Chapter 2

AN OVERVIEW OF THE
FINANCIAL SYSTEM
 The financial sector plays a vital role in the
economy because it helps money be
efficiently channeled from savers to
prospective borrowers, making it much easier
for firms to obtain financing for profitable
investment in new capital and for individuals
to borrow against their future income (e.g., to
pay for college, to buy a house or car).
 Without financial markets and institutions,

borrowers would have to borrow directly from

savers. Probably not much borrowing would
take place at all, borrowers would tend to
have a hard time finding individuals able and
willing to loan them money.
 Without much borrowing, the economy
would be a lot less developed, as few
businesses would be able to raises
funds to invest in new plant and
equipment. Likewise, relatively few
individuals would be able to own their
own homes, or buy a car.
 A well-functioning financial sector is
necessary for a well-functioning
economy.
DIRECT AND INDIRECT FINANCE
 Funds can raised directly (direct

finance) or indirectly (indirect finance)

 Direct finance refers to funds that flow

directly from the lender/saver to the

borrowers/investors in financial market.
 Indirect finance refers to funds that flow

from the lender/saver to a financial

intermediary who then channels the
funds to the borrower/investor.
Financial intermediaries (indirect
finance) are the major source of funds
for corporations.
FUNCTION OF FINANCIAL
MARKETS: DIRECT FINANCE
 Financial markets have important function in
the economy because they
1. Allow transfer of funds from person or
business without investment opportunities
to ones who have them. In the absence of
financial markets, lenders-savers and
borrower-spenders may not get together
and it becomes hard to transfer funds from
a person who has no investment
opportunities to one who has them
2. Enhance economic efficiency by allocating
productive resources efficiently, which
increases production.
 3. Improve the economic welfare because
they allow consumers to time their
purchases better.
4. Increase returns on investment and
increase business profit
5. Set firm value
6. Buy and sell risk: allow you to transfer
certain financial risks (arising from
accidents, theft, illness, early death, etc.)
to another party (in this case, the
insurance company).
 A breakdown of financial markets can result
in political instability.
STRUCTURE OF FINANCIAL
MARKETS
 Financial markets can be

categorized in four different ways:

1. Debt and Equity Markets
2. Primary and Secondary market
3. Exchanges and Over–the-Counter
Market
4. Money and Capital Markets
First: Debt and Equity Markets
 A firm or an individual can obtain
funds in a financial market in two
ways:
1. To issue the debt instrument, which is
practiced in debt markets.
2. To issue equities (such as common
stock) , which is practiced in equity
markets, is by issuing,
1. Debt Market
 Debt instrument is a contractual agreement
that obliges the issuer of the instrument (the
borrower) to pay the holder of the instrument
(the lender) fixed amounts (interest and
principal payments) at regular intervals until a
specified date (maturity date) when a final
payment is made.
 The maturity of a debt instrument is the date

on which a loan or bond, or other financial

instrument becomes due and is to be paid off.
 Debt holders do not share the benefit of

increased profitability because their dollar

payment is fixed
 A debt instrument is
1. short-term if its maturity is less than one
year,
2. long-term debt if its maturity is ten years or
longer, and
3. intermediate-term if its maturity is between
one and ten years.
 Examples of debt instruments include
government and corporate bonds.
2. Equity Market
 Equity is a contractual agreement
representing claims on the issuer's income
(income after expenses and taxes) and the
asset of the business.
 Equities often make periodic payments

(dividends) to their holders

 Equities are considered long-term financial

instruments because they have no maturity

date.
 Since equity holders own the firm, they are

entitled to (1) elect members of the firm’s

board of directors and (2) vote on major
issues concerning how the firm is managed.
 A key feature distinguishing equity from debt
is that the equity holders are the residual
claimants: the firm must make payments to its
debt holders before making payments to its
equity holders.
 Although more attention is given to the equity

(stock) markets, the debt markets are actually

much larger
Advantage and Disadvantages of Both Markets

Debt Market Equity Market

Advantag receive fixed do not benefit from
e payments, an increase in the
regardless of value of the
whether the borrower’s income
borrower’s income or asset
and assets become
more or less
valuable over time.
Dis- receive larger 1. receive smaller
advantag payments when the payments when the
e business becomes business becomes
more profitable or less profitable or
the value of its the value of its
assets rises assets falls.
Second: Primary and Secondary Markets
 A primary market is a financial market in which
newly-issued securities, such as bonds or stocks,
are sold to initial buyers by the corporation or
government agency borrowing the funds
 An important financial institution that assists in the

initial sale of securities in the primary market is the

investment bank.
 A corporation acquires new funds only when its

securities (IPOs) are sold in the primary market by

an investment bank.
 Investment Banks underwrite (insure) securities in

primary markets.
 Underwriting is a process whereby investment
bankers (underwriters) buy a new issue of
securities from the issuing corporation or
government entity and resell them to the
public. Thus, it guarantees a price for a
corporation's securities and then sells them to
the public.
 A secondary market is a financial market in
which previously issued securities can be
resold
 Brokers and dealers play an important role in

secondary markets.
◦ A broker is a securities firm or an
investment advisor associated with a firm
who matches buyers with sellers of
securities. The broker does not own the
securities but acts as an agent for the buyer
and seller and charges a commission for
these services.
◦ A dealer is a securities firm links buyers and
sellers by buying and selling securities for
its own account at stated prices and at its
 Note that the originally issuer or borrower
receives funds only when its securities are
first sold in the primary market; the issuer
does not receive funds when its securities
are traded in the secondary market.
 Nevertheless, secondary markets perform
two essential functions:
1. They make it easier for the buyers of
securities to sell them before the maturity
date, if necessary. That is, they make the
securities more liquid.
2. The price in the secondary market
determines the price that the corporation
would receive if they choose to sell more
stock in the primary market.
Third: Exchanges and Over-the-
Counter (OTC) Markets
 Secondary markets can be organized in two
ways.
 Exchange is a marketplace where buyers and

sellers of securities (or their agents or

brokers) meet in one central location to buy
and sell stocks of publicly traded companies.
Examples of exchanges include New York
Stock Exchange, Bahrain Stock Exchange
 Over-the-counter (OTC) market is a market in

which dealers at different locations trade via

computer and telephone networks.
Because over the counter dealers are in
computer contact and know the prices set by
one another, OTC is very competitive and not
very different from a market with an organized
exchange
 Many OTC stocks are traded in a market

called "NASDAQ," which is set up by the

National Association of Securities Dealers
(NASD although the largest corporations
usually have their shares traded at organized
stock exchanges.
Fourth: Money and Capital Markets
 Financial markets can be divided on the basis
of the maturity of the securities traded in
each market to money markets and capital
markets
 Money markets: Financial markets in which
only short-term debt instruments with maturity
of less than one year are traded.
 Capital markets: Financial markets in which
intermediate-term debt, long-term debt, and
equities are traded; such as stocks and long
term bonds
 Money market securities are (1) usually more
widely traded than longer-term securities and
therefore tend to be more liquid. (2)They have
smaller fluctuations in prices compared to
long-term securities making them safer
investments.
 Corporations and banks actively use money

market to earn interest on surplus funds that

they expect to have only temporarily.
 Capital market securities, such as stocks and

long-term bonds, are held by financial

intermediaries such as insurance companies
and pension funds, which have a little
uncertainty about the amount of funds they will
have available in the future.
FINANCIAL MARKET
INSTRUMENTS
A financial instrument is a financial
asset for the person who buys or holds
one, and it is a financial liability for the
company or institution that issues it.

Money Market Instruments

 All of the money market instruments are, by
definition, short-term debt instruments, with
maturities less than one year.
 The main types of money market instruments
include:
1. Treasury Bills:
 Short-term debt issued by government to
help finance its current and past deficits.
 Pay a fixed amount at maturity.
 Pay no interest but they are sold at a
price lower than their face value.
 The most liquid instruments in the money
market, and they are the most actively
traded.
 The most famous and the safest one is
US Treasury Bills
2. Negotiable Bank Certificates of Deposit
(CDs)
 A certificate of deposit (CD) is a debt

instrument that is issued by a commercial

bank against money deposited with it for a
specific period of time, usually at a specific
rate of interest, with a penalty for early
withdrawal.
 At maturity, return the original purchase

price (the principal).

 Negotiable CDs means CDs that are traded

in the secondary markets.

3. Commercial Paper.
 unsecured short-term debt instruments
(obligations) issued by large banks and well-
known corporations with high credit ratings,
such as Microsoft and General Motors.
 The investment in commercial Papers is
usually relatively low risk.
 The holding period is usually very short, and
corporation agrees to pay the money back
even earlier (on demand), if asked.
 They can be either discounted or interest-
bearing,
 They usually have a limited or nonexistent
secondary market.
 They are available in a wide range of
denominations.
4. Bankers Acceptance.
 It is a bank draft (like a check) issued by a
firm, payable at some future date.
 It is guaranteed that it will be paid by a bank
that stamps it “accepted”.
 The firm must deposit the required funds into
its account to cover the draft.
 They are created to carry out international
trade.
 The advantage to the firm is that the draft is
more likely to be accepted by foreign exporter
since the bank guarantee the payment of the
draft even if the local firm goes bankrupt.
 These “accepted” drafts are often resold in
the secondary market at a discount.
5. Repurchase Agreements (repos).
 They are usually very short-term (overnight or
one day) but can range up to a month or
more; and use Treasury bills as collateral in
case of default, between a non-bank
corporation as the lender and a bank as the
borrower.
 In the case of the repurchase agreement, the
non-bank corporation buys the Treasury bill
from the bank. Simultaneously, the bank
agrees to repurchase the Treasury bill later at
a slightly higher price. The difference
between the original price and the repurchase
price is the interest.
 This act has the effect of injecting or
removing reserves from the banking system in
order to meet central bank strategies for
implementing monetary policy.
6. The Central Bank’s Funds.
 These instruments are typically overnight
loans between banks of their deposits at the
Central Bank.
 Designed to enable banks temporarily short of
their reserve requirement to borrow reserves
from banks having excess reserves.
Capital Market Instruments
 Capital market instruments are debt and
equity instruments with maturities of greater
than a year.
 They have more price fluctuations than
money market instruments and they are
considered to be fairly risky investments.
Types of capital market instruments include

1. Stocks.
◦ Stocks are equity claims -represented by
shares- on the net income and assets of a
corporation.
2. Mortgages (Residential, Commercial, and
Farm):
 Mortgages are loans to individuals or firms to
purchase houses, land, or other real
structure.
 The structure or land serves as collateral for
the loans.
3.Corporate Bonds.
 Intermediate and long-term debt issued by
corporations with strong credit ratings to raise
capital.
 They pay the holder an interest payment in
regular intervals and pays off the face value
when bond matures.
 Corporate bonds often offer somewhat higher
4. Convertible Bonds.
 They are bonds that allow the holder to
convert them into a specified number of
shares of stock at any time up to the maturity
date.
 This feature makes them more desirable to
prospective purchasers than bond without it
and allows the corporation to reduce its
interest payments.
5. Government debt securities.
 These long-term debt instruments are issued
by the government to finance the deficits of
the government.
 They are the most liquid securities traded in
the capital market.
6. Consumer and Bank Commercial Loans.
 Loans, originally made by banks, to
businesses and households.
 They are also made by finance companies.
 Secondary markets for these loans are only
now just developing.
DERIVATIVE INSTRUMENTS
 Derivative instruments are contracts such as
options, futures, and swaps whose price is
derived from the behavior and performance of
an underlying asset (such as commodities,
bonds, and equities), index or reference rate
(such as an interest rate or foreign currency
exchange rate).
 Derivatives can be used to (1) speculate on

market movements, (2) to protect investments

against major swings in market prices, (3) to
manage risk, (4) reduce cost, and (5) enhance
returns.
 Their time horizons can be very short or quite

long.
1. Futures contracts,
◦ Futures refer to contractual obligations with
the purchase and sale of standardized
financial instruments or physical
commodities for future delivery at a fixed
price and at fixed point in the future.
◦ For commodities whose prices often
fluctuate (e.g., crops, oil), these contracts
are important ways of reducing risk.
◦ More recently, these kinds of contracts
have been used with financial instruments.
2. Options contracts:
 Options give the holder the right to buy ( call
option) or sell (put option) a fixed quantity of
a security or commodity at a fixed price,
within a specified period of time.
 Investors often use them to protect, or hedge,
an existing investment.
 Options may either be standardized,
exchange-traded, and government regulated,
or over-the-counter customized and non-
regulated.
 Options are also common, and less risky to
purchase, because you have the option of not
making that future trade if the prices have not
moved in your favor.
INTERNATIONALIZATION OF
FINANCIAL MARKETS
 The growing internationalization of financial
markets has become an important trend.
 Foreign Bonds. Bonds that are sold in a foreign

country and denominated in that country’s

currency. For example, if a Bahraini company
such as Alba sells a bond in the United States
denominated in U.S. dollars, it is classified as
a foreign bond.
 Eurobond. is a bond denominated in a currency

other than that of the country in which it is

sold. For example, a bond denominated in USD
sold in Germany.
 Eurocurrencies are foreign currencies
deposited in banks outside the home
country.
 The most important of the Eurocurrencies

are Eurodollars which are U.S. dollars

deposited in foreign banks outside the
U.S. or in foreign branches of U.S.
banks. Because these short-term
deposits earn interest, they are similar to
the short-term Eurobonds
FUNCTION OF FINANCIAL
INTERMEDIARIES: INDIRECT
FINANCE
 We have now considered a wide variety of
financial instruments that arise through the
process of direct finance, in which the lender
sells securities directly to the borrower.
 Why does some borrowing and lending take

place, instead, through indirect finance– that

is, with the help of a financial intermediary?
 Financial intermediation or indirect finance is

the process of obtaining or investing funds

through third-party institutions like banks and
mutual funds.
 As a source of funds for businesses and
individuals, indirect finance is far more
common than direct finance. In virtually every
country, credit extended by financial
intermediaries is larger as a percentage of
GDP than stocks and bonds combined.
 Commercial banks are the financial

intermediary we meet most often, but mutual

funds, pension funds, credit unions, savings
and loan associations, and insurance
companies are important financial
intermediaries.
 Financial intermediaries are so important in
current days economies because:
1. They transform fund efficiently:
◦ They attract funds from individuals,
businesses, and government and then
repackage these funds as new financial
products, such as loans, which satisfies
different needs of savers and borrowers in
relation to the amount of funds, the risk
levels, and the maturity requirements
(usually borrowing short and lending long
term).
2. They lower transaction costs.
◦ Transaction costs refer to the time and
money spent in carrying out financial
transactions. Financial intermediaries have
the abilities to lower transaction costs
because:
a. Small investors have neither the required
expertise nor the time to research what
assets they should invest in. Financial
intermediaries like professional
investment firms have the expertise and
research facilities to study firms in-depth
and to reduce the transaction costs.
b. Their large size allows them to take
advantage of economies of scale , the
reduction in average transaction costs as
the size (scale) of transactions increases.
For example, a bank can use the same
loan contract many times, thereby
reducing the cost of making new contract
form for every new loan.
3. Reducing Risk
◦ Risk here mainly refers to the uncertainty
about the returns on their investments.
◦ Financial intermediaries do reduce risk
through risk sharing and diversification.
◦ Banks mitigate risk by taking deposits from
a large number of individuals and make
loans to large number businesses and
investors. Even if a few loans are bad,
most of the loans will be repaid making the
overall return less risky. Thus, financial
intermediaries reduce risk by spreading
risky investments among a large number of
businesses and clients.
◦ This process of risk sharing is also
sometimes referred to as asset
transformation, because risky assets are
turned into safer assets for investors.
◦ Diversification means lowering the cost by
investing in a collection ( portfolio) of assets
whose returns do not always move together.
Thus, the overall risk is lower than for
individual assets.
◦ Here, again, the bank is taking advantage of
economies of scale, since it would be
difficult for a smaller investor to make a
large number of loans.
4. They provide liquidity services
◦ Liquidity services make it easier for
customers to conduct transactions.
◦ Liquidity refers to the speed and ease of
converting assets into cash.
◦ Although the intermediary may use its
funds to make illiquid loans, its size allows
it to hold some funds idle as cash to
provide liquidity to individual depositors.
5. They reduce the problem of asymmetric
information.
◦ imperfect information in financial markets is
called asymmetric information.
◦ Asymmetric Information Can be defined as
information that is known to some people but
not to other people.
◦ It refers to the situation when one party does
not know enough about the other party to
make accurate decision.
◦ Financial intermediaries use their expertise
to screen out bad credit risks and monitor
borrowers. They help solve two problems
related to asymmetric information.
◦ Asymmetric information poses two obstacles
to the smooth flow of funds from savers to
investors: adverse selection and moral
hazard.
◦ Adverse Selection is a transaction in which
one party has relevant information that the
other does not have, and therefore, exploit
these asymmetries in information to its own
advantage. For example, someone with a
dangerous occupation or hobby may be
more likely to apply for life insurance.
◦ In the financial intermediaries, the adverse
selection refers to the problem created by
asymmetric information before a loan is
made because borrowers who are bad credit
risks tend to be those who most actively
seek out loans.
◦ Because adverse selection makes it more
likely that loans might be made to bad credit
risks, lenders may decide not to make any
loans even though there are good credit
risks in the marketplace.
◦ Financial intermediaries can help reduce the
problem of adverse selection by gathering
information about potential borrowers and
screening out bad credit risks.
◦ Moral Hazard is a problem created by
asymmetric information after a loan is made
because borrowers may use their funds
irresponsibly.
◦ Moral Hazard refers to the lack of any
incentive to guard against a risk when you
are protected against it.
◦ Moral Hazard is the risk (hazard) that the
borrower might engage in activities that are
undesirable (immoral) from the lenders point
of view, because they make it less likely that
the borrower will repay the loan.
◦ Because moral hazard lowers the probability
that the loan will be repaid, lenders may
decide that they would rather make no
loans.
◦ Financial intermediaries can help reduce the
problem of moral hazard by monitoring
borrowers’ activities.
TYPES OF FINANCIAL
INSTITUTIONS:
1. Depository institutions (banks, credit unions,
savings & loan associations)
◦ Accept (issue) deposits, which then become
their liabilities (sources of funds).
◦ Make loans, which then become their
assets.
2. Insurance companies
◦ They collect premiums (regular payments)
from policy-holders, and pay compensation
to policy-holders if certain events occur
(e.g., fire, theft, sickness, and life).
◦ They invest the premiums in securities and
3. Pension funds
◦ They collect contributions from current
workers and make payments to retired
workers.
◦ Like insurance companies, they invest the
contributions in securities and real estate,
and these are their main assets.
4. Finance companies
◦ Like banks, they use people's savings to
make loans to businesses and households,
but instead of holding deposits, they raise
the cash to make these loans by selling
bonds and commercial paper.
◦ They tend to specialize in certain types of
loans, e.g., automobile or mortgage loans.
5. Securities firms
◦ Thy provide firms and individuals with
access to financial markets
◦ This category covers a wide range of
financial institutions:
◦ Investment banks: sell new securities for
companies. Unlike regular banks, they
don't hold deposits, or make loans. Closely
related are underwriters , which not only
sell the new securities but pledge to
purchase some or all of any unsold shares.
◦ Brokers: buy/sell old securities on behalf of
individuals.
◦ Mutual-fund companies: pool the money of
small savers (individuals), who buy shares
in the fund, and invest that money in stocks,
bonds, and/or other assets. These are
popular because they allow small savers
relatively easy and cheap access and also
enable them to reduce risk by holding a
diversified portfolio.
6. Government-sponsored enterprises
◦ Some of these provide loans directly, such
as to farmers and home buyers.
◦ Some guarantee or buy up private loans,
notably mortgage and student loans.
◦ Some administer social insurance
programs.
Regulation of the Financial System
 Government regulates financial markets and
institutions
1. To increase the information available to
investors by (a) reducing adverse selection
and moral hazard problems, and (b)
reducing insider trading
2. To ensure the soundness of financial
intermediaries through (a) restrictions on
entry (b) disclosure, (c) restrictions on
assets and activities, (d) deposit Insurance,
(e) limits on competition, and (f) restrictions
on interest rates