Overview of The Financial System: All Rights Reserved

CHAPTER 2
Overview of the
Financial System
Copyright © 2012 Pearson Prentice Hall.

All rights reserved.
Chapter Preview
 Suppose You want to start a business

manufacturing a household cleaning robot, but
he has no funds.
 At the same time, your friend has money he
wishes to invest for his future retirement.
 If the two of you could get together, perhaps
both of your needs can be met. But how does
that happen?
© 2012 Pearson Prentice Hall. All rights reserved. 2-2

Chapter Preview
 Financial markets and financial intermediaries
have the basic functions of getting you and your
friend together by moving funds from those who
have surplus funds (your friend) to those who
have a shortage of funds (You).
 More realistically, when Apple invents new iPod,
it required funds to bring the product to market.
 Similarly, when Govt. need to build flyover, it
also need funds.

Chapter Preview
 As simple as this example is, it highlights the

importance of financial markets and financial
intermediaries in our economy.
 We need to acquire an understanding of their
general structure and operation before we can
appreciate their role in our economy.

Chapter Preview
In this chapter, we examine the role of the financial
system in an advanced economy. We study the
effects of financial markets and institutions on the
economy, and look at their general structure and
operations. Topics include:
─ Function of Financial Markets
─ Function of Financial Intermediaries: Indirect Finance
─ Structure of Financial Markets
─ Internationalization of Financial Markets
─ Types of Financial Intermediaries
─ Regulation of the Financial System

Function of Financial Markets
 Financial markets and institutions

channels funds from person or business
without investment opportunities (i.e.,
“Lender-Savers”) to one who has them
(i.e., “Borrower-Spenders”)
 Improves economic efficiency

Financial Markets Funds Transferees

Segments of Financial Markets
1. Direct Finance
2. Indirect Finance

Function of Financial Markets

Importance of Financial Markets
 Functioning of financial market is very much
important for the growth of the economy. For
example, if you save 10,000, but there are no
financial markets, then you can earn no return
on this—might as well put the money under
your mattress.
 However, if a carpenter could use that money
to buy a new saw (increasing her productivity),
then she’d be willing to pay you some interest
for the use of the funds.

Importance of Financial Markets
 Financial markets are critical for producing an

efficient allocation of capital, allowing funds to
move from people who lack productive
investment opportunities to people who have
them.
 Financial markets also improve the well-being
of consumers, allowing them to time their
purchases better.

Functions of the Financial
Markets
 Person A is having a powerful idea and
Person B is having surplus funds.
 The Role or function of the financial
markets (bonds and Stock markets) is get
people like A and B together.
 This requires flow of funds from savers to
borrowers.
 This flow can occur in two ways; Direct
Finance and Indirect finance route.
Segments of Financial Markets
1. Direct Finance
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are
claims on the borrower’s future income or assets.
• Ex. IBM issue a new bond.
2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable
funds and loan opportunities) by issuing financial
instruments which are claims on the borrower’s future
income or assets.
• Ex. Bank issue Term deposits

A Recapitulations of last Class
 In last class we discussed following topics
─ Exchange rate market fluctuation and its
impact on consumer, producer and investors.
─ Discussed the question, why we need to
study banks and financial institutions, money
and monetary policy, money and inflation,
money and interest rate.
─ Started the 2nd Chapter which addressed
Overview of financial system.

Direct and Indirect Finance
 Direct Finance: Borrowers borrow funds
directly from the lenders in the financial
markets by selling them securities
(financial instruments), which are claims
on the borrower’s future income or
assets.
 Securities are assets for the person who
buys them but liabilities to the person or
firms that sells or issue them.
Direct and Indirect Finance
 Indirect Finance: Borrowers borrow
funds through financial
intermediaries(banks, insurance
companies, pension funds) in the form
of loans and deposits.
 Banks issue a liability(saving deposits,
time deposits etc) use these funds to
acquire an asset by a loan to Honda
motors or by buying Honda motors
bonds in the financial markets.
Why this channeling of Funds so
important for the economy?
 Financial markets are essential to
promote economic efficiency.
 Financial markets are essential to
increase production
 Financial markets are helpful to fulfill you
dreams.
 Financial markets enhance
entrepreneurial development and national
welfare
Unique Economic Functions of
Financial Intermediaries/Institutions
 Financial intermediaries also do the function of

connecting people for investments.
 What are the advantages of indirect financing?
 Financial intermediaries are important as it;
 Borrow short and lend Long
 Reduces transaction costs
 Enables risk sharing
 Removes information costs and moral hazards.

Function of Financial
Intermediaries/Institutions
 Borrow short and lend Long:

─ Banks match the savers who wants to save
for shorter time period with borrowers with
for longer time period.
─ Problem of liquidity risk management.
─ Bank can pool small amount of saving for a
big amount of loan.

 Transactions Costs
1. Financial intermediaries make profits by
reducing transactions costs
2. Reduce transactions costs by developing
expertise and taking advantage of
economies of scale

• A financial intermediary’s low transaction

costs mean that it can provide its 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

 Another benefit made possible by the FI’s low

transaction costs is that they can help 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
© 2012 Pearson Prentice Hall. All rights reserved.

2-23
2-23
Asymmetric Information:
Adverse Selection and Moral Hazard
 The presence of transaction costs in the

financial markets explain partly why the
financial intermediaries are so important.
 Additionally, in the financial market one
party has less knowledge about other
while investing.
 This inequality is called asymmetric
information.
 Asymmetric information: one party does
not know enough about other party to
make accurate decisions.
 For and example; Borrower and a lender.
 Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce
adverse outcome are ones most likely to
seek loan and be selected (Bad Credit Risk)

2-25
2-25
 Moral Hazard
1. Problem created by asymmetric information
after transaction occurs
2. Moral hazard is the risk (Hazard) that
borrower has incentives to engage in
undesirable (immoral) activities making it
more likely that won't pay loan back
3. This may be explained as the conflict of
interest.

2-26
2-26
 With the intermediaries in the market,
small savers can provide their funds to
trustworthy FIs and share risk.
 FIs have better method of screening out
bad credit risk from good credit risk and
avoid adverse selections.
 FIs have expertise to monitor the parties
they lend to and reduce moral hazards.

A Recapitulations of last Class
 Financial markets and Financial intermediaries
do the function of connecting people with users
of funds and sources of funds
 Direct and Indirect Finance
 Unique Functions of FIs;
 Borrow short and lend Long
 Reduces transaction costs
 Enables risk sharing
 Removes information costs and moral hazards.

STRUCTURE OF FINANCIAL MARKETS
Structure of Financial Markets
 Several categorization of financial
markets illustrate essential features of
Financial Markets.
 Debt and Equity markets.
 Primary and Secondary Markets
 Money and Capital Markets
 Internationalization of the Financial Markets.

Debt and Equity Markets
 A firm or individual can obtain funds in a
financial markets in two ways; issue of
bonds or issue of equities.
 Bonds: A contractual agreement by the
borrower of the fund to pay the holder of
the instrument fixed amount of interest
payments at regular interval until a
specified time (maturity period).

 Features of the Bond;
 Periodic payment / Coupon Payment. (coupon
rate x face value)
 Principal amount/ Par Value of the bond/ Face
value of the Bond
 Maturity of the Bond
─ Financial instrument dies. Bond become
payable by the issuer. Life of the Bond.

 Equity: Claims to the share in the net income

(income after expenses and taxes) and the
assets of a business.
 If you hold one share in a company who has
issued 100 shares, you are entitled to get 1% of
the firm’s net income and 1% of the firm’s
assets. You are also entitled for periodic
payments of dividends. You have right to vote in
electing the board members.

 The equity holders are the residual

claimants; the corporation must pay the
bond holders first before paying to the
equity holders.
 The equity holders directly get
advantages from any increase in the
corporation’s profitability or asset values.

Characteristics of Debt Markets
Instruments
 Debt instruments
─ Buyers of debt instruments are suppliers (of
capital) to the firm, not owners of the firm
─ Debt instruments have a finite life or maturity
date
─ Advantage is that the debt instrument is a
contractual promise to pay with legal rights to
enforce repayment
─ Disadvantage is that return/profit is fixed or
limited

2-36
2-36
Characteristics of Equity Markets
Instruments
 Equity instruments (common stock / share is most
prevalent equity instrument)
─ Buyers of common stock are owners of the firm
─ Common stock has no finite life or maturity date
─ Advantage of common stock is potential high
income since return is not fixed or limited
─ Disadvantage is that debt payments must be
made before equity payments can be made
(residual claimants).

2-37
2-37
Primary and Secondary Markets
 A primary market is a financial market in
which new issues of a security such as
bond or stocks are sold to initial buyers by
the corporations or Government.
 Secondary markets deals with securities
that previously issued. These securities are
resold in these markets.

2-38
2-38
 The public does not know the primary
markets for securities as the transactions
are done behind closed doors.
 The Investment Banks assist an initial
sale of securities in the primary markets.
 It does this by underwriting securities.
 It guarantees a price for a corporation’s
security and then sale them to the public.
2-39
2-39
 When an individual buys securities in the

secondary market, the corporation
acquires no new funds.
 A corporation gets new funds when its
securities are first sold in the primary
markets.
 Nonetheless, the functioning of the
secondary market is very important

2-40
2-40
 Brokers are the agents of investors who
match buyers with sellers of securities
 Dealers link buyers and sellers by buying
and selling securities at stated prices

2-41
2-41
Functioning of the Secondary
Markets
 Secondary markets make the financial
instruments more liquid.
 They determine the price of the securities
those are issuing firms sale in the primary
markets.
 So, condition in the secondary market
enhances the credibility of the corporations.
 Hence, we will focus more on the functioning
of the secondary markets.

2-42
2-42
Money and Capital Markets
 Another ways to distinguish between
markets is on the basis of the maturity of
the securities traded in each markets.
 The money market is the financial market
in which only short term debt instruments
are traded.
 The Capital market in the market is which
long term debt and equities are traded.

2-43
2-43
Money Market
 Money market is a financial market where money market
instruments are traded.
 Money market instruments are the financial instruments
of short term maturity or is a short term financial
instruments.
 In Finance, short term means; ONE Year or LESS
 Short-term money market instruments such as
treasury bills, Certificates of Deposit (CDs),
commercial paper and bills of exchange, which have
a maturity of up to 12 months.

Capital Market
 Capital Market is where capital market instruments are

traded.
 Capital market instruments whose maturity is more than
one year.
 Capital market instruments include stocks and bonds,
treasury bills (more than one year) , foreign
exchange, fixed deposits, debentures, etc. As they
involve debts and equity securities, the instruments are
also called securities, and the market is referred to as
securities market.

Money and Capital Market
 The following points are substantial, as far as the difference
between money market and capital market is concerned:
─ The place where short-term marketable securities are
traded is known as Money Market. Unlike Capital Market,
where long-term securities are created and traded is
known as Capital Market.
─ Capital Market is well organized which Money Market
lacks.
─ The instruments traded in money market carry low risk,
hence, they are safer investments, but capital market
instruments carry high risk.
─ The liquidity is high in the money market, but in the case
of the capital market, liquidity is comparatively less.

Money and Capital Market
─ The major institutions that work in money market are the
central bank, commercial bank and non-financial
institutions. On the contrary, the major institutions which
operate in the capital market are a stock exchange,
commercial bank, non-banking institutions etc.
─ Money market fulfils short-term credit requirements of
the companies such as providing working capital to
them. As against this, the capital market tends to fulfil
long-term credit requirements of the companies, like
providing fixed capital to purchase land, building or
machinery.
─ Capital Market Instruments give higher returns as
compared to money market instruments.
International Financial Market
 The international Financial market is a
network of individuals, companies, financial
institutions, and governments that invest
and borrow across national boundaries.
 Large international banks gather excess
cash of investors and savers around the
world and then channel it to global
borrowers

 Expanding the Money Supply for Borrowers
─ Companies unable to obtain funds from
investors in the domestic market seek
financing in the international capital market.
 Reducing the Cost of Money for Borrowers
─ An expanded money supply reduces the cost
of borrowing. The “price” reflects supply and
demand. Excess funds create a buyer’s
market, forcing interest rates lower.

Forces Expanding the
 Information Technology: Reduces time and money
needed to communicate globally. Electronic trading
after close of formal exchanges facilitates fast
response times.
 Deregulation: Increases competition, lowers cost of
financial transactions, and opens many national
markets to global investing and borrowing.
 Financial Instruments: Increased competition is
creating the need to develop innovative financial
instruments.

World Financial Centers
 Three most important financial centers are London, New York,
and Tokyo.
 Offshore Financial Centers Country or territory where financial
sector features few regulations and few, if any, taxes. They:
 (1) are economically and politically stable;
 (2) are advanced in telecommunications;
 (3) offer large amounts of funding in many currencies; and
 (4) provide a less costly source of financing.

MAIN COMPONENTS OF THE
INTERNATIONAL FINANCIAL MARKET
 International Bond Market
 International Equity Market
 Eurocurrency Market

International Bond Market
Market of bonds sold by issuing companies,
governments, and others outside their own countries
Eurobond Foreign bond Interest rates
Bond that is issued Bond sold outside a Driving growth are

outside the country borrower’s country differential interest
in whose currency and denominated in rates between
the bond is the currency of the developed and
denominated country in which it is developing nations
sold
Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 9 - 54

TYPES OF BONDS
• A Eurobond is issued outside the country in whose currency it is
denominated. For example, a bond issued in Venezuela in dollars
and sold in Britain, France, and Germany is called a Eurobond.
• A foreign bond is sold outside the borrower’s country and
denominated in the currency of the country in which it is sold. For
example, a yen-denominated bond issued by German carmaker
BMW in Japan’s bond market is called a foreign bond.
• Interest rates are driving growth in the international bond market.
Borrowers in emerging economies seek to borrow money in
developed nations where interest rates are lower, and investors in
developed nations seek to buy bonds of companies in emerging
economies to earn higher rates of return.

Internationalization of Financial
Markets
 Foreign bond: foreign bonds are sold in the
foreign country and are denominated in that
countries currencies
 EX. German auto maker issue a bond in US
denominated in Dollar
 Eurobond: A bond denominated in a
currency other than that of the country in
which it is sold. ( a bond denominated in
dollar and sold in London)
2-56
2-56
Internationalization of Financial
Markets
 The new currency called “Euro” create some
confusion regarding the above concepts. (euro
bond, Euro currencies)
 A bond denominated in Euro is called
Eurobond only when it is sold outside countries
that have adopted the euro as currency.
 In fact most Eurobonds are denominated in
dollars rather than Euro.

2-57
2-57
International Equity Market
 Consists of all stocks bought and sold outside the

issuer’s home country. Companies and governments
issue equity and buyers include other companies, banks,
mutual funds, pension funds, and individuals.
 Spread of Privatization
 a. A single privatization often places billions of dollars of
new equity on stock markets.
 b. Increased privatization in Europe is expanding
worldwide equity. European Union integration has made
investors willing to invest in stocks from other European
nations.

International Equity Market
 2. Economic Growth in Developing Countries
─ a. Growth in newly industrialized and developing countries
contributes to growth in the international equity market.
─ b. Because of a limited supply of funds in emerging economies,
the international equity market is a major source of funding.
 3. Activity of Investment Banks
─ a. Investment banks facilitate the sale of stock worldwide by
bringing together sellers and large potential buyers.
─ b. Becoming more common than listing a company’s shares on
another country’s stock exchange.
 4. Advent of Cyber markets
─ a. Stock markets that have no central geographic location, but
consist of online global trading activities that allow listing of stocks
worldwide for electronic 24-hour trading.

Eurocurrency Market
 All the world’s currencies banked outside their countries

of origin are called Eurocurrency and trade on the
Eurocurrency market (e.g., U.S. dollars in Tokyo are
called Eurodollars. British pounds in New York are called
Europounds). Characterized by large transactions
involving only the largest companies, banks, and
governments.
 Four Sources of Deposits: • Governments with excess
funds from prolonged trade surplus. • Commercial banks
with excess currency. • International companies with
excess cash. • Extremely wealthy individuals.

Types of Financial
Intermediaries
 Commercial Banks
 Non-banking financial Companies
(NBFC)
 Mutual Funds
 Insurance companies

2-61
2-61
Depository Institutions (Banks)
 Commercial banks
─ Raise funds primarily by issuing checkable,
savings, and time deposits which are used
to make commercial, consumer and
mortgage loans
─ Collectively, these banks comprise the
largest financial intermediary and have the
most diversified asset portfolios

2-62
2-62
NBFC
 Consumer Finance Companies

 Housing Finance Companies
 Venture Capital funds
 Merchant banking organizations
 Credit rating agencies
 Stock broking firms

2-63
2-63
Mutual Funds
 A mutual fund is a special type of
investment institutions.
 It pools the savings of relatively small
investors and invest them in a well
diversified sound investment.
 Mutual funds issue securities to the
investors and profits are shared by the
investors

2-64
2-64
Mutual Funds
 A Mutual fund is set up in the form of trust
which has
 A sponsor, trustee, asset management
company and a custodian
 Money Market Mutual Funds acquire
funds by selling checkable deposit-like
shares to individual investors and use the
proceeds to purchase highly liquid and
safe short-term money market
instruments
2-65
2-65

Overview of The Financial System: All Rights Reserved

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Overview of The Financial System: All Rights Reserved

Uploaded by

Copyright:

Available Formats

CHAPTER 2

Copyright © 2012 Pearson Prentice Hall.

 Suppose You want to start a business

© 2012 Pearson Prentice Hall. All rights reserved. 2-2

© 2012 Pearson Prentice Hall. All rights reserved. 2-3

 As simple as this example is, it highlights the

© 2012 Pearson Prentice Hall. All rights reserved. 2-4

© 2012 Pearson Prentice Hall. All rights reserved. 2-5

 Financial markets and institutions

 Improves economic efficiency

© 2012 Pearson Prentice Hall. All rights reserved. 2-6

© 2012 Pearson Prentice Hall. All rights reserved. 2-7

© 2012 Pearson Prentice Hall. All rights reserved. 2-8

© 2012 Pearson Prentice Hall. All rights reserved. 2-9

© 2012 Pearson Prentice Hall. All rights reserved. 2-10

 Financial markets are critical for producing an

© 2012 Pearson Prentice Hall. All rights reserved. 2-11

© 2012 Pearson Prentice Hall. All rights reserved. 2-13

© 2012 Pearson Prentice Hall. All rights reserved. 2-15

 Financial intermediaries also do the function of

© 2012 Pearson Prentice Hall. All rights reserved. 2-19

 Borrow short and lend Long:

© 2012 Pearson Prentice Hall. All rights reserved. 2-20

© 2012 Pearson Prentice Hall. All rights reserved. 2-21

• A financial intermediary’s low transaction

© 2012 Pearson Prentice Hall. All rights reserved. 2-22

 Another benefit made possible by the FI’s low

© 2012 Pearson Prentice Hall. All rights reserved.

 The presence of transaction costs in the

© 2012 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson Prentice Hall. All rights reserved. 2-27

© 2012 Pearson Prentice Hall. All rights reserved. 2-29

© 2012 Pearson Prentice Hall. All rights reserved. 2-31

© 2012 Pearson Prentice Hall. All rights reserved. 2-32

© 2012 Pearson Prentice Hall. All rights reserved. 2-33

 Equity: Claims to the share in the net income

© 2012 Pearson Prentice Hall. All rights reserved. 2-34

 The equity holders are the residual

© 2012 Pearson Prentice Hall. All rights reserved. 2-35

© 2012 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson Prentice Hall. All rights reserved.

 When an individual buys securities in the

© 2012 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson Prentice Hall. All rights reserved. 2-44

 Capital Market is where capital market instruments are

© 2012 Pearson Prentice Hall. All rights reserved. 2-45

© 2012 Pearson Prentice Hall. All rights reserved. 2-46

© 2012 Pearson Prentice Hall. All rights reserved. 2-48

© 2012 Pearson Prentice Hall. All rights reserved. 2-49

© 2012 Pearson Prentice Hall. All rights reserved. 2-50

© 2012 Pearson Prentice Hall. All rights reserved. 2-51

© 2012 Pearson Prentice Hall. All rights reserved. 2-53

Eurobond Foreign bond Interest rates

Bond that is issued Bond sold outside a Driving growth are

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 9 - 54

© 2012 Pearson Prentice Hall. All rights reserved. 2-55

© 2012 Pearson Prentice Hall. All rights reserved.

 Consists of all stocks bought and sold outside the