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CHAPTER ONE FINANCIAL SYSTEM

1. INTRODUCTION
For a company, it is crucial to raise capital 1 in order to finance their projects. The main financial sources2 available for a firm are: y y y Its own capital. From financial markets (stock, bonds) From financial institutions (banks with debt)

The financial system is the system that allows the transfer of money between savers and borrowers. It includes a set of complex and closely interconnected financial institutions, markets, instruments, services, practices and so on: A commercial demand for financing, leads to the creation and development of financial markets. The economic agents with excess of financial resources (the investors) will offer their capital towards 3 economic agents that require financial resources (the firms) in exchange of a financial compensation (an interest rate). The instruments for such transfer of capital are called Financial Assets.

Then, there are two agents: the savers (agents with surplus) who desire obtaining a profitability of their saves, and the investors, (agents with deficit) who demand for funds, and they will be willing to pay a price for the money (interest rate) 1.2. FINANCIAL ASSETS First of all, we have to know what an asset is: Is an economic resource that can be converted into cash. For example: land, stocks A financial asset is an intangible representation of the monetary value of physical items. While a real asset, such as land, has physical value, a financial asset is a document that has no fundamental value in of itself until it is converted to cash. It is an asset4 for the owner and a liability5 to the issuer. The main functions of financial assets are: y To enable6 agents with surpluses to invest part of their funds, thus7 obtaining a return8 in exchange.

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Raise Capital: Recaudar, reunir capital. Sources: Fuentes. 3 Towards: Hacia. 4 Asset: Activo 5 Liability: Pasivo 6 Enable: Permitir. 7 Thus: De este modo, as. 8 Return: Rentabilidad

y y

To enable agents with deficits to raise the funds the need for their activities. To facilitate trading on financial markets.

Common types of financial assets include certificates, bonds, stocks, and bank deposits. 1. Characteristics: y y y Liquidity: Ability to convert the asset into cash in short term without entailing9 a loss in its value. Profitability/Return: Is the income received by the owner of all the generate by the asset. Risk: Is the uncertainty over the profitability the FA is going to produce. An FA s risk may be the result of a multitude factors: - Insolvency risk: This risk is related to the possibility that the issuer (the firm) may not be able to face its obligation. - Interest rate risk: The value of certain FAs (especially fixed income assets) depends on the situation of interest rates in the economy. As a result, variations in interest rates may cause variations in the value of a FA and the profitability obtained. - Exchange rate risks: This is the risk that arises10 when the acquired11 FA is denominated 12 in a different currency from the one used by the investor. In those cases, oscillations in the exchange rate may cause oscillations in the payments derived from the FA. - Country risk: This is the risk associated with the socio-economic conditions of the country in which the FA has been issued and may affect the payments derived from the FA. 2. Classification: y By the issuer (Who issued the financial assets?) - Primary Financial Assets: These are issued by economic agents (The primary market is the financial market in which newly issued securities are offered to the public.) - Secondary Financial Assets: These are issued by financial intermediaries. (The secondary market is the financial market where previously issued securities (such as bonds, notes, shares ) and financial instruments (such as bills of exchange and certificates of deposit) are bought and sold. By return (How is the income?) - Fixed income: The returns on these assets are known in advance (treasury bills, bonds, ) - Non-fixed income: the returns on these assets are not know in advance,

Entail: Implicar. Arise: Surgir 11 Adquired: Adquirido 12 Denominated: Valorado (valor nominal)
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By negotiability (How are they traded?) - Non- Negotiable FAs: These FAs have no standardized formats and are not able to be traded on organized financial markets (e.g. some bonds) - Negotiable FAs: These FAS have a standardized format and are able to be traded on organized financial markets (e.g. Stocks, options )

1.3 FINANCIAL PARTICIPANTS


1. Government and Supervisor entities. - Banco de Espaa: Supervise credit entities and guaranties - Comisin Nacional Del Mercado Valores (CNMV) : Supervise firms, investment institutions and entity with risky capital. - Direccin General de Seguros Y Fondos de Pensiones: Supervise pension funds and insurence companies. 2. Credit entities. - Deposit/Commercial Banks vs. Saving Banks - Credit co-operatives - Instituto de Credito Oficial - Sociedades de Garanta reciproca 3. Investment entities. y Direct transaction (primary market) Investment Services Firms. - Market makers - Dealers - Brokers y Indirect transaction (secondary market) Institutional Investors. - Investment portfolio managers - Banks - Savings 4. Venture Capital (risk-capital) entities. y Capital to be invested on enterprises that are too risky for the standard capital markets or bank loans. y Attractive for new companies that are too small to raise capital in the public markets and are too immature to secure a bank loan or complete a debt offering. y In exchange for the high risk, venture capitalists usually get significant control, and or a portion of the company s value. 5. Insurance companies. y A business that provides coverage, in the form of compensation resulting from loss, damages, injury or hardship 13 in exchange for premium14 payments. The company calculates the risk of occurrence15 , then, determines the cost to replace (pay for) the loss to determine the premium amount.

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Hardship: Penuria econmica. Adversity or suffering. Premium: Prima. Occurrence: Incidencia.

Examples: life, property, healthy, credit.

6. Pension funds management. y A pension is an arrangement16 to provide people an income when they are no longer earning a regular income from employment because retirement, or disability in exchange of some contributions. y Funded system: defined contributions. Affected by economic problems (such as Chile) y Unfunded system: Pay as you go. Affected by demographic problems (such as Spain)

1.4 FINANCIAL MARKETS


A financial market is a mechanism that allows people to buy and sell (trade) easily financial securities (such as stocks and bonds), commodities (such as gold, oil, cotton) and other items of value at some transaction costs. The main functions of financial markets are: 1. 2. 3. 4. Trade financial assets, commodities Determine the prices of the assets. Provide liquidity to the participants. Reduce transaction costs.

The characteristics of financial markets are: y Market size: Some are very small, with only a few participants, while others like the New York Stock Exchange (NYSE) and the forex 17 markets trade trillions of dollars daily. Transparency: Information transparency is important to increase the confidence of participants and in addition foster18 an efficient financial marketplace. Freedom to enter or leave the market. Efficiency.

y y y

1.4.1 MAIN FINANCIAL MARKETS IN SPAIN y Capital Markets (Mercado de Capitales) - Public Debt Market ( Mercado de Deuda Pblica) - Fixed-Income Market (Mercado de Renta Fija) - Stock Market (Mercado Bursatil) - Derivatives market Currency Markets (Mercados Monetarios) - Interbank Market (Mercado Interbancario) - Foreign Exchange Market (Mercado de Divisas)

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Arrangement: Plan Forex: Foreign Exchange (also FX) 18 Foster: Incrementar