Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. The term intermediary reflects the role of these institutions in standing between savers and ‘borrowers. Here we’ consider two of the most important financial intermediaries banks and mutual funds.
If the owner of a small grocery store wants to finance an expansion of his business, he probably takes a strategy different from Intel. Unlike Intel, a small grocer would find it difficult to raise funds in the bond and stock markets. Most buyers of stocks and bonds prefer to buy those issued by larger, more familiar companies. The small grocer, therefore, most likely fiances his business expansion with a loan from a local bank Banks are the financial intermediaries with which people are most familiar. A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow. Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks’ costs and returns some profit to the owners of the banks.
Besides being financial intermediaries, banks play a second important role in the economy They facilitate purchases of goods and services by allowing people to write checks against their deposits. In other words, banks help create a special asset that people can use as a medium of exchange. A medium of exchange is an item that people can easily to engage in transactions. A bank’s role in providing a medium of exchange distinguishes it from man) other financial institutions. Stocks and bonds, like bank deposits, are a possible store of value for the wealth that’ people have accumulated in past saving, but access to this wealth is not as easy, cheap, and immediate as just writing a check. For now, we ignore this second role of banks, but we will return to it when we discuss the monetary system later in the book.
A financial intermediary of increasing importance in the U.S. economy is the mutual fund. A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both stocks and bonds. The shareholder of the mutual fund accepts all the risk and return associated with the portfolio. If the value of the portfolio rises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss. The primary advantage of mutual funds is that they allow people with small amounts of money to diversify. Buyers of stocks and bonds are well advised to heed the adage: Don’t put all your eggs in one basket. Because the value of any single stock or bond is tied to the fortunes of one company, holding a single kind of stock or bond is very risky. By contrast, people who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each company. Mutual funds make this diversification easy. With only a few hundred dollars, a person can buy shares in a mutual fund and, indirectly, become the part owner or creditor of hundreds of major companies. For this service, the company operating the mutual fund charges shareholders a fee, usually between 0.5 and 2.0 percent of assets each year A second advantage claimed by mutual fund companies is that mutual funds give ordinary people access to the skills of professional money, managers. The managers of most mutual funds pay close attention to the developments and prospects of the companies in which they buy stock. These managers buy the stock of those companies that they view as having a profitable future and sell the stock of companies with less promising prospects. This professional management, it is argued, should increase the return that mutual fund depositors earn on their savings Financial economists, however, are often skeptical of this second argument. With thousands of money managers paying close attention to each company’s prospects, the price of a company’s stock is usually a good reflection of·the company’s true value. As a result, it is hard to “beat the market” by buying good stocks and selling bad ones. In fact, mutual funds called index funds, which buy all the stocks in a given stock index, perform somewhat better on average than mutual funds that take advantage of active management by professional money managers. The explanation for the superior performance of index funds is that they keep costs low by buying and selling very rarely and by not having to pay the salaries of the professional money managers.
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