i a l Sy s tem

in anc
1 - Th e F
Lecture
 ia l Sy s t em
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Financial System
The Financial System

• Definition:
• Set of arrangements/conventions
• Embracing the lending and borrowing of funds by non-financial
economic units, and
• The intermediation of this function by financial intermediaries
• To:
• Facilitate the transfer of funds
• Create additional money when required
• Create markets in debt and equity instruments (and derivatives)
• So that the price and allocation of funds are determined efficiently
The Financial System

• The financial system comprises of:

• the financial markets
• financial intermediaries
• and other financial institutions
• That execute the financial decisions of households, firms/businesses
and governments
• The roles and functions and interrelationship of the elements of
the financial system both local and international:
• Performs the essential economic function of channeling funds (net
savers who spend less than their income) from those with a
surplus of funds to those who wish to borrow (net spenders who
wish to spend more than their income)
Roles and Functions of the financial system

• Acts as an intermediary between surplus and deficit economic

units
• Plays an important role in the allocation of funds to their most
efficient use amongst competing demands
• In a market system such as the South African financial system, this
allocation of funds is achieved through the price mechanism with
prices being set by the forces of supply and demand within the
various financial markets
• The financial system is global meaning that extensive international
telecommunication networks link financial markets and
intermediaries so that the trading of securities and transfer of
payments can take place 24 hours a day
Financial Intermediation and the Flow of Funds

Understand financial intermediation, financial instruments and the

flow of funds in the financial system
• The financial system has four elements:
• Lenders and borrowers
• Financial institutions
• Financial instruments
• Financial markets
• The interaction between the various components of the financial
system is shown on the next slide
Financial Intermediation and the Flow of Funds

Lenders and Borrowers

• Lenders are the ultimate providers of savings (can be referred
to as investors in that they expend cash on the acquisition of
financial assets such as bonds and shares and real or tangible
assets such as land, buildings, gold, and paintings)
• Borrowers are the ultimate users of those savings
• Both are non-financial entities and are referred to as surplus and
deficit economic units respectively
Financial Intermediation and the Flow of Funds

• Lenders and borrowers can be categorised into four sectors:

• Household (individuals and families; In South Africa it also
includes private charitable, religious and non-profit bodies as
well as unincorporated businesses such as farmers and
professional partnerships)
• Business or corporate (all non-financial firms or companies
producing and distributing goods and services)
• Government (central and provincial governments as well as
• local authorities)
• Foreign (all individuals and institutions situated in the rest of
the world)
Categories of Lenders and Borrowers in South Africa
Direct and Indirect Financing

• Direct financing:
• can only occur if lenders’ requirements in terms of risk, return
and liquidity exactly match borrowers’ needs in terms of cost
and term to maturity
• usually involves the use of a financial market broker who acts
as a conduit between lenders and borrowers in return for a
commission
• Financial intermediaries perform indirect financing by making
markets in two types of financial instruments – one for lenders and
one for borrowers
• To lenders they offer claims against themselves known as
indirect securities, tailored to the risk, return and liquidity
requirements of the lenders. In turn they acquire claims on
borrowers known as primary securities
• Thus the surplus funds of lenders are invested with financial
intermediaries that then re-invest the funds with borrowers
Financial Intermediation and the Flow of Funds

Financial Intermediaries
• Financial institutions that expedite the flow of funds from lenders to
borrowers
• Types of financial intermediaries include:
• Banks
• Insurance companies
• Pension and provident funds
• Collective investment schemes (also referred to as unit trusts
or mutual funds)
Financial Intermediation and the Flow of Funds

• Banks accept deposits from lenders and on-lend the funds to

borrowers
• Insurers and pension- and provident funds receive contractual
savings from households and re-invest the funds mainly in shares
and other securities such as bonds. In addition insurers perform
the function of risk diversification i.e. they enable individuals or
firms to distribute their risk amongst a large population of insured
individuals or firms
• Collective investment schemes pool the funds of many small
investors and re-invest the funds in shares, bonds and other
financial assets with each investor having a proportional claim on
such assets. Collective investment schemes play a risk
diversification role in that they spread the risk by investing in
number of different securities
Financial Instruments

• Financial instruments or claims can be defined as promises to pay

money in the future in exchange for present funds i.e. money
today
• Financial instruments (marketable and non-marketable), are
created to satisfy the needs of the various participants.
• They are created to satisfy the needs of financial system
participants and as a result of financial innovation in the borrowing
and financial intermediation processes, a wide range of financial
instruments and products exists
• Financial claims can be categorised as:
• Indirect or
• Primary securities
Financial Instruments

• Within these two categories financial instruments can be

characterised as marketable or non-marketable
• Marketable instruments can be traded in secondary markets,
while non-marketable instruments cannot
• To recover their investment, holders of marketable securities
can sell their securities to other investors in the secondary
market
• To recover their investment, holders of non-marketable
financial instruments have recourse only to the issuers of the
securities.
• Non-marketable claims generally involve the household sector
(retail sector) while marketable claims are usually issued by the
corporate and government sectors (wholesale sector)
Examples of the different categories of financial instruments are
shown on the following slide
Financial Instruments
Financial Markets
Financial Markets

Explain the structure and mechanics of the financial markets and

the participants and explain the concept of efficient markets and
its role in the financial system

• Financial markets can be defined as the institutional arrangements,

mechanisms and conventions that exist for the issuing and trading
of financial instruments
• A financial market is not a single physical place but millions of
participants, spread across the world and linked by vast
telecommunications networks that brings together buyers and
sellers of financial instruments and sets prices of those instruments
in the process
Financial Markets

Characteristics of a good financial market:

• Provision of timely and accurate price and volume information: Both on past
securities transactions and the prevailing supply and demand for securities
• Internal efficiency: Transaction costs as a percentage of the value of the
trade are low; even minimal
• Provision of liquidity: The degree to which a security can be quickly and
cheaply turned into cash. Liquidity requires marketability, price continuity and
market depth
• Marketability: The security’s ability to be sold quickly
• Price continuity: Prices do not change from one transaction to another in the
absence of substantial new information
• Market depth: The ability of the market to absorb large trade volumes without a
significant impact on prices i.e. there are many potential buyers and sellers willing
to trade at a price above and below the current market price
• External or informational efficiency: Securities prices adapt quickly to new
information so that current market prices are fair in that they reflect all
available information on the security
Financial Markets

Financial market participants

• There are a number of participants in financial markets:
• Borrowers: Issue securities
• Lenders (or investors): Buy or invest in securities
• Financial intermediaries: Expedite the flow of funds from lenders to
borrowers. As such they are issuers and buyers of securities and other
debt instruments
• Brokers (or agents): Act as conduits between lenders and borrowers or
buyers and sellers in return for a commission
• Financial advisors: Provide investors with recommendations, guidance
or proposals for the purchase of or investment in financial instruments.
In addition financial advisors such as investment banks provide advice
to corporate borrowers and / or issuers of securities
• Dealers (or jobbers): Buy and sell securities for their own account
Financial Markets

• Market makers: Stand ready to buy or sell certain securities at all times.
They quote both a bid and an offer price to the market and profit from the
spread between bid and offer prices as well as from changes in market
prices. Market makers adjust their bid or offer prices depending upon
positions that they hold and/or upon their outlook for changes in prices
• Hedgers: Are exposed to the risk of adverse market price movements and
mitigate the risk by using hedging instruments such as derivatives
• Speculators: Attempt to make a profit by taking a view on the market. If
their view is correct, they make profits. If their view is wrong, they make
losses
• Arbitrageurs: Attempt to make profits by exploiting inefficiencies in market
prices. They simultaneously buy securities in the market where the price
is relatively cheap and sell securities in the market where the price is
relatively expensive; thereby making risk-less profits
Financial Markets

• The categories of financial market participants are not necessarily

mutually exclusive.
• For example a financial intermediary such as a bank may, given the
range of its business activities, be a financial advisor, market
marker, dealer, broker, speculator, arbitrageur and hedger
Financial Terminology and Market Asset Classifications

Describe the meaning of financial terminology and explain the

different market asset classifications
• Financial markets can be described amongst others as:
• Cash and derivatives markets
• Spot and forward markets
• Primary and secondary markets
• Financial exchanges and over-the-counter markets
• Interbank markets
Financial Terminology and Market Asset Classifications

Cash and Derivative Markets

Financial Terminology and Market Asset Classifications

• The foreign exchange, money, bond and equity markets are all
considered cash markets because transactions executed in these
markets will result in physical flows of cash at some time or another.
• The commodities market; a market for the buying and selling of
physical goods is a cash market but not a financial one
• The foreign exchange market is the international forum for the
exchange of currencies
Equity, bond and currency market
Financial Terminology and Market Asset Classifications

• The money market is the marketplace for trading short-term debt

instruments while the bond market deals in longer-term debt issues
• The distinction between money and bond markets is mainly on the
basis of maturity. Most money market instruments have maturities of
less than one year while bonds are issued with terms of more than
one year. Both money and bond markets involve interest-bearing
debt instruments.
Financial Terminology and Market Asset Classifications

• Equities or shares (participation in the ownership of a company)

trade on equity markets
• Equity and bond markets are grouped together under the term
capital market: the market in which corporations, financial
institutions and governments raise long-term funds to finance capital
investments and expansion projects.
Participants of the Capital Market
Financial Terminology and Market Asset Classifications

• Derivatives are financial instruments of which the values (price) are

derived from the values of other variables
• These variables can be underlying financial instruments or
commodities in the cash market
• For example a currency option is linked to a particular currency pair
in the foreign exchange market, a bond futures contract to a certain
bond in the bond market and an agricultural future to maize or
wheat in the commodities market
• Derivatives can be based on almost any variable – from the price of
soya to the weather in Rome
• There is trading internationally and in South Africa in credit,
electricity, weather and insurance derivatives.
Derivatives Financial Market
Financial Terminology and Market Asset Classifications

• While a distinction has been drawn between foreign exchange,

money, bond, equity and derivatives markets, several financial
instruments straddle the division between these markets
• These are called hybrid financial instruments
• For example a convertible bond is a hybrid of bond and equity
securities
• It pays a fixed coupon with a return of the principal at maturity
unless the holder chooses to convert the bond into a certain number
of shares of the issuing company before maturity
Financial Terminology and Market Asset Classifications

Spot and Forward Markets

• A spot market is a market in which financial instruments are traded
for immediate delivery
• Spot in this context means instantly effective
• The spot market is sometimes referred to as the cash market
• A forward market is a market in which contracts to buy or sell
financial instruments or commodities at some future date at a
specified price are bought and sold.
Spot and Forward Market
Financial Terminology and Market Asset Classifications

Primary and Secondary Markets

• The primary market is the market for the original sale or new issue
of securities
• Issuers or borrowers in the primary market may be raising capital for
new investment or they may be going public i.e. converting private
capital into public capital
• The secondary market is a market in which previously-issued
securities are resold
• The proceeds from a sale of such securities do not go to the issuer
of the securities but to their seller - the previous owner
• A stock exchange is a secondary market in which equities are
traded. It is also a primary market where shares are issued for the
first time.
Financial Terminology and Market Asset Classifications

• A secondary market can be a call market or a continuous market

• A call market is a market on which individual securities trade at
specific times
• Buy and sell orders are accumulated for a period
• Then a single price is set to satisfy the largest number of orders and
all the orders are transacted at that price
• The method is used in smaller markets and to establish the opening
price in larger markets
• A continuous market is a market in which securities trade at any
time the market is open
Financial Terminology and Market Asset Classifications

• Securities traded on a secondary market can be priced by order (or

auction) or by quote (or dealer):
• On an order-driven (or auction) market buyers and sellers
submit bid and ask prices of a particular security to a central
location where the orders are matched, generally by a broker.
Prices are determined principally by the times of orders arriving
at the central marketplace. The JSE Ltd and most US stock
exchanges are order-driven.
• On a quote-driven (or dealer) market, individual dealers act as
market makers by buying and selling shares for themselves. In
this type of market investors must transact through a dealer.
Prices are determined principally by dealers’ bid/offer quotations.
NASDAQ is a quote-driven market.
Primary and Secondary Markets
Stock market participants

SARB
Financial Terminology and Market Asset Classifications

Exchanges and Over-the-Counter Markets

• Exchanges are formal marketplaces where financial instruments are
bought and sold
• They are governed by law and the exchanges’ rules and regulations
• An over-the-counter (OTC) market involves a group of dealers who
provide two-way trading facilities in financial instruments outside
formal exchanges
• OTC dealers stand ready to buy at the bid price and sell at the
(higher) ask or offer price hoping to profit from the difference
between the two prices
The main differences between OTC and exchange-traded markets are
shown on the following slide
Financial Terminology and Market Asset Classifications
Exchanges and Over-the-Counter Markets
Financial Terminology and Market Asset Classifications

• The major advantage of over-the-counter markets is the ability

to tailor-make securities to meet the specific needs of the
trading parties
• The advantages of an exchange relative to an over-the-
counter market are lower credit risk, anonymity of trading
parties, greater market regulation and higher market liquidity
• In South Africa and internationally, money and foreign
exchange markets are OTC markets
• Internationally, apart from corporate bond trading on the New
York Stock Exchange, bond markets are usually OTC markets
• In South Africa, the Bond Exchange of South Africa, which
became a wholly-owned subsidiary of the Johannesburg Stock
Exchange (JSE) in June 2009, controls trading in bonds
• Generally equities are exchange traded. The JSE controls
trading in South African equities
• Commodities and derivatives are traded on-exchange and
OTC
Financial Terminology and Market Asset Classifications

Interbank Markets
• An interbank market is a wholesale money market for the offering of
deposits between banks in a range of currencies usually for periods
not exceeding 12 months
• Interbank markets are over-the-counter markets and can be national
or international
• The Bank for International Settlements and the International
Monetary Fund define the international interbank market as an
international money market in which banks lend either to each other,
cross-border or locally, in foreign currency large amounts of money
usually for periods between overnight and six months
Financial Terminology and Market Asset Classifications

• Interbank markets play at least two roles in the financial system:

• Firstly interbank markets can be used by central banks to
transmit the influence of monetary policy by adding or draining
liquidity from the financial system more effectively
• Secondly, well-functioning interbank markets effectively channel
liquidity from banks with a surplus of funds to those with a
liquidity deficit.
• Various interest rates are used in the interbank market. These
include:
• The Johannesburg Interbank Agreed Rate (JIBAR)
• The London Interbank Offered Rate (LIBOR)
• The Euro Interbank Offered Rate (EURIBOR)
• The Tokyo Interbank Offered Rate (TIBOR)
Function of the Financial Market

• The core functions of the financial system include the following:

• Channeling savings into real investment
• Pooling of savings
• Clearing and settlement of payments
• Managing risks
• Providing information
Function of the Financial Market

Channel Savings into Investment

• The financial system operates as a channel through which savings
can finance real investment i.e. tangible and productive assets such
as factories, plants and machinery
• It channels funds from those who wish to save (surplus economic
units) to those who need to borrow (deficit economic units) to such
assets
• This channeling of savings can take place through time and/or
across industries and geographical regions
• The financial system provides a link between the present and the
future
• It allows savers to convert current income into future spending and
borrowers current spending into future income
Function of the Financial Market

Pooling Savings
• The financial system provides the mechanisms to pool small
amounts of funds for on-lending in larger parcels to business firms
thereby enabling them to make large capital investments
• In addition individual households can participate in investments that
require large lump sums of money by pooling their funds and then
sub-dividing shares in the investment e.g. collective investment
schemes
Pooling in Funds
Function of the Financial Market

Clearance and Settlement of Payments

• The financial system provides an efficient way to clear and settle
payments thereby facilitating the exchange of goods, services and
assets
• Payment facilities include bank notes, demand deposits, cheques,
credit cards and electronic funds transfers

Management of Risk
• Financial intermediaries transform unacceptable claims on
borrowers to acceptable claims on themselves i.e. the risky long-
term liabilities of borrowers are transformed into less-risky liquid
assets for surplus units
The transformation process is shown on the next slide
Function of the Financial Market
Intermediation Role of Banks
Function of the Financial Market

• From the previous table – example:

• Banks accept short-term deposits from lenders and transform
these into long-term loans for borrowers
• Banks accept relatively small amounts from several lenders and
pool these to lend large amounts to borrowers
• In this process the bank assumes liquidity risk and credit risk
with respect to the borrowers
• Lenders are exposed to the bank’s creditworthiness
Function of the Financial Market

Information Provision
• The financial system communicates information on the following:
• Borrowers’ creditworthiness: It is costly for individual households
to obtain information on a borrower’s creditworthiness. However
if financial intermediaries do this on behalf of many small savers,
search costs are reduced
• The prices of securities and market rates: This supports firms in
their selection of investment projects and financing alternatives.
In addition it assists asset managers to make investment
decisions and households to makes savings decisions
Financial Market Rates

• There are essentially three financial market rates:

• Interest rates: the price, levied as a percentage, paid by borrowers for
the use of money they do not own and received by lenders for deferring
consumption or giving up liquidity
• Exchange rates: price at which one currency is exchanged for another
currency. The actual exchange rate at any one time is determined by
supply and demand conditions for the relevant currencies with the
foreign exchange market
• Holding period return: total return on an asset or portfolio of assets over
the period it was held
Interest Rates
 Financial Market Rates
Interest Rates:
• Factors affecting the supply and demand for money and hence the interest
rate includes the following:
• Production opportunities: Potential returns within an economy from investing in
productive, cash-generating assets
• Liquidity: Lenders demand compensation for loss of liquidity. A security is
considered to be liquid if it can be converted into cash at short notice at a
reasonable price
• Time preference: Lenders require compensation for saving money for use in
the future rather than spending it in the present
• Risk: Lenders charge a premium if investment returns are uncertain i.e. if there
is a risk that the borrower will default. The risk premium increases as the
borrowers’ creditworthiness decreases. Sovereign (government) debt generally
has no risk premium within a country and therefore pays a risk-free rate. A
country risk premium may apply outside a country’s borders
• Inflation: Lenders require a premium equal to the expected inflation rate over
the life ofthe security
Financial Market Rates

Holding Period Return (HPR):

• Interest rates are promised rates i.e. they are based on contractual
obligation. However other assets such as property, shares,
commodities and works of art do not carry promised rates of return
• The return from holding these assets comes from the following two
sources:
• Price or capital appreciation/depreciation: Any gain (loss) in the
market price of the asset
• Cash flow produced by the asset: Cash dividends paid to
shareholders, rental income from property. Not all assets
produce cash flows e.g. commodities
• Holding period return does not take into account reinvestment
income between the time cash flows occur and the end of the
holding period.
Financial Market Rates

Holding Period Return:

Holding Period Return
Financial Market Rates

Holding Period Return Example 1:

assume at the beginning of the year a share is bought for R50
At the end of the year the share pays a dividend of R2.50
It is sold for a price is R55
In this case the holding period of the investment is one year
The holding period return (r) for the share is 15.0%; calculated as
follows:
Financial Market Rates

If the share price it is sold for is R45 at year end the holding period
return is –5%; calculated as follows:

45 .00 −50.00 2.50

𝑟= +
50.00 50.00

¿ −5 .00 %
Financial Market Rates

Holding Period Return Example 2:

Assume a painting is purchased at the beginning of 2001 for R2 000
At an auction on 31 December 2009 the painting is sold for R3 000
In this case the holding period is 9 years
The art investor’s holding period return is 50.0%; calculated as follows:
Financial Market Rates

Holding Period Return Example 2:

The 50% return represents the return over 9 years. It may be more
convenient for comparative purposes to convert this to an annual rate
as follows:
Holding Periods
Pricing of financial assets and the Impact

Explain the pricing of financial assets and the impact of the

effective market hypothesis on the prices:
• One of the most debated and controversial questions in finance is
whether the price movements of financial instruments are
predictable or random
• According to the efficient market hypothesis (EMH), at any given
time, financial instrument prices fully reflect all available information
• The market is efficient if the reaction of market prices to new
information is instantaneous and unbiased
• The main outcome of this theory is that price movements are
random and do not follow any patterns or trends
• This means that past price movements cannot be used to predict
future price movements. Rather, prices follow a random walk - an
inherently unpredictable pattern
Pricing of financial assets and the Impact

• Definition: Technical analysis

Technical analysis involves studying past asset price series and trading
volume data in attempt to profit from periodic changes in these trends

• Definition: Fundamental analysis

Fundamental analysis focuses on determining the intrinsic value of a
share. The emphasis is on future earnings. It requires the analysis of
all variables that affect the level and growth rate of a company’s
earnings such as the quality and depth of management; competitive
position of the company; strength of the company’s balance sheet;
economic, technical, political and legal environment in which the
company operates; and industry environment and characteristics
Pricing of financial assets and the Impact

• There are essentially the following three forms of the efficient

market hypothesis (EMH):
• The weak form of the EMH: All past market prices and data are fully
reflected in asset prices. The implication of this is that technical
analysis will not be able to consistently produce excess returns,
though some forms of fundamental analysis may still provide excess
returns
• The semi-strong form of the EMH: All publicly available information
is fully reflected in asset prices. The implication of this is that neither
technical nor fundamental analysis can be used to produce excess
returns
• The strong form of the EMH: All information, public and private is
fully reflected in asset prices. The implication of this is that even
insider information cannot be used to beat the market
Efficient Market Hypothesis