CHAPTER ONE
1. AN OVERVIEW OF THE FINANCIAL SYSTEM
1.1. The Role of financial system in the economy
A financial system (within the scope of finance) is a system that allows the exchange of funds
between lenders, investors, and borrowers. Financial systems operate at national, global, and
firm-specific levels. They consist of complex, closely related services, markets, and institutions
used to provide an efficient and regular linkage between investors and depositors.
A modern financial system may include banks (operated by the government or private sector),
financial markets, financial instruments, and financial services. Financial systems allow funds to
be allocated, invested, or moved between economic sectors. They enable individuals and
companies to share the associated risks.
Financial systems, i.e. financial intermediaries and financial markets, channel funds from those
who have savings to those who have more productive uses for them. They perform two main
types of financial service that reduce the costs of moving funds between borrowers and lenders,
leading to a more efficient allocation of resources and faster economic growth. These are the
provision of liquidity and the transformation of the risk characteristics of assets.
Provision of liquidity
The link between liquidity and economic performance arises because many high return
investment projects require long-term commitments of capital, but risk adverse lenders (savers)
are generally unwilling to delegate control over their savings to borrowers (investors) for long
periods. Financial systems mobilize savings by agglomerating and pooling funds from disparate
sources and creating small denomination instruments. These instruments provide opportunities
for individuals to hold diversified portfolios. Without pooling individuals and households would
have to buy and sell entire firms.
Financial markets can also transform illiquid assets (long-term capital investments in illiquid
production processes) into liquid liabilities (financial instrument). With liquid financial markets
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savers/lenders can hold assets like equity or bonds, which can be quickly and easily converted
into purchasing power, if they need to access their savings.
Transformation of the risk characteristics of assets
The second main service financial intermediaries and markets provide is the transformation of
the risk characteristics of assets. Financial systems perform this function in at least two ways.
First, they can enhance risk diversification and second, they resolve an information asymmetry
problem that may otherwise prevent the exchange of goods and services, in this case the
provision of capital.
Financial systems facilitate risk-sharing by reducing information and transactions costs. If there
are costs associated with the channeling of funds between borrowers and lenders, financial
systems can reduce the costs of holding a diversified portfolio of assets. Intermediaries perform
this role by taking advantage of economies of scale; markets do so by facilitating the broad offer
and trade of assets comprising investors’ portfolios.
Financial systems can reduce information and transaction costs that arise from an information
asymmetry between borrowers and lenders. In credit markets an information asymmetry arises
because borrowers generally know more about their investment projects than lenders. A
borrower may have an entrepreneurial “gut feeling” that cannot be communicated to lenders, or
more simply, may have information about a looming financial risk to their firm that they may not
wish to share with past or potential lenders.
1.2. Financial assets: role and properties
An asset is defined as any resource that is expected to provide future benefits and, hence, has
economic value. Assets can be divided into two categories: tangible assets (real assets) and
intangible assets (financial assets).
The value of a tangible asset (real assets) depends on its physical properties. Buildings, aircraft,
land, and machinery are examples of tangible assets. An intangible asset represents a legal claim
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to some future economic benefits. The value of an intangible asset bears no relation to the form,
physical or otherwise, in which the claims are recorded.
Financial assets (intangible) are intangible assets where typically the future benefits come in the
form of a claim to future cash .i.e., it is a claim against the income or wealth of business firm,
household, or unit of government, represented usually by a certificate, receipt, computer record
file, or other legal document and usually evaluated by or related to the lending of money.
Another term used for a financial asset is a financial instrument. Certain types of financial
instruments are referred to as securities and generally include stocks and bonds. For every
financial instrument there is a minimum of two parties. The party that has agreed to make future
cash payments is called the issuer; the party that owns the financial instrument and therefore the
right to receive the payments made by the issuer is referred to as the investor.
Familiar examples include:
Money: any financial asset that is generally accepted in payment for purchases of goods
and services. Thus, checkable accounts and currency are financial assets servings as
payment media and therefore are forms of money.
Equity/stocks: represent ownership shares in a business firm and as such, are claims
against the firm’s profits and against proceeds from the sale of its assets.
Debt securities: include such familiar instruments as bonds, notes, and accounts payable.
Insurance policies, contracts, etc…
1.2.1. Properties or Characteristics of Financial Assets
Financial asset do not provide a containing stream of services to their owners as a home, an
automobile or a washing machine would do. These assets are sought after because. They
promise, future returns to their owners and serve as a store of value (Purchasing power). A
number of other features make financial assets unique. They cannot be depreciated because they
do not wear out like physical goods, moreover, their physical condition or form usually is not
relevant in determining their market value (price).
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Generally, financial assets have the following properties:
Moneyness: some financial asset used as a medium of exchange or in settlement
of transactions. Could be cash or near money, such as time & savings deposits and
Treasury Bills.
Divisibility and denomination:
Reversibility: the cost of investing in a financial asset and then getting out of it
and back into cash again.
Cash flow,
Term to maturity,
Convertibility,
Currency,
Liquidity,
Return predictability,
Complexity, and
Tax status
1.2.2. The roles of financial assets
Financial assets serve two principal economic roles or functions. First, they allow the
transference of funds from those entities that have surplus funds to invest to those who need
funds to invest in tangible assets. Second, they permit the transference of funds in such a way as
to redistribute the unavoidable risk associated with the cash flow generated by tangible assets
among those seeking and those providing the funds. However, the claims held by the final wealth
holders generally differ from the liabilities issued by those entities that are the final demanders of
funds because of the activity of entities operating in financial systems, called financial
intermediaries, who seek to transform the final liabilities into different financial assets preferred
by the public.
1.3. Financial markets: role, classifications and participants
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A financial market is a market in which people trade financial securities, commodities, and
other fungible items of value at low transaction costs and at prices that reflect supply and
demand. Securities include stocks and bonds, and commodities include precious metals or
agricultural products.
In economics, typically, the term market means the aggregate of possible buyers and sellers of a
certain good or service and the transactions between them.
The term "market" is sometimes used for what are more strictly exchanges, organizations that
facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This
may be a physical location (like NYSE (New York stock exchange) or an electronic system.
Much trading of stocks takes place on an exchange; still, corporate actions (e.g., merger) are
outside an exchange, while any two companies or people, for whatever reason, may agree to sell
stock from the one to the other without using an exchange.
1.3.1. Role of financial markets
One of the important sustainability requisite for the accelerated development of an economy is
the existence of a dynamic financial market. A financial market helps the economy in the
following manner.
Saving mobilization: Obtaining funds from the savers or surplus units such as household
individuals, business firms, public sector units, central government, state governments
etc. is an important role played by financial markets.
Investment: Financial markets play a crucial role in arranging to invest funds thus
collected in those units which are in need of the same.
National Growth: An important role played by financial market is that, they contribute
to a nation's growth by ensuring unfettered flow of surplus funds to deficit units. Flow of
funds for productive purposes is also made possible.
Entrepreneurship growth: Financial markets contribute to the development of the
entrepreneurial claw by making available the necessary financial resources.
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Industrial development: The different components of financial markets help an
accelerated growth of industrial and economic development of a country, thus
contributing to raising the standard of living and the society of well-being.
1.3.2. Types or Classification of Financial Markets
Financial markets can be divided in the following ways:
1. Based on the nature the claim
2. Based on the maturity of the claims
3. Based on the newly issued or not
4. Based on the Cash versus derivative instruments…
1. On the basis of the nature of claims
The claims traded in a financial market may be either for a fixed dollar amount or a residual
amount and financial markets can be classified according to the nature of the claim. The former
financial assets are referred to as debt instruments and, and the financial market in which such
instruments are traded is referred to as the debt market. The latter financial assets are called
equity instruments and the financial market where such instruments are traded is referred to as
the equity market or stock market. Preferred stock represents an equity claim that entitles the
investor to receive a fixed dollar amount. Consequently, preferred stock has in common
characteristics of instruments classified as part of the debt market the equity market. Generally,
debt instruments and preferred stock are classified as part of the fixed income market.
2. On the basis of maturity of the claims
On the basis of this, financial market is classified as money market and capital market.
Money market: is a market where short-term funds are borrowed and lent. It is a
market for short-term financial assets, which are near substitute for money. The
instruments dealt within the money market are liquid and can be turned over quickly at
low transaction cost and without loss. Generally, a financial asset with a maturity of one
year or less is considered short-term and therefore part of the money markets.
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Capital market: is a market in which firms and other institutions that require
funds to finance their long term operations come together with individuals and
institutions that have money to invest. Capital market makes long term debt financing
and capital possible. The capital market can be divided into bond market and stock
market. On the basis of this classification also for example, a financial market for short
term financial assets is called the money market, and the one for longer maturity
financial assets is called the capital market. The traditional cutoff between short term and
long term is one year. That is, a financial asset with a maturity of one year or less is
considered short-term and therefore part of the money market. A financial asset with a
maturity of more than one year is part of the capital market. Thus, the debt market can be
divided into debt instruments that are part of the money market and, and those that are
part of the capital market, depending on the number of years to maturity.
3. On the basis of whether the financial claims are newly issued or not
A third way to classify financial markets is by whether the financial claims are newly issued.
When an issuer sells a new financial asset to the public, it is said to be “issue” the financial asset.
The market for newly issued financial assets is called the primary market. After a certain period
of time, the financial asset is bought and sold (i.e., exchanged or traded) among investors. The
market where this activity takes place is referred to as the secondary market. The primary
markets for securities are not well known to the public because the selling of securities to initial
buyers often takes place behind closed doors. An important financial institution that assists in the
initial sale of securities in the primary market is the investment bank. It does this by
underwriting securities: it guarantees a price for a corporation’s securities and then sells them to
the public.
Secondary markets can be organized in two ways- one method is to organize exchanges, where
buyers and sellers of securities (or their agents or brokers) meet in one central location to
conduct trades (E.g. New York stock exchange (NYSE)) and over-the-counter market (OTC)
where trading occurs over sophisticated telecommunications networks (E.g. National Association
of Securities Dealers Automated Quotation System (NASDAQ)).
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4. On the basis of cash versus derivative instruments
Some financial assets are contracts that either obligates the investor to buy or sell another
financial asset or grant the investor the choice to buy or sell another financial asset. Such
contracts derive their value from the price of the financial asset that may be bought or sold.
These contracts are called derivative instruments and the markets in which they trade are referred
to as derivative markets. The array of derivative instruments includes: options contracts, futures
contracts, forward contracts, swaps etc.
Financial markets also can be divided as follows:
Open versus negotiated Markets
Another distinction between market in the global financial system focuses on open market versus
negotiated markets. For example, some corporate bonds are sold in the open market to the
highest bidder and are bought and sold any number of times before they mature and are paid off.
In contrast, in the negotiated market for corporate bonds, securities generally oversold to one or a
few buyers under private contract.
An individual who goes to his or her local banker to secure a loan for new furniture enters the
negotiated market for personal loans. In the market for corporate stocks there are the major stock
exchanges which represent the open market.
Spot vs. forward market
A spot market is any market where buyers and sellers contract for immediate payment and
delivery at the moment of contractual agreement. A forward market is any market where the
buyer and seller enter into a contractual agreement today for payment and delivery at specific
dates in the future. A contract is a legal agreement between the parties to perform specific
actions at a specified date.
Derivative Markets
So far we have focused on the cash market for financial instruments. With some financial
instruments, the contract holder has either the obligation or the choice to buy or sell a financial
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instrument at some future time. The price of any such contract derives its value from the value of
the underlying financial instrument, financial index, or interest rate. Consequently, these
contracts are called derivative instruments.
Types of Derivative Instruments
The two basic types of derivative instruments are futures/forward contracts and options
contracts. A futures contract or forward contract is an agreement whereby two parties agree to
transact with respect to some financial instrument at a predetermined price at a specified future
date. One party agrees to buy the financial instrument; the other agrees to sell the financial
instrument. Both parties are obligated to perform, and neither party charges a fee.
An option contract gives the owner of the contract the right, but not the obligation, to buy (or
sell) a financial instrument at a specified price from (or to) another party. The buyer of the
contract must pay the seller a fee, which is called the option price. When the option grants the
owner of the option the right to buy a financial instrument from the other party, the option is
called a call option. If, instead, the option grants the owner of the option the right to sell a
financial instrument to the other party, the option is called a put option.
