Environment of

Economics, Finance and Monetary

Chapter 2

The Financial System

1
Chapter Introduction
2.1 Definition and Function
2.2 Structure of Financial Market
2.3 Instruments of Financial Market
2.4 Forms of Financial Market
2.5 Internationalization of Financial Market
2.6 Financial Institutions
 2.1 Definition and Function
2.1.1 Definitions

The financial system is the

process by which money
flows from savers to users.

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 2.1.2 Function of Financial Markets

• Channels funds from person or business

without investment opportunities (i.e.,
“Lender-Savers”) to one who has them
(i.e., “Borrower-Spenders”)
• Improves economic efficiency

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 2.1.3 Importance of Financial Markets
• This is important. For example, if you save $1,000, but there
are no financial markets, then you can earn no return on this-
might as well put the money under your mattress.
• However, if a carpenter could use that money to buy a new
saw (increasing her productivity), then she’d be willing to pay
you some interest for the use of the funds.
▪ Financial markets are critical for producing an efficient
allocation of capital, allowing funds to move from people who
lack productive investment opportunities to people who have
them.
▪ Financial markets also improve the well-being of consumers,
allowing them to time their purchases better.

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 2.2 Structure of Financial Market

2.2.1 Financial Markets Funds Transferees

Lender-Savers Borrower-Spenders
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners

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2.2.2 Segments of Financial Markets

1. Direct Finance
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are
claims on the borrower’s future income or assets
2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable
funds and loan opportunities) by issuing financial
instruments which are claims on the borrower’s future
income or assets

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 2.2.3 Flows of Funds through Financial System
Indirect Finance

Financial
FUNDS Intermediaries FUNDS

F
U
N
D
S

Lender-Savers Borrower-Spenders
- Households Financial - Business firms
- Business firms FUNDS Market
FUNDS
- Government
- Government - Households
- Foreigners - Foreigners

- Financial Intermediaries include:
Commercial Banks, Security Company,
Financial Company, Investment Fund,
Insurance Institutions
Direct Finance
- Insurance Institutions: Social Insurance
Institution, Life Insurance Company, Non-life
Insurance Company ->to get premiums 8
compensation
Structure of financial market
• Money market
The money market is a financial market in
which only short-term debt instruments are
traded, short maturity(<12 months)
• Capital market
The capital market is the market in which
longer-term debt and equity instruments are
traded(>12 months)
2.3 Instruments of Financial Market

• Instruments of money market

• Instruments of capital market

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 2.3.1 Money Market Instruments

• Short-term Debt Securities

– Issued by governments, financial institutions
and corporations
• Investors are paid interest for the use of
their funds.
• Generally low-risk

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2.3.1 Money Market Instruments

• Treasury bill
• Bank certificates of deposit
• Commercial paper
• Banker’s acceptances
• Repurchase agreements
• …

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Treasury bills

- Who issues treasury bills?

- What is the main characteristic
of treasury bills?
Treasury bills

- Government issues treasury

bills
-Treasury bills are the most
liquid of all the money market
instruments
Why are treasury bills the most liquid of all
the money market instruments?
Treasury bills

Treasury bills have no

possibility of default
A certificate of deposit (CD)

-who issues CD?

- What is CD used for?
A certificate of deposit (CD)

- CD is a debt instrument sold by

a bank to depositors
- Banks raise money
Commercial paper

-who issues commercial paper?

- What is it used for?
Commercial paper

-Commercial paper is a debt

instrument issued by large banks and
well-known corporation
- Borrow money from the seller. Today
commercial paper is also issued to
raise money in the financial market
Commercial paper
Banker’s acceptances

-who issues banker’s acceptances?

- What is it used for?
Banker’s acceptances

- Banker’s acceptances are issued by a

firm and guaranteed for a fee by a bank
that stamps it “accepted”
- This is the promise of payment of a
firm that guaranteed by a bank.
Banker’s acceptances often used in
international trade
2.3.2 Capital Market Instruments

- Stocks
- Corporate Bonds
- Government securities
- State and local government bonds
- Consumer and bank commercial loans
- Mortgages
2.3.2 Bonds
What’s bond ?
• A bond is a debt investment in which an
investor loans money to an entity which
borrows the funds for a defined period of
time at a variable or fixed interest rate.
• variable /'veəriəbl/

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2.3.2 Bonds
• Government Bonds
– Bonds sold by the U.S. Department of the Treasury.
• Municipal Bonds
– Bonds issued by state or local governments
• Revenue bonds are used toward a project that will
produce revenue (projects on road, bridge…). Interest and
principle is paid on the basis of the income of the project.
• General Obligation Bonds: the local governments
guarantee that they will pay interest and principle by all
their financial receipt and tax revenue

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2.3.2 Bonds

• Corporate Bonds
– Issued by corporations

Among the types of bonds, which one have

the highest interest rates?

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2.3.3 Stocks

• What’s stock?
• Stock is a type of security that signifies
ownership in a corporation and represents
a claim on part of the corporation's assets
and earnings.

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2.3.3 Stocks

• Common stock – ownership claims in

corporations.
– Vote on major company decisions
– Cash dividends
– Price appreciation
• Preferred stock – stockholders with
preference in the payment of dividends.

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The differences between common stock
and preferred stock
Common stock
has variable dividend payments
that fluctuate with company
profits
in the event of bankruptcy,
common shareholders are paid
off after the preferred
shareholder (but still after debt
holders).
Preferred stock
a fixed dividend
in the event of bankruptcy,
preferred shareholders are paid
off before the common
shareholder (but still after debt
holders).
2.3.4 Convertible Securities

Stockholder has the

right to exchange the
bond or preferred
stock for a fixed
number of shares of
common stock.

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 2.4. Forms of Financial Market
• Debt Markets
Debt instruments are issued
─ Short-Term (maturity < 1 year)
─ Long-Term (maturity > 10 year)
─ Intermediate term (maturity in-between)
• Equity Markets
Equity instruments are issued
─ Pay dividends, in theory forever
─ Represents an ownership claim in the firm

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 2.4. Forms of Financial Market
• Primary Market – firms and governments issue securities
and sell them initially to the public.
– New issued securities sold to initial buyers
– When a firm offers a stock for sale to the general
public for the first time.
• Secondary Market – collection of financial markets in
which previously issued securities are traded among
investors.
- Securities previously issued are bought and sold
? Why do we need secondary market?

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Even though firms don’t get any money from the secondary
market, it serves two important functions:
• Provide liquidity, making it easy to buy and sell the
securities of the companies
• Establish a price for the securities

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2.4. Forms of Financial Market
• Exchanges
─ Trades conducted in central locations (e.g., New York
Stock Exchange, CBT)
• Over-the-Counter Markets
─ Dealers at different locations buy and sell
─ Best example is the market for Treasury securities
? What’s the main difference between Exchanges
market and OTC market

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2.4. Forms of Financial Market

• Money Market: Short-Term

(maturity <= 1 year)
• Capital Market: Long-Term
(maturity > 1 year) plus equities

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 n d ing St o c k
Understa
Markets

Stock market (exchange) –

market in which common
stocks are traded, such as the
New York Stock Exchange.

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 c h a n g e s
k E x
S to c
• The New York Stock Exchange – the Big Board is the
most famous and one of the oldest stock markets in the
world. More than 3,000 stocks are listed on NYSE.
• The Nasdaq Stock Market – the second largest stock
market. Over 5,000 companies have their stocks listed on
Nasdaq but many are smaller firms.
• Other U.S. Stock Markets
– The American Stock Exchange/AMEX
– Regional Stock Exchanges
– Foreign Markets
In Vietnam?

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 Investor Participation in the Stock Markets
• Investors use brokerage firms:
1) Establish an account
2) Enter orders
3) Trade stock

• The brokerage firm executes the trade

on behalf of the investor, charging a fee
for the order
– Market Order
– Limit Order

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 2.5 Internationalization of Financial Markets

• Eurocurrency Market
– Foreign currency deposited outside of home country
– Eurodollars are U.S. dollars deposited, say, London.
– Gives U.S. borrows an alternative source for dollars.
• World Stock Markets
– U.S. stock markets are no longer always the largest—
at one point, Japan’s was larger

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2.6 Financial Institutions
✓ Depository institutions
✓ Contractual saving institutions
✓ Investment intermediaries

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2.6 Financial Institutions
✓ Depository institutions are financial
institutions that accept deposits from
individuals and institutions and make
loans
✓ Commercial bank
✓ Savings and loan associations
✓ Mutual savings banks
✓ Credit unions

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2.6 Financial Institutions
✓ Contractual saving institutions are
financial institutions that acquire funds
at periodic intervals on a contractual
basis
✓ Life insurance companies
✓ Pension funds

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2.6 Financial Institutions
✓ Investment intermediaries
✓ Finance companies
✓ Mutual funds
✓ Money market mutual funds
✓ Investment bank

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END OF CHAPTER 2