2. An Overview Of The Financial System

2. An Overviewof the FinancialSystem

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 questionsCopyright 2007 Pearson Addison-Wesley. All rights reserved.2-2

Function of Financial Markets Perform the essential function of channeling funds fromeconomic players that havesaved surplus funds to those that have a shortage offunds Promotes economic efficiency by producingan efficient allocation of capital, which increasesproduction Directly improve the well-being of consumers by allowingthem to time purchases better They provide funds to young people to buy what theyneed and can eventually afford without forcing them towait until they have saved up the entire purchase price.2-3

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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 andequity instruments2-5

Debt an Equity Markets The are two ways to obtain funds in afinancial market: debt and equity A debt instrument is a contractualagreement by the borrower to pay theholder of the instrument fixed amounts ofmoney at regular intervals until aspecified date (maturity date) Examples of debt instruments includebonds, treasury bills, mortgagesCopyright 2007 Pearson Addison-Wesley. All rights reserved.2-6

Debt and Equity Markets cont’d The date on which the final payment is be made iscalled the maturity date A debt instrument can either be short-term (Maturity ayear) or long-term (Maturity10 yrs or more) The second ways is to issue an equity such as commonstock - which is a claim to share in the net income andassets of a business Equities often make periodic payments (dividends) totheir holders and are considered long-term securitiesbecause they have no maturity date. In addition, owning stock means that you own a portionof the firm and have the right to vote on issuesimportant to the firm and to elect its directors.Copyright 2007 Pearson Addison-Wesley. All rights reserved.2-7

Primary and Secondary Markets Primary Market: a financial market in which new issues of asecurity are sold to initial buyers by the corporation orgovernment agency borrowing the funds Secondary Market: a market in which securities that havebeen previously issued can be resold. (securities changehands). Investment Banks underwrite (guarantees) securities inprimary 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 makethe financial instruments more liquid. Second, they determine the price of the security that theissuing firm sells in the primary marketCopyright 2007 Pearson Addison-Wesley. All rights reserved.2-8

Exchanges and Over-the-CounterMarkets Secondary markets can be organised into (1) exchangesand (2) over-the-counter (OTC) markets Exchanges are organised markets where buyers andsellers of securities meet in one central location to trade(e.g. NSX) OTC markets are markets in which dealers at differentlocations who have an inventory of securities stand readyto buy and sell securities “over the counter” to anyonewho comes to them and is willing to accept their prices Because over-the-counter dealers are in computercontact and know the prices set by one another, the OTCmarket is very competitive and not very different from amarket with an organized exchange.Copyright 2007 Pearson Addison-W“over the counter” to anyonewho comes to them and is willing to accept their pricesesley. All rights reserved.2-9

Money and Capital Markets Money market: financial market in whichonly short-term debt instruments aretraded Capital market: market in which longerterm debt and equity instruments aretraded Money market securities are usuallymore widely traded than longer-termsecurities and so tend to be more liquidCopyright 2007 Pearson Addison-Wesley. All rights reserved.2-10

Money Market Instruments Treasury bills – short-term debt instruments issuedby govt to finance govt operations Certificate of deposit (CD): debt instrument sold bya bank to depositors that pays annual interest of agiven amount and maturity pays back the originalpurchase price Commercial paper: are short-term debt instrumentsissued by large banks and corporations Banker’s Acceptances - instruments are created inthe course of carrying out international trade and havebeen in use for hundreds of years Repurchase agreements(repos): short-term loansfor which treasury bills serve as collateralpyright 2007 Pearson Addison-Wesley. All rights reserved.2-11

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Capital Market Instruments Stocks: equity claims on the net incomeand assets of a corporation Mortgages: loans to households andfirms for purchase of housing, land, orother real structures, where the structureor land itself serves as collateral for theloans Corporate bonds: long-term bondsissued by corporations with very strongcredit ratingCopyright 2007 Pearson Addison-Wesley. All rights reserved.2-13

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Internationalizationof Financial Markets Foreign Bonds—sold in a foreign country anddenominated in that country’s currency E.g. if the German automaker Porsche sells a bond inthe United States denominated in U.S. dollars, it isclassified as a foreign bond. Foreign Eurobond—bond denominated in a currency other thanthat of the country in which it is sold for example, a bond denominated in U.S. dollars soldin London Eurocurrencies—foreign currencies deposited in banksoutside the home country Eurodollars—U.S. dollars deposited in foreign banksoutside the U.S. or in foreign branches of U.S. banks World Stock Markets2-15

Function of Financial Intermediaries:Indirect Finance Lower transaction costs Economies of scale (bank become specialised on lending reducingcost of lending) Liquidity services Reduce Risk Risk of theft, inflation, default etcRisk Sharing (Asset Transformation), risky assets are turned intosafer assets for investorsDiversification - investing in a collection (portfolio) of assets whosereturns do not always move together, with the result that overall riskis lower than for individual assetsAsymmetric Information Adverse Selection (before the transaction)—more likely to selectrisky borrower Adverse selection in financial markets occurs when the potentialborrowers who are the most likely to produce an undesirable(adverse) outcome—the bad credit risks Moral Hazard (after the transaction)—less likely borrower will repayloan2-16

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Types of Financial Intermediaries Depository Institutions: financialintermediaries that accept deposits and makeloans. They include commercial banks, creditunions, mutual savings banks and savings &loan associations Contractual Savings Institutions: financialintermediaries that acquire funds at periodicintervals on a contractual basis, such pensionfunds and insurance companies Investment Intermediaries: These includefinance companies, mutual funds, and moneymarket mutual fundsCopyright 2007 Pearson Addison-Wesley. All rights reserved.2-19

Types of Investment Intermediaries Finance companies: Sell commercialpaper to raise funds and by issuing stocksand bonds and uses the funds to lend toconsumers. Mutual Funds: acquire funds by sellingshares to many individuals and use theproceeds to purchase diversified portfoliosof stocks and bonds Money market Mutual Funds: in additionselling shares, they offer deposit-typeaccountsCopyright 2007 Pearson Addison-Wesley. All rights reserved.2-20

Types of Investment IntermediariesCont’d Investment bank: advises corporationson which type of securities to issue andunderwrites securitiesCopyright 2007 Pearson Addison-Wesley. All rights reserved.2-21

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 withimpeccable credentials and a large amount of initial funds willthey be given a charter Disclosure- stringent reporting requirements for financialintermediaries Restrictions on Assets and Activities - restrictions on whatfinancial intermediaries are allowed to do and what assetsthey can hold Deposit Insurance - insure people’s deposits so that they donot suffer any financial loss if the financial intermediary fail. Limits on Competition Restrictions on Interest Rates2-22

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Review Questions A company will go bankrupt next year. Thecompany issues both bonds and equities. As aninvestor, which one is a good decision, buy astock in the company or purchase the company’sbond? Explain In a world without transaction costs, financialintermediaries would not exist, true or false?Explain You have money to lend to a friend. Instead oflending the money to him/her, you deposit themoney in a savings account to earn 5% interestrate. The bank will lend the money to your friendat 10%, is this a decision? Explain2-26Copyright 2007 Pearson Addison-Wesley. All rights reserved.

2-5 Structure of Financial Markets Debt and Equity Markets Primary and Secondary Markets Investment Banks underwrite securities in primary markets Brokers and dealers work in seconda