3 main functions of the financial system are to –

● Allow entities to save & borrow money, raise equity capital, manage risks, trade assets
currently or in future & trade based on their estimates of asset values.
● Determine the returns that equate the total supply of saving with total demand for borrowing.
● Allocate capital to its most efficient uses.
The financial system allows the transfer of assets & risks from one entity to another as well as across
time. Entities who utilize the financial system include individuals, firms, govt., charities & others.

Achievement of purpose of financial system –

Financial system allows entities to save, borrow, issue equity, manage risks, exchange assets &
utilize info. It is best at fulfilling these roles when markets are liquid, transaction cost is low, info. Is
available & regulation ensures the execution of contracts.

Savings – people save for retirement & expect a return that compensates them for risk & use of their
money. Firms save to fund future expenditures through saving portions of sales. Vehicles used for
savings include stocks, bonds, deposits, real & other assets.

Borrowing – people borrow in order to buy a house, fund education, etc .A firm may borrow in order to
financial capital expenditure or other purposes. The Government may issue debt to fund their
expenditures. Lenders require collateral to protect them in the event of default.

Issuing equity – method of raising capital, where capital owners will share any future profits.
Investment banks help with issuance, analysts value the equity, & regulators & accountants
encourage the dissemination of information.

Risk mgmt. – entities face risks from changing interest rates, currency values, commodities values &
defaults on debt, among other things. Firms use hedging to reduce this risk. E.g – hedging allows the
firm to enter a market that it would otherwise be reluctant to enter by reducing the risk of transaction.
Hedging instruments are available from exchanges, investment banks, insurance firms & other
institutions.

Exchanging assets – financial systems allow entities to exchange assets. E.g - P&G may sell soap in
Europe but have costs denominated in USD, P&G can exchange their euros from soap sales for
dollars in currency markets.

Utilizing information – investors with information expect to earn a return on info. In addition to their
usual return. Investors who can identify assets that are currently undervalued in the market can earn
extra returns for investing based on the info.

Return determination –
Financial system provides a mechanism to determine the rate of return that equates the amount of
borrowing with the amount of lending in an economy. Low rates of return increase borrowing but
reduce saving. High rates of returns increase saving but reduce borrowing. Equilibrium interest rate is
the rate at which the amount individuals, businesses & govt. Desire to borrow is equal to the amount
that individuals, businesses & govt. Desire to lend. Equilibrium rates for different types of borrowing &
lending will differ due to differences in risk, liquidity & maturity.

Allocation of capital –
With limited capital, an important function of capital is to allocate capital to its most efficient uses.
Investors weigh the expected risks & returns of different investments to determine their most preferred
investments. As long as investors are well informed regarding risk & return & market function well, this
results in an allocation to capital to its most valuable uses.
Financial assets include stocks, bonds, derivatives & currencies. Real assets include real estate,
equipment, commodities & other physical assets.
Financial securities can be classified as debt or equity. Debt is a promise to repay borrowed funds.
Equity represents ownership.

Publicly traded securities are traded on exchanges or through securities dealers & are subject to
regulation. Securities that are not traded on public are private securities. Private companies are illiquid
& not subject to regulation.

Derivative contracts have values that depend on the values of other assets. Financial derivative
contracts are based on equities, indexes, debt or other financial contracts. Physical derivative
contracts derive their values from the values of physical assets like gold, oil or wheat.

Markets for immediate delivery are called spot markets. Contracts for future delivery of physical &
financial assets include forwards, futures, options.

Primary market is market for newly issued securities. Subsequent sales of securities are said to occur
in the secondary market.

Money markets refer to markets for debt securities with maturities of one year or less. Capital market
refers to longer-term debt securities & equity securities that have no specific maturity.

Traditional investment markets refer to those for debt & equity. Alternative markers refer to those for
hedge funds, commodities, real estate, collectibles, leases & equipment. Alternative assets are more
difficult to value, illiquid, require investor due diligence & often sell at discount.

Assets can be classified as securities, currencies, contracts, commodities & real assets.
Securities – can be classified as fixed income or equity securities & individual securities can be
combined in pooled investment vehicles. Corporations & govt. Are most common issuers of individual
securities. The initial sale is called an issue when a security is sold to the public.

FI securities refer to debt securities that are promises to repay borrowed money. Short term FI
securities have maturity of less than 1 year or 2 years. Long term maturities fall under 5 to 10 years &
intermediate falls in between this range.

Bonds are generally long term, whereas notes are intermediate. Commercial paper is short-term debt
issued by firms. Govt issues bills & banks issue certificates of deposits. In repurchase agreements the
borrower sells high quality assets & has the right & obligation to buy it again at a higher price in future.
Repurchase can be as short as one day.

Convertible debt is debt that an investor can exchange for a specific no. of equity shares of the
issuing firm.

Equity securities represent ownership in a firm & include common stock, preferred stock & warrants –
Common stock – residual claim on firm’s assets. Dividends are paid only after interest is paid to
debtholders & dividends are paid to preferred shareholders. In the event of liquidation debtholders &
preferred holders have priority over them.
Preferred stock – is equity security with scheduled dividends that do not change over security’s life &
must be paid before any dividends on common stock is paid.
Warrants – similar to options, give the holder the right to buy firm’s equity shares(common stock) at a
fixed exercise price prior to warrant’s expiration.
Pooled investment vehicles mutual funds, depositories & hedge funds. Structure refers to funds of
many investors in a portfolio of investments. The investor’s ownership interests are referred to as
shares, units, depository receipts or limited partnership interests.
MF – are pooled investment vehicles in which investors can purchase shares(open-end), either from
the fund itself or in the secondary market(closed-end).
Exchange traded funds & exchange traded notes – trade like closed-end funds but have provisions
allowing conversion into individual portfolio securities, or exchange portfolio shares for ETF shares,
that keep their market prices close to value of their proportional interest in the overall portfolio. These
funds are referred to depositories with their shares referred to depository receipts.
Asset backed securities – represent a claim to a portion of a pool of financial assets like mortgage, car
loans, or credit card debt. The return from the assets is passed through investors, with different
classes of claims having different levels of risks.
Hedge funds – are organized as limited partnerships, with the investors as limited partners & fund
managers as GP. They are restricted to investors with wealth & knowledge. Hedge funds often use
leverage. Hedge fund managers are compensated based on the amount of assets under mgmt & their
investment returns.

Currencies –
Are issued by a government. Central bank. Some are referred to as reserve currencies, which are
those held by the government. & central banks worldwide. These include dollar, euro, secondarily the
British pound, Japanese yen & Swiss franc. In spot currency markets, currencies are traded for
immediate delivery.

Contracts –
Are agreements between 2 parties that require some action in the future, like exchanging an asset for
cash. Financial contracts are often based on securities, commodities or security indexes. They include
futures, forwards, options, swaps & insurance contracts.

Forward contract (known)

Future contract(known) – same as forward & but standardized, liquid & traded on exchange.
Swap contracts – (interest rate swap – floating for fixed rate). A currency swap loan in one currency or
loan in another currency. (equity swap – exchange of return on equity index or portfolio for interest
payment on debt instruments.
option(known)
Insurance contract – pays a cash amt. If a future event occurs. They are used to hedge against
unfavourable, unexpected events.
CDS(known).

Commodities –
Trade in spot, forward, futures market. They include precious metals, industrial metals, and agri.
Products, energy products & credits for carbon reduction.
Futures & forwards allow both hedgers & speculators to participate in commodity markets without
having to deliver or store physical commodities.

Real assets –
Are real estate, equipment & machinery. They are increasingly held by institutional investors both
directly & indirectly.
Buying real assets provides income, tax advantages, and diversification benefits. However, they often
entail substantial mgmt. Costs. They require knowledge. They are illiquid because their specialization
may result in a limited pool of investors for a particular asset.
Investors may also choose to buy them indirectly through REIT or MLP. The investor owns an interest
in these vehicles, which hold the assets directly. Indirect ownership interests are more liquid than
ownership of the assets themselves. Another indirect ownership method is to buy the stock of firms
that have large ownership of real assets.

Financial intermediaries stand between buyers & sellers, facilitating exchange of assets, capital & risk.
Their services allow for greater efficiency & vital for the economy. Financial intermediaries include
brokers, exchanges, dealers, securitizers, depository institutions, insurance companies, arbitrageurs
& clearinghouses.

Brokers, dealers & exchanges –

Brokers – help their clients buy, sell securities by finding counterparties to trades in a cost efficient
manner. They may work for large brokerage firms for banks or at exchanges.
Block brokers – help with placement of large trades. Large trades are difficult to place without moving
the market. For example, a large sell order might cause a security’s price to decrease before the order
can be fully executed. Block brokers help conceal their client’s intentions so that the market does not
move against them.
Investment banks – help corporations sell common, preferred stock & debt securities to investors.
They also provide advice to firms about mergers, acquisitions & raising capital.
Exchanges – provide a venue where trades can meet. Exchanges act as brokers by providing
electronic order matching.Exchanges regulate their members & require firms that list on the exchange
to provide timely financial disclosures & promote shareholder democratization. Exchanges acquire
their regulatory power through member agreement or from their government.
ATS, which serve the same trading function as exchanges but have no regulatory function, are also
known as electronic communication networks(ECNs) or multilateral trading facilities(MTFs). ATS that
do not reveal current client orders are known as dark pools.
Dealers facilitate trading by buying for or selling from their own inventory. Dealers provide liquidity in
market & profit primarily from spread(difference) between price at which they will buy(bid price) &
price at which they will sell(ask price).
Some dealers also act as brokers. Broker-dealers have an inherent conflict of interest. As brokers,
they should seek the best prices for their clients but as dealers their goal is to profit through prices or
spreads. As a result, traders can place limits on how their orders are filled when they transact with
broker-dealers.
Dealers that trade with central banks when banks buy or sell govt. Securities in order to affect the
money supply are called primary dealers.

Securitizers –
They pool large amounts of securities or other assets & then sell interests in the pool to other
investors. The returns from the pool, net of securitizer’s fees are passed through to the investors. By
securitizing the assets, the securitizer creates a diversified pool of assets with more predictable cash
flows than individual assets in the pool. This creates liquidity in the assets because the ownership
interests are more easily valued & traded. There are also economies of scale in mgmt costs of large
pools of assets & potential benefits from the manager’s selection of assets.

Assets that are often securitized include mortgages, car loans, credit card receivables, bank loans &
equipment leases. The primary benefit of securitization is to decrease the funding costs for the assets
in the pool. A firm may set up a special purpose vehicle or special purpose entity to buy firm assets,
which removes them from the firm’s balance sheet & may increase their value by removing the risk
that financial trouble at firm will give other investors a claim to assets’ cash flows.

The cash flows from securitized assets can be segregated by risk. The different risk categories are
called tranches. The senior tranches provide the most certain cash flows, while junior tranches have
greater risk.

Depository institutions –
Examples include banks, credit unions & savings & loans. They pay interest on customer deposits &
provide transaction services like checking accounts. These financial intermediaries then make loans
with the funds, which offer diversification benefits. The intermediaries have expertise in evaluating
credit quality & managing the risk of a portfolio of loans of various types.

Other intermediaries, like payday lenders & factoring companies, lend money to firms & individuals on
the basis of their wages, accounts receivables & other future cash flows. These intermediaries often
finance the loans by issuing commercial paper or other debt securities.

Securities brokers provide loans to investors who purchase securities on margin. When this margin
lending is to hedge funds & other institutions, brokers are referred as prime brokers.

The equity owners of banks, brokers or other intermediaries absorb any loan before depositors &
other lenders. The more equity capital an intermediary has, the less risk for depositors. Poorly
capitalized intermediaries have less incentive to reduce the risk of their loan portfolios because they
have less capital at risk.

Insurance companies –
Are intermediaries in that they collect insurance premiums in return for providing risk reduction to
insured. The insurance firm can do this efficiently because it provides protection to a diversification
pool of policyholders, whose risks of loss are typically uncorrelated. This provides more predictable
losses & cash flows compared to a single insurance contract, in the same way that a bank’s
diversified portfolio of loans diversifies the risk of loan defaults.

Insurance firms also provide a benefit to investors by managing the risk inherent in insurance, more
hazard, adverse selection & fraud. Moral hazard occurs because the insured may take more risk once
he is protected against losses. Adverse selection occurs when those most likely to experience losses
are predominant buyers of insurance. In fraud, the insured purposely causes damage or claims
fictitious losses so he can collect on his insurance policy.

Arbitrageurs –
Arbitrage refers to buying an asset in one market & selling it in another market at a higher price. By
doing so, arbitrageurs act as intermediaries, providing liquidity to participants in the market where the
asset is purchased & transferring the asset to the market where it is sold.
In markets with good info., pure arbitrage is rare because traders will favor markets with the best
price. Arbitrageurs try to exploit pricing differences for similar instruments. (example later).

CCH & custodians –

Clearinghouses act as intermediaries between buyers & sellers in financial markets & provide –
Escrow services (transferring cash & assets to the respective parties).
Guarantees of contract completion.
Assurance that margin traders have adequate capital.
Limits on agg. Net order quantity of members.

Through these activities, clearinghouses limit counterparty risk, the risk that the other party to a
transaction will not fulfill its obligation. In some markets, the clearinghouse ensures only the trades of
its members, brokers & dealers in turn, ensure the trades of their retail customers.
Custodians also improve market integrity by holding client securities & preventing their loss due to
fraud or other events that affect the broker or investment manager.

An investor who owns an asset, or has right to obligation under a contract to purchase an asset, is
said to have a long position. A short position can result from borrowing an asset & selling it, with an
obligation to replace the asset in the future(a short sale).
The party to a contract who must sell or deliver an asset in future is also said to have a short position.
In general, investors who long benefit from an increase in the price of an asset & those who are short
benefit when asset price declines.

Hedgers use short positions in one asset to hedge an existing risk from a long position in another
asset that has returns that are strongly correlated with the returns of asset shorted.e.g – wheat
farmers may take short positions in wheat futures contracts. If wheat prices fall, the resulting increase
in value of short future position offset, partially or fully, the loss in value of farmer’s crop.

The buyer of an option contract is said to be long the option. The seller is short the option and is said
to have written the option. Investor who is long(buys) a call option on an asset profits if the underlying
asset increases in value, while the party short the option has losses. A long position in a put option on
an asset has the right to sell the asset at a specified price & profits when the price of underlying asset
falls, while the party short the option has losses.

In swaps, each party is long one asset & short the other, so the designation of the long & short side is
often arbitrary. However the side that benefits from an increase in the quoted price or rate is referred
to as the longside.

In currency contracts, each party is long one currency & short another. For example, the buyer of euro
futures contracts priced in dollars is long the euro & short the dollar.

Short sales & positions –

In a short sale, the short seller simultaneously borrows & sells securities through a broker, must return
the securities at the request of the lender or when the short sale is close, must keep a portion of the
proceeds of short sale with the broker. Short sellers hope to profit from a fall in price of the security or
asset sold short, buying at a lower price in future in order to repay the loan of the asset originally sold
at a higher price. The repayment of the borrowed security or other asset is called covering the short
position.