Chapter One

Overview of the Financial System

Asamnew T

Department of Accounting and Finance,

Addis Ababa University
 Chapter Objectives
 Understanding the role of financial system in the
economy
 Understanding financial assets: its characteristics
and roles
 Understanding what a financial market is, its
classifications, its actors
 Understanding function of financial intermediaries:
 Lending and borrowing in the financial system
Financial System
 What is a financial system?
 An economic arrangement wherein financial
institutions facilitate the transfer of funds and
assets between borrowers, lenders, and
investors.
 Financial System
 The financial system has six parts, each of which
plays a fundamental role in our economy.
 Those parts are:
 money,
 financial instruments,
 financial markets,
 financial institutions,
 government regulatory agencies, and
 central banks.
 Financial System…
 We use money to pay for our purchases and to store
our wealth.
 We use financial instruments, to transfer resources
from savers to investors and to transfer risk to
those who are best equipped to bear it.
 Stocks, mortgages, and insurance policies are examples of
financial instruments.
 financial markets allows us to buy and sell financial
instruments quickly and cheaply
 Financial System…
 Financial institutions provide a myriad of services,
including access to the financial markets and
collection of information about prospective
borrowers to ensure they are creditworthy.
 Government regulatory agencies are responsible for
making sure that the elements of the financial
system—including its instruments, markets, and
institutions—operate in a safe and reliable manner.
 central banks monitor and stabilize the economy.
 National bank of Ethiopia is our central bank
 Core Functions OF A Financial
System
1. The investment chain
2. Risk Management
3. Payment systems
4. Providing information
 1. The investment chain
 Through the investment chain, savers and
borrowers are brought together.
 Savers provide financing to businesses,
 and businesses that wish to grow offer
opportunities for savers to take part in the
growth and resulting potential returns.
 The efficiency of this chain is critical to
allocating what would otherwise be
uninvested capital to businesses
………….that can use it to grow their enterprises
 1. The investment chain…..
 Pooling resources and subdividing shares
 Financial systems enable multiple investors to
contribute to projects that no one of them
alone could afford.
 Transferring resources across time and
space.
 Firms in one industry, or in one location, may
seek to invest surplus funds in other
industries or at other locations.
 2. Managing Risk
 Financial systems provide ways for investors
to exchange, and thereby to control, risks.
 For example,
 insurance enables the pooling of risks,
 hedging enables the transfer of risk to speculators,
 diversification exploits low correlations that may
exist among risky projects
 3. Payment systems
 Financial systems provide mechanisms that
facilitate exchanges of goods and services,
as well as assets,
 followed by settlement, transferring ownership
in return for the agreed remuneration.
 It is an essential requirement for
commercial activities to take place and for
participation in international trade and
investment.
 4. Providing information
 One of the most prominent friction in the financial
market is asymmetric information
 Financial markets, institutions and intermediaries
produce useful information of potential borrowers to
investors.
 Financial systems enable price discovery
– that is, for those who wish to trade to observe the
prices (rates of exchange) at which agreements can be
made.
– other information, for example about expectations of
future asset price volatility, can be inferred from market
prices.
 Financial Assets
 An asset, broadly speaking, is any possession that
has value in an exchange.
 Assets can be classified as tangible or intangible.
 A tangible asset is one whose value depends on particular
physical properties—examples are buildings, land, or
machinery.
 Intangible assets, by contrast, represent legal claims to
some future benefit.
 Their value bears no relation to the form, physical or otherwise,
in which these claims are recorded.
 Financial assets are intangible assets.
 For financial assets, the typical benefit or value is a claim to future cash.
 Real Assets Vs Financial Assets
Real Assets:
- are assets used in the process of production in the
economy, i.e., items such as factories, machinery,
patents, human capital, knowledge .

Financial assets:
- are claims to the output of the production process. In other

words, they are legal contract representing the right to receive

future financial benefits under a stated set of conditions. E.g.
equity shares, bonds (corporate/government), deposit with banks,
mutual fund shares, insurance policies, and derivative instruments
 Financial Assets…
 The claim that the holder of a financial asset has
may be either a fixed dollar amount or a varying, or
residual, amount.
 In the former case, the financial asset is referred to as a
debt instrument.
 An equity instrument (also called a residual claim)
obligates the issuer of the financial asset to pay the
holder an amount based on earnings, if any, after holders
of debt instruments have been paid.
 Some securities fall into both categories….Preferred stock
 Both debt and preferred stock that pay fixed dollar
amounts are called fixed-income instruments.
 The Price of a Financial Asset
and Risk
 A basic economic principle is that the price of any
financial asset is equal to the present value of its
expected cash flow, even if the cash flow is not
known with certainty.
 By cash flow, we mean the stream of cash payments over
time.
 Financial Assets versus Tangible
Assets
 Both are expected to generate future cash flow for
their owner
 Financial assets and tangible assets are linked.
 Ownership of tangible assets is financed by the issuance of
some type of financial asset—either debt instruments or
equity instruments
 Ultimately, the cash flow for a financial asset is generated
by some tangible asset.
 PROPERTIES OF FINANCIAL
ASSETS
 Moneyness
 Divisibility and Denomination
 reversibility,
 cash flow,
 term to maturity,
 convertibility,
 currency,
 liquidity,
 return predictability, and
 complexity
Financial Systems - Approaches

◼ Faced with end users desire (lend or borrow), there are

three approaches:
◼ First, they may decide to deal directly with one
another.
◼ Second, they may decide to deal via markets

◼ Third, they may decide to deal via intermediaries.

L B

Markets

Intermediaries
 Financial Markets
 In a market economy, the allocation of economic
resources is driven by the outcome of many private
decisions
 Prices are signals that direct economic resources to their
best use
 Financial Markets…
 Two types of markets in an economy:
1. The market for products (manufactured
goods and services)
2. The market for factors of production( labor
and capital)
 Our focus is one part of the factor
market, the market for financial
assets……financial market
 Financial Markets….

 A financial market is a market where financial

assets are exchanged (i.e.» traded).
 Financial markets are markets in which funds are
transferred from people and firms who have an
excess of available funds to people and firms who
have a need of funds.
Financial Markets…
 Financial markets, such as bond and stock
markets, are crucial in an economy.
 These markets channel funds from savers
to investors, thereby promoting economic
efficiency.
 Well functioning financial markets, such as
the bond market, stock market, and foreign
exchange market, are key factors in
producing high economic growth.
 Financial Markets…
 Debt markets, or bond markets, allow governments,
corporations, and individuals to borrow to finance
activities.
 In this market, borrowers issue a security, called a
bond, that promises the timely payment of interest
and principal over some specific time horizon.
 The interest rate is the cost of borrowing.
 There are many different types of market interest
rates, including mortgage rates, car loan rates,
credit card rates, etc.
 Financial Markets…
 The stock market is the market where common
stock (or just stock), representing ownership in a
company, are traded.
 Companies initially sell stock (in the primary
market) to raise money. But after that, the stock is
traded among investors (secondary market).
 The foreign exchange market is where international
currencies trade and exchange rates are set.
 Foreign exchange (FX) markets are the largest of all
financial markets, with average daily turnover in
excess of US$5 trillion.
 Financial Markets…
 Exercise: Of all the active markets, the
stock market receives the most
attention from the media. Why?
Functions of Financial Market
◼
Financial markets provide the following three major
economic functions:
❑ Price discovery
❑ Liquidity
❑ Reduced transaction costs
◼ Price discovery:
◼ Since the interactions of buyers and sellers in a Financial market
determine the price of the traded asset, they determine the required
return that participants in a financial market demand in order to buy
a financial instrument.
Functions of Financial Market
Functions of Financial Market
 Functions of Financial Market

Reduced Transaction Costs:

◼ This is performed when Financial Market participants
are charged and /or bear the costs of trading a
financial instruments.
Functions of Financial Market
Functions of Financial Market
 Classification of Financial
Markets
 There are many ways to classify financial markets.

 Financial Intermediaries
 Instead of savers lending/investing directly with
borrowers, a financial intermediary (such as a bank)
plays as the middleman:
 The intermediary obtains funds from savers
 The intermediary then makes loans/investments with
borrowers
 This process, called financial intermediation, is
actually the primary means of moving funds from
lenders to borrowers.
 More important source of finance than securities
markets (such as stocks).
 Financial Intermediaries…
 Financial intermediary needed because of
transactions costs, risk sharing, and asymmetric
information
1. Transactions Costs
 Financial intermediaries make profits by reducing
transactions costs.
 Reduce transactions costs by developing expertise and
taking advantage of economies of scale.
Financial Intermediaries…
2. Risk Sharing
 Financial Intermediaries low transaction costs allow
them to reduce the exposure of investors to risk,
through a process known as risk sharing.
 Financial Intermediaries create and sell assets with
lesser risk to one party in order to buy assets with
greater risk from another party.
 This process is referred to as asset transformation, because
in a sense risky assets are turned into safer assets for
investors.
 Financial Intermediaries…
 Financial intermediaries also help by providing the
means for individuals and businesses to diversify
their asset holdings.
 Low transaction costs allow them to buy a range of
assets, pool them, and then sell rights to the
diversified pool to individuals.
 Financial Intermediaries…
3. Asymmetric Information
 Another reason Financial intermediaries exist is to reduce
the impact of asymmetric information.
 One party lacks crucial information about another party,
impacting decision-making.
 We usually discuss this problem along two fronts: adverse
selection and moral hazard.
 Financial Intermediaries…
 Adverse Selection
 Before transaction occurs
 Potential borrowers most likely to produce adverse
outcome are ones most likely to seek a loan
 Similar problems occur with insurance where unhealthy
people want their known medical problems covered
Financial Intermediaries…
 Moral Hazard
 After transaction occurs
 Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more likely
that won’t pay loan back
 Again, with insurance, people may engage in risky
activities only after being insured
 Another view is a conflict of interest
Financial Intermediaries…
 Financial intermediaries reduce adverse selection
and moral hazard problems, enabling them to
make profits.
 Because of their expertise in screening and
monitoring, they minimize their losses, earning a
higher return on lending and paying higher yields
to savers.
 41

Types of Financial Intermediaries