Topic 2

CONTENTS
FINANCIAL MARKETS
FINANCIAL INSTITUTIONS
I. What is a financial system?
 Financial system (FS) – a framework for describing set of
markets, organisations, and individuals that engage in the
transaction of financial instruments (securities), as well as
regulatory institutions.
• the basic role of FS is essentially channelling of funds
within the different units of the economy – from surplus
units to deficit units for productive purposes.

The financial system consists of:

 A set of markets
The individuals and institutions that trade in those markets
Financial Intermediaries
The regulatory bodies, which supervise the markets and
intermediaries.
What is Financial Markets?
 Financial markets perform the essential function of
channeling funds from economic players that have saved
surplus funds to those that have a shortage of funds.
• Exchange between these two groups of agents is settled in
financial markets.

• Hence a financial market is an organisational framework in

which financial instruments can be bought and sold.
I. What is Financial Markets?
 There exist two different forms of exchange in financial
markets. The first one is direct finance, in which lenders
and borrowers meet directly to exchange securities.
 Securities are claims on the borrower’s future income or

assets. Common examples are stock and bonds.

 The second type of financial trade occurs with the help of

financial intermediaries and is known as indirect finance.
In this scenario borrowers and lenders never meet directly,
but lenders provide funds to a financial intermediary such as
a bank and those intermediaries independently pass these
funds on to borrowers
I.2 Structure of Financial Markets
Financial markets can be categorized as follows:

Debt vs Equity markets

Primary vs Secondary markets
Exchange vs Over the Counter (OTC)
Money vs Capital Markets
 Debt vs Equity
Debt titles are the most commonly traded security. In these
arrangements, the issuer of the title (borrower) earns some
initial amount of money (such as the price of a bond) and the
holder (lender) subsequently receives a fixed amount of
payments over a specified period of time.

Debt titles can be issued on short term (maturity < 1 yr.),

long term (maturity >10 yrs.) and intermediate terms (1 yr. <
maturity < 10 yrs.).
The holder of a debt title does not achieve ownership of the

borrower’s enterprise.
Common debt titles are bonds or mortgages.
 Debt vs Equity
 The most common equity title is (common) stock.

 Firstand foremost, an equity instruments makes its buyer

(lender) an owner of the borrower’s enterprise.

 Formally this entitles the holder of an equity instrument to

earn a share of the borrower’s enterprise’s income, but
only some firms actually pay (more or less) periodic
payments to their equity holders known as dividends.
Often these titles, thus, are held primarily to be sold and
resold.

 Equity titles do not expire and their maturity is, thus,

indefinite. Hence they are considered long term
securities.
8
PRIMARY MARKETS Vs
SECONDERY MARKETS
Markets are divided into primary and secondary markets

 Primary markets are markets in which financial instruments

are newly issued by borrowers.

 Secondary markets are markets in which financial

instruments already in existence are traded among lenders.

 Secondary markets can be organized as exchanges, in

which titles are traded in a central location, such as a stock
exchange, or alternatively as over-the-counter markets in
which titles are sold in several locations.
MONEY MARKETS VS CAPITAL
MARKETS
Finally, we make a distinction between money and capital
markets.

 Money markets are markets in which only short term

debt titles are traded.

 Capital
markets are markets in which longer term debt
and equity instruments are traded.
 I.3 INSTRUMENTS TRADED
IN THE FINANCIAL MARKETS
Most commonly you will encounter:
 Corporate stocks are privately issued equity
instruments, which have a maturity of infinity by definition
and, thus, are classified as capital market instruments

 Corporate bonds are private debt instruments which have

a certain specified maturity. They tend to be long-run
instruments and are, hence, capital market instruments

 The short-run equivalent to corporate bonds are

commercial papers which are issued to satisfy short-run
cash needs of private enterprises.
 Functions of Financial markets
Borrowing and Lending
 Financial markets channel funds from households, firms,
governments and foreigners that have saved surplus funds
to those who encounter a shortage of funds (for purposes of
consumption and investment)

Clearing & settling payments.

Price Determination
 Financialmarkets determine the prices of financial assets.
The secondary market herein plays an important role in
determining the prices for newly issued assets
 Functions of Financial markets
Coordination and Provision of Information
 The exchange of funds is characterized by a high amount
of incomplete and asymmetric information. Financial
markets collect and provide much information to facilitate
this exchange.

Managing risk.
 Allowing investors to diversify and make frequent
portfolio adjustments.
 Insurance, pooling, hedging, diversification.
 Functions of Financial markets
Liquidity
 The existence of financial markets enables the
owners of assets to buy and resell these
assets. Generally this leads to an increase in
the liquidity of these financial instruments

Efficiency
 The facilitation of financial transactions
through financial markets lead to a decrease
in informational cost and transaction costs,
which from an economic point of view leads to
an increase in efficiency.
14
 II.FINANCIAL
INSTITUTIONS
What are Financial Institutions?
Financial Institutions and their function
Types of Financial Institutions
Financial Institutions
Financial Institutions.
Institutions in individual countries
i. Central Banks
ii. Retail Banks
iii. Investment Banks
iv. Moneylenders
v. Stock exchanges
vi. Commodity exchanges
vii. Regulatory bodies
International Institutions.
i. IMF
ii. World Bank
iii. International Bank for Reconstruction and Development
iv. United Nations
v. International Regulatory Bodies e.g. Bank for International
Settlements ‘Basel Committee on Banking Supervision’
 II.1What are Financial
Institutions ?
 Financial intermediaries are firms whose primary
business is to provide customers with financial products
and services that can not be obtained more efficiently
by transacting directly in securities markets (Z.Bodie
&Merton)

 Any classification of financial institutions is ultimately

somewhat arbitrary, since financial markets are
subject to high dynamics and frequent innovation.
Thus, we roughly use four Engage in trade of securities
categories:
 Brokers (direct finance)
 Dealers
 Investment banks Engage in financial asset
transformation (indirect finance)
 Financial intermediaries
II.1What are Financial Institutions?
(Cont)
Brokers are agents who match buyers with sellers for a
desired transaction.

A broker does not take position in the assets she/he trades

(i.e. does not maintain inventories of those assets)

 Brokers charge commissions on buyers and/or sellers

using their services

 Examples: Real estate brokers, stock brokers

II.1What are Financial Institutions?
(Cont)
 Like brokers, dealers match sellers and buyers of financial assets.

 Dealers, however, take position in their assets, their trading.

 As opposed to charging commission, dealers obtain their profits from

buying assets at low prices and selling them at high prices.

A dealer’s profit margin, the so-called bid-ask spread is the difference

between the price at which a dealer offers to sell an asset (the asked
price) and the price at which a dealer offers to buy an asset (the bid
price)
II.1What are Financial Institutions?
(Cont)
Investment Banks

 Investment banks assist in the initial sale of newly issued

securities (e.g. IPOs)

 Investment banks are involved in a variety of services for

their customers, such as advice, sales assistance and
underwriting of issuances
II.1What are Financial Institutions?
(Cont)
Financial Intermediaries

 Financial intermediaries match sellers and buyers indirectly

through the process of financial asset transformation.

 As opposed to three above mentioned institutions, they buy a

specific kind of asset from borrowers –usually a long term
loan contract – and sell a different financial asset to savers –
usually some sort of highly-liquid short-run claim.
 Although securities markets receive a lot of media attention,
financial intermediaries are still the primary source of
funding for businesses.

 Even in the United States and Canada, enterprises tend to

obtain funds through financial intermediaries rather than
through securities markets.
 II.2 Function of Financial Intermediaries:
Indirect Finance
1. Maturity transformation (Asset transformation)
Intermediaries take a large number of small deposits from savers
and bundle them together for lending to agents making large
purchases. Short-term savings are converted into loans of longer
duration. Borrowers get large-scale long-term loans

2. Financial intermediaries reduce transaction costs.

Costs in the absence of a financial intermediary are high:
Search for a perfectly matched borrower / lender pair
 Expensive to drawing up and enforce contracts for each
individual transaction.
Intermediaries have standard contracts for savers.
Commission charges for large-scale transactions are relatively low.

Search costs are driven to very low levels by wide and detailed
knowledge.
 II.2 Functions of Financial
Intermediaries: Indirect Finance
3.Intermediaries transform (reduce) the risk of
lending:
People are “risk averse”.
Intermediaries have expertise in screening borrowers
Intermediaries also offer savers “diversified” portfolios
Holding a portfolio of assets is less likely to generate
unexpected outcomes than “putting all eggs in one basket”.
Efficient Market
Definition
An efficient stock market is one in which prices
fully reflect
all known, relevant information, and adjust
instantaneously
and in an unbiased manner to any piece of new
information.
Types of Efficiency
Operational Efficiency
Cheap transaction costs
Allocational Efficiency
Resources flow to where they are required
Pricing Efficiency
Prices instantaneous adjust to reflect relevant information

The Efficient Market Hypothesis (EMH) relates to

pricing efficiency.
 Implications of Efficiency

In an efficient market:
Share value determines share price
Shares are priced to give shareholders their required return
There are no obvious over-valued or under-valued shares

Remember however that in practice valuations are based

on future expectations and prices can only reflect estimated
economic value
Levels of Efficiency
Following earlier research by Fama most texts identify 3 levels of
market efficiency:

- Weak
- Semi-strong
- Strong
Weak-Form Efficiency
The share price reflects all information contained in
past share prices

If the market is weak-form efficient then:

Past share prices or patterns in prices cannot predict future
share prices
Share prices move in a random way
Technical analysis will not yield abnormal profits
Semi-Strong Form
Prices reflect all publicly available information
i.e. all company announcements, earnings and dividend
news, technological breakthroughs

If the market is semi-strong form efficient then:

Trading rules based on publicly available information will
not yield abnormal profits
Fundamental analysts will not achieve abnormal profits
Strong-Form Efficiency
Prices reflect all relevant information
i.e. any information, public or not, is incorporated in the
share price

If the market is strong form efficient then:

Even traders using “inside” information cannot make
abnormal profits
It will also be semi-strong and weak form efficient
Summary of Tests of the EMH
Weak form is supported, so technical analysis cannot
consistently outperform the market.

Semi-strong form is mostly supported , so fundamental

analysis cannot consistently outperform the market.

Strong form is generally not supported. If you have secret

(“insider”) information, you can use it to earn excess returns on
a consistent basis.

Ultimately, most believe that the market is very efficient,

though not perfectly efficient. It is unlikely that any system of
analysis could consistently and significantly beat the market
(adjusted for costs and risk) over the long run.