ECO432

Money and Banking

ECO 432
Lecture#1

Chapter#2

Financial System Defined

 Financial System is a Group of institutions (financial markets and intermediaries) channelling

funds from different entities having surplus funds to those who have shortage of funds.

Direct finance and Indirect finance

 Direct finance – funds are directly transferred from lenders to borrowers

 Indirect finance – financial intermediaries receive funds from savers and lend them to
borrowers

 Securities are assets for the holder and liabilities for the issuer

Function of Financial Markets 1. Allows transfers of funds from person

or business without investment
opportunities to one who has them

2. Improves economic efficiency

 Direct Finance- Financial Markets
Debt Markets (debt financing)
• Bond/mortgage- debt security;
receive fixed dollar amount at regular interval until maturity
• Short-term (maturity < 1 year)
• Intermediate-term (1 ≤ maturity <10 year)
• Long-term (maturity ≥ 10 year)

Equity Markets (equity financing)

• Stocks/shares
• Considered as long term securities as having no maturity date

Direct Finance- Financial Markets

1.Primary Market
• New security (can be bond or stock) issues sold to initial buyers
• Investment bank is a financial institution that assists corporations and government agencies in
raising financial capital by underwriting or acting as the client's agent in the issuance of
securities
• In Bangladesh investment banking is well known as merchant banking. Almost all the banks
provide this service.
Direct Finance- Financial Markets
2. Secondary Market
• Securities previously issued are bought and sold
• Better known to public as compared to primary market
• New York Stock Exchange, NASDAQ, Dhaka Stock Exchange etc.
• Major functions of secondary markets- making financial instruments liquid; determining the
price in the primary market
• Can be organized in two ways: Exchanges & OTC
Direct Finance- Financial Markets
1. Exchange Market
 Trades conducted in central locations (e.g., Toronto Stock Exchange New York Stock
Exchange, Dhaka Stock Exchange, Chittagong Stock Exchange etc.)
2. Over-the-Counter (OTC) Markets
Dealers at different locations buy and sell securities
Direct Finance- Financial Markets
 On the basis of maturity of the securities, markets are divided into-
1. Money Market
 Short term debt instruments (maturity <1 yr.)
 More widely traded
 Smaller fluctuations in prices – Least risky investments
 Example: Treasury bill (T-Bill), Certificate of Deposit (CD)
2. Capital Market –
 Longer term debt instruments (maturity >1 yr.)
 equity instruments – Wider price fluctuations – Fairly risky investments
Example: Stocks, Mortgages ,Corporate Bonds

Money Market Instruments

1.Treasury bill (T-Bill) –
 Short-term debt instrument backed by the government with maturity of less than
one year –
 Pay set amount at maturity; no interest payment but sold at a discount –
 Most liquid, safest MM instrument
2.Certificate of Deposit (CD) –
 Sold by banks –
 Pays annual interest;
 at maturity original purchase price is paid
3. Commercial Paper –
 Issued by large banks & well-known corporations –
 Usually sold at a discount from face value and generally carries lower interest
repayment rates than bonds
 Commercial paper is not usually backed by any form of collateral, so only firms with
excellent credit ratings will be able to sell at a reasonable price
  The proceeds from this type of financing can only be used on current assets (i.e.
inventories) and are not allowed to be used on fixed assets

4.Repurchase Agreements (Repos)

 Short-term loan usually with maturity of less than two weeks
 T-bills serve as a collateral
 Large corporations are the most important lenders in this market
 Secured funding and liquidity are met
5.Federal Funds
 Typically have an extremely short duration: overnight loans between banks
 Relatively low interest rate called Federal Funds Rate
 Federal funds help commercial banks meet their daily reserve requirements

Capital Market Instruments

1.Stocks
 Equity claims on net income and assets of a corporations
 There are two main types of stock: common stock and preferred stock.
 Differences arise in terms of voting rights, receiving dividends in case of bankruptcy
and liquidation
2.Mortgages
 Loans to households or firms to purchase housing, land or other real structures,
where the land/structure itself serves as collateral for the loans
3.Corporate Bonds
 Issued by corporations with very strong credit ratings
 Interest (usually twice a year) + face value at maturity
 Convertible bonds- hybrid security that offers both bond and equity feature
4.Municipal Bonds
 State and local bonds offered by state and local govt.
 To finance expenditures on schools, roads etc.
 Holders receive tax exemption
Others – Govt. securities, govt. agency securities, consumer & commercial loans etc.

International financial markets

 Foreign bond = bond issued by a foreign entity that is denominated in
the currency of the country in which the bond is sold
 Foreign bonds may be used to avoid exchange-rate risk
 For example, if the German automaker sells a bond in
Canada denominated in Canadian dollars, it is classified as a foreign bond
Eurobond = bond denominated in a currency other than that of the country in
which the bond is sold
Eurocurrencies –
 deposits denominated in a currency other than that of the country in
which the bank is located
 London, Tokyo and other foreign stock exchanges have grown in
importance
Eurobond
 A popular international bond
 bond denominated in a currency other than that of the country in which the bond is
sold
 Example, a bond issued by a Canadian corporation that is denominated in Japanese
yen and sold in Germany.
Eurocurrencies –
 Deposits denominated in a currency other than that of the country in which the
bank is located
 London, Tokyo and other foreign stock exchanges have grown in importance

Financial intermediaries
 Those institutions that act as a medium between borrowers and lends
 Channels fund from savers to borrowers
Example: Banks, Insurance companies etc.
Financial intermediaries
Financial intermediaries have some distinguished functions:
 Reduce transaction costs (due to economies of scale and lower information costs)
 Allow for differences in the desired lending and borrowing time horizons
 Risk sharing (asset transformation) lowers risk through diversification
 Reduces the costs of Asymmetric information

Types of financial intermediaries

1. Depository institutions
2. Contractual savings institutions
3. Investment Intermediaries
 Types of financial intermediaries
1. Depository Institutions
 Commercial Banks –
 Raise funds thorough checkable deposits, savings deposits, time deposits –
 Make commercial, consumer, mortgage loans etc.
 Savings & Loan Associations (S&Ls) and Mutual Savings Banks –
 Mostly made mortgage loans for residential housing in past.
 Now has similar functions as commercial banks
 Credit Unions
 Small cooperative lending institution
 Obtain funds from deposits & make consumer loans

Types of financial intermediaries

2. Contractual Savings Institutions
• Life Insurance Companies
• Fire and Casualty Insurance Companies
• Pension Funds & Govt. Retirement Funds
 These institutions obtain funds at periodic intervals, on contractual basis;
reasonable accuracy in predicting future payout
 Invest their funds primarily in long term securities such as bonds, stocks and
mortgages
Types of financial intermediaries
3. Investment Intermediaries
• Finance Companies
– Raise funds through issuing commercial papers, stocks, bonds
– Lend funds to small businesses, consumer purchase of automobile, furniture, home improvements etc.
•Mutual Funds
– Raise funds by selling shares
– Use proceeds to purchase diversified portfolio of stocks, bonds and other securities; thus allowing
shareholders to hold diversified portfolio
– Low transaction cost
• Money Market Mutual Funds
– Have the features of mutual fund & partly of depository institutions
– Deposit-type account; shareholders can write checks – Buy money market instruments from the
proceeds • Investment Banks
– Assist corporations through advisory service, underwriting, mergers/acquisitions