Three Main Components of Financial System
Financial System
One of the biggest problems for
any economy is to figure out is how to
get money from people who want to
save to people who want to borrow.
Finance is the answer to that problem.
If you think of the economy as a body,
finance would be the heart. In
economic terms, the financial system
is responsible for a lot of the world’s
resource allocation. It decides which
investments get funded and which ones
do not. This makes it quite important
and quite powerful.
Financial Markets
Financial markets, from the name itself, are a
type of marketplace that provides an avenue for
the sale and purchase of assets such as bonds,
stocks, foreign exchange, and derivatives.
1. FINANCIAL MARKETS - A market where buyers and sellers trade
commodities, financial securities, foreign exchange, and other freely
exchangeable items (fungible items) and derivatives of value at low
transaction costs and at prices that are determined
by market forces.
2. FINANCIAL INTERMEDIARIES - an entity that acts as the middleman
between two parties in a financial transaction, such as a commercial
bank, investment banks, mutual funds and pension funds.
3. FINANCIAL REGULATORS - a person or organization that has been
given the official job of making sure that banks, financial businesses,
etc. act in a responsible way and do not break the law.
Financial assets represent
investments in the assets and
securities of other institutions.
Financial assets include stocks,
sovereign and corporate bonds,
preferred equity, and other
hybrid securities. Financial
assets are valued depending on
how the investment is
categorized and the motive
 Financial Instrument

A contract we can trade in market. It represents an

asset to one entity and a liability or equity to the other.

1. Debt instrument: The issuer agrees to pay interest and

repay the amount borrowed; Ex: Bonds.

2. Equity instrument: Obligates the issuer of the financial

instrument to pay the holder an amount based on
earnings, if any, after the holders of the debt
Classification of Financial Market instruments have been paid.

Ex: common stock, a partnership share in a business.

Debt Market: The market where fixed claims or
debt instruments, such as debentures or bonds
are bought and sold between investors.

Equity Market: Equity market is a market wherein

the investors deal in equity instruments. It is the
Currency Trading
market for residual claims.
Currency trading, often referred to as
Money Market: The market where monetary
foreign exchange or FOREX, is the
assets such as commercial paper, certificate of
deposits, treasury bills, etc. which mature within purchasing and selling of currencies in the
a year, are traded is called money market. foreign exchange marketplace, done with
the objective of making profits. It is
Capital Market: The market where medium and
referred to as 'speculative Forex trading.'
long term financial assets are traded is a capital
market. It is divided into two types: Forex trading is the largest market in the
world, with nearly $2 trillion traded on a
Primary Market: A financial market, wherein the
daily basis, with quick growth projections.
company listed on an exchange, for the first
time, issues new security or already listed
The main factor that differentiates
company brings the fresh issue. currency trading from other types of
trading is its liquidity.
Stock market, a secondary market is an
organized marketplace, wherein already issued
securities are traded between investors, such
as individuals, merchant bankers, stock brokers
and mutual funds.

Cash Market: The market where the transaction

between buyers and sellers are settled in real
time.

Futures Market: where the delivery or

 How Currencies Are Traded
The spot market is where financial instruments, such as commodities, currencies and securities, are traded for
immediate delivery. Delivery is the exchange of cash for the financial instrument. A futures contract, on the other hand, is
based on the delivery of the underlying asset at a future date.

Exchanges and over-the-counter (OTC) markets may provide spot trading and/or futures trading.

A futures market is an auction market in which participants buy and sell commodity and futures contracts for delivery
on a specified future date.

Options Market, options are financial instruments that are derivatives that are based on the value of underlying
securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of
contract they hold—the underlying asset

The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options,
which are derived from other forms of assets. The market can be divided into two, that for exchange-traded derivatives
and that for over-the-counter derivatives. Four most common examples of derivative instruments are Forwards, Futures,
Options and Swaps.

Currency Markets and Related Markets

GEARING UP - Gearing refers to the relationship, or ratio, of a company's debt to equity. Gearing shows the
extent to which a firm's operations are funded by lenders versus shareholders—in other words, it measures a
company's financial leverage.

Players of Financial The Main Trading Location HERSTATT RISK - also

Markets known as settlement risk or
1. London – largest and
1. Exporters and most important market
cross-currency settlement
Importers forex risk, is the risk associated
2. Investors 2. New York – second with settlement of foreign
3. Speculators largest exchange transactions.
4. Government
Factors affecting the change of exchange rate
When a country raises its interest rate or its domestic interest rate is higher than the foreign interest
rate, it will cause capital inflow, thereby increasing the demand for domestic currency, allowing the
currency to appreciate and the foreign exchange depreciate.
A real interest rate is an interest rate that Covered interest rate parity refers to a
has been adjusted to remove the effects of theoretical condition in which the
inflation to reflect the real cost of funds to relationship between interest rates and the
the borrower and the real yield to the spot and forward currency values of two
lender or to an investor. The real interest countries are in equilibrium. The covered
rate reflects the rate of time-preference for interest rate parity situation means there is
current goods over future goods. The real no opportunity for arbitrage using forward
interest rate of an investment is calculated contracts, which often exists between
as the difference between the nominal countries with different interest rates.
interest rate and the inflation rate:

Real Interest Rate = Nominal Interest Rate -

Covered interest arbitrage is a strategy in
Inflation (Expected or Actual)
which an investor uses a forward contract to
hedge against exchange rate risk. Covered
interest rate arbitrage is the practice of
using favorable interest rate differentials to
invest in a higher-yielding currency, and
hedging the exchange risk through a
forward currency contract.

MANAGING EXCHANGE RATES

An exchange rate regime is closely related to that country's monetary policy. There are three basic
types of exchange regimes: floating exchange, fixed exchange, and pegged float exchange.

The GOLD STANDARD is a monetary system where a country's currency or paper money has a value
directly linked to gold.

The 1944 BRETTON WOODS agreement established a new global monetary system. It replaced the
gold standard with the U.S. dollar as the global currency. By so doing, it established America as the
dominant power in the world economy. After the agreement was signed, America was the only
country with the ability to print dollars.

A currency PEG is a country or government's exchange rate policy whereby it attaches, or links, the
central bank's rate of exchange to another country's script. Also referred to as a fixed exchange rate
or a pegged exchange rate, a currency peg stabilizes the exchange rate between countries. Doing
so provides long-term predictability of exchange rates for business planning and can anchor rates at
advantageous levels for large importers
 Money Market
The money market is the trade in short-term
debt investments. At the wholesale level, it
involves large-volume trades between
institutions and traders. At the retail level, it
includes money market mutual funds bought
by individual investors and money market
accounts opened by bank customers.
A bank is a financial institution licensed to
receive deposits and make loans. Banks may
also provide financial services, such as
wealth management, currency exchange, and
safe deposit boxes. There are two types of
banks: commercial/retail banks and
investment banks. In most countries, banks
are regulated by the national government or
central bank.
TYPES OF INSTRUMENTS
 Commercial Paper
 Banker's Acceptance
 Treasury Bill (T-Bill)
 Government Agency Notes
 Local Government Notes
 Interbank Loans
 Time Deposit
 Paper issued by international
organization
Disintermediation, in finance, is the
withdrawal of funds from intermediary
financial institutions, such as banks and
savings and loan associations, to invest them
directly. Generally, disintermediation is the
process of removing the middleman or
intermediary from future transactions.
Disintermediation is usually done to invest in
instruments yielding a higher return.
A repurchase agreement (repo) is a form
of short-term borrowing for dealers in
government securities. In the case of a
repo, a dealer sells government securities
to investors, usually on an overnight basis,
and buys them back the following day.
A credit rating is a quantified assessment
of the creditworthiness of a borrower in
general terms or with respect to a
particular debt or financial obligation.
FIXED EXCHANGE RATE SEMI-FIXED EXCHANGE RATE.
This occurs when the government This occurs when the government
seeks to keep the value of a seeks to keep the value of a currency
currency fixed against another between a band of the exchange rate. In
currency. For example, the value other words, the exchange rate can
of the Pound Sterling fixed fluctuate within a narrow band. For,
against the Euro at £1 = €1.1 example the Exchange rate mechanism.
For example, the Pound Sterling could
Advantages and Disadvantages of
fluctuate between a target exchange
Fixed Interest Rates
rate of £1 = €1.05 and £1 = €1.15
Fixed rates are typically higher
than adjustable rates. Loans with FLOATING EXCHANGE RATE
adjustable or variable rates
A floating exchange rate is a regime
usually offer lower introductory
where the currency price of a nation is
rates than fixed-rate loans,
set by the forex market based on
making these loans more
supply and demand relative to other
appealing than fixed-rate loans
currencies. This is in contrast to a fixed
when interest rates are high.
exchange rate, in which the
Borrowers are more likely to opt government entirely or predominantly
for fixed interest rates during determines the rate.
periods of low interest rates
when locking in the rate is
particularly beneficial. The
opportunity cost is still much less
than during periods of high
interest rates if interest rates go
lower.