in raising equity capital, where investors trade cash for a share of ownership in the company. While equities don’t promise investors a fixed payment in the future, investors expect payments in the form of future dividends or capital gains. In addition, analysts help investors accurately value company shares, while regulatory reporting requirements and accounting standards aim to ensure that a company’s financial statements do not mislead investors.

4. Managing Risks

To manage risks, investors use forward contracts, futures contracts, options contracts, insurance contracts, and other derivatives. These contracts serve to offset the effect of adverse price movements in assets that a party may need to buy or sell in the future. For example, an airline may enter into a forward contract to buy jet fuel at a certain price on some fixed date in the future, hedging the risk of rising prices. The party on the other side of the trade may be the fuel supplier, hedging the risk of falling prices. While their risks are opposite, both parties achieve their purposes with a single transaction.

5. Exchanging Assets for Immediate Delivery (Spot Market Trading)

People and companies use the spot market to trade a currency to acquire other currencies or commodities, which will be delivered immediately when the transaction occurs.

6. Information-Motivated Trading

While both investors and information-motivated traders ultimately try to buy low and sell high, information-motivated traders are different in that they expect to earn excess returns from their informational advantage in addition to the normal returns traditional investors earn for the risk of holding an asset over time. Information-motivated traders believe the information they have allows them to buy undervalued companies and sell overvalued companies, expecting to profit when the share prices more accurately reflect the intrinsic value of the companies.

Active investment managers all participate in information-motivated trading to beat their benchmark or the return earned by “buy and hold” investors taking similar risks. In theory, active managers can gain an information edge over other market participants by hiring skilled professionals and conducting thorough research on potential investments. Investors are also information-motivated traders when they allocate funds with the expectation of earning conditional returns greater than the unconditional returns they would earn in the same asset class.

Determining Appropriate Rates of Return

Since savers are on the opposite end of transactions with borrowers and equity sellers, the rate of return must be set at the point where both parties are satisfied. The cost of moving money through time, or the equilibrium interest rate, is the rate at which aggregate supply for funds through savings equals aggregate demand. Savers won’t supply capital if too low of a rate is offered, and borrowers won’t demand capital if too high of a rate is offered. To determine the rate of return, the equilibrium interest rate must be adjusted depending on the risk characteristics, terms, and liquidity of the security.

Efficient Capital Allocation

Efficient capital allocation allows the market’s scarce capital to be allocated to only the most productive investments. A market is efficient when market participants have access to accurate information. When investors are thorough in their analysis of available information, they improve the efficiency of the market by simply acting in their own best interests. For example, well-informed investors will not make a loan to someone with poor credit without being appropriately compensated with a higher rate of return, nor will they invest in projects unless the value of future cash flows exceeds the cost.

Question

As the portfolio manager of an equity fund, you decide to allocate a percentage of the fund’s capital to invest in the common stock of ABC after its share price plummeted on lower-than-expected earnings. You believe that ABC’s stock is currently undervalued due to an overreaction of the market to the earnings announcement. In this instance, you were using the financial system for:

1. Saving.
2. Managing Risk.
3. Information-Motivated Trading.

Solution

The correct answer is C.

You were acting as an information-motivated trader because you traded with the intention of earning excess profit from information that had not been priced into the market.