FINANCIAL MARKETS AND

CHAPTER 2
INSTITUTIONS
IN THIS CHAPTER
1. What is the financial system and the flow of funds?
2. What are the functions of the financial system?
3. What are the differences between financial market and financial intermediaries?
4. What are about some financial market rates?
5. What is financial infrastructure and regulation?
FINANCIAL SYSTEM
• The financial system encompasses the markets, intermediaries, service firms, and
other institutions used to carry out the financial decisions of households, business firms,
and governments
• Sometimes a market for a particular financial instrument has a specific geographic
location (New York Stock Exchange, etc)
• But usually the market has no one specific location, what we call over-the-counter
markets or off-exchange markets
• Financial markets and intermediaries are linked through a vast international
telecommunications network
THE FLOW OF FUNDS

Markets

Surplus Deficit
units units

Intermediaries
THE FLOW OF FUNDS
• Surplus unit: Agent (households or firms with profits in excess of its need for new
investment spending
• Deficit unit: Agent (households or firms that needs to finance a major expansion
• Funds flow from the surplus units to deficit units through financial intermediaries (the
lower route), whereas some funds flow through the financial markets (the upper route)
Example:
• The upper route: Households buy stocks from firms that issue stocks (directly or with a
broker)
• The lower route: A large part of flows through the lower route (depositing savings in
a banking account, etc)
THE FLOW OF FUNDS
• There has also the connection between the financial market and financial
intermediaries
For example
• From intermediary to market: A surplus unit agent may invest in savings in an
insurance company account or deposit money in a banking account (intermediary),
which then invests its funds in stocks and bonds (market)
• From market to intermediary: A finance company that makes loans to households
might raise those funds by issuing stocks and bonds in the markets for those securities
FUNCTIONS OF THE FINANCIAL SYSTEM
• Transferring resources across time and space
• Managing risk
• Clearing and settling payments to facilitate trade
• Pooling of resources and for the subdividing of ownership in various enterprise
• Price information
• Dealing with the incentive problems
FINANCIAL MARKET
Debts (fixed income instruments)
•Issued by anyone who borrow money (corporate bonds, government bonds,
residential and commercial mortgages, etc)
•Short- term debt (less than one year) is called the money market
•Long- term debt (more than one year) is called the capital market
FINANCIAL MARKET
Equity
• The claim of the owners of a firm
• Called common stocks in U.S and shares in UK
• Bought and sold in the stock market
• Each share is entitled to the same amount of profits and is entitled to one vote
of corporate governance (However, this is not always the case). Some
corporations issue stocks without voting rights
FINANCIAL MARKET
Equity
• Common stock represents a residual claim on the assets of a corporation (entitled to
assets after meeting all of the firm’s other financial obligations
• Common stock has the feature of limited liability (the creditors cannot access the
common stockholders for more money in the case of indebtedness
FINANCIAL MARKET
Derivatives
• Financial instruments that derive their value from the prices of one or more other
assets such as equity securities, fixed-income securities, foreign currencies, or
commodities
• A tool for managing exposures to the risks associated with the underlying assets
• Most common types of derivatives are options and forward contracts
FINANCIAL MARKET
Derivatives - Option
• A call option: an instrument that gives a holder the right to buy some asset at a
specified price on or before some specified expiration date
• A put option: an instrument that gives a holder the right to sell some asset at a
specified price on or before some specified expiration date
• When an owner of an asset buys a call option, he is ensured against an increase in
its price above the price specified in the call option contract and vice versa (for the
holder of put option contract)
FINANCIAL MARKET
Derivatives- Forward contract
• Instruments that oblige one party to the contract to buy, and the other party
to sell, some asset at a specified price on some specified date
• Permit buyers and sellers of the asset to eliminate the uncertainty about the
future price at which the assets will be exchanged
FINANCIAL INTERMEDIARIES
Banks
• Are considered the largest (in terms of assets) and oldest of all financial
intermediaries
• Two main functions: take deposits and make loans (with simple- functioned
bank)
• Offering also mutual funds and insurance (for banks are all- purpose
financial intermediaries)
For example: In Germany, universal banks
FINANCIAL INTERMEDIARIES
Mutual funds
• Perhaps the simplest example of a financial intermediary
• Pooling the financial resources of many small savers and invests their money in
securities
• Help small investors diversify their portfolio
• Has substantial economies of scale
FINANCIAL INTERMEDIARIES
Other depository savings institutions
• May be called thrift institutions, or simply thrifts, used to refer to saving banks,
savings and loan, credit unions
• In the U.S, these institutions compete with commercial banks in both deposit and
lending activities
• There is a variety of special- purpose savings institutions
FINANCIAL INTERMEDIARIES
Insurance companies
• Primary function is to allow households and businesses to shed specific risks
• Insurance policies are assets for people who buy them, but are liabilities for
insurance companies
• Customers pay premium (payment made to insurance companies for being protected
as risks occur) and insurance companies use these premiums to invest in assets such as
stocks, bonds, and real estate
FINANCIAL INTERMEDIARIES
Pension and Retirement Funds
• Replacing a person’s preretirement earnings when combined with Social Security
retirement benefits and private savings
• Sponsored by an employer, a labor union, or an individual
• Two types
• Defined- contribution pension plan: Employer and usually the employee make regular
contributions
• Defined- benefit pension plan: The benefits for employee depend on the working years and
in most cases, wages and salary
FINANCIAL MARKET RATES
Interest rates
• Promised rate of return
• Different interest rates for different kinds of borrowing and lending
Ex: Loans for buying homes (mortgage rate), loans for business (commercial loan rate), etc
• Interest rates depend on some factors: unit of account, maturity, default risk
• Unit of account: usually a currency, sometimes is a commodity (gold, silver, or standard “basket” goods
and services)
• Maturity: the length of time until repayment of entire borrowed amount
• Default risk: the possibility that some portion of interest or principal will not be paid in full
FINANCIAL MARKET RATES
Interest rates dominated in different currencies
• In this case, the rate of return in any currency is uncertain because it depends on the
rate of exchange between currencies (The exchange rate is the price of one currency
in terms of the other)
• Hence, an investor does not necessarily choose a higher rate bond with the same
maturity
Example: Invest £100 in a U.K bond with the exchange rate £1 = ¥150, the value of
initial investment in yen is ¥15000
The interest rate in U.K is 9%, in Japan is 3%
FINANCIAL MARKET RATES
• If you decide to invest in U.K, you will have £109 for sure
• But the value of £109 in yen is not known because the future ¥/£ exchange rate is
unknown
(£109 ×𝐹𝑢𝑡𝑢𝑟𝑒 𝑌𝑒𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑃𝑜𝑢𝑛𝑑) − ¥ 15000
• Yen rate of return =
¥ 1 5000
(£109 ×140) − ¥15000
• Realized yen rate = = 0.0173
¥ 1 5000
• Realized yen rate is less than 3% risk free yen interest rate
FINANCIAL MARKET RATES
Rates of Return on Risky Assets – For example: investment in stocks
• Rates of return when you invest in equity securities such as common stocks
• Return comes from two sources: cash dividends and any gain or loss in the market
price of the stock
• Cash dividends: are not contractually required (not called interest payments)
• Capital gain or loss
𝐸𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒 −𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒+𝐶𝑎𝑠ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
r=
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐸𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒 −𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
r= +
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
r = Dividend Income Component + Price Change Component
FINANCIAL MARKET RATES
Market Indexing: board diversification and low trading activity
• A passive investment strategy that seeks to match the investment returns of a
specified stock marker index
• A simple truth: It is impossible for all stock investors in the aggregate to outperform
the overall stock market
• A strategy in which an investor manager attempts to replicate the investment results
of a target index by holding all or in the case of very large indexes, a
representative sample of the securities in the index
• No attempt to use “active” money management or to make “bets” on individual
stocks or narrow industry sectors to outpace the index. If have, just luck or may be
skill
FINANCIAL MARKET RATES
Inflation and Interest rates
• Economists distinguish between nominal and real variables (Variables that are
corrected for inflation)
• For interest rates, we also have nominal interest rate and real interest rate
• Nominal interest rate: the promised amount of money you receive per unit you lend
• Real interest rate: the nominal interest rate you earn corrected for the change in the purchasing power
parity
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 −𝑅𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
• Real rate of return =
1+𝑅𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
FINANCIAL MARKET RATES
Inflation and Interest Rates
For example: The nominal interest rate is 6% whereas the inflation rate (normally
measured by CPI) is 3% with an initial investment is $100
• After one year, an investor will have $106 (the growth of number of currency due to
6% nominal interest rate)
• At the same time, the basket cost is assumed to cost $100 at initially, after one year
will cost $103
• The question is: How much will your future value of $106 be worth in terms of
consumption goods?
• The answer is $106/$103 = 1.029 baskets (What is your interpretation in terms of
baskets?)
FINANCIAL MARKET RATES
Interest rate equalization- the issue of interest rate arbitrage
• Competition in financial market ensures that interest rates on equivalent assets are
the same (same maturity, same default risk,…)
• If does not, there is a chance for an investor to carry out interest rate arbitrage
FUNDAMENTAL DETERMINANTS OF RATES OF RETURN

• Productivity of capital goods

• Degree of uncertainty regarding the productivity of capital goods
• Time preferences of people: consumption now and consumption in the future
• Risk aversion: the amount people are willing to give up in order to reduce their
exposure to risk
FUNDAMENTAL DETERMINANTS OF RATES OF RETURN

Expected productivity of capital goods

• Capital goods are goods produced in the economy that can be used in the
production of other goods
• Tangible capital: roads, bridges, factories, machinery, inventories,…
• Intangible capital: patents, contracts, brand-name recognition
• Capital’s productivity can be called the rate of return on capital. This is the source of
the dividends and the interest paid to investors (stocks, bonds, other financial
instruments issued by firm)
• Higher expected return on capital induces higher interest rates in the economy
FUNDAMENTAL DETERMINANTS OF RATES OF RETURN

The degree of uncertainty about the productivity of capital goods

• Machines breakdown from time to time
• Demand for goods and services may change due to changing tastes and results in
the variation of profits by firms
• Technological progress leads to an unpredicted rate of return on capital
• The greater the degree of uncertainty about the productivity of capital goods, the
higher the risk premium on equity securities
FUNDAMENTAL DETERMINANTS OF RATES OF RETURN

Time preferences for people

• The interest rate in the economy is likely to increase if people prefer to consume in
current time to consume in the future
Risk aversion
• Rate of return on capital is always risky
• However, financial system provides some mechanisms for people who want to invest
in risk-free assets by giving up some of their expected return
• The greater the degree of risk aversion of the population, the higher the risk
premium required and the lower will be the risk-free rate of interest
FINANCIAL INFRASTRUCTURE AND REGULATION

• Financial infrastructure consists of the legal and accounting procedures, the

organization of trading and clearing facilities, the regulatory structures that govern
the relations among users of the financial system
• These laws may differ from country to country and change over time
• Some regulatory tasks are performed by private sector organizations, some are
performed by governmental organizations
• Rules of trading
• Accounting systems