2. An Overview of the Financial System

Overview

• Functions of financial markets • Structure of financial markets • Internationalization of financial markets • Function of Financial Intermediaries • Types of Financial Intermediaries • Regulation of the Financial System • Review questions Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-2

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Function of Financial Markets • Perform the essential function of channeling funds from

economic players that have saved surplus funds to those that have a shortage of funds

• Promotes economic efficiency by producing an efficient allocation of capital, which increases production

• Directly improve the well-being of consumers by allowing them to time purchases better

They provide funds to young people to buy what they need and can eventually afford without forcing them to wait until they have saved up the entire purchase price.

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Structure of Financial Markets

• Debt and Equity Markets

• Primary and Secondary Markets Investment Banks underwrite securities in primary markets Brokers and dealers work in secondary markets

• Exchanges and Over-the-Counter (OTC) Markets

• Money and Capital Markets Money markets deal in short-term debt instruments Capital markets deal in longer-term debt and

equity instruments

Debt an Equity Markets • The are two ways to obtain funds in a

financial market: debt and equity • A debt instrument is a contractual

agreement by the borrower to pay the holder of the instrument fixed amounts of money at regular intervals until a specified date (maturity date)

• Examples of debt instruments include bonds, treasury bills, mortgages

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Debt and Equity Markets cont’d • The date on which the final payment is be made is

called the maturity date • A debt instrument can either be short-term (Maturity < a

year) or long-term (Maturity10 yrs or more) • The second ways is to issue an equity such as common

stock - which is a claim to share in the net income and assets of a business

• Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date.

• In addition, owning stock means that you own a portion of the firm and have the right to vote on issues important to the firm and to elect its directors.


Primary and Secondary Markets • Primary Market: a financial market in which new issues of a

security are sold to initial buyers by the corporation or government agency borrowing the funds

• Secondary Market: a market in which securities that have been previously issued can be resold. (securities change hands). Investment Banks underwrite (guarantees) securities in

primary markets Brokers and dealers work in secondary markets

• secondary markets serve two important functions. First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they make

the financial instruments more liquid. Second, they determine the price of the security that the

issuing firm sells in the primary market

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Exchanges and Over-the-Counter Markets

• Secondary markets can be organised into (1) exchanges and (2) over-the-counter (OTC) markets

• Exchanges are organised markets where buyers and sellers of securities meet in one central location to trade (e.g. NSX)

• OTC markets are markets in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices

• Because over-the-counter dealers are in computer contact and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange. Copyright © 2007 Pearson Addison-W“over the counter” to anyone

who comes to them and is willing to accept their pricesesley. All rights reserved. 2-9

Money and Capital Markets

• Money market: financial market in which only short-term debt instruments are traded

• Capital market: market in which longer-term debt and equity instruments are traded

• Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid


Money Market Instruments • Treasury bills – short-term debt instruments issued

by govt to finance govt operations • Certificate of deposit (CD): debt instrument sold by

a bank to depositors that pays annual interest of a given amount and maturity pays back the original purchase price

• Commercial paper: are short-term debt instruments issued by large banks and corporations

• Banker’s Acceptances - instruments are created in the course of carrying out international trade and have been in use for hundreds of years

• Repurchase agreements(repos): short-term loans for which treasury bills serve as collateral

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Capital Market Instruments • Stocks: equity claims on the net income

and assets of a corporation • Mortgages: loans to households and

firms for purchase of housing, land, or other real structures, where the structure or land itself serves as collateral for the loans

• Corporate bonds: long-term bonds issued by corporations with very strong credit rating


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Internationalization of Financial Markets • Foreign Bonds—sold in a foreign country and

denominated in that country’s currency E.g. if the German automaker Porsche sells a bond in

the United States denominated in U.S. dollars, it is classified as a foreign bond. Foreign

• Eurobond—bond denominated in a currency other than that of the country in which it is sold for example, a bond denominated in U.S. dollars sold

in London • Eurocurrencies—foreign currencies deposited in banks

outside the home country Eurodollars—U.S. dollars deposited in foreign banks

outside the U.S. or in foreign branches of U.S. banks • World Stock Markets

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Function of Financial Intermediaries: Indirect Finance • Lower transaction costs

Economies of scale (bank become specialised on lending reducing cost of lending)

Liquidity services

• Reduce Risk

Risk of theft, inflation, default etc Risk Sharing (Asset Transformation), risky assets are turned into

safer assets for investors Diversification - investing in a collection (portfolio) of assets whose

returns do not always move together, with the result that overall risk is lower than for individual assets

• Asymmetric Information Adverse Selection (before the transaction)—more likely to select

risky borrower Adverse selection in financial markets occurs when the potential

borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks

Moral Hazard (after the transaction)—less likely borrower will repay loan

Types of Financial Intermediaries • Depository Institutions: financial

intermediaries that accept deposits and make loans. They include commercial banks, credit unions, mutual savings banks and savings & loan associations

• Contractual Savings Institutions: financial intermediaries that acquire funds at periodic intervals on a contractual basis, such pension funds and insurance companies

• Investment Intermediaries: These include finance companies, mutual funds, and money market mutual funds


Types of Investment Intermediaries • Finance companies: Sell commercial

paper to raise funds and by issuing stocks and bonds and uses the funds to lend to consumers.

• Mutual Funds: acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds

• Money market Mutual Funds: in addition selling shares, they offer deposit-type accounts Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-20

Types of Investment Intermediaries Cont’d

• Investment bank: advises corporations on which type of securities to issue and underwrites securities


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Regulation of the Financial System • To increase the information available to investors:

Reduce adverse selection and moral hazard problems Reduce insider trading

• To ensure the soundness of financial intermediaries: Restrictions on entry - Only upstanding citizens with

impeccable credentials and a large amount of initial funds will they be given a charter

Disclosure- stringent reporting requirements for financial intermediaries

Restrictions on Assets and Activities - restrictions on what financial intermediaries are allowed to do and what assets they can hold

Deposit Insurance - insure people’s deposits so that they do not suffer any financial loss if the financial intermediary fail.

Limits on Competition Restrictions on Interest Rates

Review Questions • A company will go bankrupt next year. The

company issues both bonds and equities. As an investor, which one is a good decision, buy a stock in the company or purchase the company’s bond? Explain

• In a world without transaction costs, financial intermediaries would not exist, true or false? Explain

• You have money to lend to a friend. Instead of lending the money to him/her, you deposit the money in a savings account to earn 5% interest rate. The bank will lend the money to your friend at 10%, is this a decision? Explain Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-26

2. An Overview of the Financial System · 2016-05-10 · 2-3 Function of Financial Markets •...

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