Chapter 2 The Financial System

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‡ Intermediaries, instruments, and regulations. ‡ Financial markets: bond and stock markets ‡ Financial intermediaries: banks, insurance companies, pension funds ‡ Moving funds from those who have a surplus of funds to those who have a shortage of funds.

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1. ALOMAR_212_3 3 .Functions of the Financial Markets: ‡ Financial markets channel funds: surplus of funds to shortage of funds. ‡ Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities (financial instruments) which are claims on the borrower¶s future income or assets.

ALOMAR_212_3 4 . debts) that (sell. issue) them.‡ Securities are assets for the person who buy them but liabilities (IOU.

ALOMAR_212_3 5 .Functions of the Financial Markets: ‡ With no lending or borrowing opportunities.1. an individual who saved KD1000 will remain the same ‡ But giving the KD(1000) to another person with productive use of it (earning KD200/year) sharing the KD200 (100/100).

therefore: ‡ Financial markets allow funds to move from people who lack productive investment opportunities to people who have such opportunities. personal uses (house).‡ Using financial markets for: increasing/improving production. ALOMAR_212_3 6 .

2. mortgage: a contractual agreement by the borrower to pay the holder of the instrument fixed amount at regular intervals (interest and principle payment) until specific date (maturity date). Issue a debt instrument: bond. ALOMAR_212_3 7 .The Structure of the Financial Market: ‡ Debt and Equity Markets: can obtain funds in financial markets in two ways: A.

‡ Maturity: the time that a debt instrument expires. ALOMAR_212_3 8 . ‡ If maturity is less than a year: Short-Term debt instrument ‡ if the maturity is ten years or longer: Long-Term debt instrument ‡ in between: Intermediate-Term.

2.The Structure of the Financial Market: ‡ B. Issuing Equities: such as common stock. which are claims to share in the net income and assets of a business. ALOMAR_212_3 9 . ‡ Equities usually make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date.

‡ The Advantage: the holder can benefit directly from any increase in profits or asset value.‡ An equity holder is a residual claimant claimant: the corporation must pay all its debt holders before it pays its equity holders (disadvantage of owing a firm¶s equity). ALOMAR_212_3 10 .

ALOMAR_212_3 11 . ‡ Broker: an agent of investors who match buyers with sellers of securities. ‡ Dealer: link buyers and sellers by buying and selling securities at stated prices. ‡ Secondary market: a financial market in which securities that have been previously issued are resold.Primary and Secondary Markets: ‡ Primary market: a financial market in which new issues of a security (bond or stock) are sold to initial buyers.

they make financial instrument more liquid ‡ Determine the price of the security (pay for the issuing corporation no more than what you think it will be sold at the secondary market). ‡ Secondary markets serve 2 functions: ‡ Easier to sell financial instruments to raise cash. ALOMAR_212_3 12 .‡ A corporation acquires new funds only when its securities are first sold in the primary market.

‡ Exchanges and over-the-counter markets: (to organize secondary markets) ‡ Exchanges. a central location where buyers and sellers of securities meet. ‡ Over the counter market (OTC): dealers in different locations with inventory of securities stand ready to buy and sell securities ³over the counter´ to anyone accept their price. ALOMAR_212_3 13 .

‡ Money and capital markets: depends on the maturity of the securities traded in each market. ‡ Capital market: the market in which longer term debt and equity instrument are traded. ALOMAR_212_3 14 . ‡ Money market: only short-term debt instrument are traded.

Negotiable bank certificates of deposits. least risky investments. Federal funds. ‡ US Treasury bills. ALOMAR_212_3 15 . Banker¶s acceptances. least price fluctuations. Commercial paper. Repurchase agreements.3.Financial Market Instrument: ‡ Money market instrument: Short-term to maturity.

Corporate bonds. ALOMAR_212_3 16 . Consumer and Bank commercial loans. Mortgages. US government securities. State and Local government bonds.‡ Capital market instrument: ‡ Stocks. US government agency securities.

Asymmetric information: Adverse Selection and Moral Hazard.Function of Financial Intermediaries . ALOMAR_212_3 17 .Transaction Costs: economies of scale .‡ 4.

.Financial Intermediaries A. Depositary Institutions.Mutual Savings Banks .Commercial Banks. ALOMAR_212_3 18 .Credit Unions. .Savings and Loan Association .5.

Financial Intermediaries B.5. ALOMAR_212_3 19 . Contractual Savings Institutions: .Fire and Casualty insurance companies. .Pension funds and government retirement funds.Life insurance companies .

Money market mutual funds.Mutual funds . ALOMAR_212_3 20 . Investment Intermediaries: .Finance companies .Financial Intermediaries C.5.

Regulations of the Financial System: A.6. Increasing information available to investors. B. Improving control of monetary policy ALOMAR_212_3 21 .

Restrictions on assets and activities.Disclosure. .Regulations of the Financial System: C.Limits on competition. .6.Deposit insurance. Ensuring the soundness of financial intermediaries: .Restrictions on interest rates ALOMAR_212_3 22 . . .Restrictions on entry. .