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Ch. 2 an Overview of the Financial System

Ch. 2 an Overview of the Financial System

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Published by coldpassion
Econ 248, By Dr.Alwosabi
Econ 248, By Dr.Alwosabi

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Published by: coldpassion on Dec 07, 2009
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11/09/2013

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 1
 Ch. 2
 
AN OVERVIEW OF THE FINANCIAL SYSTEM
 
To "finance" something means to pay for it. Since money (or credit) is the meansof payment,
"financial"
basically means
"pertaining to money or credit."
 
 
Financial markets and financial intermediaries are crucial to a well-functioningeconomy because they channel funds from those who do not have a productive usefor them to those who do.
 
The financial sector plays a vital role in the economy because it helps money beefficiently channeled from savers to prospective borrowers, making it much easierfor firms to obtain financing for profitable investment in new capital and forindividuals to borrow against their future income (e.g., to pay for college, to buy ahouse or car).
 
Without financial markets and institutions, borrowers would have to borrowdirectly from savers. Probably not much borrowing would take place at all,borrowers would tend to have a hard time finding individuals able and willing toloan them money.
 
Without much borrowing, the economy would be a lot less developed, as fewbusinesses would be able to raises funds to invest in new plant and equipment.Likewise, relatively few individuals would be able to own their own homes, or buya car.
 
A well-functioning financial sector is necessary for a well-functioning economy.
DIRECT AND INDIRECT FINANCE
 
Funds can raised directly (direct finance) or indirectly (indirect finance)
 
Direct finance
refers to funds that flow directly from the lender/saver to theborrowers/investors in financial market.
 
 2
 
Borrowers sell
securities
(
financial instruments
), which represents a claim overreal assets or a future income stream. Such instruments are usually tradable.Examples of securities include bonds, stocks, bills of exchange, promissory notes,and certificates of deposit.
 
Securities are assets for the person who buys them but liabilities (IOUs or debts)for the individuals or firms who sell (issue) them.
 
Examples of direct finance include when a person take a loan from his friend, or acorporation issues new shares of stock or bonds.
 
Indirect finance
refers to funds that flow from the lender/saver to a financialintermediary who then channels the funds to the borrower/investor. Financialintermediaries (indirect finance) are the major source of funds for corporations.
FUNCTION OF FINANCIAL MARKETS: DIRECT FINANCE
 
 
Financial markets have important function in the economy because they1.
 
Allow transfer of funds from person or business without investmentopportunities to ones who have them. In the absence of financial markets,lenders-savers and borrower-spenders may not get together and it becomeshard to transfer funds from a person who has no investment opportunities toone who has them2.
 
Enhance economic efficiency by allocating productive resources efficiently,which increases production.3.
 
Improve the economic welfare because they allow consumers to time theirpurchases better.4.
 
Increase returns on investment and increase business profit5.
 
Set firm value6.
 
Buy and sell risk: allow you to transfer certain financial risks (arising fromaccidents, theft, illness, early death, etc.) to another party (in this case, theinsurance company).
 
A breakdown of financial markets can result in political instability.
 
 3
STRUCTURE OF FINANCIAL MARKETS
 
Financial markets can be categorized in four different ways:1.
 
Debt and Equity Markets2.
 
Primary and Secondary market3.
 
Exchanges and Over–the-Counter Market4.
 
Money and Capital Markets
First: Debt and Equity Markets
 
A firm or an individual can obtain funds in a financial market in two ways.
 
 
The first method of raising fund, which is practiced in
debt markets
, is to issuethe debt instrument.
 
Debt instrument
is a contractual agreement that oblige the issuer of the instrument(the borrower) to pay the holder of the instrument (the lender) fixed amounts(interest and principal payments) at regular intervals until a specified date(maturity date) when a final payment is made.
 
The
maturity
of a debt instrument is the date on which a loan or bond, or otherfinancial instrument becomes due and is to be paid off.
 
 
Debt holders do not share the benefit of increased profitability because their dollarpayment is fixed
 
A debt instrument is1.
 
short-term if its maturity is less than one year,2.
 
long-term debt if its maturity is ten years or longer, and3.
 
intermediate-term if its maturity is between one and ten years.
 
Examples of debt instruments include government and corporate bonds.
 
The second method of raising fund, which is practiced in
equity markets
, is byissuing
equities,
such as
common stock.
 
Equity
is a contractual agreement representing claims on the issuer's income(income after expenses and taxes) and the asset of the business.
 
 
Equities often make periodic payments (dividends) to their holders
 

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