Chapter two: An overview of the

financial system
• Characteristics of financial Instruments

• Function of financial Markets

• Structure of financial Markets

• Function of financial intermediaries

• Classification of financial Intermediaries

 1. Characteristics of financial Instruments

• Liquidity

• Risk

• yield
 liquidity
• Liquidity refers to the ease & willingness with which
an asset may be converted into money on short
notice.

• There are 3 prerequisites for a financial instrument

to be considered highly liquid
1- the instrument must be easily converted to cash
2- the transaction costs of doing so must be low
3- the principle must remain relatively stable over time
 Risk
• The possibility of not recovering the full value of original funds
invested.

A) Default Risk
• refer to the possibility of not receiving the contractual interest
payments or of not recovering the principle due to the
insolvency of the instrument’s issuer.

B) Market Risk
Refer to risk of fluctuation in the price or market value of the
financial instrument
 yield
The yield :is the rate of return on an assets ,
expressed as a percentage per year.

Computed as: the yearly return on the instrument

divided by the price or initial principal
(current yield)

The yield to Maturity takes into consideration any

capital gain or loss realized at maturity.
Relationship between liquidity, Risk and yield

• Investors will normally accept a lower yield in order to obtain

increased liquidity

• Risk & yield are positively related, because most investors

are risk averse and must be compensated with higher
returns for accepting a higher degree of risk

• Risk & liquidity are also related. More liquid financial

instruments are less risky, because they may be cased in a
short time, at a price not significantly lower than the original
purchase price
 2. Function of financial Markets
• The basic function of financial markets is to
channel funds from people who have an excess of
available funds to people who have a shortage.

• Financial markets are important in channelling

funds from people who do not have a productive
use for them to those who do, a process that
results in greater economic efficiency
• Financial markets can do this either through

A) Direct finance: in which borrowers borrow funds

directly from lenders by selling them financial
instrument

B) Indirect finance: which involves a financial

intermediary who stands between the lender savers
and the borrower spenders and helps transfer funds
from one to the other.
 3. Structural classification of financial
Markets
• Debt and Equity markets

• Primary and secondary markets

• Exchanges and over the counter markets

• Money and capital markets

 a) Debt and Equity Markets
• Debt instrument (such as bond or mortgage)
which is a contractual agreement by the borrower
to pay the holder of the instrument fixed amount
of money at regular intervals until a specified date

• Equity (such as shares) which are claims to share

in the net income and the assets of a business.
Long term securities because they have no
maturity date.
• The main disadvantage of owning a
corporation’s equity is that: the corporation
must pay all its debt holders before it pays its
equity holder

• The advantage of holding equities is that: they

benefit directly from any increases in the
corporation’s profitability or asset value.
b)Primary and secondary Markets
• Primary market is a financial market in which
new issues of a security are sold to initial
buyers by the corporation or government
agency borrowing the funds.
• A secondary Market is a financial market in
which securities that have been previously
issued can be resold.
• ex: Newyork stock exchange & NASDAQ
 c) Exchange and over the counter
Markets
• Exchange Market: where buyers and sellers of
securities meet in one central location to conduct
trades.(organized exchanges)

• Over the counter market :

in which dealers at different locations who have an
inventory of securities stand ready to buy and sell
securities “over the counter” to anyone who comes
to them and is willing to accept their prices.
 d) Money and capital Markets
• The Money Market is one in which short term
debt instruments are traded (less than year)

• The capital Market is one in which long term

debt and equity instruments are traded
 4. Function of Financial Intermediaries

• Financial intermediaries are financial

institutions that acquire funds from lenders
savers by issuing liabilities and use the funds
to make loans to borrowers spenders.

• Financial intermediation benefits both surplus

and deficit spending units.
 From the point of view of surplus
units (savers)
• Financial intermediaries can overcome the
obstacles that stop savers from purchasing primary
claims directly.

• Some of these obstacles are:

1- lack of information
2- lack of financial expertise
3- limited access to financial markets
From the point of view of deficit spenders

• Financial intermediaries broader the range of

instruments, and maturities an institution can
issue, which significantly reduce transactions
costs.
• For example, a bank can give a loan to General
Motors or buy a GM bond from the primary financial
market .
• The ultimate result from this is that funds have been
transferred from the public (the lenders-savers) to
GM (the borrower- spender) with the help of the
financial intermediary (the bank).
• By charging a higher interest rate on loans than they
pay on the funds they acquire (the interest
differential), financial intermediaries make profit
 Problems associated with asymmetric
information between lender and borrower

• Adverse selection

• Moral Hazard

• Transaction costs
 Adverse selection
• Is the problem created by asymmetric
information before the transaction occurs .
• Adverse selection is a problem associated with
equity and debt contracts arising from the
lender's relative lack of information about the
borrower's potential returns and risks of his
investment activities.
• Adverse selection is the tendency for those
persons with the highest probability of
experiencing financial problems to seek out
and be granted loans
• Financial intermediaries face the problem of
Adverse selection If bad credit risks are the
ones who most actively seek loans and,
therefore, receive them from financial
intermediaries.
 Moral Hazard
• Occurs after a loan is made. Moral hazard in
financial markets occurs when borrowers have
incentives to engage in activities that are
undesirable (immoral from the lender point of view)

• Moral hazard arises because the debt contract

allows the borrower to keep any and all returns that
exceed the fixed payments in the loan agreement.
 Transactions costs
• Involves the money & time spent carrying out
financial transactions

• Financial intermediaries make profits by

reducing transactions costs. (reducing
transactions cost by developing expertise and
taking advantage of economies of scale.
 Question
• Because there is an imbalance of information in a
lending situation, we must deal with the problems of
adverse selection and moral hazard.
• Define these terms and explain how financial
intermediaries can reduce these problems.
• Adverse selection is the asymmetric information problem
that exists before the transaction occurs.
For lenders, it is the difficulty in judging a good credit risk
from a bad credit risk.
• Moral hazard is the asymmetric information problem that
exists after the transaction occurs.
For lenders, it is the difficulty in making sure the borrower
uses the funds appropriately.
• Financial intermediaries can reduce adverse selection
through intensive screening and can reduce moral hazard by
monitoring the borrower.
• Financial intermediaries improve the efficiency of
financial markets. The reasons are the following:
• 1) People’s small savings can get a higher interest
rate when they are marketed as a part of a larger
loan.
• 2) Households and small firms, for which it would
be impossible to get funds as direct finance, can
get relatively large loans from banks.
• 3) Financial intermediaries reduce the costs of collecting
information of all borrowers and lenders. It would be very
expensive for lenders to identify all potential borrowers, and
for borrowers to identify all potential lenders.
• 4) Once a lender finds a potential borrower, he/she has the
problem of finding out whether the borrower is likely to repay
his debts. Financial intermediaries, on the other hand, have
regular information of the financial situation and credibility of
their clients by following the movements on their accounts.
This gives them superior information as compared with
outsiders in evaluating the risk related to a certain client.
• 5) Financial intermediaries reduce the transaction
costs which would have to be paid if every lender and
borrower himself writes an appropriate loan contract,
or pays the brokerage commission for the transaction.
Smaller transaction costs related to one client do not
threaten the existence of the whole bank, which
might happen in the case of a small financial unit.
• large loan as compared with many small loans
creates economies of scale (lower unit costs at a
larger scale of operation) into the lending business.
• 6) Financial intermediaries can create maturity
transformations between financial
agreements. From a continuous inflow of
small short-term deposits from various
sources with varying interest rates, a bank can
issue large long- term loans with a fixed
interest rate.
• 7) The expertise and education of the personnel
in banks allows them to make better investment
decisions as compared with small savers with less
information. The investing of large sums of
money may though create large losses in the case
banks make unsuccessful investment decisions.
• 8) If a bank has enough independent depositors
and borrowers, the risks related to one
 5. Classification of financial
Intermediaries
Financial intermediaries may be classified into
three categories:

• Depository institution (banks)

• Contractual saving institutions

• Investment intermediaries
 Depository Institutions
1- commercial Banks:

2- savings & loan Associations

3- credit unions
1- commercial banks:

Are financial intermediaries that raise funds by issuing

checkable deposits( deposits on which checks can
be written),
saving deposits (deposits that are payable on demand
but do not allow their owner to write checks),
and time deposits (deposits with fixed terms to
maturity)
2- savings& loan association:

Obtain funds primarily through savings deposits( often

called shares), and time & checkable deposits

3- credit union:
These financial institutions are very small cooperative
lending institutions organized around a particular
group: union members, employees of a particular firm
 Contractual savings institutions
1-Life insurance companies

2- fire and causality insurance

3- pension funds
1- life insurance companies:

• Insure people against financial hazards

following a death.
• They acquire funds from the premiums that
people pay to keep their policies in force& use
them mainly to buy corporate bonds.
2- fire and casualty insurance companies:
• These companies insure their policyholders against loss
from theft, fire and accidents.

• They receive funds through premiums for their policies,

but they have a greater possibility of loss of funds

• For this reason, they use their funds to buy more liquid
assets than life insurance companies do.
3- pension funds:
Provide retirement income to employees who
are covered by a pension plan. Funds are
acquired by contributions from employers or
from employees.
 Investment intermediaries
1- finance companies

2- Mutual funds

3- money market mutual funds

1- finance companies:

Raise funds by selling commercial paper (short term

debt instrument) & by issuing stocks and bonds

2- Mutual Funds:
These financial intermediaries acquire funds by selling
shares to many individuals & use the proceeds to
purchase diversified portfolios of stock & bonds
3- Money market mutual funds:

These financial institutions have the

characteristics of a mutual fund, but also
function to some extent as a depository
institution because they offer deposit type
accounts