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CHAPTER 3 FINANCIAL SYSTEM

Zoubida SAMLAL - MBA , CFA Member, PHD candidate for HBS

program

The financial system is the process by which money flows

from savers to users.

THE FINANCIAL SYSTEM

Provides for efficient flow of funds from saving to investment by bringing savers and borrowers together via financial markets and financial institutions.

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BASIC COMPONENTS OF THE FINANCIAL SYSTEM: MARKETS AND INSTITUTIONS

• Financial markets are markets for financial instruments, also called financial claims or securities.

• Financial institutions (also called financial intermediaries) facilitate flows of funds from savers to borrowers.

• Financial System– Savers

– Users

– Financial Institutions

– Financial Markets

• Savings is a function of many variables.

• Funds can be transferred between users and savers directly or indirectly.

UNDERSTANDING THE FINANCIAL SYSTEM

• Securities– Financial instruments– Obligations on the part of the issuer• Businesses and Governments

– Provide rate of return to purchasers• Money Market Instruments• Bonds• Stock

TYPES OF SECURITIES

• Short-term Debt Securities– Issued by governments, financial institutions and

corporations• Investors are paid interest for the use of their

funds.• Generally low-risk• U.S. Treasury bills, commercial paper, and

bank certificates of deposit

MONEY MARKETS INSTRUMENTS

• Government Bonds– Bonds sold by the U.S. Department of the

Treasury.• Municipal Bonds– Bonds issued by state or local governments • Revenue bonds are used toward a project that will

produce revenue

BONDS

• Price is determined by risk and interest rate.

• Several firms rate bonds– Standard & Poor’s (S&P)– Moody’s

• Investment-grade• Speculative/Junk

BONDS RATING

• Common stock – ownership claims in corporations.– Vote on major company decisions– Cash dividends– Price appreciation

• Preferred stock – stockholders with preference in the payment of dividends.

STOCKS

Stockholder has the right to exchange the

bond or preferred stock for a fixed number of

shares of common stock.

CONVERTIBLE SECURITIES

• Primary Market – firms and governments issue securities and sell them initially to the public.– When a firm offers a stock for sale to the general

public for the first time.

• Secondary Market – collection of financial markets in which previously issued securities are traded among investors.

FINANCIAL MARKETS

Stock market (exchange) – market in which common stocks are traded, such as the New York Stock Exchange.

UNDERSTANDING STOCK MARKET

Commercial Banks

Savings Banks and Credit Unions

Non-depository Institutions

FINANCIAL INSTITUTIONS

Insurance Companies

Pension Funds

Finance Companies

NON DEPOSITORY FINANCIAL INSTITUTIONS

INTERMEDIARIES PERFORM 5 BASIC SERVICES AS THEY TRANSFORM CLAIMS.

• Denomination Divisibility – pool savings of many small SSUs into large investments.

• Currency Transformation – buy and sell financial claims denominated in various currencies.

• Maturity Flexibility – Offer different ranges of

maturities to both DSUs and SSUs.

INTERMEDIATION SERVICES, CONT.

• Credit Risk Diversification – Assume credit risks of DSUs; spread risk over many different types of DSUs.

• Liquidity – Give SSUs and DSUs different choices about when, to what extent, and for how long to commit to financial relationships.

FUNCTION OF FINANCIAL MARKETS1. Allows transfers of funds from person or business without investment opportunities to one who has them2. Improves economic efficiency

EFFICIENCY IN FINANCIAL MARKETS

• Allocational Efficiency: highest/best use of funds– DSUs try to fund projects with best cost/benefit ratios – SSUs try to invest for best possible return for given

maturity and risk

• Informational Efficiency: prices reflect relevant information– Informationally efficient markets reprice quickly on

new information; – informationally inefficient markets offer opportunities

to buy “underpriced” assets or sell “overpriced” assets

• Operational Efficiency: transactions costs minimized

RISKS OF FINANCIAL INSTITUTIONS

• Credit or default risk: risk that a DSU may not pay as agreed

• Interest rate risk: fluctuations in a security's price or reinvestment income caused by changes in market interest rates

• Liquidity risk: risk that a financial institution may be unable to disburse required cash outflows, even if essentially profitable

Risks of Financial Institutions, cont.

• Foreign exchange risk: effect of exchange rate fluctuations on profit of financial institution

• Political risk: risk of government or regulatory action harmful to interests of financial institution.

REGULATION OF FINANCIAL MARKETS

Two Main Reasons for Regulation1. Increase information to investors

A. Decreases adverse selection and moral hazard problems

B. Securities commissions force corporations to disclose information

2. Ensuring the soundness of financial intermediaries

A. Prevents financial panicsB. Chartering, reporting requirements, restrictions on

assets and activities, deposit insurance, and anti-competitive measures