CHAPTER 2 FEDERICA IELASI Overview of the Financial System.

CHAPTER 2

FEDERICA IELASI

Overview of the Financial System

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-2

Agenda

• We examine the role and the structure 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

– Structure of Financial Markets

– Function of Financial Intermediaries

– Financial Intermediaries

– Regulation of the Financial System


Function of Financial Markets

• Channel funds from person or business without investment opportunities (i.e., “Lender-Savers” – surplus agents) to one who has them (i.e., “Borrower-Spenders” – deficit agents)

• Surplus agents have funds that they wish to invest; deficit agents do not have sufficient current funds themselves and need to borrow money


Financial Markets Funds Transferees

Lender-Savers

1. Households

2. Firms

3. Government

Borrower-Spenders

1. Firms

2. Government

3. Households

Financial Markets Funds Transferees

• You have a business…

• You need money…


Segments of Financial Markets

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-6Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-6



1. Direct Finance (bottom route)• Borrowers borrow directly from lenders in financial markets by

selling financial instruments (securities) which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them but they are liabilities for the individual or firm that sells (issues) them.

2. Indirect Finance (top route)• Borrowers borrow indirectly from lenders via financial

intermediaries. A financial intermediary stands between the lender and the borrower and helps transfer funds from one to the other.


• A financial intermediary borrows funds from savers (for example a bank might acquire funds by issuing a liability in the form of saving deposits) and lends money to deficit agents…– …by making a loan

– …by buying a bond in the financial market



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.

Importance of Financial Markets

• When financial markets break down during financial crises, as they have in Mexico, East Asia and Argentina in recent years, severe economic hardship results, which can even lead to dangerous political instability.

• Financial markets break downs led to economic instability and led to widespread social problems.


Structure of Financial Markets

It helps to define financial markets along a variety of dimensions (not necessarily mutually exclusive). For starters, …



• Debt markets

• Debt instrument (bond): contractual agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals (interest and principal payment) until a specified date (the maturity date)

• The payments for debt holders are fixed

• Equity markets

• Equities: claims to share in the net income and the assets of a business

• Equities often make periodic payments (dividends) to their holders and are considered long-term securities

• Equity holder is a residual claimant (the corporation must pay all its debt holders before it pays its equity holders)

• Equity holders benefit directly from any increases in the corporation’s profitability or asset value




1. Primary Market– New security issues sold to initial buyers

– Typically involves an investment bank

2. Secondary Market– Securities previously issued are bought

and sold

– Examples include the NYSE and Nasdaq



Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:

• Provide liquidity, making it easy to buy and sell the securities of the companies

• Establish a price for the securities



We can further classify secondary markets as follows:

1. Exchanges– Trade conducted in central locations

(e.g., New York Stock Exchange)

2. Over-The-Counter Markets– Dealers at different locations who have an inventory

of securities are ready to buy and sell securities OTC to anyone who comes to them and is willing to accept their price

NYSE home pagehttp://www.nyse.com

http://www.nyse.com/

http://www.nyse.com/


Classifications of Financial Markets

We can also further classify markets by the maturity of the securities:

1. Money Market: Short-Term (maturity < 1 year)

2. Capital Market : Long-Term (maturity > 1 year) plus equities



National and international market

• International Bond Market– Foreign bonds

• Denominated in a foreign currency• Targeted at a foreign market

– Eurobonds• Denominated in one currency, but sold in a different market• Example: a bond denominated in U.S. dollars sold in London• Over 80% of new issues in the international bond market are

Eurobonds.



• A variant of the Eurobond is Eurocurrencies

• Eurocurrency Market– Foreign currency deposited outside of home country

– Eurodollars are U.S. dollars deposited, say, London.

The € can cause confusion with these terms…


A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro.

Eurodollars have nothing to do with euros, but are U.S. dollars deposited in banks outside the United States.


Key terms

Italian English

Risparmio

Emettere un titolo

Negoziare un titolo

Possedere un titolo

Concedere un finanziamento

Ottenere un finanziamento

Rimborsare un prestito

Azionista

Azione

Obbligazione

Borsa

ObbligazionistaCopyright © 2009 Pearson Prentice Hall. All rights reserved. 2-20

Key terms

Italian English

Risparmio Saving

Emettere un titolo To issue a security

Negoziare un titolo To trade a security

Possedere un titolo To hold a security

Concedere un finanziamento To lend funds

Ottenere un finanziamento To borrow funds

Rimborsare un prestito To pay back a loan

Azionista Shareholder / stockholder / equity holder

Borsa Stock Exchange

Obbligazionista Bondholder / Debt holder


Key terms

English Italian

Maturity

Bond

Common stock

Asset

Liability

Security

Mortgage

Bank supervision

Disclosure


Key terms

English Italian

Maturity Scadenza

Bond Obbligazione

Common stock Azione ordinaria

Asset Attività

Liability Passività

Security Titolo

Mortgage Mutuo

Bank supervision Vigilanza bancaria

Disclosure Trasparenza


CHAPTER 2 FEDERICA IELASI Overview of the Financial System.

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