Part I Introduction To The Financial System (Revised For 2e)

Fundamentals of Financial Markets
&
Securities Analysis
Regulatory
50 Hours Short-Term Training

Organized by: AAU, School of Commerce, Capital Market Project Office
AAU, School of Commerce, Capital Market Project Office 1
Part I
INTRODUCTION TO THE FINANCIAL SYSTEMS
AAU, School of Commerce, Capital Market Project Office

Outline
1.1. What is the Financial System
1.2. The Key Concepts of the Financial System
1.3. Direct Finance and Indirect Finance
1.4. The Components of the Financial System
1.5. Financial Markets & Their Functions
1.6. Classification of Financial Markets
1.7. Financial Institutions & Their Functions
1.8. Classification of Financial Institutions
1.9. Types of Financial Instruments
1.10. The Central Bank & Monetary Policy

1.1. What is financial system?

1.1. What is a financial system?
A financial Financial System

system matches the
needs of savers &
Is a system that borrowers
brings savers directly through
and borrowers financial markets
in an economy or indirectly
directly or through financial
indirectly. institutions.

The Financial System

Sources of External Funds for Nonfinancial Businesses: A Comparison of the United States with
Germany, Japan, and Canada
%
100
United States
90 Germany
80 Japan
Canada
70
60
50
40
30
20
10
0
Bank Loans Nonbank Loans Bonds Stock
1.2. Key Concepts of the Financial System

Key Concepts of the Financial System
1) Risk and reward: The returns that investors expect to earn are positively related
to the risk they must bear
2) Supply and demand: The price of financial instruments such as shares, bonds,
options, futures, or swaps depends ultimately on supply and demand.
3) No-arbitrage: A trader cannot buy a financial instrument in one market at a low
price while simultaneously selling that same thing at a higher price in a different
market
4) The time value of money: An interest rate is the cost of borrowing or the price
paid to rent funds, usually expressed as a percentage.

1.3. How Financial System Functions?
Direct Finance vs Indirect Finance

The direct and indirect finance

1.4. Components of the Financial System

Components of the Financial System
1) Financial institutions: Channel funds from those with surplus funds (suppliers of funds)
to those with shortages of funds (users of funds).
2) Financial markets: Provide the platform where financial assets (securities) such as
stocks and bonds are traded.
3) Financial instruments: known as financial securities, financial claims, or financial
assets are claims on future assets or earnings. They are assets to the investors and
liabilities to the issuers
4) Regulation of the financial system: needed to prevent market failures by improving
efficiency, reducing costs, and fostering competition.
5) Technology and financial infrastructure: improves the efficiency of financial markets
where electronic trading of stocks, bonds, and derivatives continues to replace physical
markets.

1.5. Financial Markets and Their Functions

What are Financial Markets
• Financial markets: markets where people and firms trade two

kinds of assets
– Currencies
– Securities – claims on future income flows,
e.g. stocks and bonds

Why Financial Markets?
Financial markets are crucial in the economy.
➢Channel funds from savers to investors, promoting economic
efficiency.
✓Capital markets fund more than 70% of economic activity in the United
States.
➢Market activity affects: personal wealth, business firms, and
economy.
➢Capital markets are one of the most powerful drivers of
economic growth and wealth creation.
✓They match capital to ideas .

Functions of Financial Markets

1) Price Determination
• The prices of financial instruments traded in the financial market are
determined by the market forces, i.e., demand and supply.
• Financial market provides the vehicle by which the prices are set for
both financial assets which are issued newly and for the existing stock of
the financial assets.

2) Funds Mobilization
• Funds available from the lenders/investors will get allocated among the
funds demanders through the financial markets
• Businesses raise funds by issuing financial instruments in the financial
market.
• So, the financial market helps in the mobilization of the investors’ savings.

3) Liquidity
• Financial market provides an opportunity for the investors to sell
their financial instruments
• Investors can sell their securities readily and convert them into cash
in the financial market
• In the absence of financial market, the investor will be obligated to
hold the financial securities until the conditions to sell arise

4) Risk sharing
• Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
• Allows for diversification, the distribution of wealth among many
assets
✓Losses or low returns on some assets offset by higher returns on others
• An easy way to diversify:
✓buy shares of mutual funds, financial firms that buy and hold many
different stocks and bonds

5) Easy Access
• Financial market platform provides the potential
buyer and seller easily
– This helps to save their time and money in finding the
potential buyer and seller.

6) Reduction in Transaction Costs and information

asymmetry
• The traders require information for transacting
• Financial market provide different types of information
to the traders.
–In this way, the financial market reduces the cost of the
transactions.

6) Capital Formation
• Financial markets provide the channel through which the
new investors’ savings flow in the country, which aids in the
country’s capital formation.

1.6. Classification of Financial Markets

Classification of Financial Markets
Basis of classification Types of Financial Markets
Freshness of securities Primary market Secondary market
Nature of claim Debt market Equity market
Maturity of claim Money market Capital market
Timing of claim Spot/cash market Futures market
Organizational structure Exchange traded market OTC market

1. Freshness of Securities
Financial Markets
Primary Markets Secondary Markets
New Existing
Securities Securities
Cash Cash
Corporation Investor A Investor B
Definition First time offering securities Existing securities are offered
Beneficiary Corporation Investors
1. Issuing Corporation Investors buy and sell amongst

Transaction
2. Investment Bank (Origination) each other via investment
Stakeholders
3. Institutional Investors banks that are broker/dealers

1. Freshness Of Securities …
Financial Markets
Primary Markets Secondary Markets
New Existing
Securities Securities
Cash Cash
Corporation Investor A Investor B
Investment Bank, Origination Investment Bank, Sales & Trading

Intermediary
Initial Public Offering (IPO) Existing securities are offered
Products Traded Follow-on Public Offering (FPO)
Selling Frequency One-time event Ongoing trading among investors
Corporation sells shares to Supply and demand sets price

Price
investors at fixed price

2) Nature of Claim
Debt •
•
Debt securities are traded in debt market
Debt Claims are the most commonly traded security.
• Debt Securities can be short term or long term
Market • Examples are treasury bills, bonds or mortgages
• The most common equity security is stock or

Equity share
• Equity security makes the buyer owner of the
issuer’s enterprise.
Market • Equity securities entitles the holder to earn
dividend, and held primarily to be sold and resold

BASIS FOR COMPARISON DEBT EQUITY
Meaning Creditors can only claim the Equity is sharing the

loaned amount plus the ownership of the company
interest
Cost of Capital Fixed Variable
Voting rights No voting rights Has voting rights
Income Interest Dividend
Profit sharing No. Yes
When the holders are paid? Irrespective of earning profit When the company makes
profit
Time of payment Paid first Paid last

3) Maturity of Claims
Money • Markets in which only short-term securities are

traded
Market
Capital • Markets in which longer term debt securities are
traded.
Market
Basis for Comparison Money Market Capital Market
Types of instruments T-bill, CD, Cp Bonds and stocks

Liquidity of the market More liquid Comparably less liquid
Maturity period Up to 1 year Long term maturity
Risk factor Low risk High risk
To fulfills short-term credit To fulfills long-term credit
Purpose
needs of the business needs of the business

4) Timing of claim
Spot Market Future Market
Delivery of underlying asset Immediate delivery. Delivery on designated,
later, date
Price influence Volatility and market More factors
sentiment
Parties involved Buyers and sellers Buyers, sellers and
intermediaries
Counterparty risk Low risk High risk
Capital required High capital required Low Capital required
Settlement time Settlement made Pre-defined price at a
immediately (T+2) specified time in the
future
5) Structure of Market
• A centralized platform where buyers and sellers can

Securities trade securities
Exchange • Operates according to pre-established rules and
regulations.
• Securities are traded with out centralized trading

location
Over- • Geographically dispersed dealers are linked by
the- electronic network.
• Securities that aren't listed on an exchanges are
Counter traded here.

5) Structure of Market

1.7. Financial Institutions & Their Functions

Financial Institutions
Financial intermediaries help to bring together those who have
money (savers) and those who need money (borrowers).
Savers/
Financial BORROWERS/
Investors Institutions Issuers

Functions of Financial Institutions
• Indirect finance involves a financial intermediary that stands

between the lender-savers and the borrower-spenders
• The Functions of Financial Intermediation
• Asset transformation
• Maturity transformation
• Liquidity transformation
• Reducing information asymmetry
• Reducing transaction costs /Economies of scale

Function of Financial
Institutions: Indirect Finance
1. Asset transformation
▪ FI can reduce the exposure of investors to risk, through a
process known as risk sharing
▪ FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from another
party
▪ This process is referred to as asset transformation,

because in a sense risky assets are turned into safer
assets for investors

2. Maturity & Denomination Intermediation

➢ FIs can better bear the risk of mismatching
the maturities of their assets and liabilities
➢ FIs such as mutual funds allow small investors
to overcome constraints to buying assets
imposed by large minimum denomination
size.

3) Liquidity Service
• FI provide their customers with liquidity
services, services that make it easier for
customers to conduct transactions
1. Banks provide depositors with checking accounts
that enable them to pay their bills easily
2. Depositors can earn interest on checking and
savings accounts and yet still convert them into
goods and services whenever necessary

4. Reducing Information asymmetry

▪ Another reason FIs exist is to reduce the impact of
asymmetric information.
▪ One party lacks crucial information about another party,

impacting decision-making.
▪ This problem is usually discussed along two fronts: adverse

selection and moral hazard.

5. Reducing Monitoring Costs

▪ Aggregation of funds in an FI provides greater
incentive to collect a firm’s information and
monitor actions.
▪ The relatively large size of the FI allows this
collection of information to be accomplished
at a lower average cost (economies of scale)

1.8. Classification of Financial Institutions

Classification of Financial Institutions
• The main function of financial institutions is intermediation to channel

funds from savers/surplus funds/ to users /deficit units/.
• Financial institutions can be classified as:
1. Depository institutions
2. Contractual Saving Institutions
3. Investment Intermediaries

Classification of FI
Commercial Banks
Depository Saving or Thrift
Institutions Institutions
Credit Union
Financial Contractual
Pension
Funds
Institution Saving
Institution Insurance
Companies
Non Depository Finance
Institutions Companies
Investment Investment
Intermediaries Funds
Investment
Banks

Roles of Depository Institutions
• Depository institutions accept deposits from surplus units and
provide credit to deficit units through loans and purchases of
securities.
• Roles of depository institutions.
▪ Offer deposit accounts
▪ Repackage funds received from deposits to provide loans
▪ Accept the risk on loans provided.
▪ Have more expertise than individual surplus units in evaluating the
creditworthiness of deficit units.
▪ Diversify their loans among numerous deficit units

Non Depository Institutions
• Non-depository institutions generate funds from sources other

than deposits but also play a major role in financial intermediation.
• Types of non-depository institutions
1. Finance companies
2. Investment banks investment intermediaries
3. Mutual funds
4. Insurance companies
5. Pension funds contractual institutions

Roles among Financial Institutions

1.9. Classification of financial instruments

Classification of financial instruments
• A financial instruments are documents representing a legal agreement

involving any kind of monetary value.
– Are evidence of an ownership interest in an entity or a contractual right to
receive or deliver in the form of currency
• Financial instruments of securities can be divided into:

1. Money market securities
2. Capital market securities
3. Derivatives

Major Money Market Securities
Securities Issued By Common Investors Common Market
Maturities Activities
1. Treasury bills Federal government Households, firms, 4 weeks, 13 High
and financial weeks, 26
institutions weeks, 1 year
2. Negotiable Large banks and Firms 2 weeks to 1 Moderate
certificates of deposit savings institutions year
(NCDs)
3. Commercial paper Bank holding Firms 1 day to 270 Low
companies, finance days
companies, and other
companies
4. Repurchase Firms and financial Firms and financial 1 day to 15 days Non-existent
agreements institutions institutions

Capital Market Instruments
• Capital market securities are commonly issued to finance the

purchase of capital assets, such as buildings, equipment, or
machinery.
• The three common types of capital market securities are:
1. Stocks/equity
2. Bonds
3. Mortgages

Derivative Securities
• Derivative securities are financial contracts whose values are

derived from the values of underlying assets.
• Purpose:
1) Speculation Derivative securities allow an investor to speculate on
movements in the value of the underlying assets without having to
purchase those assets.
2) Risk Management Derivative securities can be used in a manner that
will generate gains if the value of the underlying assets declines.

Four Types of Derivative Contracts
1. A futures contract is a contract to buy (or sell) a specified amount of a
commodity or financial instrument at a price determined today for delivery or
payment at a future date. Futures contracts are standardized contracts that are
traded through a futures exchange.
2. A forward contract is similar to a futures contract but is typically more flexible
and is negotiated over the counter with a commercial bank or investment
bank.
3. An option contract gives the buyer of the option the right—but not an
obligation—to buy (or sell) the designated asset at a specified date or within a
specified period during the life of the contract, at a predetermined price.
4. A swap contract is an arrangement to exchange specified future cash flows.

1.10. The Central Bank & Monetary Policy

Monetary and Fiscal Policy
Adjusting interest rates (to control inflation)

Monetary and the money supply to manage fluctuations
in economic activity. Monetary policy is often
Policy the responsibility of a country’s Central Bank.
Governments attempt to manage fluctuations

Fiscal in economic activity through taxation and
expenditure. These measures are known as
Policy stabilisation policies categorised as fiscal
policy.

The Central Bank and Monetary policy
The central banks are the government authorities in charge of monetary policy.
Central banks’ actions affect:
Interest rates The amount of credit The money supply
To understand the conduct of monetary policy, we need to understand the role that the central bank
plays in financial markets and the overall economy.

C o m m e r c i a l B a n k s I n v e s t m e n t B a n k s C e n t ra l B a n k s
Activities: Activities: Activities:
Provides credit cards for Advise businesses wanting to
borrow money in bond Provides a depositors’ protection scheme
customers
markets (debt)
Provides personal loans for Issues notes and coins
customers Advise businesses wanting to
issue shares (equity) Acts as a banker to the banking system i.e.
Currency exchange for Commercial banks
people travelling Advise businesses on strategy
and growth (Mergers and Acts as a banker to the government
Mortgage lending for people acquisitions)
to buy homes Regulates the domestic banking system
Advise businesses on strategy
and growth (Mergers and
Provides savings and current Influences the value of a nation’s currency
acquisitions)
accounts for individuals
Sets the official short-term rate of interest (base
Arranges overdraft facilities Buy and sell financial assets to
or bank rate)
for customer accounts make a profit
Manages the national debt
Controls the money supply

Goals of
Monetary Policy
1. Exchange rate stability

2. Price stability
3. Stabilization of income
4. Full employment
5. Economic growth
How does Monetary Policy Work?
By adjusting the supply of money in the nation, the central bank

can speed up the economy or slow it down.
To get out of a recession, the bank encourages people to spend by

increasing the money supply.
To stop inflation, the central bank discourages people from

spending by decreasing the money supply.

Monetary
Policy Tools
T H R E E TO O L S O F T H E C E N T R A L B A N K S :
1. Reserve Requirement
2. Discount Rate
3. Open-Market Operations
Monetary Policy Tools
1) Reserve Requirement
Reserve Requirement Money Supply
Reserve Requirement Money Supply

2) Discount Rate
• It is the rate at which the central bank lends money to banks.
• By either lowering or raising the interest rate they charge the banks, they
can influence the interest rate that banks charge their customers.
• When the central bank raises the rate, the commercial banks
increase their interest, and less people get loans
• When the central bank lower the rate, the commercial banks also
lower their interest rates, and more people get loans

• Discount Rate Money Supply
• Discount Rate Money Supply

When the government buys and sells bonds.

3) Open Market Operation Selling bonds takes money out of circulation
Buying bonds puts money back into circulation

Selling Bonds Money Supply
Buying Bonds Money Supply

Monetary Policy Strategy: Targeting Framework
1. Intermediate Targets 2. Operating Targets
• Are variables that the central bank
controls directly with monetary policy
Include financial
variables (money tools
supply or short-term – that are closely related to intermediate
interest rates) that help
targets.
to achieve goals.
• Examples of operating targets include
non-borrowed reserves.
Enable the central bank
to have a better chance
of reaching goals which
are not directly under
its control.

Thank you!

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Fundamentals of Financial Markets

50 Hours Short-Term Training

INTRODUCTION TO THE FINANCIAL SYSTEMS

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

A financial Financial System

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office 8

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

• Financial markets: markets where people and firms trade two

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

6) Reduction in Transaction Costs and information

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

Freshness of securities Primary market Secondary market

Nature of claim Debt market Equity market

Maturity of claim Money market Capital market

Timing of claim Spot/cash market Futures market

Organizational structure Exchange traded market OTC market

AAU, School of Commerce, Capital Market Project Office

Primary Markets Secondary Markets

Corporation Investor A Investor B

Definition First time offering securities Existing securities are offered

Beneficiary Corporation Investors

1. Issuing Corporation Investors buy and sell amongst

AAU, School of Commerce, Capital Market Project Office

Primary Markets Secondary Markets

Corporation Investor A Investor B

Investment Bank, Origination Investment Bank, Sales & Trading

Selling Frequency One-time event Ongoing trading among investors

Corporation sells shares to Supply and demand sets price

AAU, School of Commerce, Capital Market Project Office

• The most common equity security is stock or

AAU, School of Commerce, Capital Market Project Office 31

Meaning Creditors can only claim the Equity is sharing the

AAU, School of Commerce, Capital Market Project Office

Money • Markets in which only short-term securities are

Types of instruments T-bill, CD, Cp Bonds and stocks

AAU, School of Commerce, Capital Market Project Office

• A centralized platform where buyers and sellers can

• Securities are traded with out centralized trading

AAU, School of Commerce, Capital Market Project Office 36

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

AAU, School of Commerce, Capital Market Project Office

• Indirect finance involves a financial intermediary that stands

AAU, School of Commerce, Capital Market Project Office