The Financial System

• Payment System
• Pooling of Funds
• Transfer of Resources
• Risk Management
1. Hedging
2. Diversification
3. Insurance
• Price Information for Decentralized Decision Making
• Dealing with Incentive Problem
1. Moral Hazard
2. Adverse Selection
 Functions of Financial Markets
• Facilitates Price Discovery
• Provides Liquidity – reduces time horizon
mismatch
• Negotiability
• Transferability
• Reduces cost of transaction
1. Search cost
2. Information cost
 Classification of Financial Markets
• Nature of Claim
– Debt Market
– Equity Market
• Maturity of Claim
– Money Market
– Capital Market
• Seasoning of Claim
– Primary Market
– Secondary Market
• Timing of Delivery
– Cash or Spot Market
– Forward or Futures Market
• Organizational Structure
– Exchange Traded Market
– Over-the-counter Market
 Financial Market Returns
• Interest Rates
– Unit of account (rupees, dollar, yen, gold)
• Interest rate is low in less inflationary environment
as unit of account hardly depreciates
– Maturity
– Default risk
• Inflation and Real Interest Rates
• Rates of return on Risky Assets
– Equity (dividend yield + capital yield)
Principal Determinants of Rates of
Return
• Expected Productivity of Capital
• Degree of Uncertainty about Productivity
of Capital
• Time Preferences of People
• Degree of Risk Aversion
 Other Factors that Influence
Interest Rate Levels
• Money Supply (contractionary &
expansionary monetary policy)
• Fiscal Deficit or Surplus
• International Trade Factors ( larger trade
deficit – greater borrowing – higher
interest rates)
• Level of Business Activity
 Key Interest Rates in India
• Repo Rate (Banks Funds RBI)
• Reverse Repo Rate (RBI Funds Banks)
• Bank Rate
• Treasury Bill Rate
• Prime Lending Rate
• G Sec Rate
• Bank Deposit Rate
 Financial Intermediaries
• Commercial Banks
• Financial Institutions
• Insurance Companies
• Mutual Funds
• Non-Banking Financial Companies
• Non-Banking Financial Services Companies
– Merchant Banks
– Credit Rating Agencies
– Depositories
 Financial Development
Assessment Ratios
• Finance Ratio = Total financial claims/
National Income
• New Issue Ratio = Primary Issues (non-financial sector)/
Net Physical Capital Formation
• Intermediation
Ratio = Issue of Financial Institutions/
Total Issues in the economy