An Overview

of the Financial System

 Chapter Preview

 Suppose you want to start a business, but

you have no start up funds.
 At the same time, Mebratu has money to
invest for retirement.
 If the two of you could get together, perhaps
both of your needs can be met. But how
does that happen?

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 The Financial System

 Provides for efficient flow of funds from

saving to investment by bringing savers and
borrowers together via financial markets and
financial institutions.
 It is the process by which money flows from
savers to users.

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 The Financial System

 Three main parts

– Financial assets (loans, deposits, bonds, equities,
etc.)
– Financial institutions (banks, mutual funds,
insurance companies, etc.)
– Financial markets (money market, capital market,
forex market, etc.)

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 Financial System

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Functions of the Financial System

 Saving function
– Public saving find their way into the hands of
those in production through the financial system.
– Financial claims are issued in the financial
markets which promise future income flows.
– The funds with the producers result in production
of goods and services thereby increasing society
living standards.
 Functions of the
Financial System (cont.)

 Liquidity function
– Liquidity is the ability to sell an asset within
reasonable time at current market prices and for
reasonable transaction costs
– The financial markets provide the investor with
the opportunity to liquidate investments like
stocks, bonds, debentures, etc whenever they
need the fund.
Functions of the Financial System
(cont.)

 Payment function
– The financial system offers a very convenient
mode for payment of goods and services.
– Check system, credit card system etc are the
easiest methods of payments.
– The cost and time of transactions are drastically
reduced.
 Functions of the Financial System
(cont.)

 Risk function
– The financial system provide protection against
life, health and income risks. These are
accomplished through the sale of life and health
insurance and property insurance policies.
– The financial markets provide immense
opportunities for the investor to hedge himself
against or reduce the possible risks involved in
various investments.

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 Functions of the Financial System
(cont.)

 Policy function
– The government intervenes in the financial
system to influence macroeconomic variables like
interest rates or inflation
– If country needs more money government would
cut rate of interest through various financial
instruments and if inflation is high and too much
money is there in the system then government
would increase rate of interest.

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 Financial Instruments (Assets)

 Are claims by lenders against income or wealth of

borrowers, represented usually by a certificate,
created in the lending of money, and eventually
destroyed upon returning of money. E.g., stocks,
bonds, insurance policies, bank loans, notes etc.
 Financial instruments specify payment will be made
at some future date.
 Financial instruments specify certain conditions
under which a payment will be made.

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 Uses of Financial Instruments

 Three functions:
I. Financial instruments act as a means of payment (like money).
 Employees take stock options as payment for working.

II. Financial instruments act as stores of value (like money).

 Financial instruments generate increases in wealth that are
larger than from holding money.
 Financial instruments can be used to transfer purchasing power
into the future.
III. Financial instruments allow for the transfer of risk (unlike money).
 Futures and insurance contracts allows one person to transfer
risk to another.

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 Characteristics of Financial Assets

 do not provide physical services to owners, instead

provide a stream of (expected) CFs
 do not depreciate unlike physical goods,
 their physical condition or form is usually not relevant
in determining their market value.
 Their cost of transportation and storage is low, such
that they have little or no value as a commodity.
 Financial assets are fungible – they can easily be
changed in form and substituted for other assets.

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 Underlying Versus Derivative
Instruments

 Two fundamental classes of financial instruments.

 Underlying instruments are used by savers/lenders
to transfer resources directly to investors/borrowers.
– This improves the efficient allocation of resources.
– Divided into equity and debt

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Underlying Versus Derivative
Instruments

 Equity
– Ownership interest in an asset
– Residual claim on earnings and assets
 Dividend
 Liquidation
– Types
 Ordinary share
 Hybrid (or quasi-equity) security
– Preference shares
– Convertible notes
Underlying Versus Derivative
Instruments

 Debt
– Contractual claim to
 Periodic interest payments
 Repayment of principal
– Ranks ahead of equity
– Can be secured or unsecured
Underlying Versus Derivative
Instruments

 Derivatives
– A synthetic security providing specific future rights
that derives its price from a
 Physical market commodity
– Gold and oil
 Financial security
– Interest rate-sensitive debt instruments, currencies and
equities
– Used mainly to manage price risk exposure, and
to speculate
– Examples: futures, options, etc
A Primer for Valuing Financial
Instruments

Four fundamental characteristics influence the value of

a financial instrument:
1. Size of the payment:
– Larger payment - more valuable.
2. Timing of payment:
– Payment is sooner - more valuable.
3. Likelihood payment is made:
– More likely to be made - more valuable.
4. Conditions under which payment is made:
– Made when we need them - more valuable.

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 Financial Markets

 Financial markets are places where financial

instruments are bought and sold.
 These markets are the economy’s central
nervous system.
 These markets enable both firms and
individuals to find financing for their activities.
 These markets promote economic efficiency:
 They ensure resources are available to those who
put them to their best use.

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The Role of Financial Markets

 Borrowing and Lending: Financial markets permit the

transfer of funds (purchasing power) from one agent to
another for either investment or consumption purposes.
 Price Determination: Financial markets provide vehicles
by which prices are set both for newly issued financial
assets and for the existing stock of financial assets.
 Information Aggregation and Coordination:
Financial markets act as collectors and aggregators of
information about financial asset values and the flow of
funds from lenders to borrowers.

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 The Role of Financial Markets

 Risk Sharing: Financial markets allow a transfer of

risk from those who undertake investments to those
who provide funds for those investments.
 Liquidity: Financial markets provide the holders of
financial assets with a chance to resell or liquidate
these assets.
 Efficiency: Financial markets reduce transaction
costs and information costs.

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 Structure of Financial Markets

1.  Debt and Equity Markets 

 Firms and individuals can obtain funds in a financial market in
two ways:
 A. Issue a debt instrument (e.g. bond) by which the borrower
pays the holder of the instrument specified amounts in the
future.
 Debt instruments are defined by their maturity as follows:
 Short term Instruments: instruments that mature in 3 to 12
months.
 Long term Instruments: Instruments that mature in more
than one year.
 Structure of Financial Markets

B. Issue equities (e.g. common stocks), which are claims to

share in the net income and assets of a business.

 The owner of the equity receives dividends (fraction of

profits) at specified periods plus receiving part of the business
assets if it goes bankrupt.
 Disadvantage: equity holder is a residual claimant (i.e. is paid
whatever lefts paying debt holders)
2. Primary and Secondary Markets

 A primary market is a financial market in which

new issues of a security (e.g. bond, stock) are sold to
initial buyers.
 A secondary market is a financial market in which
securities that have been previously issued are resold.
  Secondary markets serve two functions:
A. They make financial instruments more liquid.
B. They determine the price of the security (through
supply and demand).
3. Exchanges and Over the Counter Markets

Secondary markets can be organized in two ways:

Exchanges: Trades are conducted in central
locations where sellers and buyers (or their agents
or brokers) meet.
Over-the-Counter Markets: Dealers at different
locations, connected by computers, buy and sell
securities.
4. Money and Capital Markets

 Another way of distinguishing between markets is on the

basis of the maturity of the securities traded in each
market.
Money Market: Financial market in which only short-
term debt instruments are traded.
Example: Treasury Bills, Commercial Papers.
Capital Market: Financial market in which longer-term
debt and equity instruments are traded.
Example: Government Bonds, Corporate Bonds, Stocks.
Financial Market Participants

 Brokers and dealers

 Households
 Business firms
 Federal, state, and local governments & their
agencies
 Regulators
 Lending and Borrowing in the
Financial System

 Business firms, households and governments play a

wide variety of roles in modern financial system.
 It is quite common for an individual/institution to be a
lender of funds in one period and a borrower in the
other, or to do both simultaneously
 Indeed financial intermediaries, such as banks and
insurance agencies operate on both sides of the
financial market; borrowing funds from customers by
issuing attractive financial claims and simultaneously
making loan available to other customers

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Lending and Borrowing in the
Financial System

 Economists John Gurley and Edward Shaw (1960)

pointed out that each business firm, household, or
unit of government active in the financial system must
conform to:
R – E = FA – D
where R = Current income receipts
E = Current expenditures
FA = Change in holdings of financial assets
D = Change in debt and equity outstanding
 Lending and Borrowing in the
Financial System

 If current expenditure (E) exceeds current

income receipts (R), the difference will be
made up by:
– Reducing our holdings of financial assets (-ΔFA),
for example by drawing money out of a saving
account
– Issuing debt or stock (+ΔD) or
– Using some combination of both

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 Lending and Borrowing in the
Financial System

 On the other hand, if current income receipts

(R) in the current period are larger than
current expenditure (E),
– Build up our holdings of financial assets (+ΔFA) for
example, by placing money in a saving account or
buying a few shares of stock
– Pay off some outstanding debt or retire stock
previously issued by the business firm (-ΔD) or
– Do some combination of both of these steps

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Lending and Borrowing in the
Financial System

 So, for any given period of time, the individual

economic unit falls into one of three groups:
 Deficit-budget unit (DBU): E > R, D > FA
i.e. net borrower of funds
 Surplus-budget unit (SBU): R > E, FA > D
i.e. net lender of funds
 Balanced-budget unit (BBU): R = E, D = FA
i.e. neither net lender nor net borrower
Lending and Borrowing in the
Financial System

 The global financial system permits

businesses, households, and governments to
adjust their financial position from that of net
borrower (DBU) to net lender (SBU) and
back again, smoothly and efficiently.