CHAPTER 1

INTRODUCTION TO THE FINANCIAL SYSTEM

1 of 18
 Brain storming questions

 What is market?
 What are financial assets, Financial
instruments, Financial securities?
 What is Financial Market?
 What is financial institutions and
intermediaries?
 What are the Category of financial
Instruments?
 What is risk and as well as financial risk?
2 of 18
 Contents
 The role of financial resources in the
economy
 Characteristics of financial assets
 The role and type of financial markets
 The role and type of financial institutions
 Financial asset innovation

3 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
 1.1 The role of financial resources

 transfer funds from surplus units to deficit

units
 redistribute the unavoidable risk associated
with the cash flow generated by tangible
assets among the deficit units and surplus
units.

4 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.2 Characteristics of financial assets
 Moneyness-used as a medium of exchange
 Divisibility & denomination-denominated
in smaller sizes
 Reversibility-ability to be converted back
to cash at a lower cost(low round trip cost)

5 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.2 Characteristics of financial assets
 Term to maturity-length of time between
when the instrument is issued and its
liquidation.
 Some instruments are liquidated upon
demand by the creditor
 Instruments may be issued with the term of
a few days to so many years. Eg. T.bill Vs
Bonds
 instruments may be liquidated prematurely
6 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.2 Characteristics of financial assets
 Liquidity-can be resold without substantial
loss of value.
 liquidity differs based on the issuer‘s identity
the degree of market capitalization.(thin/tick)
 Convertibility-ability to be converted into
other financial assets
 Currency- are denominated in a certain
currency.
7 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
 1.2 Characteristics of financial assets

 Cash flow and return predictability-

return on a financial asset depends on the
cash flow expected to be received
 Complexity- some financial assets may
be combinations of two or simpler assets.
 Tax status-financial assets have different
tax status.
8 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.3 The role and type of financial markets
The role of financial markets
Eliminate arbitrage i.e. buying and selling
simultaneously in different market.
Raising capital
 Commercial transactions- financial
markets provide the grease that makes
many commercial transactions possible

9 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.3 The role and type of financial markets
The role of financial markets
 Investing- provide an opportunity to earn
a return on funds that are not immediately
needed
 Risk management- futures, options and
other derivatives contracts can provide
protection against many types of risk

10 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.3 The role and type of financial markets
Classification of financial markets
 Money markets and Capital markets
 Primary and secondary market
 Fixed claim and residual claim markets

11 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.4 The role and type of financial
Institutions
The role of financial Institutions
 Maturity intermediation- they create loans
of long term maturity out of deposits that
mature in the short term.
 Risk reduction through diversification-they
diversify risk by investing in different
sectors of the economy.

12 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.4 The role and type of financial
Institutions
The role of financial Institutions
 Reducing the cost of contracting and
information processing-they are better
equipped in completing contracts and
processing information
 Providing a payment mechanism-enable
individuals and businesses to effect
payments using checks, credit cards, debit
cards, and through electronic transfer.
13 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.4 The role and type of financial
Institutions
Types of financial Institutions
 Deposit taking institutions
 Commercial Banks
 Saving and Loan Associations
 Microfinance Institutions
 Non-deposit taking institutions
 Insurance companies
 Mutual funds
 Pension funds
 Investment Banks
14 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.5 Financial asset innovation
Types of financial Innovations
FI: is process of creating new financial
products, services or strategies. Categorized as:
 Market broadening instruments
 Risk management instruments
 Arbitrage instruments

15 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.5 Financial asset innovation
 Market broadening instruments
increase market liquidity and availability
of funds by attracting new investors and
offering new opportunities for borrowers
E.g:- Mortgage backed securities.
 Risk management instruments-reallocate
financial risk to the less risk averse, who have
offsetting position and thus have the ability to
shoulder them e.g. derivative instruments.
16 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.5 Financial asset innovation
Arbitraging instruments and processes
• Arbitrage is simultaneous purchase and sale of
an asset to profit from imbalance in the price.
Used as a result of market inefficiency.
• enable traders to take advantages of
difference in the costs and returns between
markets.

17 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
1.5 Financial asset innovation
Drivers of financial innovation
 endeavor to circumvent regulations and find
loopholes in tax rules.
 a need to efficiently redistribute risks among
market participants
 Increased volatility of interest rate, inflation
and equity prices and exchange rates
 advances in computer and communication
technologies
18 of 18
Capital Market: By Dagnu L. (PhD) 1/6/21
 End of Chapter 1

19 of 18