Transcript The Financial System

CHAPTER 3 FINANCIAL SYSTEM
Zoubida SAMLAL - MBA , CFA
Member, PHD candidate for HBS
program
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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.
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.
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UNDERSTANDING THE FINANCIAL
SYSTEM
• 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.
TYPES OF SECURITIES
• Securities
– Financial instruments
– Obligations on the part of the issuer
• Businesses and Governments
– Provide rate of return to purchasers
• Money Market Instruments
• Bonds
• Stock
MONEY MARKETS INSTRUMENTS
• 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
BONDS
• 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 RATING
• Price is determined by risk and interest
rate.
• Several firms rate bonds
– Standard & Poor’s (S&P)
– Moody’s
• Investment-grade
• Speculative/Junk
STOCKS
• 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.
CONVERTIBLE SECURITIES
Stockholder has the
right to exchange the
bond or preferred stock
for a fixed number of
shares of common
stock.
FINANCIAL MARKETS
• 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.
UNDERSTANDING STOCK MARKET
Stock market (exchange) –
market in which common stocks
are traded, such as the New York
Stock Exchange.
FINANCIAL INSTITUTIONS
Commercial Banks
Savings Banks and Credit Unions
Non-depository Institutions
NON DEPOSITORY FINANCIAL
INSTITUTIONS
Insurance Companies
Pension Funds
Finance Companies
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 MARKETS
1. Allows transfers of funds from
person or business without
investment opportunities to one who
has them
2. 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 Regulation
1. 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 panics
B. Chartering, reporting requirements, restrictions on
assets and activities, deposit insurance, and anticompetitive measures