PRESENTATION OF CONTENT

FINANCIAL ENVIRONMENT
 It is a part of an economy that affects the diverse functions of the economy on the fiscal
outcomes of a nation, with the key players being investors, firms, and markets.
o Investors are individuals or businesses that expect returns from the already placed capital
into companies.
o Any business that offers goods or services to consumers is recognized as a firm, while
markets signify the economic environment that makes all this possible.
 The financial sector (or system) is vital for the smooth functioning of the economy since it helps
money to be channeled efficiently from savers (or surplus units) to prospective borrowers (or
deficit units).

FINANCIAL SYSTEM
 Definitions of Financial System
 It is a network of financial institutions, financial markets, financial instruments, and
financial services that facilitate money transfer.
 It is a system that allows the exchanged of funds between the financial market and
participants such as the leader investors and borrowers.
 It is the set of interrelated and interconnected components consisting of financial
institutions, markets, and securities.” (Dhanilal)
 It is the integrated form of financial institutions, financial markets, financial securities, and
financial services which aim is to circulate the funds in an economy for economic growth. (Amit
Chaudhary)
 Its aim is to facilitate the circulation of funds in an economy. In this way, the financial
system makes it easier:
o for firms to obtain financing for profitable investments opportunities (investments in
new technology, capital equipment, or for acquisition of other companies), and
o for individuals to borrow against future income (e.g., to pay for university, to buy a
house or car, etc).

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o Without financial markets and institutions, borrowers would have to borrow directly
from savers. In such a case it is easy to imagine that not much borrowing would take
place since it would be very difficult for people in need to borrow to find other people
able and willing to lend the same amounts and with exactly the same terms (time,
interest rate, collateral, etc).
 o In other words, we need to have “a double coincidence of wants”. Therefore, we can
easily conclude that a well-functioning financial system is necessary for a well-
functioning economy.

 Services Provided by the Financial System

 Risk Sharing: The Financial System provides risk sharing by allowing savers to hold many
assets and enables individuals to transfer risk. Financial markets can create instruments to
transfer risk from savers to borrowers who do not like uncertainty in returns or payments to
savers or investors who are willing to bear the risk.
 Liquidity: It provides for savers and borrowers liquidity. If an individual needs their assets for
their own consumption and investment, they can just exchange it. Bonds, stocks, or checking
accounts are created by financial assets, which have more liquid than cars, machinery, and
real estate.
 Information: The first informational role the financial system plays is to gather information
which includes finding out about prospective borrowers and what they will do with
borrowed funds. The second informational role that financial system plays is communication
of information. Financial markets do that job by incorporating information into the prices of
stocks, bonds, and other financial assets. Savers and borrowers receive the benefits of
information from the financial system by looking at asset returns.

 Functions of Financial System

 Pooling of Funds: In a financial system, the savings of people are transferred from
households to business organizations. With these, production increases and better goods
are manufactured, which increases the standard of living of people.
 Capital Formation: Business requires finance. These are made available through banks,
households and different financial institutions. They mobilize savings which leads to Capital
Formation.
 Facilitates Payment: The financial system offers convenient modes of payment for goods and
services. New methods of payments like credit cards, debit cards, cheques, etc. facilitate
quick and easy transactions.
 Provides Liquidity: The financial market provides the investors the opportunity to liquidate
their investments, which are in instruments like shares, debentures, bonds.
 Short and Long-Term Needs: The financial market takes into account the various needs of
different individuals and organizations. This facilitates optimum use of finances for
productive purposes.
 Risk Function: The financial markets provide protection against life, health, and income
risks. Risk Management is essential component of a growing economy.
 Better Decisions: Financial Markets provide information about the market and various
financial assets. This helps the investors to compare different investment options and
choose the best one. It helps in decision making in choosing portfolio allocations of their
wealth.
 Finances Government Needs: The government needs a huge amount of money for the
development of defense infrastructure. It also requires finance for social welfare activities,
public health, education, etc. This is supplied to them by financial markets.
 Economic Development: If the Government intervenes in the financial system to influence
macroeconomic variables like interest rate or inflation, credits can be made available to
corporate at a cheaper rate. This leads to the economic development of the nation.
FINANCIAL MARKET
 Definitions of Financial Market
 It is a market where buyers and sellers trade
commodities, financial securities, foreign
exchange, and other freely exchangeable
items (fungible items) and derivatives of value
at low transaction costs and at prices that are
determined by market forces.
 It is a place where the savings from several
sources are mobilized towards those who need
funds.
Source: https://marketbusinessnews.com/financial-
 It facilitates financing and investing by glossary/financial-
households, firms, and government agencies. market/#:~:text=A%20financial%20market%20is%20a,are%20de
termined%20by%20market%20forces.
 Participants that provide funds are called surplus units (e.g., households)
 Participants that enter markets to obtain funds are deficit units (e.g., the government)
 A major participant in financial markets is the government, because it controls the
money supply.

 Types of Markets
1. Physical asset market versus financial asset markets
 Physical asset markets – (also called “tangible” or “real” assets markets) are for
products such as wheat, autos, real estate, computers and machinery.
 Financial asset markets – deal with stocks, bonds, notes and mortgages. They also deal
with derivative securities whose values are derived from changes in the prices of other
assets. (A share of Ford stock is a “pure financial asset” while an option to buy Ford
shares is a derivative security whose value depends on the price of Ford stock.)

2. Spot markets versus futures markets

 Spot markets – are markets in which assets are bought or sold for “on-the-spot” delivery
(literally, within a few days).
 Futures markets – are markets in which participants agree today to buy or sell an asset
at some future date. (A farmer may enter into a futures contract in which he agrees
today to sell 5,000 bushels of soybeans 6 months from now at a price of $13,00 a
bushel.)

3. Money markets versus capital markets

 Money markets – the financial markets in which funds are borrowed or loaned for short
periods (less than one year). (The New York, London and Tokyo money markets are
among the world’s largest.)
 Capital markets – the financial markets for stocks and for intermediate or long-term
debt (one year or longer). (The New York Stock Exchange, where the stocks of the
largest U.S. Corporations are traded, is a prime example of a capital market.)

4. Primary markets versus secondary markets

 Primary markets – are the markets in which corporations raise new capital. (If GE were
to sell a new issue of common stock to raise capital, a primary market transaction would
take place. The corporation selling the newly created stock, GE, receives the proceeds
from the sale in a primary market transaction.)
 Secondary markets – are markets in which existing, already outstanding securities are
traded among investors. (If Jane Doe decided to buy 1,000 shares of GE stock, the
purchase would occur in the secondary market.)
 5. Private markets versus public markets
 Private markets – markets in which transactions are worked out directly between two
parties. (Examples are bank loans and private debt placements with insurance
companies.)
 Public markets – markets in which standardized contracts are traded on organized
exchanges. (For example, common stocks and corporate bonds)

 Functions of Financial Markets

a. Price Determination - The financial market performs the function of price discovery of the
different financial instruments which are traded between the buyers and the sellers on the
financial market.

b. Funds Mobilization - Because of this function of the financial market only, it is signaled that
how funds which available from the lenders or the investors of the funds will get allocated
among the persons who are in need of the funds or raise the funds through the means of
issuing financial instruments in the financial market. So, the financial market helps in the
mobilization of the savings of the investors.

c. Liquidity - The liquidity function of the financial market provides an opportunity for the
investors to sell their financial instruments at its fair value prevailing in the market at any
time during the working hours of the market.

d. Risk Sharing - Financial market performs the function of the risk-sharing as the person who
is undertaking the investments are different from the persons who are investing their fund
in those investments.

e. Easy Access - The financial market platform provides the potential buyer and seller easily,
which helps them in saving their time and money in finding the potential buyer and seller.

f. Reduction in Transaction Costs and Provision of the Information - The financial market
helps in providing every type of information to the traders without the requirement of
spending any money by them. In this way, the financial market reduces the cost of the
transactions.
g. Capital Formation - Financial markets provide the channel through which the new savings of
the investors flow in the country which aid in the capital formation of the country.

 Illustrative Example
 Let’s consider an example of the company XYZ ltd, which requires the funds to start a new
project but at present, it doesn’t have such funds. On the other side, there are investors who
have spare money and want to invest in some areas where they can get the required rate of
expected returns.
 So, in that case, the financial market will function where the company can raise funds from
the investors and the investors can invest their money through the help of the financial
market.
FINANCIAL INSTITUTION
 Definitions of Financial Institution
 It is a company engaged in the business of dealing with financial and monetary transactions
such as deposits, loans, investments, and currency exchange.
 It encompasses a broad range of business operations within the financial services sector
including banks, trust companies, insurance companies, brokerage firms, and investment
dealers.
 It is a firm that provides access to financial markets, both to savers who want to place their
savings in financial instruments and to borrowers who want to borrow from banks or issue
debt securities.
 It is called financial intermediary (businesses that connect savers with borrowers) since it
serves as middlemen between individuals, firms, and financial markets.

 Types of Financial Institutions

a. Investment Bank – an organization that underwrites and distributes new investment
securities and helps businesses obtain financing.
 Traditionally, they help companies raise capital by: (a) designing securities with features
that are currently attractive to investors; (b) buy these securities from the corporation,
and (c) resell them to savers.
b. Commercial Bank – the traditional department store of finance serving a variety of savers
and borrowers.
c. Financial Services Corporation – a firm that offers a wide range of financial services,
including investment banking, brokerage operations, insurance and commercial banking.
d. Credit Unions – are cooperative associations whose members are supposed to have a
common bond, such as being employees of the same firm.
e. Pension Funds – are retirement plans funded by corporations or government agencies for
their workers and administered primarily by the trust departments of commercial banks or
by life insurance companies.
f. Life Insurance Companies – take savings in the form of annual premiums; invest these funds
in stocks, bonds, real estate and mortgages; and make payments to the beneficiaries of the
insured parties.
g. Mutual Funds – organizations that pool investor funds to purchase financial instruments and
thus reduce risks through diversification.
h. Money Market Funds – mutual funds that invest in short-term, low-risk securities and allow
investors to write checks against their accounts.
i. Exchange Traded Funds (ETFs) – are similar to regular mutual funds and are often operated
by mutual fund companies. They buy a portfolio of stocks of a certain type and then sell their
own shares to the public.
j. Hedge Funds – are also similar to mutual funds because they accept money from savers and
use the funds to buy various securities but there are some important differences. While
mutual funds (and ETFs) are registered and regulated by the SEC, hedge funds are largely
unregulated.
k. Private Equity Companies – are organizations that operate much like hedge funds; but
rather than buying some of the stock of a firm, private equity players buy and then manage
entire firms.
 Roles of Financial Institutions
a. Regulation of Monetary Supply - Financial institutions like the central bank help in
regulating the money supply in the economy in order to maintain stability and control
inflation. The central bank applies various measures like increasing or decreasing repo
rate, cash reserve ratio, open market operations, i.e., buying and selling government
securities to regulate liquidity in the economy.

b. Banking Services - Financial institutions, like commercial banks, help their customers by
providing savings and deposit services, credit facilities like overdraft facilities to the
customers for catering to the need for short-term funds and several kinds of loans like
personal loans, education loans, mortgage or home loans to their customers.

c. Insurance Services - Financial institutions, like insurance companies, help to mobilize savings
and investment in productive activities. In return, they provide assurance to investors
against their life or some particular asset at the time of need.

d. Capital Formation - Financial institutions help in capital formation (increase in capital

stock like the plant, machinery, tools and equipment, buildings, means of transport and
communication) by mobilizing the idle savings from individuals in the economy to the
investor through various monetary services.

e. Investment Advice - Almost all financial institutions (banking or non-banking) have an

investment advisory desk that helps customers, investors, businesses to choose the best
investment option available in the market according to their risk appetite and other factors.

f. Brokerage Services - These institutions provide their investors access to a number of

investment options available in the market that ranges from stock, bonds (common
investment alternative) to hedge funds, and private equity investment (lesser-known
alternative).

g. Pension Fund Services - Financial institutions, through their various kinds of investment
plans, help the individual in planning their retirement. One such investment options is
a pension fund, where the individual contributes to the pool of investment set up by
employers, banks, or other firms and get the lump sum or monthly income after retirement.

h. Trust Fund Services - Some financial organization provides trust fund services to their
clients, manage the client’s assets, invest them in the best option available in the market,
and take care of its safekeeping as well.

i. Financing the Small and Medium Scale Enterprises - Financial institutions help small and
medium scale enterprises set up themselves in their initial days of business by providing
long-term as well as short-term funds to these companies.

j. Act as A Government Agent for Economic Growth - Financial institutions are regulated by
the government on a national level. They act as a government agent and help in the growth
of the nation’s economy as a whole.
FINANCIAL INSTRUMENTS
 Definitions of Financial Instrument
 It is an asset that can be traded, or it can also be seen as packages of capital that may be
traded.
 It can be cash, a contractual right to deliver or receive cash or another type of financial
instrument, or evidence of one's ownership of an entity.
 It represents the issuing of investments in the form of financial assets and liabilities, as well
as equity.
 It is considered a contract between the two parties involved, so technically, a financial
instrument is a piece of paper or a virtual document with monetary value that can be
printed.

 Types of Financial Instruments

a. Cash Instruments
 The values of cash instruments are directly influenced and determined by the markets.
These can be securities that are easily transferable.
 Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.
b. Derivative Instruments
 The value and characteristics of derivative instruments are based on the vehicle’s
underlying components, such as assets, interest rates, or indices.
 An equity options contract, for example, is a derivative because it derives its value from
the underlying stock. The option gives the right, but not the obligation, to buy or sell the
stock at a specified price and by a certain date. As the price of the stock rises and falls, so
too does the value of the option although not necessarily by the same percentage.
 There can be over-the-counter (OTC) derivatives or exchange-traded derivatives. OTC is a
market or process whereby securities–that are not listed on formal exchanges–are priced
and traded.

 Types of Asset Classes of Financial Instruments

a. Debt-Based Financial Instruments
 Short-term debt-based financial instruments last for one year or less.
o Securities of this kind come in the form of T-bills and commercial paper.
o Cash of this kind can be deposits and certificates of deposit (CDs).
o Exchange-traded derivatives under short-term, debt-based financial instruments can
be short-term interest rate futures.
o OTC derivatives are forward rate agreements.
 Long-term debt-based financial instruments last for more than a year.
o Under securities, these are bonds.
o Cash equivalents are loans.
o Exchange-traded derivatives are bond futures and options on bond futures.
o OTC derivatives are interest rate swaps, interest rate caps and floors, interest rate
options, and exotic derivatives.
b. Equity-Based Financial Instruments
 Securities under equity-based financial instruments are stocks.
 Exchange-traded derivatives in this category include stock options and equity futures.
 The OTC derivatives are stock options and exotic derivatives.
 REFERENCES

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Management 13th Edition Cengage Learning Asia Pte Ltd 2016
 Bautista, Leodegario SM. et al Mathematics of Investment 3rd Edition C&E Publishing, Inc. 2012
 Kolb, Burton A. & DeMong, Richard F. Principles of Financial Management Business
Publications, Inc. 1988

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