CHAPTER TWO

FINANCIAL SYSTEMS, MARKETS

AND INSTITUTIONS
Financial Systems
What Is a Financial System?
A financial system is a set of institutions, such as
banks, insurance companies, and stock exchanges
that permit the exchange of funds.
 Financial systems exist on firm, regional, and global
levels.
 Borrowers, lenders, and investors exchange current
funds to finance projects, either for consumption or
productive investments, and to pursue a return on
their financial assets.
 The financial system also includes sets of rules &
practices that borrowers & lenders use to decide
which projects get financed, who finances projects,
& terms of financial deals.
Financial Systems…
We will survey the financial system in three
steps:
1. Financial instruments or securities:
◦ Stocks, bonds, loans and insurance
◦ What is their role in our economy?
2. Financial Markets
◦ New York Stock Exchange, Nasdaq.
◦ Where investors trade financial
instruments.
3. Financial institutions
◦ What they are and what they do
Financial Instruments
 Financial Instruments: The written legal
obligation of one party to transfer something of
value, usually money, to another party at some
future date, under certain conditions.
 The enforceability of the obligation is important.
 Financial instruments obligate one party (person,
company, or government) to transfer something to
another party.
 Financial instruments specify payment will be
made at some future date.
 Financial instruments specify certain conditions
under w/c a payment will be made.
 Uses of Financial Instruments
Three functions:
Financial instruments act as a means of payment
(like money)
 Employees take stock options as payment for working.
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.
Financial instruments allow for the transfer of risk
(unlike money)
 Futures & insurance contracts allows one person to
transfer risk to another.
Financial Institutions
 Firms that provide access to the financial
markets, both to savers who wish to
purchase financial instruments directly and
to borrowers who want to issue them.
 Also known as financial intermediaries.
 Examples: banks, insurance companies,
securities firms, and pension funds.
 Healthy financial institutions open the flow
of resources, increasing the system’s
efficiency.
The Role of Financial Institutions
To reduce transaction costs by specializing in
the issuance of standardized securities.
To reduce the information costs of screening
and monitoring borrowers.
They curb asymmetries, helping resources
flow to most productive uses.
To give savers ready access to their funds.
 Financial Markets

Deloitte Consulting, January 2017 Personal Selling Skills Training, 10

Financial Markets
Financial markets are places where financial
instruments are bought & sold.
These markets are the economy’s central
nervous system.
These markets enable both firms &
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.
◦ They keep transactions costs low.
Functions of Financial Markets
Perform the essential function of channeling
funds from economic players that have saved
surplus funds to those that have a shortage of
funds
Promotes economic efficiency by producing
an efficient allocation of capital, which
increases production
Directly improve the well-being of
consumers by allowing them to time
purchases better.
The Role of Financial Markets
1. Liquidity:
◦ Ensure owners can buy and sell financial
instruments cheaply.
◦ Keeps transactions costs low.
2. Information:
◦ Pool and communication information about
issuers of financial instruments.
3. Risk sharing:
◦ Provide individuals a place to buy and sell
risk.
The Role of Financial Markets…
Financial markets play a vital role in
facilitating the smooth operation of capitalist
economies by allocating resources and
creating liquidity for businesses and
entrepreneurs.
The markets make it easy for buyers and
sellers to trade their financial holdings.
Financial markets create securities products
that provide a return for those with excess
funds (investors/lenders) and make these
funds available to those needing additional
money (borrowers).
Structure of Financial Markets

Definition of Structure of Financial Markets;

1. Distinguish between markets where new
financial instruments are sold & where they
are resold or traded: primary or secondary
markets.
2. Categorize by the way they trade:
centralized exchange or not.
3. Group based on the type of instrument they
trade: as a store of value or to transfer risk.
Structure of Financial Markets…
Primary and Secondary Markets
 Primary market = financial market in w/c
newly issued securities are sold.
 Secondary market = financial market in
which previously owned securities are sold.
 Investment Banks underwrite securities in
primary markets
 Brokers and dealers work in secondary
markets
Broker –match buyers and sellers
Dealers –buy and sell securities
The Structure of Financial Markets…

 Debt and Equity Markets

Debt instruments –contractual obligation to pay
the holder fixed payments at specified dates (e.g.,
mortgages, bonds, car loans, student loans)
Short-term debt instruments have a maturity of less
than one year
Intermediate-term debt instruments have a
maturity between 1 and 10 years
Long-term debt instruments have a maturity of ten
or more years
Equity –sale of ownership share (owners are
residual claimants).
Owners of stock may receive dividends
Direct Finance and Indirect Finance
 Direct finance – funds are directly
transferred from lenders to borrowers
 Indirect finance – financial intermediaries
receive funds from savers and lend them to
borrowers
Securities are assets for the holder and
liabilities for the issuer
1.Allows transfers of funds from person or business without
investment opportunities to one who has them
2. Improves economic efficiency
Function of Financial Intermediaries: Indirect Finance

Lower transaction costs

Economies of scale
Liquidity services
 Reduce Risk
Risk Sharing (Asset Transformation)
Diversification
 Asymmetric Information
Adverse Selection (before the transaction) - more
likely to select risky borrower
Moral Hazard (after the transaction)—less likely
borrower will repay loan
Types of Financial Intermediaries
 Depository institutions
Commercial banks
Savings and Loan Associations
Mutual savings banks
Credit unions
 Contractual savings institutions
Life insurance companies
Fire and casualty insurance companies
Pension funds and government retirement funds
 Investment intermediaries
Finance companies
Mutual funds
Money market mutual funds
Investment banks
Internationalization of Financial Markets

 Foreign Bonds - sold in a foreign country and

denominated in that country’s currency
 Foreign bonds may be used to avoid exchange-rate
risk
 Eurobond - bond denominated in a currency other
than that of the country in which it is sold
 Eurocurrencies - foreign currencies deposited in banks
outside the home country
 Eurodollars - U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S.
banks
 World Stock Markets
 London, Tokyo and other foreign stock exchanges
have grown in importance
Regulation of the Financial System

 Two Main Reasons for Regulation (Financial sector

is one of the most heavily regulated sectors of the
economy)
 To increase the information available to investors:
 Reduce adverse selection and moral hazard problems
 SEC forces corporations to disclose information to reduce
insider trading
 To ensure the soundness of financial intermediaries:
Restrictions on entry
Disclosure Laws (SEC)
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates (no longer in effect)
Figure 2.3: Flow of Funds through Financial
Institutions
Financial Market Instruments…

Capital Market Instruments

Stocks: largest instruments, hold by individuals
(1/2), pensions, mutual funds, and insurance
companies
Mortgages
Corporate bonds: convertible or non-convertible
Securities: issued by Treasury, most liquid
security
State and local government bonds: also called
municipal bonds, interest-exemption
Consumer and bank commercial loans
A Primer for Valuing Financial Instruments

 Four fundamental cxrs influence the value

of 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 with payment is made:
 Made when we need them -more valuable.
A Primer for Valuing Financial Instruments…
 We organize financial instruments by how they are
used:
 Primarily used as stores of value
1. Bank loans
◦ Borrower obtains resources from a lender to be repaid in
the future.
2. Bonds
◦ A form of a loan issued by a corporation or government.
◦ Can be bought and sold in financial markets.
3. Home mortgages
◦ Home buyers usually need to borrow using the home as
collateral for the loan.
◦ A specific asset the borrower pledges to protect the
lender’s interests.
A Primer for Valuing Financial Instruments…
4. Stocks
◦ The holder owns a small piece of the firm and entitled
to part of its profits.
◦ Firms sell stocks to raise money. Primarily used as a
stores of wealth.
5. Asset-backed securities
◦ Shares in the returns or payments arising from specific
assets, such as home mortgages & student loans.
◦ Mortgage backed securities bundle a large # of
mortgages together into a pool in w/c shares are sold
◦ Securities backed by sub-prime mortgages played an
important role in the financial crisis of 2007-2009.
A Primer for Valuing Financial Instruments…
 Primarily used to Transfer Risk
1. Insurance contracts
◦ Primary purpose is to assure that payments will be made under
particular, & often rare, circumstances.
2. Futures contracts
◦ An agreement between two parties to exchange a fixed quantity of a
commodity or an asset at a fixed price on a set future date.
◦ A price is always specified
◦ This is a type of derivative instrument.
3. Options
◦ Derivative instruments whose prices are based on the value of an
underlying asset.
◦ Give the holder the right, not obligation, to buy or sell a fixed
quantity of the asset at a pre-determined price on either a specific
date or at any time during a specified period.
◦ These offer an chance to store value & trade risk in almost any
way one would like.