Chapter 2

Overview of the Financial System

The Role (Function) of the Financial Markets:

Financial Markets performs the essential economic function of channeling funds from those who have saved surplus funds(lender-savers) to those that have shortage of funds ( borrower-spenders)

Financial Markets Move Funds from

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

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The Role of The Financial Markets in the Economy

Funds flow form lenders-savers to borrower-spenders via two routes: 1-Direct Finance: Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrowers future income or assets. 2-Indirect Finance: Borrowers borrow indirectly from lenders via financial intermediaries

Function of Financial Markets

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Why is this channeling of funds important to the economy?

Improves economic efficiency, 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. This will contribute to higher production and efficiency for the overall economy. Financial markets also improve the well-being of consumers, allowing them to time their purchases better. they provide funds to People to buy what they need and can afford without forcing them to wait until they save enough money to make the purchase.

Structure of Financial Markets

Categorization of financial markets Debt and Equity Markets: Firms can obtain funds in a financial market in two ways: Issuing debt instrument: a contractual agreement by the borrower to pay the holder of the instrument a fixed dollar amount at a regular interval until maturity such as: bonds, mortgages. Issuing equities: claims to share in the net income and the assets of a business such as: common stock Owners of equities are called residual claimant

The maturity of a debt instrument is the number of years until expiration short tem: claims with maturity of less than one year. long term claims with maturity of 10 years or longer. Intermediate term: maturity between one and ten years

Structure of Financial Markets

We can categorize the financial Markets is according to whether the financial claim are newly issued or not: Primary Market: is a financial market in which new issues of a security are sold to initial buyers . The original issuer benefit From the sale of the security. Secondary Market: financial markets in which securities that have been previously issued can be resold . The original issuer does not benefit From the sale of the security.

Primary vs. Secondary

- Investment banks assist in the initial sale of securities in the primary market by the function of underwriting-

New York Stock Exchange and NASDAQ are the best examples of secondary markets

Structure of Financial Markets

Even though firms dont get any money, per share, from the secondary market, it serves two important functions: Secondary markets make it easier and quicker to sell the financial instrument to raise cash; that is, they make the instruments more liquid. Establish a price for the securities

Classifications of Financial Markets

Secondary markets can be organized in two ways Organized Exchange:
Trades conducted in central locations, where brokers help buyer and seller to execute the transactions at commission. (e.g., New York Stock Exchange, PSE) Dealers at different locations who have inventory of securities stand ready to buy and sell secruities over the counter to anyone who accept their price using electronic Forums.

Over-the-Counter Markets

(Best example is the NASDAQ)

Money and Capital Markets

Another way of distinguishing between markets is on the basis of the maturity of the securities traded Money Market is a financial market in which only short term debt instruments are traded Capital Market is the market in which longer term debt and equity instruments are traded. Money market securities are usually more widely traded so they tend to be more liquid.

Internationalization of Financial Markets The growth of foreign financial markets has been a result of: 1. Large increase in the pool of savings in foreign countries 2. Deregulation of foreign financial markets firms in any country seeking to raise funds need not be limited to their Domestic Financial Market. Investors in a country are not limited to the securities issued in their domestic Market.

What are the factors that have lead to the integration of Financial Markets. Deregulation and liberalization of Markets enforced by the global competition Technological advances that linked the Market participants, and make it easier for monitoring world Markets, executing orders, and analyzing financial opportunities. Increased institutionalization of financial Markets. here institutional investors are more willing than retail investor to transfer funds across boarders to improve the risk reward opportunities especially in developing countries (the emerging Markets) .

International Bond Market, Eurobonds, and Eurocurrencies

Foreign Bonds are bonds sold in a foreign country and are denominated in that countrys currency. For example, a German Company selling bonds in the United States denominated in the U.S dollars. Eurobond: a bond denominated in a currency other than that of the country in which it is soldfor example, a bond denominated in U.S dollars sold in London
A bond denominated in Euros is called a Eurobond only if it is sold outside the countries that have adopted the euro.

International Bond Market, Eurobonds, and Eurocurrencies

Eurocurrencies: foreign currencies deposited in banks outside the home country. Eurodollars: U.S dollars deposited in foreign banks outside the United States or in foreign branches of U.S banks. Eurodollars have nothing to do with Euros

World Stock Market

Foreign stock markets have been growing in important in the U.S. Mutual Funds specialized in trading in foreign stocks have been developed. Foreigners are becoming an important investors in the U.S corporations and also helping finance the Federal government which in return helped the growth of the U.S economy

Functions of the Financial Intermediaries: Indirect finance

Funds can move from lender to borrower directly. Or Indirectly through a financial intermediary (such as a bank) that stands between the lender-savers and the borrower-spenders: the intermediary borrow funds from savers, the intermediary then use these funds to make loans to the spenders. This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers. And it represent a more important source of finance than securities markets. Why are F.I so important in the financial markets? To answer this, we need to understand the role of

1-Transactions Costs
The time and money spent in carrying out financial transactions are the major problem for Investors.

Financial intermediaries reduce transactions costs because they have developed expertise in lowering them, and because their large size allows them to take advantage of Economies of Scale, the reduction in transaction costs per dollar of transaction as the size of transaction increases.
A financial intermediarys low transaction costs make it possible to provide customers with liquidity services, services that make it easier for customer to conduct transaction. For Example, (checking account) Banks provide depositors with checking accounts that enable them to pay their bills easily.
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2-Risk sharing
Financial institutions help reduce investors exposure to risk (the uncertainty about the returns investors will earn on assets.) F.I. do this through the process of risk sharing In that they create and sell assets with risk characteristics that people are comfortable with, and then use the fund they acquire to purchase other assets that my have far more risk (This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors)
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Risk sharing
Financial intermediaries also help individuals and businesses to diversify their asset holdings and thereby lower the amount of risk. ( diversification: investing in a portfolio of assets whose returns do not always move together) Low transaction costs allow Financial institutions to buy a range of assets, pool them, and then sell rights of the diversified pool to individuals

3-asymmetric information
A situation in which one party often does not know enough about the other party to make accurate decisions. For example, a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment for which the funds are earmarked than lender does.

Information Asymmetry can lead to two main problems Adverse selection- the problem created by asymmetric information before the transaction. It occurs when the potential borrowers who are most likely to produce an undesirable ( adverse) outcome are the ones who most actively seek out a loan and are thus likely to be selected. because of Adverse selection lenders make decide not to make any loans even though there are good credit risks in the market place.

 Moral Hazard- immoral behavior that takes advantage of asymmetric information after a transaction. It is the risk ( hazard) that the borrower might engage in activities that are undesirable ( immoral) for the lenders point of view, because they make it less likely that the loan will be paid back. Another way of describing the moral hazard is that it leads to conflicts of Interest, in which one party in a financial contract has incentive to act in its own interest rather than in the interest of the other party.

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How do Financial Intermediaries alleviate these problems?

Financial Intermediaries are better equipped than individuals and can solve the Asymmetric information problem by. Screening. Prior to a loan being given, a bank investigates a firm's or individual's credit history and financial status. Such information is fed into sophisticated computer programs that compute a "credit score" The higher the score, the better the borrower. This reduces losses due to Adverse selection.

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 Monitoring. Once the loan is made, the bank

must ensure that the borrower does not engage in risky activities that could lead to default. One way to prevent this is for banks to place "restrictive covenants" into the loan contract to prohibit certain activities, and then to check compliance and enforce the agreement when necessary. This reduces losses due to moral hazard.

 Creating long-term customer relationships. Repeat customers will not require the same effort for screening and monitoring that new customers. Also, customers have an incentive to establish a good repayment record in order to get loans from the same bank in the future.
Collateral. Requiring a potential borrower to pledge assets to be turned over in case of default reduces credit risk in several ways. Obviously, it protects the bank from total financial loss in the event of a default. But it also screens out questionable borrowers (who will not have sufficient collateral) and reduces moral hazard problems since the borrower risks losing his/her property if a default occurs.

 Credit rationing. Riskier borrowers will be expected to pay higher interest rates to compensate for this risk. However, ONLY the riskiest borrowers are willing to pay the highest rates. This is an extreme case of adverse selection. In this case, banks may be unwilling to assume the high risk levels and simply refuse to lend to these types of borrowers. Alternatives, banks would lend out only small amounts, giving the borrower the incentive to establish a good payment record to obtain additional loans. Disclosure. Disclosure rules for public companies also mitigate the problems of asymmetric information. The SEC requires companies that sell securities to disclose information in a timely manner. The requirement are not foolproof, the scandals with Enron and WorldCom, among others, demonstrate that financial statements may be manipulated in ways to deceive investors.

Types of financial Intermediaries:

Financial Intermediaries fall into three categories:
1. depository institutions: accept deposits form individuals and institutions and make loans. They include commercial banks, saving and loan associations, mutual savings banks, and credit unions 2. contractual savings institutions such as insurance companies and pension funds. They acquire funds at periodic intervals on a contractual basis. 3. investment institutions: includes finance companies, mutual funds, and money market mutual funds

Finance Companies
finance companies raise funds by selling commercial paper (a short term debt instrument )and by issuing stocks and bonds .they lend these funds to consumers, who make purchases of such items as furniture, automobiles, and home improvements, and to small businesses. some finance companies are organized by a parent corporation to help sell its product. for example ,ford motor credit company makes loans to consumers who purchase ford automobiles.

Mutual Funds
These financial intermediaries acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds . Shareholders can sell (redeem) shares at any time. Shareholders can sell shares at any time, but the value of the shares will be determined by the value of the MFs holdings of securities.

Money Market Mutual funds

These financial institutions have the characteristics of mutual funds but also function to some extent as a depositary institution because they offer deposit type accounts. Like most mutual funds, they sell shares to acquire funds that are then used to buy money market instruments that are both safe and very liquid . the interest revenue on these assets is paid out to the shareholders. A key feature of these funds is that shareholders can write checks against the value of their share- holdings.

Investment banks
An investment bank is not a bank or a financial intermediary in the ordinary sense. Its a different type of intermediary that helps a corporation issue securities. First it advises the corporation on which type of securities to issue (stocks or bonds) ;then it helps sell (underwrite) the securities by purchasing them from the corporation at a predetermined price and reselling them in the market. investment banks also act as deal markers by helping corporations acquire other companies through mergers or acquisitions.