20200920180007HCTAN008S T2 Financial System

Topic 2- Introduction to Financial System
Topic 2
Introduction to Financial Systems
Outline for Topic 2- Introduction to Financial System

1. Functions of Financial Markets
(Channels funds & Improves economic efficiency)
2. Functions of financial systems:
(1) Economics function – direct finance & indirect finance
(2) monetary function
3. Financial system comprises:
(1) financial markets (e.g. stock market, bond market)
(2) financial securities (e.g. shares and bonds)
(3) financial intermediaries
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Outline for Topic 2

4. Types of financial instruments:
(1) debt instruments
zero-coupon bond, coupon bond, Perpetual bonds, Floating rate bonds,
Index-linked bonds, Callable bonds, Puttable bonds, Convertible bonds,
Foreign bond, Eurobonds, treasury bill, government notes and bonds,
municipal bonds and corporate bond
Theory for the term structure of interest rate:
(a)Expectation theory
(b)Liquidity premium theory
(c)Segmented market theory
(2) equity instruments (common stocks, preferred stocks)

3
Outline for Topic 2

5. Structure of Financial markets
(i) Exchange market vs Over-the-counter (OTC) traded
(ii) Primary market vs secondary market
(iii) Money market vs capital market
(iv) Quote-driven Dealer markets, Order-driven markets &
Brokered markets
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Learning outcomes of Topic 2
① To explain the functions of financial systems.

② To investigate the nature and characteristics of financial systems (namely
financial intermediaries, securities & financial markets)
③ To describe and explain the characteristics of the financial intermediaries
(e.g. depository institutions, contractual savings institutions and investment
intermediaries) in the USA and the world.
④ To explain the type and features of financial securities (i.e. bonds, notes,
bills and stocks) traded on financial markets.
⑤ To discuss the theories related to the shape of the yield curve.
⑥ To explain the structure of financial markets in the USA and the world (e.g.
UK, France and Germany):
– primary versus secondary markets,
– money versus capital markets,
– organised versus over-the-counter markets (OTC),
– quote-driven dealer markets versus order-driven markets & brokered 5
markets
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Part A: Two Functions of Financial System

i. Economics function [Direct vs indirect financing]
ii. Monetary function
Structure of Financial System:

Part B: Financial Intermediaries
Part C: Financial Securities
Bonds (+ Term Structure of Interest Rate: Yield curve, 3 Theories)
Stocks (Preferred Stock vs Common Stocks)
Part D: Financial Markets
Primary vs Secondary market,
Exchange traded vs OTC,
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Money vs Capital Markets
Functions of Financial Systems – (a) Economic Function

• Two functions of financial systems: (1) Economics function & (2) monetary function
(a) Economic function

• channelling funds from units who have surplus funds (i.e. saving) to units who
have a shortage of funds (borrowing)
• lender-savers: The units who have saved can lend funds, usually households
• borrower-spenders:The units with a shortage of funds borrow funds to finance their
spending, eg: firms and the government
(i) Direct Finance - Borrowers borrow directly from lenders in financial markets
by selling financial instruments
(ii) Indirect Finance - Borrowers borrow indirectly from lenders
via financial intermediaries
(the intermediary helps to transfer funds from one to the other)
– The process of indirect finance, known as financial intermediation,
9
is the most important way of transferring funds from lenders to borrowers.
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2013-2b-ZAB
10
Functions of Financial Systems – (a) Economic Function
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2-11
Source: Mishkin & Eakins (2011) Financial Markets and Institutions
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Functions of Financial Systems –(b) Monetary Function

The main functions of financial systems are to provide the mechanism of:
i) lending & borrowing (i.e. funds can be transferred from surplus units
to units with a shortage of funds)
ii) Payment (e.g. cheques, debit cards & credit cards)
iii) adjustment for the portfolio composition
risk transfer (Firm or household transfer the risk of loss of wealth due to
theft/fire to an insurance company by paying a fee, i.e. insurance premium.
The insurance company can allocate the risk more efficiently by pooling and
diversification through a large number of insurance contracts.)
12
Source: M. Buckle (2011) Principles of Banking and Finance, ch2
Concept Check Activity:

Direct Financing vs Indirect Financing
Direct Financing InDirect Financing
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2 functions of Financial System
(1) _______________ Function (2) _______________ Function
i) i)
ii) ii)
iii)
Exam Focus
PYQ-QA2- Introduction to Financial Systems
1. Outline the main functions of financial systems. (10 marks) 2007-1a
2 Discuss the main functions of a financial system and explain why these2012-1a-ZA
are important for an economy. (13 marks)
3 Describe the main functions of a financial system. (9 marks) 2019-3a-ZAB
4 (a) Explain the channels through which funds can flow from20111a-ZB
lenders/savers to spenders/borrowers in a financial system and discuss
the relative risks faced by lenders/savers in relation to the different
channels. (15 marks)
5 Explain the essential differences between direct and indirect financing20101b-ZB
identifying the characteristics of the financial instruments used in each type
of financing. (7 marks)
6 2(b) Explain the essential differences between direct and indirect financing2013-2b-ZAB
identifying the characteristics of the financial instruments used in each type of
financing. (7 marks)
7 Explain the essential differences between direct and indirect financing20071a-ZA
identifying the characteristics of the financial instruments used in each type of
financing. (7 marks)
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Structure of Financial Systems- (1) Financial Market

A financial system comprises: 2007-1a-ZA
(1) financial markets (2) financial securities (3) financial intermediaries
(1) Financial markets

• markets in which securities are traded (e.g. bond & stock markets)
• are markets where funds are moved
from people who have excess funds (but lack of investment opportunities)
to people who have investment opportunities (but lack of funds).
• have direct effects on personal wealth, the behaviours of businesses & consumers.
• contribute to increase the production & efficiency of the economy.
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Structure of Financial Systems- (2) Financial Securities

(2) Securities (= financial instruments)
• financial claims on the issuer’s future income or assets.
(a) financial assets - for the buyer (lender or investor in the financial claim).
(b) financial liabilities - for individual/ firm that sells them (borrower or issuer
of the financial claim) in return for money
sum of financial assets = sum of financial liabilities.
Governments & corporations raise funds by issuing:

(a) Shares (=stocks) (i.e. equity instruments)
- securities that represent a share of ownership in the firm.
(b) Bonds (ie. debt instruments) or
- securities that promise to make periodic payments of a sum of money
for a specified period of time. 18
Structure of Financial Systems- (3) Financial Intermediaries

(3) Financial intermediaries
• economic agents who specialise in buying & selling (at the same time)
(i) financial contracts (loans & deposits) - easily marketable
(ii) financial securities (bonds & stocks) - cannot be easily sold (marketed).
(a) Banks
• largest financial institution
(i) accept deposits (loans by individuals/firms to banks) and
(ii) make loans (sums of money lent by banks to individuals/ firms):
• Banks borrow deposits from depositors & make loans to borrowers.
(b) Other financial intermediaries

e.g. mutual funds, pension funds, insurance companies &
investment banks
• growing at the expense of banks. 19
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Activity 3:
Structure of Financial System include:
Financial __________ [e.g.
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Structure of Financial Systems- (3) Financial Intermediaries

3a) depository institutions- (i) commercial banks
(ii) savings & loans institutions
(iii) credit unions
3b) contractual (i) insurance companies (property & causality)
savings institutions- (ii) pension funds
3c) investment intermediaries- (i) mutual funds (long vs short)
(ii) finance companies
(iii) investment banks
(iv) securities firms
(3a) Depository institutions

• funds derived from customer deposits.
• 3 types: (i) commercial banks (ii) savings institutions (iii) credit unions.
23
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(3a) Depository Institutions – (i) Commercial Banks

largest financial intermediary
Accept deposits (liabilities) to make loans (assets) & to buy govn securities.
Many banks were consolidated through mergers & acquisitions.
Commercial banks reduced from 14,416 in Yr1984 to 7402 in Yr2006)
US banks improved their performance in 1990s
Return on Equity (ROE) of the US banking industry averaged 9.9%.
Deposits
(i) checkable deposits (deposits with cheques)
(ii) savings deposits (payable on demand, no cheques)
(iii) time deposits (fixed maturity deposits).
Loans
(i) Consumer loan
(ii) commercial loan
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(iii) mortgage loans.
UOL
25
Source: M. Buckle (2011) Principle of Banking and Finance, ch2
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Depository Institutions – (ii) Savings & Loan Associations (S&Ls)

• 2nd largest financial intermediaries
• mainly on residential mortgages (by acquiring funds primarily through
savings deposits)
• 1950-1960: grew more rapid than commercial banks
• 1979-1982: slowdown due to monetary policy (increase in interest rates)
Interest rate increased after remove the Regulation Q
(i.e. interest rate ceilings on deposits),
S&Ls resulted in:
(i) negative interest spreads (=interest income - interest expense)
in the fixed-rate long-term residential mortgages.
(ii) pay more competitive (higher) interest rates on savings deposits.
S&Ls are allowed to expand:
(i) deposit taking (i.e. to offer checking accounts) and
(ii) Loan offering (i.e. to make consumer loans, commercial loans).
Advantages: Resulted safer & more diversified S&Ls. 26
Disadvantages: to improve profitability by taking more risk.
3a) Depository Institutions – (iii) Credit unions

• Non-profit institutions
• Mutually organised & owned by their members, i.e. depositors.
• Provide deposit & loan to their members

(identified by occupation, association, geographical location).
• Members’ deposits are used to provide loans to other members.
Loans earnings are used to pay a higher interest rate to member depositors.
27
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(3b) Contractual Savings Institutions
• Acquire funds at periodic intervals on a contractual basis.

• Liquidity of assets is less important (than for depository institutions)
• Can predict reasonable accuracy the future payments due to their customers.
• Invest their funds in long-term securities
(e.g. corporate bonds, stocks & mortgages).
• 2 groups: (i) insurance companies & (ii) pension funds.
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(3b) Contractual Savings Institutions-(i) Insurance companies

• To protect the policy-holders (i.e. individuals & firms) from adverse events.
• Receive premiums from policy-holders and
• Pay compensation to policy-holders if particular events occur.
• 2 main insurances:
(i) life insurance
• protects against death, illness and retirement
• largest contractual savings institutions in US in year 2006.
• Today, they emphasis on annuities (i.e. contracts that accumulate funds &
pay out a fixed / variable income stream
for a fixed period of time /over the lifetimes of the contract)
(ii) property & causality insurance

• protection against personal injury & liabilities, e.g. accidents / theft/ fire.
• hold more liquid assets because of a higher probability of loss of funds.
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Pension funds
(3b) Contractual Savings Institutions-(ii)
• Provide retirement income (annuities payment) to employees covered by
a pension plan.
• Receive contributions from employers or employees.
• Invest in corporate bonds & stocks.
• 2 types: private pension funds & public pension funds.
• Very important in USA & UK. (US government promotes to expand its
number & variety)
• Not so important in France, Germany & Italy (because of the different
importance of State pension schemes)
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(3c) Investment intermediaries

Investment intermediaries comprise:
(i) mutual funds (long term vs short term)
(ii) finance companies
(iii) investment banks
(iv) securities firms
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(3c) Investment intermediaries- (i) Mutual funds

• pool resources from many individuals & companies.
• invest in diversified portfolios (bonds, stocks & money markets)
• 2nd important financial intermediary (asset size).
• Commercial bank industry Mutual funds industry insurance industry
Open-ended mutual fund
• major type, continuously allows
shareholders to sell (redeem) outstanding shares, &
investors to buy new shares at any time.
• value of shares depends on the value of the mutual fund’s holding assets.
Advantages of mutual funds:
• provide opportunities to small investors (to invest in financial securities
& diversify risk)
• lower transaction costs (when they buy larger blocks of financial
securities) 33
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(3c) Investment intermediaries- (i) Mutual funds

Long-term mutual funds
comprise:
• bond funds (funds that contain fixed-income debt securities),
• equity funds (funds that contain stock securities) and
• hybrid funds (funds that contain both debt & stock securities).
Short-term mutual funds

• Comprise of money market mutual funds (funds that contain
various mixes of money market securities)
• partially allow shareholders to write cheques against the value of
their holdings:
• the presence of deposit-type accounts makes money market mutual funds
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to some extent similar to depository institutions.
(3c) Investment intermediaries- (iii) Finance companies

• Provide loans to individuals and corporations (e.g. consumer lending,
business lending, mortgage financing)
• Similar to commercial banks (except do not accept deposits)
• Raise funds by selling commercial paper (a short-term debt instrument) and
by issuing stocks & bonds.
• Lend to customers perceived as too risky by commercial banks.
3 types of finance companies:

(i) Sales finance institutions- loans to customers of a
particular retailer or manufacturer (e.g. Ford Motor Credit).
(ii) Personal credit institutions - loans to consumers perceived as too
risky by commercial banks (e.g. Household Finance Corp).
(iii) Business credit institutions - financing to companies through
equipment leasing & factoring (purchase by the finance company 36 of
accounts receivable from corporate customers).
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(3c) Investment intermediaries- (iii) Investment banks

• Assist corporations or governments to issue new debt or equity securities.
• Investment banking services includes:
(i) origination
(ii) Underwriting (see notes below)
(iii) placement of securities in primary financial markets
(iv) financial advisory (e.g. advising on mergers & acquisitions).

charge fee as a fixed percentage of the size of the deal.
Underwriting of stock or bond issue

• Purchase the entire issue at a predetermined price and resell it in the market.
• Bears the risk that they are not able to resell the entire issue
(then it will hold the unsold stock on its own balance sheet)
• Receives underwriting fee from the issuing company. 38
(3c) Investment intermediaries-(iv) Securities firms

• assist in the trading of existing securities in the secondary markets.
Dealers
• agents who link buyers & sellers by buying & selling securities.
• They hold inventories of securities
• Sell these securities for a slightly higher price than they paid for them.
• earn bid-ask spread (= ask – bid)
[i.e. best ask (lowest price charged for immediate purchase of stock) –
best bid (highest price received for an immediate sale of a unit of stock)]
Brokers
• agents of investors who match buyers with sellers of securities.
• earn a commission
• main service: securities orders
• Securities orders are trade instructions specifying what traders want to trade,
whether to buy or sell, how much, when and how to trade, & on what terms.
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Traders issue orders when they cannot personally negotiate their trades.
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Types of securities orders:
Market orders
• Instruct to trade at the best price currently available in the market.
• Market order traders pay the bid-ask spread (they demand immediacy).
• It follows that there is price uncertainty.
• Large market orders can have substantial & unpredictable price impacts.
Limit orders
• instruct to trade at the best price available,
• but only if it is no worse that the limit price specified by the trader.
• standing limit orders (i.e. limit orders that are not immediately executed)
provide the market with liquidity as they sit in the order book allowing traders
who submit a market order to obtain immediate execution. 40

In the USA, the securities firms and investment banking industry includes:
• National full-line firms - acting both as broker-dealers & underwriters.
e.g. Merrill Lynch, Morgan Stanley.
specialise more in corporate finance & are highly active in trading securities,
e.g. Goldman Sachs, Smith Barney.
• Specialised investment bank subsidiaries of commercial banks –
e.g J.P. Morgan Chase
• Specialised discount brokers - stockbrokers that conduct trading
activities for customers without offering any investment advice (e.g.Charles Schwab)
• Specialised electronic trading securities firms (e.g. E*trade)
enabling trades on a computer via the internet.
• Regional securities firms- concentrating in the service of customers of
a particular geographical region.
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Retail and Wholesale Banks

• 2 types of commercial banking: (i) retail banking (ii) wholesale banking.
• Size is the key different between retail and wholesale banking.
(i) Retail banks

• for individuals & small businesses
• Emphasizes lending to individuals
• deal with a large number of small value transactions.
(ii) Wholesale banks

• For wholesales business (e.g. investment banks)
• deal with a smaller number of larger value transactions.
• In practice it is difficult to identify purely retail banks.

• large banks combine retail & wholesale activities in UK, US & developed
countries
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Exam Focus
14 Explain the characteristics of the following types of bonds: 2010-1c-ZA
(i) zero coupon bond (ii) perpetual bond (iii) puttable bond
(iv) convertible bond (v) Eurobond (10 marks)
15 What is the difference between US Government bonds and 2007-8d-ZB
notes? Why do 2-year Treasury bonds typically have lower
interest rates than 4-year Treasury bonds? Why do corporate
bonds have higher rates than government bonds?(8 marks)
16 Explain why corporate bonds generally have higher returns than 2014-8d-ZA
government bonds. (4 marks)
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Nature Of Financial Instruments- (1) Debt instruments

2 types of financial instruments: (1) debt instruments (2) equity instruments
(1) Debt instruments
• promise the payment of given sums to the investor. For example:
a) Short term- bills (<1 year )
b) Medium term- notes ( 1~ 10 years)
c) Long term- bonds (10 ~20 years)
Bonds
• debt owed by the issuer to the investor.
• claims that pay periodic interest (coupon payments) until the maturity
date & pay back the par value (face value) to the investor at the maturity
date.
• coupon payments (%) are fixed interest rate, usually.
• coupon interest is the cost of borrowing or price paid for the rental of funds
• Bonds can be (i) zero coupon bonds or (ii) coupon bonds
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Extra
46
Source: Essentials of Investment by Bodie, Kane & Marcus 8ed (chapter 10)
Zero Coupon Bonds

• borrower (i.e. the issuer) promises to pay the lender (i.e. bondholder)
one specified face value ($1000) at a specified future date (i.e. maturity).
the borrower receives the bond price which is lower than the face value of
$1000 (i.e. discount bonds) at the current date.
Coupon Bonds
• the borrowers (i.e. issuer) make regular payments (i.e. coupons interest) until
a specified date (i.e. maturity date), when the amount borrowed (principal) is
repaid.
• 2 cash flows to the bondholder:
(i) Face value = par value = principal: the issuer repays the face
value of the bond to the bondholder at the end of the bond’s lifetime (i.e. maturity)
(ii) Coupon interest payments:
– regular (annually or semi-annual) interest payments to the
bondholder.
– Is a fixed fraction (%) of the face value, i.e. the cost of borrowing47or the
price paid for the rental of funds
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Other Types Of Bonds
Perpetual bonds (= consols)

• The borrower simply pay coupons of a specified amount forever.
Floating rate bonds

• Bonds with coupon rates which vary over the bond’s lifetime.
• floating coupon rate is a premium over market interest rate
(e.g LIBOR or US T-bill rate) and is reset on a pre-specified basis.
Index-linked bonds
• coupons and principal grow in line with inflation
• first issued in the UK,
• increasingly frequently issued by governments as real, risk-free securities.
48

Callable bonds
• can be repaid early (i.e. before maturity) by the issuer if he/she so chooses.
• Early repayment might be restricted to a specified date (European style
bond) or may be allowed at any time prior to maturity (American style).
Puttable bonds
• the redemption date is under the control of the holder
• opposite to the callable bond
Convertible bonds
• Bonds which can be converted into a share in the firm’s equity
(either at a specific date or at any time).
• allows bondholders, as well as shareholders, to participate in upside gains
49
of a corporation.
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Foreign bond
• issued by a borrower in a country different from that borrower’s country of
origin (i.e. the borrower is selling debt abroad).
• denominated in the currency of the country in which it is sold.
• E.g. a Russian firm sells Sterling denominated debt in the UK.
• Sterling denominated foreign bonds are colloquially known as bulldog bonds.
Eurobonds
• are bonds denominated in the currency of one country
but actually sold or traded in another, different country.
• E.g. a Eurosterling bond denominated in Sterling but sold outside the UK.
• Coupons on Eurobonds are paid on an annual basis.
• London is one of the major Eurobond markets. 50
Bonds, Notes & Bills By Issuer
Treasury bills
• Note that among government debt instruments
• money market securities (maturity <1 year).
• do not pay interest
• issued at discount from their par value (i.e. less than the par value)
• repay the par value ($1000) at the maturity date.
• Yield to the investor = issue value - par value
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Government Notes and bonds
• issued by the government to finance national debt.
– Gilt: UK government bonds
– Treasuries: USA government bonds
– Bunds: Germany government bonds
• Notes : maturity of 1-10 years

• Bonds: maturity of 10-20 years.
• free of default risk (unable to make interest payments & principal
repayment).
• the issuer (the government) can print money to pay off the debt if necessary.
• Government bonds pay lower interest rates than corporate bonds.
52

Municipal bonds
• debt instruments issued by US local, county or state governments
to finance public interest projects.
• not default-free and are not as liquid as Treasury bonds.
• secured on their own revenues and not guaranteed by central government.
• pay lower interest rates than Treasury bonds (exempt from federal taxation)
• an implicit increase in the actual interest rates received by investors.
53
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Corporate bonds
• issued by large corporations when they need long-term financing.
• Pay coupon interest semi-annually
• not risk-free.
• Higher risk & higher return than government & municipal bonds
• The risk depend on the nature of the corporation’s activities
(e.g. contrast utilities with biotech firms)
• bondholders have senior claims on corporate assets in the event of
bankruptcy.
54
Default Risk & Bond Rating

• Bond is in default if the borrower is unable to meet the financial
obligations (i.e. to repay the coupon interest or/and principal) at specified
dates.
• Bondholder has a senior claim on the borrower’s assets.
• The likelihood of a borrower defaulting will affect the terms of the bond.
• A bond with higher possibility of default (and will have a lower credit
rating) will have a higher coupon interest rate
(i.e. default risk premium)
55
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Nature of Bonds
B. Debt instruments - Bonds
B____ (<1 yr) N____ (1~ 10 yr), B____ (10 ~20 yrs)
The borrower (i.e. bond ______) pay to the lenders (i.e. bondholders =
________)
(i) coupon ________ (annually or ____________) until the maturity date &
(ii) pay back the principal = p___ value(= f_____ value= $1000) at the maturity
date
Concept Check Activity: Types of Bond

C_________ Bonds The issuer pay the coupon interest to the bondholders
regularly (annually or semiannually) until maturity.
Z C The issuer DOES NOT pay the coupon interest to the
Bonds bondholder, rather it is sold at deep discount.
(= deep d_______ e.g. Treasury Bill (maturity < 1 year)
bond)
Perpetual bonds The issuer pay the coupons interest forever.
(= consols)
F_________ rate The coupon rates vary over the life of bond.
bonds The floating coupon rate is a premium over market
interest rate (e.g LIBOR or US T-bill rate) and
is reset on a pre-specified basis.
I______________ Bond’s coupons & principal grow together with index
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bonds (e.g.stock market index, consumer price index-inflation.
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Concept Check Activity: Types of Bond

F_____bond bonds issued in foreign country (using ________ currency)
E.g. a Russian firm sells in UK (in Sterling)
B_________ bonds- Sterling denominated foreign bonds.
E_____bond bonds denominated in country A’s currency but sold in country B.
s (E.g. E_________ bond denominated in Sterling but sold outside
the UK). Coupons on Eurobonds are paid on an annual basis.
London is one of the major Eurobond markets.
Bond is in d_______ if the borrower is unable to repay

the coupon interest or/and principal at specified dates.
Bond has a h______ coupon interest rate (i.e. default risk premium)
if has higher possibility of default (i.e. lower credit rating)
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Exam Focus
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Exam Focus
62
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Bonds
+ Term Structure of Interest Rate: Yield curve, 3 Theories
63
Term Structure of Interest Rates

• Is factors that influence the shape of the yield curve.
• 3 theories of the term structure of interest rate:
(a) Expectation theory
(b)Liquidity premium theory
(c) Segmented market theory
64
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Term Structure of Interest Rates – (a) Expectation Theory

(a) Expectations Theory
• The long-term rate is a geometric average of
today’s short-term rate & expected short-term rates in the future.

• Requires there is an implicit relationship between
current bond yields & forward rates.
• Forward rate of interest
= interest rate payable on funds beginning at some future date.
(1 + R)2 = (1 + r1) x (1 + r2)
• Where R : annual yield on a 2-year bond,
r1: annual return from a 1-year bond, and
r2: 1-year forward rate beginning in 1 year’s time
65
Term Structure of Interest Rates –(a) Expectation Theory

• an investor who invests will receive the same return from either
(i) £1,000 in either a 2-year bond, or
(ii) a 1-year bond subsequently reinvesting the proceeds from the 1st
year in another 1-year bond
• The existence of arbitrageurs in bond markets ensures that this relationship
holds.
Example
• Yield on a 2-year government bond, R=9% p.a.
• Yield on an equivalent 1-year bond, r1 =8% p.a.
• Yield implied on a 1-year bond held during
Year 2 of the two year bond’s life,
r2, = (1 + R)2 = (1 + r1) (1 + r2)= £1,000 x (1.09) x (1.09) = £1,188.10
= £1,000 (1.08) (1 + r2) =
r2 = 10.01%
Upward sloping yield curve 66
because Yield on 1-year bond < Yield of 2-year bond
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Term Structure of Interest Rates –(a) Expectation Theory

• Normally, the yield curve is upward sloping.
(i) current long rate (after 3 years) > current short rate
so the short-term rates must be expected to rise in the future.
upward sloping yield curve
(ii) Current long rate < current short rate
then short-term rates are expected to decline in the future
downward sloping yield curve
(iii) If no change is expected in short rates
current long rate = current short rate
flat yield curve.
• In sum, expectations of future interest rates

determine the shape of the yield curve 67
68
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Term Structure of Interest Rates – (b) Liquidity Premium Theory

• in a world of uncertainty, investors and lenders prefer to hold assets
which can be converted into cash quickly.
• So investors demand a liquidity premium for holding long term debt.
• Uncertainty causes borrowers to prefer to borrow for a longer period
at a rate which is certain now.
• so borrowers will be willing to pay a liquidity premium.
• A higher rate of interest on a longer-term debt.
• As a result, the yield curve will normally be upward sloping,
in the absence of any other influences.
• In reality, we need to consider the combined effect of
expectations together with liquidity preference.
• A downward sloping yield curve occur when expectations 69
of an interest rate fall are sufficient to offset the liquidity premium.
Term Structure of Interest Rates – (c) Market Segmentation Theory
(c) Market segmentation

• bond market is actually made up of a number of separate markets
distinguished by time to maturity, each with their own supply & demand
• Different classes of investors and issuers will have a strong
preference for certain segments of the yield curve.
• So, the yield curve will not necessarily move up, or down, over its entire
range.
70
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3 Types of Yield Curves
= factors that influence the shape of the yield curve
Expectations of future interest rates determine the shape of the yield curve
U________ sloping current long rate (after 3 years) > current short rate
yield curve short-term rates are expected to rise in the future.
(normal)
D________ sloping Current long rate < current short rate
yield curve short-term rates are expected to decline in the future
F________ sloping If no change is expected in short rates

yield curve current long rate = current short rate
71

Term Structure of Interest Rates (3 Theories)
an investor who invests will receive the same return from either
E___________ (a) £1,000 in either a 2-year bond, or
(b) a 1-year bond subsequently reinvesting the proceeds from the 1st year
_ into another 1-year bond
theory The long-term rate is a geometric average of today’s
short-term rate and expected short-term rates in the
future. Requires there is an implicit relationship between
current bond yields and forward rates.
Forward rate of interest = interest rate payable
on funds beginning at some future date. (1 + R)2 = (1 + r1) x (1 + r2)
L_____________ Investors /lenders prefer to hold assets which can be converted into ________
quickly.
_ theory Investors demand a liquidity premium for holding long term debt.
Borrowers prefer to borrow for a longer period at a rate which is certain now.
Borrowers will be willing to pay a liquidity premium. A higher rate of interest on
a longer-term debt. Yield curve normally is upwards sloping
Combine the expectations & liquidity preference in reality
A downward sloping yield curve occur when expectations of an interest rate fall
are sufficient to offset the liquidity premium.
S_____________ bond market is actually made up of a number of separate markets distinguished
by time to maturity, each with their own supply & demand 72
_ theory Different classes of investors and issuers will have a strong preference for certain
segments of the yield curve. Yield curve may move up, or down over its entire
T2-pg34
Exam Focus
23 Explain the yield curve for government bonds and discuss the 2013-7e-ZAB
main theories for explaining the shape of the yield curve.(12m
24 7(d) Explain the concept of the yield curve for bonds and 2015-7a-
distinguish between the main theories of the term structure of ZAB
interest rates. (12 marks)
74
T2-pg35

75
Common Stocks
• Common stockholders are the owners of the firm.
• Common stockholder have the voting right.
• Common stockholders
(i) receive dividends (when distributed, annually or semi-annually)
(ii) take capital gains (or losses)
when the stock market price increases (or decreases)
76
T2-pg36
Preferred Stocks
• Represents equity claims
• Preferred stockholders have limited ownership rights (as compare with
common stocks)
• preferred stockholder receive fixed constant preferred dividend (more
similar to bonds with fixed coupon interest; different to common stocks as
common stockholder may not receive dividend )
• Price of preferred stocks is relatively stable (as preferred dividend is fixed)
• Preferred stockholders do not have voting rights (common stockholders
have voting right)
• Preferred stockholders have a residual claim on assets and income left over
after creditors but before common stockholders.
77
Concept Check Activity

Common Stocks vs Preferred Stocks vs Bonds
Common Stocks Preferred Stocks Bond
(= o shares) (= p__________ shares) (bill, notes, debenture)
O_______ (equity) Creditor (equity but with Creditor (debt)
limited ownership rights)
With v______ right ___ voting right ___ voting right
High risk, high return Lower risk, lower return Low risk, low return
Capital gain (Selling- cost) (investor- for diversification)
Dividend (option) Preference dividend C_______ i_______

(must but accumulative) (must)
annually, semi-annually annually, semi-annually annually, semi-annually
R_________ claims Claims after bondholder Priority claims
T2-pg37
Exam Focus
17 Describe the characteristics of common stocks and preferred stocks. What 2007-7b-ZB
are the main differences between common stocks and preferred stocks? (6
marks)
18 An investor is considering investing in one or more of the following types of 2010-1b-ZA
assets: corporate bonds, preferred stocks or common stocks. Discuss
the relative returns, risks and ownership rights of each of these asset
types. (8 marks)
19 Compare and contrast the characteristics of preferred stock and corporate 2013-2a-ZAB
bonds from the perspective of both an investor and a firm issuing such
financial claims. (8 )
Exam Focus
20 6. (a) Discuss the empirical evidence on the risk-return relationship for the 2014-6a-ZAB
following US securities: Treasury bills, Treasury bonds, large firm common
stocks and small firm common stocks. (8 marks)
21 1(c) An investor is considering investing in the following securities: [2019-3c- [2019-3c-ZA]
ZA]
(i) Treasury bills – short term (money market), government debt
(ii) Corporate bonds – longer term (capital market) company debt
(iii) Common stocks – company equity with uncertain cash flow
(iv) Preferred stock – company equity with fixed cash flow
Explain the main characteristics (including risk, return and maturity) of
each type of investment. (12 marks)
22 3(c) An investor is considering investing in the following securities: 2019-3c-ZB
(i) Treasury bonds (ii) Corporate bonds (iii) Common stocks (iv)
Preferred stock
Explain the main characteristics (including risk, return and maturity) of
each type of investment. (12 marks)
T2-pg38


81
Types Of Financial Markets

Financial market consists of (i) primary market and (ii) secondary markets
Primary market
• financial market where newly issued financial securities
(both bonds & stocks) are sold to initial buyers.
• Primary markets facilitate new financing to corporations
Secondary market
• Financial market for resale of previously issued securities.
• Most of the trading of securities takes place in the secondary markets.
82
T2-pg39
Functions of Secondary Market
a) make financial securities more liquid

The improvement in liquidity makes securities more desirable to investors,
and easier for the firm to sell them in the primary market.
b) they set the price of the securities the firm sells in the primary
market. This means that the price of the securities’ issues on the primary
markets is partly determined by the price of similar securities traded in the
secondary market.
83
Financial Markets: Exchange market vs OTC

Financial securities may be
(i) Exchange market traded or
(ii) Over-the-counter (OTC) traded
(i) Exchange market traded

• buyers and sellers (through their brokers) transact in
one central location to conduct trades.
• E.g. New York Stock Exchange (NYSE) which recently acquired
the American Stock Exchange (AMEX) &
the London Stock Exchange (LSE).
84
T2-pg40
Stock Exchanges Extra
85 85
Quote-driven Dealer Markets, Order-driven Markets &

Brokered Markets
(i) Quote-driven dealer markets
• a dealer (= market-maker) is on one side of every trade.
• A dealer quotes prices & stand ready to buy & sell at these quotes,
so that they provide liquidity.
• Dealers hold an inventory of the security, which fluctuates as they trade.
• Dealer profit from charging a bid-ask spread and from speculating.
(ii) Order-driven markets

• buyers & sellers trade directly without any intermediation.
• Mostly auction markets.
• Trading rules formalise the process by which
buyers seek the lowest available prices &
sellers seek the highest available prices (price discovery process).86
T2-pg41
Quote-driven Dealer Markets, Order-driven Markets &

Brokered Markets
(iii) Brokered markets

• brokers match the buyers & sellers.
• brokers find liquidity but do not provide liquidity
[note: dealer provide liquidity]
• brokers do not hold inventory as they do not trade themselves.
• important for large blocks of stocks and bonds.
87
Concept Check Activity

Primary market vs Secondary markets
Financial market consists of (i) primary market and (ii) secondary markets
P_______________ market S___________ markets
For n_______ issued financial For resale of issued financial securities
securities
facilitate new financing Facilitate most of the securities trading
Make financial securities more liquid.
Issuer sell the securities Investors sell the securities
e.g. IPO, Right issue
Functions of Financial Markets
make financial securities more l_________ (i.e. more marketable)
investor prefer more liquid (secondary) market,
easier for the firm to sell the securities in the primary market.
b) they set the price of the securities the firm sells in the primary market.
i.e. securities’ prices issues on the primary markets is partly determined by the securities’
price traded in the secondary market.
T2-pg42

Exchange Market Vs Over-the-counter (OTC)
Financial securities may be traded in the Exchange market or Over-the-counter (OTC)
E market O (OTC)
With central location for securities no central location for securities trading
trading Securities are traded by dealers at
(i.e. buying or selling) different locations.
e.g. NYSE (recently acquired the e.g. US government bond market

LSE & American Stock Exchange e.g. NASDAQ (2nd largest US market)
(AMEX)
competitive as dealers use technology to
link prices. Significant in the USA with strict
listing requirement

Money Markets vs Capital Markets
Different types of financial markets, e.g. money market, capital markets, forex market
etc. M_________ Markets C___________ Markets
where s_______-term securities (maturity where l_____-term securities (maturity > 1
<1 year) year)
are issued & traded are issued & traded
For wholesale markets (large size - provide longer-term (more stable)
transactions) sources of finance for borrowers
e.g. treasury bills or certificates of e.g. government / corporate bonds
deposit (CD)
equity (infinite life)
Securities are often held by Securities are often held by
firms & financial institutions to manage financial intermediaries
their short-term liquidity needs (e.g. mutual funds, pension funds &
(i.e. to earn interest on temporary insurance companies)
surplus funds).
T2-pg43
Exam Focus
25 What is the difference between primary and secondary markets? What are 20082a-ZAB
the main functions of secondary markets? (6 marks)
26 What is the difference between money markets and capital markets? (4) 20082b-ZAB
27 Distinguish between money markets and capital markets giving examples 20101a-ZB
of financial instruments traded in each market. (5 marks)
28 Distinguish between money markets and capital markets giving examples of 2013-2c-ZA
financial instruments traded in each market. (5 marks)
29 Compare and contrast the following categories of markets: 2012-1a-ZA
i. Primary and secondary markets
ii. Organised exchanges and Over-the-counter (OTC) markets
iii. Money and capital markets
iv. Order-driven and quote-driven markets (12 marks)
30 1(b) Distinguish between the following types of market 2019-1b-ZA
(i) primary and secondary markets
(ii) exchange traded and over-the counter markets (4 marks) [2019-3b-ZA]
31 2(b) Distinguish between the following types of market: [2019-3b-ZB] :2019-2b-ZB
(i) primary and secondary markets (ii) order driven and quote driven
markets (4 marks)
Revision Exercise
Topic 2-Introduction to Financial Systems
1. Discuss the main functions of a financial system and

explain why these are important for an economy. (10, 13
marks)
2. Explain the essential differences between direct and indirect
financing identifying the characteristics of the financial
instruments used in each type of financing. (7,7,7 marks) [+
graph]
3. Explain the characteristics of the following types of bonds:
(iv) convertible bond (v) Eurobond (10 marks) 92
T2-pg44
4. What is the difference between US Government bonds and

5. Explain why corporate bonds generally have higher returns than
6. An investor is considering investing in one or more of the
following types of assets: corporate bonds, preferred stocks or
common stocks. Discuss the relative returns, risks and
ownership rights of each of these asset types. (8 marks)
7. Compare and contrast the characteristics of preferred stock and
corporate bonds from the perspective of both an investor and a
firm issuing such financial claims. (8 marks)
93
8. Explain the concept of the yield curve for bonds and distinguish
between the main theories of the term structure of interest
rates. (12,12 marks) [+graph]
9. Compare and contrast the following categories of markets:[12
marks]
i. Primary and secondary markets [6m]
ii. Organised exchanges and Over-the-counter (OTC) markets
iii. Money and capital markets [4,5,5]
iv. Order-driven and quote-driven markets
94
T2-pg45
Summary for Topic 2

• This topic has investigated financial systems by using a functional
perspective (analysing the functions of financial systems in order to
understand why they exist) and a structural perspective (to outline the
structure of financial systems and describe the main entities that comprise
financial systems).
– From a functional perspective, financial systems perform two essential
economic functions: the credit function and the monetary function.
– From a structural perspective, financial systems comprise financial
intermediaries, securities and financial markets.
95
Summary for Topic 2

• With reference to the US financial system, there is a taxonomy of each of
these three entities:
– Financial intermediaries comprise depository institutions (commercial
banks, savings and loan associations and credit unions), contractual
savings institutions (insurance companies and pension funds), and
investment intermediaries (mutual funds, finance companies, investment
banks and securities firms).
– Financial securities traded in financial markets are debt instruments
(bonds, notes and bills), and equity instruments (common and preferred
stocks).
– Financial markets can be classified as primary versus secondary markets,
organised exchanges versus over-the-counter markets, capital markets
versus money markets, quote-driven dealer markets versus order-driven
markets and brokered markets.
• Furthermore, the chapter provided an overview of the differences between
96
national financial intermediaries and financial markets across the world.
T2-pg46
Sample Examination Questions

Q1.
a. What is a financial system? Frame your answer both from a structural
and a functional perspective.
b. What is the primary function of depository institutions? How does this
function compare with the primary function of insurance companies?
c. What is a mutual fund? What are the differences between shortterm and
long-term mutual funds? Where do mutual funds rank in terms of asset size
among all financial intermediaries in the USA?
Q2.
a. Explain how securities firms differ from investment banks. Which categories of
firms are there in this industry? In what way are they financial
intermediaries?
b. What distinguishes stocks from bonds? What are the differences with
reference to the risk/return relationship?
c. ‘Because corporations do not actually raise any funds in secondary markets,
97
they are less important to the economy than primary markets’. Comment.
Sample Examination Questions

Q3.
a. With reference to examples, discuss globalisation of the financial markets
around the world.
b. Compare and contrast quote- and order-driven markets
c. Explain the purpose of money markets and give examples of the types of
money markets and their users.
98
T2-pg47
References
• M. Buckle (2011) Principle of Banking and Finance Subject Guide, Chapter 2.

Essential reading
• Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT
Press, 2001) Chapter 3.
• Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapters 1, 2 and 10.
Further reading
• Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance.
(Boston, London: McGraw-Hill/Irwin, 2010) Chapter 14.
• Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004) Chapter 1.
• Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The
MIT Press, 2008) Chapter 2.
• Saunders, A. and M.M. Cornett Financial Institutions Management: a Risk
Management Approach. (New York, McGraw-Hill/Irwin, 2007) Chapters992,3, 4,
5 and 6.
T2-pg48

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Topic 2- Introduction to Financial System

Outline for Topic 2- Introduction to Financial System

Outline for Topic 2

(2) equity instruments (common stocks, preferred stocks)

Outline for Topic 2

Learning outcomes of Topic 2

① To explain the functions of financial systems.

Part A: Two Functions of Financial System

Structure of Financial System:

Functions of Financial Systems – (a) Economic Function

(a) Economic function

Functions of Financial Systems – (a) Economic Function

Functions of Financial Systems –(b) Monetary Function

Concept Check Activity:

Concept Check Activity:

Part A: Two Functions of Financial System

Structure of Financial System:

Structure of Financial Systems- (1) Financial Market

(1) financial markets (2) financial securities (3) financial intermediaries

(1) Financial markets

Structure of Financial Systems- (2) Financial Securities

Governments & corporations raise funds by issuing:

Structure of Financial Systems- (3) Financial Intermediaries

(b) Other financial intermediaries

Financial __________ [e.g.

Financial __________ [e.g.

Financial __________ [e.g.

Part A: Two Functions of Financial System

Structure of Financial System:

Structure of Financial Systems- (3) Financial Intermediaries

(3a) Depository institutions

(3a) Depository Institutions – (i) Commercial Banks

Depository Institutions – (ii) Savings & Loan Associations (S&Ls)

3a) Depository Institutions – (iii) Credit unions

• Provide deposit & loan to their members

(3b) Contractual Savings Institutions

• Acquire funds at periodic intervals on a contractual basis.

(3b) Contractual Savings Institutions-(i) Insurance companies

(ii) property & causality insurance

(3c) Investment intermediaries

(3c) Investment intermediaries- (i) Mutual funds

(3c) Investment intermediaries- (i) Mutual funds

Short-term mutual funds

to some extent similar to depository institutions.

(3c) Investment intermediaries- (iii) Finance companies

3 types of finance companies:

(3c) Investment intermediaries- (iii) Investment banks

(iv) financial advisory (e.g. advising on mergers & acquisitions).

Underwriting of stock or bond issue

(3c) Investment intermediaries-(iv) Securities firms

(3c) Investment intermediaries-(iv) Securities firms

(3c) Investment intermediaries-(iv) Securities firms

Retail and Wholesale Banks

(i) Retail banks

(ii) Wholesale banks

• In practice it is difficult to identify purely retail banks.

Part A: Two Functions of Financial System

Structure of Financial System:

Nature Of Financial Instruments- (1) Debt instruments

Zero Coupon Bonds

Other Types Of Bonds

Perpetual bonds (= consols)

Floating rate bonds

Dividend (option) Preference dividend C_ i_