Topic 2

Introduction to Financial Systems

Source of picture: http://www.insidertech.co.uk/

Outline for Topic 2

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, perfered stocks)

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
③ intermediaries, securities & financial markets)
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 markets

Functions of Financial Markets

a) Channels funds from person or business without investment opportunities
(i.e., “Lender-Savers”) to

one who has them (i.e., “Borrower-Spenders”)

b) Improves economic efficiency

Source of picture: http://otwo.in/finance/

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2-7

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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,
is the most important way of transferring funds from lenders to borrowers. 9

Functions of Financial Systems – (a) Economic Function

10
2-10
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:
a) lending and borrowing (i.e. funds can be transferred from units in surplus to
units with a shortage of funds)
b) Payment (e.g. cheques, debit cards & credit cards)
c) 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 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) Principle of Banking and Finance, ch2

13
Source: M. Buckle (2011) Principle of Banking and Finance, ch2

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 Structure of Financial Systems- (1) Financial Market
A financial system comprises:
(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.

14

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.

15

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 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) – cannot be easily marketable
(ii) financial securities (bonds & stocks) - can 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.
16

Structure of Financial Systems- (3) Financial Intermediaries

3a) depository institutions- (i) commercial banks
(ii) savings institutions
(iii) credit unions
3b) contractual savings institutions- (i) insurance companies
(ii) pension funds
3c) investment intermediaries- (i) mutual funds
(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.
17

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

19
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. 22
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.

23

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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:
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)
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.26

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 (3b) Contractual Savings Institutions-(ii) Pension funds
• 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
(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)
29

30
Source: M. Buckle (2011) Principle of Banking and Finance, ch2

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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 and 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
to some extent similar to depository institutions. 31

(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 and bonds.
• Lend to customers perceived as too risky by commercial banks.

3 types of finance companies:

• Sales finance institutions- loans to customers of a particular retailer or
manufacturer (e.g. Ford Motor Credit).
• Personal credit institutions - loans to consumers perceived as too risky by
commercial banks (e.g. Household Finance Corp).
• Business credit institutions - financing to companies through equipment
leasing & factoring (purchase by the finance company of accounts receivable
from corporate customers). 33

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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:
– origination
– Underwriting (see notes below)
– placement of securities in primary financial markets
– 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. 34

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

• assist in the trading of existing securities in the secondary markets.
Dealers
• agents who link buyers and 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.
Traders issue orders when they cannot personally negotiate their trades. 35

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

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 and are highly active in trading
securities, e.g. Goldman Sachs, Smith Barney.
• Specialised investment bank subsidiaries of commercial banks - eg 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.
Retail banks
• for individuals & small businesses
• Emphasizes lending to individuals
• deal with a large number of small value transactions.

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 38

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 39

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 40
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 borrowing or the
price paid for the rental of funds 42

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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.
43

Other Types Of Bonds

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
44
of a corporation.

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 Other Types Of Bonds
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.
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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

46

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 Bonds, Notes & Bills By Issuer
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.

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Bonds, Notes & Bills By Issuer

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.

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 Bonds, Notes & Bills By Issuer
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.

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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)

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 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

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Term Structure of Interest Rates –(a) Expectation Theory

(a) The 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

53

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 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 into
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
Year2 of the two year bond’s life, r2, is given as:(1 + R)2 = (1 + r1) x (1 + r2)
£1,000 x (1.09) x (1.09) = £1,188.10 = £1,000 x (1.08) x (1 + r2)
r2 = 10.01%
 Upward sloping yield curve
because Yield on 1-year bond < Yield of 2-year bond 54

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
55

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 56
Source: M. Buckle (2011) Principle of Banking and Finance, ch2

Term Structure of Interest Rates – (b) Liquidity Premium Theory

(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 57
of an interest rate fall are sufficient to offset the liquidity premium.

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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.

58

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)

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 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.

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Structure 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.

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 Functions of Financial Markets
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.

63

Structure of Financial Markets

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) & London Stock Exchange (LSE).

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 Structure of Financial Markets
(ii) Over-the-counter (OTC) markets traded
• dealers at different locations have an inventory of securities, and are ready
to buy and sell these securities ‘over-the-counter’ to anyone willing to
accept their price.
• OTC markets are competitive as dealers use technology to link prices. OTC
is very different from organised exchanges.
• OTC trading is most significant in the USA where listing requirements are
quite strict.
OTC markets
e.g. US government bond market
e.g. NASDAQ (National Association of Securities Dealers Automated Quotation System)
stock exchange.
– NASDAQ: 2nd largest US market.
– Used to be a pure dealer market. Following controversies about dealer
collusion, since 1997 public limit orders are allowed to compete with
dealers.
– Market order and limit order can be entered onto the Small Order
Execution System (SOES), which automatically routes market orders 66 to
the dealer quoting the best price.

Money Markets vs Capital Markets

Money markets (maturity of <1 year)
• financial markets for short-term debt instruments
• are mainly wholesale markets (large transactions)
where firms & financial institutions manage their short-term liquidity needs
(i.e. to earn interest on their temporary surplus funds).

Capital markets (maturity of >=1 year).

• Financial markets for long-term securities
(e.g. equity instruments(infinite life), government bonds, corporate bonds.
• Securities are often held by financial intermediaries
(e.g. mutual funds, pension funds & insurance companies)

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 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 &
70
sellers seek the highest available prices (price discovery process).

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.

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 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.

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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
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national financial intermediaries and financial markets across the world.

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 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,
they are less important to the economy than primary markets’. Comment.
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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.

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 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) Chapters 2,3, 4,
5 and 6.
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