FINANCIAL MARKETS AND

INSTITUTIONS
NGUYEN QUANG MINH NHI
Email: nhinqm@due.edu.vn

TEXT BOOKS
Viney, C. (2008) Financial Institutions,

Instruments and Markets

Madura, J. (2008) Financial institutions
and markets

Mishkin, F. (2006) Financial markets

and Institutions

WEBSITES
www. bonds.yahoo.com
www.ssi.com.vn
www.cafef.vn
www.ssc.gov.vn
www.cophieu68.com

ASSESSMENT
20%: Average of all the end of chapter

Quizz
Multiple

choice

questions

(group

evaluating)

20%: Mid-exam & group presentations

60%: One Final Exam

TEACHING PLAN
Lecture 1: An overview of the Financial System

Lecture 2: The Money Market

Lecture 3: The Bond Market
Lecture 4: The Stock Market
Lecture 5: Derivative Security Markets
Lecture 6: Foreign Exchange Markets

Lecture 7: Financial Institutions

6

LECTURE 1
AN OVERVIEW OF THE FINANCIAL
SYSTEM

LECTURE CONTENTS
1. Financial System
2. Financial Institutions
3. Financial Markets
4. Financial Instruments

5. Financing
Reading list:

- Madura: chapter 1
- Viney: chapter 1
8

- Mishkin: chapter 2

LEARNING OUTCOMES

Understand
the
linkages
between
financial institutions, instruments and
markets.
Distinguish between equity, debt and
derivatives.
Distinguish
between
primary
and
secondary markets; money and capital
markets.
Distinguish between direct financing and
indirect financing.

LECTURE CONTENTS
1. Financial System

2. Financial Institutions
3. Financial Markets
4. Financial Instruments
5. Financing

10

1. A FINANCIAL SYSTEM
Role of markets:
Facilitate

exchange

of

goods

and

services by:
bringing opposite parties together
establishing rates of exchange; i.e. Prices.

Surplus units:
Savers of funds available for lending.

Deficit units:
Borrowers of funds for capital investment
11

and consumption.

1. A FINANCIAL SYSTEM
Flow of funds:
Movement of funds through the
financial system between savers and
borrowers giving rise to financial
instruments.

12

1. A FINANCIAL SYSTEM

13

1. A FINANCIAL SYSTEM

14

A financial system is made up of financial

institutions and financial markets that allow
funds to flow between lenders/investors and
borrowers.
The
institutions
develop
financial
instruments and products that encourage
people with excess funds to invest. They
also develop financial instruments and
products that allow people who need funds
to borrow.
A financial system provides the framework
and markets through which the government
can affect the flow of funds.

LECTURE CONTENTS
1. Financial System

2. Financial Institutions
3. Financial Markets
4. Financial Instruments
5. Financing

15

2. FINANCIAL INSTITUTIONS
Most people have used the services of a
financial institution at some stage, even
if the service was simply a basic bank
account.
Financial institutions may specialise in:
taking

deposits,
providing
advice
to
corporate and government clients or offering
financial contracts such as insurance.

16

Financial institutions are essential to the

operation of the modern financial
system.

2. FINANCIAL INSTITUTIONS
Financial institutions permit the flow of
funds between borrowers and lenders
by facilitating financial transactions.
Institutions may be categorised by
differences in the sources and uses of
funds.

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2. FINANCIAL INSTITUTIONS
Depository

institutions:

commercial

banks, savings and loan associations and

mutual savings banks, credit unions.
Contractual

saving

institutions:

insurance company, pension funds.

Investment

intermediaries:

Finance

companies, mutual funds, money market

mutual funds.
18

2. FINANCIAL INSTITUTIONS
Depository financial institutions:
Mainly

attract the savings of depositors

through on-demand deposit and term deposit
accounts; e.g. commercial banks, building
societies and credit cooperatives.
Mainly

provide loans to borrowers

household and business sectors.

19

in

2. FINANCIAL INSTITUTIONS
Contractual savings institutions:

The

liabilities of these institutions are

contracts that require, in return for periodic
payments to the institution, the institution to
make payments to the contract holders if a
specified event occurs; e.g. life and general
insurance companies and superannuation
funds.
The large pool of funds is then used to

purchase both primary and secondary market

securities.

Payouts are made for insurance claims and

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to retirees.

2. FINANCIAL INSTITUTIONS
Finance companies:
Funds

are raised by issuing financial

securities, such as commercial paper,
medium-term notes and bonds, directly into
money markets and capital markets.
Funds are used to make loans and provide

lease finance to customers in the household

and business sectors.

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2. FINANCIAL INSTITUTIONS
Mutual Funds
acquire

funds
individuals.

by

selling

shares

to

many

use the proceeds to purchase diversified portfolios

of stocks and bonds.

Money market mutual funds:

have the characteristics of a mutual fund but also

function to some extent as a depository institution

because they offer deposit-type accounts. Like most
mutual funds, they sell shares to acquire funds.
funds used to buy money market instruments that
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are both safe and very liquid.

2. FINANCIAL INSTITUTIONS

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2. FINANCIAL INSTITUTIONS

Asset Sizes of all Financial Institutions in the US.

24

Source: Board of Governors, Fed, 2009.

LECTURE CONTENTS
1. Financial System

2. Financial Institutions
3. Financial Markets
4. Financial Instruments
5. Financing

25

3. FINANCIAL MARKETS
Financial markets are arrangements
where financial instruments are traded.

A principal role of financial institutions

and markets is to bring together
providers of funds (savers) with users of
funds.
Matching principal.

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Efficient allocation of capital -> higher

production and efficiency for the overall
economy.

3. STRUCTURE OF FINANCIAL MARKETS

27

Based on the maturity of instruments

traded:
Money markets
Capital markets
Based on the nature of the flow between
savers and borrowers:
Primary markets
Secondary markets
Based on organization of secondary
markets:
Organized market.
Over-the-counter (OTC) markets.

LECTURE CONTENTS
1. Financial System

2. Financial Institutions
3. Financial Markets
4. Financial Instruments
5. Financing

28

4. FINANCIAL INSTRUMENTS
Financial

instruments

entitlement

to

specified

represent
future

an
cash

flows.
Their value will reflect the present value of

these future cash flows.

There are three main types of financial

instruments:

derivatives.
29

equity,

debt

and

4.1. EQUITY
The main form of equity is represented
by the issue of ordinary shares by a firm.
Shareholders will receive an ownership

share in the firm.

Shareholders may also receive dividends
if the firm is profitable in the future.

Another form of equity is a hybrid

security, such as a preference share or
convertible note, that also has some
characteristics of a debt security.
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4.2. DEBT
Debt
instruments
represent
a
contractual claim against an issuer, and
require the borrower to make specified
payments, such as periodic interest
payments and principal repayments over
a defined period.
This involves an amount being borrowed
today (present value) which is repaid
with interest at a later date (future
value).
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4.2. DEBT
Debt instruments entitle the holder to a
claim to the income stream produced
by the borrower and to the assets of
the borrower if the borrower defaults on
loan repayments.
Borrowers will be subject to higher interest

rates the higher the probability they cannot

repay the debt (i.e. credit risk).
Considered as less riskier than equity
capital as the dividend policy of an issuing
firm can be uncertain.
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4.2. DEBT
Examples:

debentures,

overdraft,

leases,

term

commercial

loans,
bills,

commercial notes and bonds.

Some

of

these

have

short-term

maturity while others have a longerterm maturity.

33

4.3. DERIVATIVES
Derivative contracts are not used by
borrowers to raise funds or lenders to
invest funds.
They are mainly used to help manage
an individuals or firms exposure to
changing market prices (i.e. foreign
exchange risk, interest rate risk, equity
price risk).
Their value is derived from the value of

physical market instruments trading in the

debt and equity markets.

34

Examples: forward contracts, futures

contracts, options contracts and swap
contracts .

LECTURE CONTENTS
1. Financial System

2. Financial Institutions
3. Financial Markets
4. Financial Instruments
5. Financing

35

5. FINANCING
Financing
Direct financing

- Investors and
borrowers
deal
directly with each
other.
- The borrower
issues securities
in
a
financial
market and they
are purchased by
investors.

36

Indirect financing:

- Investors and
borrowers
deal
indirectly
with
each other.
The
investor
deposits
their
funds
with
a
financial institution
who takes over
ownership of the
funds.

DIRECT FINANCING FLOWS

Source: Figure 1.4 (Viney 2009, p.18)

Suppliers of funds
(surplus units)

provide funds

Users of funds
(deficit units)

Brokers and
dealers
Financial instruments

INDIRECT FINANCING FLOWS

Source: Figure 1.5 (Viney 2009, p.19)

funds
Suppliers of funds funds
Intermediaries
(surplus units)

37

Financial instrument

Users of funds
(deficit units)

Financial instrument

INTEREST AND FEES

financing:
Direct

Borrowers

can employ an advisor/underwriter

to assist them in issuing securities while
investors may purchase securities through a
dealer/broker.
The cost to borrowers and investors for these

services will be fee or commission.

Indirect financing:

FIs receive interest on their assets (loans)

and pay interest on their liabilities (deposits).

A

38
38

FIs profit is based on the size of their interest

rate spread and any fees it imposes on deposits and
loans.
Interest rate spread = average interest rate on
assets less average interest rate on liabilities.

ADVANTAGES OF DIRECT FINANCING

Remove the
intermediary.

cost

of

financial

Diversify funding sources.

Greater flexibility in the types of

funding instruments.
Enhance firms international profile.

39

DISADVANTAGES OF DIRECT
FINANCING
Problem of matching: amount of funds
and maturity.
Liquidity and marketability.
Search and transaction costs: high.
Default risk.
40

ADVANTAGES OF INDIRECT
FINANCING
Asset transformation:

FIs provide depositors and borrowers with a

wide range of products and services.

This provides an incentive to depositors that only

have a small amount to invest.

It allows customers to choose the product and
service that best suits their needs.

Maturity transformation:

FIs can offer products to both short-term

investors and long-term borrowers.

41
41

FIs overcome the maturity mismatch by

maintaining a large deposit base, holding and
trading liquid money market securities and
requiring regular loan repayments.

ADVANTAGES OF INDIRECT
FINANCING
Absorption of credit risk:

FIs have the expertise to reduce the probability

of borrowers defaulting.

- For example, they undertake an in-depth analysis of a

borrowers likelihood to default and diversify their loans.

Economies of scale:

The size and volume of business undertaken by

FIs allow them to spread their costs over a larger

number of transactions.
This

42
42

decreases the transaction costs imposed on

customers.
It allows FIs to provide cost-efficient payment distribution
systems, such as ATM, EFTPOS, phone banking and internet
banking.
Effective knowledge management and the accumulation
of financial, economic and legal expertise.
Reduction in search costs.

CREDIT OF DEFAULT RISK

The risk that the borrower cannot repay
their debt will affect different parties under
direct and indirect financing.
In direct financing the investor is subject
to the credit risk.
Advisors, underwriters, brokers and dealers

only help facilitate the transaction.

In indirect financing the FIs bear the

direct burden of the credit risk.
The
43
43

FIs still have a commitment to the

depositor even if the borrower cannot repay
their loan.

ASYMMETRIC INFORMATION
One party lacks crucial information about

another

party,

impacting

decision-

making.
eg:

-> We usually discuss this problem along

two fronts: adverse selection and moral
hazard.

44
44

ASYMMETRIC INFORMATION
Adverse Selection:

Before transaction occurs.

Potential borrowers most likely to produce
adverse outcome bad credit risks - are
ones most likely to seek out a loan.

Lenders do not make any loan even though

there are good credit risks.

Moral Hazard:

After transaction occurs.

Hazard that borrower has

45
45

incentives to
engage in undesirable (immoral) activities
making it more likely that wont pay loan
back.
Another view is a conflict of interest.

ASYMMETRIC INFORMATION:
Adverse Selection and Moral Hazard
Financial intermediaries reduce adverse
selection and moral hazard problems,
enabling them to make profits.
Because of their expertise in screening
and monitoring, they minimize their
losses, earning a higher return on
lending and paying higher yields to
savers.
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46

REVIEW
1. Explain the functions of a modern financial

system.
2. Categorise

the

main

types

of

financial

of

financial

institutions.
3. Define

the
instruments.

main

classes

4. Disscuss

the nature of the flow of funds

between savers and borrowers, including
primary markets, secondary markets, direct
financing and intermediated financing.

5. Distinguish between various financial markets

47

structure, including money markets and capital

markets.

3.1. MONEY VS CAPITAL MARKETS

The money market is a finanical
market
in
which
only
short-term
instruments (original maturity of less
than 1 year) are traded.

The capital market is the market in

which longer-term instruments (original
maturity of 1 year or greater) are traded.

48

3.2. PRIMARY VS SECONDARY MARKETS

A primary market is a finanical market
in which new issues of a security
eg. the sale of new corporate stock or new
Treasury securities.
funds are obtained by the issuer
the issue of a new financial instrument ->

price ??
is not well known to the public

49

Suppliers of funds
(surplus units)

Supply funds

Users of funds
(deficit units)

Issue new financial instruments

(debt or equity) to the suppliers of funds

Use funds to acquire

goods, services or
assets

PRIMARY MARKET TRANSACTIONS

Source: Figure 1.2 (Viney 2009, p.16)

50

3.2. PRIMARY VS SECONDARY MARKETS

A secondary market is a finanical
market in which securities that have

been previously issued (and are thus

secondhand) can be resold.
eg. the sale of existing stock
the buying and selling of existing financial

securities -> price ??

transfer of ownership, no new funds raised by

issuer
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increase liquidity of instruments

Surplus entity 1
Sell marketable
Holders of
previously issued
securities to
financial instruments

Surplus entity 2
Surplus entity n

and receive market value

SECONDARY MARKET TRANSACTIONS

Source: Figure 1.3 (Viney 2009, p.16)

52

3.3. ORGANIZED VS OTC MARKETS

A visible marketplace for secondary
market transactions is an organized
exchange.
buyers and sellers meet in one central

location to conduct trades.

Some

transactions

occur

over-the-counter (OTC)

in

market

(a telecommunications network).
53

the