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The Financial SystemThe financial system is the collection of markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other se- curities are traded, interest rates are determined, financial services are
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produced and delivered around the world. The financial system is an integral part of the economic system and cannot be viewed in isolation from it. Its primary task is to move scarce loanable funds from those who save to those who borrow for consumption and investment. By making funds available for lending and borrowing (credit) the financial system provides the means whereby modern economies grow and increase the standard of living of their citizens. Most of the credit goes to purchase machinery and equipment, to construct new highways, factories, and schools, and to stock the shelves of businesses with goods. The financial system determines both the cost of credit and how much credit will be available to pay for the thousands of different goods and services we purchase daily. When credit becomes more costly and less available, total spending for goods and services falls. As a result, un- employment rises and the economy’s growth slows down as businesses cut back production and reduce their inventories. In contrast, when the cost of credit declines and loanable funds become more readily avail- able, total spending in the economy increases, more jobs are created, and the economy’s growth accelerates. For every real transaction there is a financial transaction that mir- rors it. When you buy a house, you’ll probably pay for part of that house with a mortgage, which requires that you borrow money from a bank. The bank, in turn, borrows from individuals the money it lends to you. Similar situation can be observed when you buy a car or refrigerator on credit. Thus there’s a financial transaction reflecting every real transac- tion. The financial sector is important for the real sector. If the financial sector doesn’t work, the real sector doesn’t work. All trade involves both the real sector and the financial sector. To understand the financial sector and its relation to the real sector, you must understand: (1) what financial assets are, (2) how financial institutions work, (3) what financial markets are, and (4) how they work. Real assets are created by real economic activity. For example, a house or a machine must be built. Financial assets are created whenever some- body takes on a financial liability. For example, say Mr. Smith promises to pay Mr. Jones $1,000,000 in the future. Mr. Jones now has a financial asset and Mr. Smith has a financial liability. Understanding that finan- cial assets can be created by a simple agreement of two people is funda- mentally important to understanding how the financial sector works. Nearly all financial transactions between buyers and sellers involve the creation or destruction of a special kind of asset—a financial asset. Financial assets possess a number of characteristics that make them unique among all the assets held by individuals and institutions. What is a financial asset? It is a claim against the income or wealth of a busi-
ness firm, household, or unit of government, represented usually by a certificate, receipt, or other legal document, and usually created by the lending of money. Examples include stocks, bonds, insurance policies, and deposits held in a commercial bank, credit union, or savings bank. Thus an asset is something that provides its owner with expected fu- ture benefits. There are two types of assets: real assets and financial as- sets. Real assets are assets such as houses or machinery whose services provide direct benefits to their owners, either now or in the future. A house is a real asset—you can live in it. A machine is a real asset—you can produce goods with it. Financial assets are assets, such as stocks or bonds, whose benefit to the owner depends on the issuer of the asset meeting certain obligations. These obligations are called financial liabili- ties. Every financial asset has a corresponding financial liability; it’s the financial liability that gives the financial asset its value. In the case of bonds, for example, a company’s agreement to pay interest and repay the principal gives bonds their value. If the company goes bankrupt, the asset becomes worthless. The financial liability created by a financial asset can be either an eq- uity liability or a debt liability. An example of an equity liability is a share of stock that a firm issues. It is a liability of the firm; it gives the holder ownership rights which are spelled out in the financial asset. An equity liability, such as a stock, usually conveys a general right to dividends, but only if the company’s board of directors decides to pay them. A debt li- ability conveys no ownership right. It’s a type of loan. An example of a debt liability is a bond that a firm issues. A debt liability, such as a bond, usually conveys legal rights to interest payments and repayment of prin- cipal. Look through the text once again and say which statements are true. Correct the false ones. 1. The financial system is the body of laws and regulations. 2. The financial system is an integral part of the economic system. 3. Its primary task is to create funds. 4. Most of the credit goes to purchase goods and services. 5. The financial system determines both the cost of credit and how much credit will be available to pay for different goods and services. 6. When credit becomes less costly, total spending for goods and ser- vices falls. 7. When the cost of credits falls, total spending grows. 8. The financial asset doesn’t provide its owner with any benefit. 9. Every financial asset has corresponding financial liabilities. 10. Debt liability conveys certain ownership rights.
Text 2 Read the text. Divide it into logical parts. In each paragraph, find the topic phrase or sentence and those related and unrelated to it. Stock Stock is ownership in a company, with each share of stock represent- ing a tiny piece of ownership. The more shares you own, the more of the company you own. The more shares you own, the more dividends you earn when the company makes a profit. In the financial world, own- ership is called equity. Businesses issue stock to raise money. They use this money to finance expansions, pay for equipment, and fund projects, etc. Corporations issue stock when they may need additional capital to operate successfully. The term for issuing stock to raise money is equity financing. The money received from investors who buy stocks is called equity capital. In the world of securities, the word “equity” usually refers to stocks. The other method of raising money is debt financing, which involves selling bonds. When companies make profits, they may reward their stockholders with pieces of their profits, known as dividends. Divi- dends are an incentive for investors to hold stocks. Stocks are grouped on the basis of their issuer’s capitalization. “Cap” is short for capitaliza- tion, which is the market value of a stock. Capitalization gives a picture of a stock’s size. You can calculate a stock’s capitalization by multiplying its market price by the number of its shares outstanding (“outstanding” means in the hands of the public). For example, if Stock A has a present value of $20 per share, and there are one million shares of it in the hands of public investors, then Stock A has a capitalization of $20million. Some corporations issue both common and preferred stock. Each pro- vides unique benefits to investors. Both common and preferred share- holders own a company, so the two types vary largely by rights. Common stock confers voting and pre-emptive rights. Preferred stock may trade voting and pre-emptive rights for dividends and a higher claim to liqui- dated company assets than common stock. Both common and preferred shareholders have the following rights and privileges (although preferred shareholders may have theirs restricted or applied only in certain situ- ations). Owners of common stock have the right to vote on company matters. For example, they can vote on whether to allow a stock split, or whether the objective of the company should be changed. They cannot, however, vote on whether dividends should be distributed. A shareholder has one vote for each share owned. To cast their votes, most shareholders use a form of absentee ballot called a proxy. Shareholders also elect the management of the corporation. Pre-emptive rights may give shareholders the right to keep their proportionate ownership of the company. With 229
pre-emptive rights, they can maintain voting control, share of earnings and share of assets. Preemptive rights let common shareholders buy new shares of stock before non-stockholders. Shareholders have the right to inspect the books and records of the company. They also have the right to sue the management for any unauthorized activities. Preferred share- holders are paid before common shareholders. If the corporation issuing the stock goes bankrupt and has to sell its assets, common stockhold- ers will receive the assets, but only after all other creditors. Bondhold- ers and preferred stockholders receive them first. Preferred stock pays a fixed dividend that is specified and set down in advance. Unless the stock is retired or called back, it will continue paying dividends forever. Preferred stock is usually issued with a $100 par (face) value. The divi- dend payments are a fixed percentage of the par. For example, if the par value of a stock share were $100 with a 6 percent annual dividend rate, the annual dividend would be $6 on that share. In recent years, some companies have also begun issuing preferred shares with variable rates tied to interest rates. Look through the text once again and answer the following questions: 1. What is stock? 2. When do corporations issue stock? 3. What bases are stocks grouped on? 4. How can a stock’s capitalization be calculated? 5. What rights do shareholders possess?
Text 3 Read the text. Name the information from the text which is new to you. Be ready to characterize each type of the dividends described in the text.
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