lOMoARcPSD|35334589

Introduction to Financial Systems and Financial Market

Financial Management (Polytechnic University of the Philippines)

Scan to open on Studocu

Studocu is not sponsored or endorsed by any college or university

Downloaded by Lia_rah (beachyliarah@gmail.com)
 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

INTRODUCTION

Financial System is a set of institutions, such as banks, insurance companies,

and stock exchanges that permit the exchange of funds. Financial systems exist on
firm, regional, and global levels. Borrowers, lenders, and investors exchange current
funds to finance projects, either for consumption or productive investments, and to
pursue a return on their financial assets. The financial system also includes sets of rules
and practices that borrowers and lenders use to decide which projects get financed,
who finances projects, and terms of financial deals.

KEY TAKEAWAYS

 A financial system is the set of global, regional, or firm-specific institutions and

practices used to facilitate the exchange of funds.

 Financial systems can be organized using market principles, central planning, or

a hybrid of both.

 Institutions within a financial system include everything from banks to stock

exchanges and government treasuries.

Financial markets refer broadly to any marketplace where the trading of

securities occurs, including the stock market, bond market, forex market, and
derivatives market, among others. Financial markets are vital to the smooth operation of
capitalist economies.

Financial markets play a vital role in facilitating the smooth operation of capitalist
economies by allocating resources and creating liquidity for businesses and
entrepreneurs. The markets make it easy for buyers and sellers to trade their financial
holdings. Financial markets create securities products that provide a return for those
who have excess funds (Investors/lenders) and make these funds available to those
who need additional money (borrowers).

NATURE AND IMPORTANCE OF FINANCIAL SYSTEM

The Financial System plays the key role in the economy by stimulating
economic growth, influencing economic performance of the actors, affecting economic
welfare. This is achieved by financial infrastructure, in which entities with funds allocate
those funds to those who have potentially more productive ways to invest those funds. A
financial system makes it possible a more efficient transfer of funds. As one party of the
transaction may possess superior information than the other party, it can lead to the
information asymmetry problem and inefficient allocation of financial resources. By
overcoming the information asymmetry problem the financial system facilitates balance
between those with funds to invest and those needing funds.
. 1

Downloaded by Lia_rah (beachyliarah@gmail.com)

 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

According to the structural approach, the financial system of an economy consists of

three main components:

1) Financial Markets

֍ Facilitate the flow of funds in order to finance investments by corporations,

governments and individuals.

֍ Organized forums in which the suppliers and users of various types of funds
can make transactions directly

2) Financial Intermediaries (Institutions)

֍ Are the key players in the financial markets as they perform the function of
intermediation and thus determine the flow of funds

֍ Examples of Financial Institutions:

o Commercial Banks – the deposited funds in the commercial banks

are used to provide loans to firms and personal loans to individuals,
and purchase debt securities issued by firms or government agencies.

o Insurance Companies – individuals purchase insurance (life,

property and casualty, and health) protection with insurance
premiums. The insurance companies pool these payments and invest
the proceeds in various securities until the funds are needed to pay off
claims by policyholders.

o Mutual Funds – it is owned by investment companies which enable

small investors to enjoy the benefits of investing in a diversified
portfolio of securities purchased on their behalf by professional
investment managers

o Pension Funds - Financial institutions that receive payments from

employees and invest the proceeds on their behalf.

o Other financial institutions – includepension funds like Government

Service Insurance System (GSIS) and Social Security System (SSS),
unit investment trust fund (UITF), investment banks, and credit unions,
among others.

3) Financial Regulators - perform the role of monitoring and regulating the

participants in the financial system.

. 2

Downloaded by Lia_rah (beachyliarah@gmail.com)

 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

Figure 1. Structure of Financial System

Significance of the Financial System:

1. To attain economic development, financial systems are important since they induce
people to save by offering attractive interest rate. These savings are then
channelized by lending to various business concerns which are involved in
production and distribution.

2. It helps in monitor corporate performance

3. It links savers and investors. This process is known as capital formation

4. It helps in lowering the transaction cost and increase returns which will motivate
people to save more

5. It helps government in deciding monetary policy

ELEMENTS OF FINANCIAL SYSTEM

1. Lenders and Borrowers – also known as fund providers and fund demanders,
respectively. These are the most essential stakeholders that make up the
foundation of a transaction in the financial system. Without these two parties, the
financial system will not exist.

Lenders are parties that have excess funds that they can lend out to other
entities for a required return. Borrowers are parties who are willing to pay the
required return to obtain additional funds to finance their investment initiatives.

. 3

Downloaded by Lia_rah (beachyliarah@gmail.com)

 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

2. Financial Intermediaries – are special type of financial entity that acts as a third
party to facilitate the borrowing activity between lenders and borrowers. Often,
potential borrowers do not have an idea which parties or entities are willing to lend
out money to them and vice versa. This gap in awareness makes it difficult for
financial transactions to occur. This is where financial intermediaries come into the
picture. They gather funds from lenders and redistribute it to borrowers through an
investment vehicle like loans. Potential lenders and borrowers then just need to
visit a financial intermediary to participate in the financial transaction.

3. Financial Instruments – are medium of exchange of contractual obligation of a

party, where such contract can be traded. These can be tangible or intangible.
There are two types of financial instruments, it could be cash or derivative financial
instruments. International Financing Reporting Standards defined Financial
Instruments as a contract where a party recognize it as an asset and another is a
liability.

4. Financial Markets – is same with the other economic markets where suppliers
and buyers of financial instruments meet. There are two type of financial markets
depending on the instrument that were being traded. For cash financial
instruments, these are exchanged in the money market. For derivative financial
instruments, it will be traded in the capital markets.

5. Regulatory Environment – risk is inherent in every business operation. Moreover,

for financial systems since it involves different business and financial risks,
government should intervene in the system. Regulatory environment is the
governance body to ensure that the transactions that within the financial systems
complies with the laws and regulations imposed to the actors as well as the
elements that plays within the system. Financial systems are normally regulated by
Central banks.

6. Money Creation – with the flow of financial instruments, money is created. Money
is used to either be reinvested or earned out from the system flows. In economics,
the money as it was given value out of the financial transactions because of the
exchange that occurred in the system may be converted into another form.

7. Price Discovery – as the financial system continuously flows and operates, the
financial instruments create value. Price discovery is the process of determining or
valuing the financial instruments in the market. The price is normally driven by the
level of risk on how the issuer of the financial instruments. . 4

Downloaded by Lia_rah (beachyliarah@gmail.com)

 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

NATURE AND IMPORTANCE OF FINANCIAL MARKET

Investors exchange financial instruments in a financial market. The more popular

term used for the exchanging of financial instruments is that they are “traded.” Financial
markets provide the following three major economic functions: (1) price discovery, (2)
liquidity, and (3) reduced transaction costs.

Price discovery means that the interactions of buyers and sellers in a financial
market determine the price of the traded asset. Equivalently, they determine the
required return that participants in a financial market demand in order to buy a financial
instrument. Financial markets signal how the funds available from those who want to
lend or invest funds are allocated among those needing funds. This is because the
motive for those seeking funds depends on the required return that investors demand.

Second, financial markets provide a forum for investors to sell a financial

instrument and therefore offer investors liquidity. Liquidity is the presence of buyers
and sellers ready to trade. This is an appealing feature when circumstances arise that
either force or motivate an investor to sell a financial instrument. Without liquidity, an
investor would be compelled to hold onto a financial instrument until either (1)
conditions arise that allow for the disposal of the financial instrument, or (2) the issuer is
contractually obligated to pay it off. For a debt instrument, that is when it matures, but
for an equity instrument that does not mature—but rather, is a perpetual security—it is
until the company is either voluntarily or involuntarily liquidated. All financial markets
provide some form of liquidity. However, the degree of liquidity is one of the factors that
characterize different financial markets.

The third economic function of a financial market is that it reduces the cost of
transacting when parties want to trade a financial instrument. In general, we can
classify the costs associated with transacting into two types: search costs and
information costs. . 5

Downloaded by Lia_rah (beachyliarah@gmail.com)

 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

Search costs in turn fall into two categories: explicit costs and implicit costs.
Explicit costs include expenses to advertise one’s intention to sell or purchase a
financial instrument. Implicit costs include the value of time spent in locating a
counterparty—that is, a buyer for a seller or a seller for a buyer—to the transaction. The
presence of some form of organized financial market reduces search costs.

MONEY MARKET VS. CAPITAL MARKET

Capital Markets are financial markets for the buying and selling of long-term debt
or equity-backed securities. The primary role of the capital market is to raise long-term
funds for governments, banks, and corporations while providing a platform for the
trading of securities. Money Market is a market for short-term financial assets that can
be turned over quickly at a low cost. A short-term financial asset in this context may be
construed as any financial asset which can be quickly converted into money with
minimum transaction cost within a period of one year.

Capital Market:

Securities that are traded in Capital Market include stocks, bonds, debentures,
etc. The maturity period of securities in Capital Market is more than one year or
irredeemable (i.e. without maturity). Capital Market is divided into two major categories:
Primary and Secondary Market.

Money Market:

Trade Credit, Commercial Paper, Certificate of Deposit, Treasury Bills are some
examples of the short-term debt instruments. Money Market securities are very liquid in
nature, and hence, their redemption period is restricted to one year. Although the return
of investment in money market securities are low compared to Capital Market
securities, they are comparatively safer than Capital Market securities. Trading in
Money Market takes place off the exchange, i.e. Over the Counter (OTC) between two
parties.

Money Market is characterized by two segments:

1. Organized Segment: Organized Money Market is subject to tight control by the

Reserve Bank of India. They function under fairly rigid and complex rules. Some
of the participants of organized money market are Banks, NBC’s, and Co-
operative Societies, etc.

2. Unorganized Segment: Unorganized Segment is primarily used by borrowers

who are not able to get credit from the organized money market. Unorganized
Money Market has comparatively flexible terms, informal procedures, and higher
interest rate for borrowers etc. Some of the participants of the unorganized
money market are Money Lenders, Nidhi Company, Chit Fund Company etc. . 6

Downloaded by Lia_rah (beachyliarah@gmail.com)

 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

The Basis of
Money Market Capital Market
Comparison

A section of the financial market

A section of the market where long-
Meaning where short-term securities are
term securities are issued and traded
issued and traded

Government Securities, Certificate of

Financial
Deposit, Commercial Papers (CPs) Shares, Bonds, Debentures, etc.
Instruments
etc.

Helps in fulfilling short-term credit Helps in fulfilling long-term credit

Purpose
requirements of the business. requirements of the business.

Risk Factor Low High

Return on
Low Comparatively High
Investment

Time Horizon Less than one year More than one year

Relevance to Helps Increasing liquidity of funds in Helps in Mobilization of savings in the

Economy the economy economy

Nature of Market Informal Formal

Capital Market are classified between

There is no subdivision in Money
Classification Primary Market and Secondary
Market like it exists in Capital Market
Market

Capital Market gets influenced by

Linkage with Central Money Market is directly and closely Central Bank’s policies and decisions
Bank of Country` linked with Central Bank of Country but there is no direct linkage with
Central Bank of Country

PRIMARY MARKET VS. SECONDARY MARKET

The term market in the finance world usually refers to both – primary market and
the secondary market. Both markets are part of the capital market. The primary market,
as the name suggests, is the space where securities are created. The secondary, on the
other hand, is meant for trading those securities. Capital markets are complex,. thus7

Downloaded by Lia_rah (beachyliarah@gmail.com)

 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

without having clear segregation, it becomes challenging to understand the concepts in-
depth. One of the first steps to understand both the markets entirely is to know the
difference between primary market vs secondary market.

Primary Market – The market where a company raises capital for the first time is
known as the primary market. Companies issue IPO (initial public offering) in the
primary market only. The market offers an opportunity for investors to buy securities
directly from the issuing company. By buying securities or stock from the primary
market, investors help companies to raise capital. So, the overall capital that the
company has on the balance sheet includes the contribution from the investors in the
primary market.

Prior to the IPO, the issuer and the investment bankers carry a marketing
campaign, where they convince investors about the worth and potential of the
investment. Generally, the prices are very volatile in the primary market because of
abrupt demands. This is one reason why companies prefer to keep the price of the
initial issue low.

A company can raise money from the primary market even after the securities list
on the secondary market. A company can do so by issuing the right shares to the
investors at a price lower than the prevailing secondary market price. This way, the
company also rewards the investor for contributing to the company at an early stage.

Secondary Market – Shares that the company issued in the primary market get
listed on the secondary market. Secondary markets allow retail investors to invest in
the securities and earn a profit. Investors in the secondary market trade between
themselves, and there is minimum or no interference of the issuing company.

We can further divide the secondary market into:

Auction Market – as the name suggests, it is the place where individuals and
institutions come together and announce the buy and sell prices. The underlying idea is
that there should be an efficient market that offers the opportunity to all the parties.
Therefore, the mutually agreeable price between the buyer and the seller would be the
best price to execute the trade.

Dealer Market –unlike the auction market, the dealer market does not require the
parties to gather in a central location. Instead, all market participants participate through
electronic networks. Dealers are in possession of the inventory of security, and carry
trade with the buyers or sellers. Dealers are known as the market makers as they
compete among themselves and declare the best price to buy and sell the security. The
underlying theory is that the competition between the dealers will offer the best possible
price for the investors.

Basis of Primary Market Secondary Market

Comparison . 8

Downloaded by Lia_rah (beachyliarah@gmail.com)

 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

The market where investor’s trade already

A platform that offers security for the
Meaning issued securities is known as the secondary
first time is the primary market.
market.

Another name New issue market (NIM). Aftermarket or share market.

Products are limited, and mainly

Type of Many products are available such as
include IPO and FPO (Follow-on Public
product shares, warrants, derivatives and more.
Offer).

All the purchases in this market The issuer (company raising capital) is not
Purchase type
happen directly. involved in the trading.

Frequency of Security can be sold to the investors Here the traders can buy and sell the
selling just once in this market. shares as many times they want.

Company and the investors are

Parties Here investors buy and sell the securities
involved in buying and selling the
involved among themselves.
security.

Beneficiary Company Investor

Several tools are available to the investors

How to Investors primarily rely on prospectus
to help them pick good investments, such
identify and word-of-mouth publicity to pick an
as price to earnings (P/E), price to book
investment? investment in the primary market.
(P/B), price to sales (P/S) and more.

Underwriters are the intermediaries in

Intermediary Here the intermediaries are the brokers.
the primary market.

Help new and existing companies to

Does not provide funding to companies;
Purpose raise capital for expansion
rather help investors to make money.
and diversification.

The company sells the shares to the Both buy and sell-side investors work
Price
investors at a fixed price. towards finding the best price for the trade.

There is a geographical setup and

There is no organization set up for the
Presence organizational presence for the secondary
primary market
market.

Rules and The company issuing securities goes Here investors and brokers need to follow
Regulations through a lot of regulation and due the rules set by the exchange and the
diligence. governing agency. . 9

Downloaded by Lia_rah (beachyliarah@gmail.com)

 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

SOURCES:

֍ Financial System Definition. (n.d.). Retrieved October 9, 2020, from

https://www.investopedia.com/terms/f/financial-system.asp

֍ Shreya Rahut (Delhi). (n.d.). Meaning of Financial System. Retrieved October 9,

2020, from https://www.estartindia.com/knowledge-hub/blog/meaning-of-financial-
system

֍ Financial Markets Definition. (n.d.). Retrieved October 9, 2020, from

https://www.investopedia.com/terms/f/financial-market.asp

֍ Lascano, M. V., Baron, H. C., & Cachero, A. T. L. (n.d.). Fundamentals of Financial

Markets (2019th ed., Vol. 1).

֍ Money Market vs Capital Market. (n.d.). Retrieved October 9, 2020, from

https://www.educba.com/money-market-vs-capital-market/

֍ Sanjay Bulaki Borad. (2019, September 20). Primary Market vs Secondary Market –
All You Need To Know. Retrieved October 9, 2020, from
https://efinancemanagement.com/investment-decisions/primary-market-vs-
secondary-market

֍ VALDONĖ DARŠKUVIENĖ. (n.d.). Financial Markets (n. a ed., Vol. n.a). Retrieved
from https://docplayer.net/5989798-Leonardo-da-vinci-transfer-of-innovation-valdone-
darskuviene-vytautas-magnus-university-financial-markets-leonardo-da-vinci-
programme-project.html

֍ Fabozzi, F. J., & Drake, P. P. (n.d.). The Basics of Finance: An Introduction to

Financial Markets, Business Finance, and Portfolio Management (Frank J. Fabozzi
Series) - PDF Drive. Retrieved October 9, 2020, from https://www.pdfdrive.com/the-
basics-of-finance-an-introduction-to-financial markets-business-finance-and-portfolio-
management-frank-j-fabozzi-series-e184936291.html

QUESTIONS:

1) It is the set of global, regional, or firm-specific institutions and practices used to

facilitate the exchange of funds.

a. Financial Market

b. Financial Institution

c. Financial System

d. Financial Instruments
. 10
2) The following are the importance of Financial System, except:
Downloaded by Lia_rah (beachyliarah@gmail.com)
 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

a. Helps in attaining Economic Development

b. Helps the company in deciding monetary policy

c. Helps in monitoring corporate performance

d. Helps in lowering transaction costs

3) These are the medium of exchange of contractual obligation of a party, where such
contract can be traded; it can be tangible or intangible.

a. Financial Market

b. Financial Institution

c. Financial System

d. Financial Instruments

4) It is the process of determining or valuing the financial instruments in the market.

a. Price Discovery

b. Price Creation

c. Valuation of Instrument

d. Valuation Process

5) The financial markets provide a forum for investors to sell a financial instrument and
therefore offer investors Liquidity; one of the function of a financial market is that it
reduces the cost of transacting when parties want to trade a financial instrument.

a. First statement is True; second statement is False

b. First statement is False; second statement is True

c. Both Statements are True

d. Both Statements are False

6) Financial markets provide the following three major economic functions except:

a. Reduced transaction costs

b. Solvency

c. Price Discovery
. 11
d. Liquidity
Downloaded by Lia_rah (beachyliarah@gmail.com)
 lOMoARcPSD|35334589

I
nt
ro
duc
ti
ont
oFi
nan
cia
lSy
ste
msa
ndF
ina
nci
alMa
rke
t

7) Capital Market:___________; Money Market:_________

a. Stocks; Treasury Bills

b. Treasury Bills; Stocks

c. Bonds; Debentures

d. Certificate of Deposit; Commercial Paper

8) A section of the financial market where short-term securities are issued and traded.

a. Capital Market

b. Money Market

c. Financial Market

d. Market Market

9) ____: The market where a company raises capital for the first time;

____: Products are limited, and mainly include IPO and FPO (Follow-on Public
Offer).

a. Primary Market; Secondary Market

b. Secondary Market; Primary Market

c. Primary Market; Primary Market

d. Secondary Market; Secondary Market

10)In Primary market, the company and the investors are involved in buying and
selling the security while in Secondary Market, investors buy and sell the
securities among themselves.

a. True

b. False

c. Both a and b

d. None of the above

. 12

Downloaded by Lia_rah (beachyliarah@gmail.com)