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The Financial System and the Level of Interest Rates

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The chapter entitled “The Financial System and the Level of Interest Rates” by Parrino, Kidwell, and Bates outlines the way the financial system channels money to business, the backgrounds and rules of different financial systems and markets, and defines the determinants of interest rates. According to the authors, the efficiency of a financial system, consisting of financial markets and financial institutions, is critical for the operations of a complex industrial economy. It gathers money from households, businesses, and governments with surplus funds to invest it for those who need it. The banks gather money from consumers and fund business loans. The competitiveness of the system may be defined by the interest rates the banks can afford to pay on certificates of deposit (CDs) and the loan rates of banks' cost of interest. The proper system contributes to higher production and efficiency in the overall economy by directing the money from lender-savers to borrower-spenders to the best opportunities for investment. It does so either directly, through wholesale financial markets, or indirectly, through financial institutions. The companies gather the money needed for their further development by issuing and selling securities (bonds) on which they pay interest to the bondholders.

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Investment banks and money center banks that are now quite similar are important participants of the direct financial market. The former help companies to sell new debt or equity, and the latter provide traditional and investment banking services. The chapter also explains originating, underwriting, and distribution as the three stages of the process of selling security issue. It particularly mentions that financial managers usually prefer to have new securities underwritten on a firm-commitment basis. In this case, investment bankers buy them from the client company at their own risk to resell to the investors at the underwriting spread cost. The primary market for new securities was described by the money going into the company as a result of transactions. And the secondary market where owners can sell their outstanding securities and no money goes to the firm is said to play an important role for the companies and investors. Having active secondary markets enables companies to enjoy lower funding costs. Also, the investors can buy and sell securities as frequently as they want.

The securities are characterized in terms of their marketability and liquidity. The former determines the ease of sale of a security and partly depends on the transaction costs. The latter stands for the asset's ability to be quickly converted into cash without loss of its value. In contrast to liquidity, marketability does not imply preservation of the value of a security once it is sold. The authors also reveal the principles of work, the way of deriving value, risks, and amount of money in different types of financial markets including exchanges and over-the-counter markets, money and capital markets, public and private markets, and futures and options markets. Their operational and informational efficiency depends on the degree of reflection of the knowledge and expectations of all investors at a particular point of time. The chapter explains the efficient market hypothesis as a theory that helps to evaluate the efficiency of the financial markets. The semi-strong form of this hypothesis is said to be representing the public stock markets in the developed countries including the US. The authors have also examined the role of financial institutions as intermediaries in the indirect financial market standing between the lender-savers and borrower-spenders, and satisfying the needs of a specific market. Finally, the chapter examines the factors determining the level of interest rates varying over the business cycle and provides the equations to compute the nominal rate when one has the real rate and the inflation rate. The expectations of businesses on the rate of return and individuals’ time preference for consumption are described as key factors defining the real rate of interest.

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Learning about the general level of interest rates in the economy and the way they vary over the business cycle will help me to use the financial instruments and services described throughout this chapter. I have studied the financial system as a definitely ordered set of financial relations and learned the principles businesses use to gather money for their development and projects. I will now be able to define the degree of competitiveness of a specific financial system in terms of interest rates for loans and interest rates for deposits. It will be important for my future career to understand the key components of the process of selling new securities by the firm. I have also comprehended the differences between small businesses, big corporations, and individuals in terms of their interests and accessibility to the specific financial markets and learned how important for the companies’ securities is to have active secondary markets. Finally, I have acquired considerable analytical skills to define the efficiency of various financial markets by means of the efficiency hypothesis.

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