International Finance 


and 

Financial Markets

Financial Intermediaries and Financial Markets

MBA 2020
University of Colombo

MBAIB5214 Lecture II 13 Sept. 2020

 Recall of Lecture 1
• The importance of studying International Finance and Financial Markets

• Structure of the economy and the relationship between the economy and
the financial system

• Distinction between a Monetary System and a Financial System and

their relationships

• The role of the Financial System in efficient allocation of resources Flow

of funds through different channels of a financial system

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 Nature of a Financial System

FINANCIAL
OTHER
REGULARORY INTERMEDIARIES
AUTHORITIES

CENTRAL
BANK
FINANCIAL FINANCIAL
INFRASTRUCURE PRODUCTCS

FINANCIAL

MARKETS

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Flow of Funds through the Financial System
INDERECT FINANCE

Financial
FUNDS
FUNDS
Intermediaries

FU
N
DS
Lender/Saver Borrower/Spender

1. Households 1. Households

2. Business Firms 2. Business Firms

3. Government 3. Government
Financial
4. Foreigners FUNDS FUNDS 4. Foreigners
Markets

DERECT FINANCE
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Financial Intermediaries

Main Functions of Financial Intermediaries

• Mobilizing Financial Resources from Surplus Units to Deficit Units

• Reduce the Information Asymmetry or Information Gap
• Maturity Transformation
• Reduce transaction cost (economies of scale and economies of
scope)
• Provide more liquidity
• Pooling risk

5
Major Types of Financial Intermediaries in Sri Lanka

• Banking Sector (Excluding the Central Bank)

• Commercial Banks (Special type of Financial Intermediaries ?)
• Specialized Banks
• Other Deposit Taking Financial Institutions
• Specialized Financial Institutions
• Contractual Savings Institutions

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Balance Sheet of a Commercial Bank (Asset Side)
• Loans and Advances
• Loans
• Overdrafts
• Bills Purchased
• Local
• Import
• Exports
• Investments
• Government Securities
• Treasury Bills
• Treasury Bonds
• Other
• Cash in hand
• Dues from Central Bank
• Due from Domestic Banks
• Cash in Collection

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Balance Sheet of a Commercial Bank (Liability Side)
• Paid up Capital, Reserve Funds and Undistributed Profits
• Demand Deposits
• Interbank
• Foreign
• Domestic
• Government
• Residents
• Non-Residents
• Time and Savings Deposits
• Government
• Residents
• Non-Residents
• Borrowings
• Domestic Interbank
• Foreign
• Other
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 Why are Commercial Banks Special?
• Operations of the Central Bank, Commercial Banks and economic agents affect
the supply side of the monetary sector
• Money supply is about the liquidity and its is measured with different monetary
aggregates,
M1 = Cp + DD

M2 = Cp + DD + TSD

M2b = Cp + DD + TSD + FCD

M4 = Cp + DD + TSD + FCD + LSB + LFC

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Total Assets of Financial System in Sri Lanka
Major Sector 2018 2019
Rs. Bn Share (%) Rs. Bn Share (%)
Banking Sector 13,711 72.3 14,442 71.6
Central Bank 1,917 10.1 1,919 9.5
Commercial Banks 10,372 54.7 10,944 54.3
Specialised Banks 1,421 7.5 1,578 7.8

Other Deposit Taking 1,603 8.5 1,678 8.2

Institutions
Specialized Financial 241 1.3 282 1.4
Institutions
Contractual Saving 3,414 18.0 3,787 18.8
Institutions
Of Which EPF 2,289 12.1 2,540 12.6

Total 18,968 100.00 20,159 100.00

Source: Central Bank of Sri Lanka, Annual Report 2019

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Money Supply Process
• 

11
Credit/Deposit Creation Process of Commercial Banking System
Credit Creation Process of the Commercial Banking System Rs. Mn.

Stage of the Process DD RR Credit

The original round of Cash deposits and 1st round of Credit creation 1,000.0 100.0 900.0

The 1st round of Check deposits and the 2nd round of Credit creation 900.0 90.0 810.0

The 2nd round of Check deposits and the 3rd round of Credit creation 810.0 81.0 729.0

The 3rd round of Check deposits and the 4th round of Credit creation 729.0 72.9 656.1

.. and so on 656.1    

       
       
The Nth round 00 00 00

Sum of all values 10,000 1,000 9,000

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Financial Markets
Different Dimensions of Financial Markets
• Money market (Short term, less than 12 months)
• Interbank Call Money Market
• Repo Market
• Foreign Exchange Market

• Capital Markets (Long term, more than 12 months)

• Debt Securities Market
• Equity Market

• Primary Market
• Secondary Market
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Money Market Liquidity and Short Term Interest

MKt i

SF (Supply of Short-term Liquidity by

Surplus Banks)

Market
Clearing
Interest
Rate
 

DF (Demand for Short-term Liquidity

by Deficit Banks)

0
Volume of Liquidity
 
 

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Capital Market: Government Debt Securities
Debt Securities are of two types
a. Treasury Bills
• Discount Bonds
• Always issued at a discounted price (below face value) which depends on the
discount rate
• Short term securities (maturity period less than 12 months)
b. Treasury Bonds
• Coupon Bonds
• Can be issued at three different prices:
• At the face value (par value)
• With a discount (lower than par value)
• With a premium (higher than par value)
• Long term securities (maturity period more than 12 months)
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Government Debt Securities Market (Sri Lanka)
Debt Securities Market is an Environment for exchange of government debt securities
Primary Market:

• Follows a dual systems of Auctions and Direct Placements

• Operates between the issuer and primary dealers

• Primary Dealers are Specialized Financial Intermediaries appointed by the

Superintendent of Public Debt of the Central Bank (as the government agent) under the
Local Treasury Bill Ordinance No. 8 of 1923 and Registered Stock and Securities
Ordinance No. 7 of 1937

Secondary Market:

• Market operates under a free market environment

• Investors and primary dealers are active

• The Central Bank could also be an active player depending on the liquidity situation in
the market and Central Banks expectations 16


Role of Primary Dealers 


• strengthen the primary market by

• Helping to build stable, dependable source of demand for securities by
effectively participating in the primary auctions

• providing liquidity in the secondary market

• building distribution channels (to act as intermediaries)

• providing market information, including prices, volumes and spreads between

bids and offers

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The Primary Auction
Face Value of T Bond = Rs.100 and the Coupon Rate = 10%

Amount of the Bid Bid Price for Rs. Coupon Payment Amount Payable Cumulative  
Rs. Mn 100 for Rs. 100 Rs.Mn Amount Payable Rate of Return (%)
Rs. Mn
1000 110.00 10 1,100.00 1,100.00 9.09

2000 105.00 10 2,100.00 3,200.00 9.52

1500 100.00 10 1,500.00 4,700.00 10.00

2500 100.00 10 2,500.00 7,200.00 10.00

2000 95.00 10 1,900.00 9,100.00 10.53

1000 90.00 10 900.00 10,000.00 11.11

1800 85.00 10 1,530.00 11,530.00 11.76

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Determinants of Bond Prices and Yield at the Auction
Secondary market conditions
• Liquidity situation in the secondary market affects the yield rate and it could have an impact on
the bidding pattern and the yield rate at the primary auction

Government cashflow requirements

• The decisions based on the requirements affect the cut off rate and the weighted average rate.

Monetary policy environment

• Changes in policy interest rates affects the market interest rates which could be reflected in the
bidding prices and yield at the primary auction

Expectations on Future movement of interest rates

• Expectations of market participants on the future movements of interest rates could affect the
outcome of the auction

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Lecture 3 - Outline
• Financial Markets
- Distinction between Money Market and Capital
Market
- Financial Products in Money and Capital Markets
- Interdependence between Money and Capital markets

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