The Financial

System

The financial system

Its a collection of markets, institutions, laws,
regulations and techniques through which bonds,
stocks and other securities are traded, interest
rates are determined, and financial services are
produced and delivered around the world.
Its primary task is to move scarce loanable funds
from those who save to those who borrow to buy
goods and services and make investments in new
equipment and facilities so that the global
economy can grow and raise standards of living.
Financial system determines COST and
AVAILABILITY of credit to pay for thousands of
goods and services. When credit is costly and less
available total spending falls and unemployment
rises.

Types of markets
Factor markets: consumers sell their labor and
other resources to producers. They ALLOCATE
factors of production (land, labor, managerial
skills, capital) and DISTRIBUTE income (wages,
rentals, etc.) to owners of productive resources.
Product markets: where consumers use most of
income from factor markets to purchase goods
and services.
Financial markets: channel savings to individuals
and institutions in need of more funds for
spending than are provided by their current
incomes. FMs attract and allocate savings, set
interest rates and prices of financial assets.

Nature of savings
Savings (amount of funds left-over of current
income) differs according to unit that is saving.
i. Households: savings = current income
(current consumption + taxes)
ii. Business: retained earnings after payment of
taxes, stockholder dividends, other expenses,
etc.
iii. Government: if revenues > expenditures =
budget surplus

Nature of investment
Investment (expenditures on capital goods,
inventory goods, raw materials that are used to
produce other goods)
i. Business: capital goods (fixed assets like
buildings & equipment) and inventories (raw
materials and goods for sale)
ii. Households: expenditures on capital account
(e.g. new homes, cars, etc.) and other durable
goods. Non-durable goods like fuel, clothing ,
food are consumption spending (current
account)
iii. Government: build and maintain public facilities
(buildings, roads, etc)

Financial markets
FMs make it possible:
The exchange of current income for future income
The transformation of savings into investment so
that production, employment and incomes can grow.

Suppliers of funds receive only PROMISES in

return for their loan money. The promises are
packaged attractively in form of financial claims
and services.
Financial claims promise lender a future flow of
income in form of dividends, interest and other
returns.
NO guarantee the expected income will be
recovered.

Functions of financial
system
1. Savings: FMs provide conduit for publics
savings. Bonds, stocks and other financial claims
provide profitable, relatively low-risk outlet for
publics savings.
2. Wealth: provide means to store purchasing
power (or wealth) until funds are needed for
spending. Bonds, stocks, and other financial
instruments do not wear (like cars) and risk of
loss is often less than other stores of wealth.
Wealth is sum of values of all assets, i.e.,
Net wealth, i.e. wealth less liabilities (debts) is:

Functions of financial
system
Wealth

is built up overtime through current saving

and income from previous wealth.
That is,
Where r is interest rate.
Income emerges from wealth, that is,
The higher the wealth created income the higher
the consumption and new saving.
3. Liquidity: provides financial instruments holders
the ability to easily convert them to cash at minimal
risk of loss. Though money is the most liquid, its
value is easily eroded by inflation.

Functions of financial
system
4. Credit: FMs provide credit to government, businesses
and households to finance consumption and investment.
5. Payments: credit cards, current accounts, etc. provide
means of payment for goods and services.
6. Risk: makes it possible the sale of insurance policies.
Additionally they provide hedging, i.e., enable self
insurance.
7. Reduction of contracting, search and information costs:
most agents lack time, skill and resources to analyze
deficit agents, draw up and enforce legal contracts. FMs
can fulfill that role by exploiting economies of scale and
thus reduce search and information costs.
8. Policy: governments use FMs as principal channel in
stabilizing the economy. This is done by controlling
credit and interest rates.

Types of financial markets

Money markets: deal in short-term assets that can
be quickly transformed to money
Securities markets: deals with raising of new
capital and trading of existing shares and bonds
Foreign exchange markets: different currencies
traded for one another
Derivative markets: where future obligations to
buy/sell, or options to buy/sell, underlying
financial assets are traded.

Primary vs. secondary

markets
Primary markets deal in issues of new securities, which
include government bonds, shares in new companies. They
are concerned with raising of new funds.
merchant, commercial and investment banks participate in
underwriting and distributing new issues (i.e. advise on
terms, timing, marketing of offers).
Underwriting methods:
Bought deal: lead firm offers issuer of debt a bid to purchase
issue. Issuer can accept or reject offer. If accepted then its
bought deal
Auction: underwriters bid for new issues.
Preemptive rights offering: new issues offered to existing
shareholders at below market value. Excess is then bought by
underwriter
Private placement: new issues placed with institutional firms
such as investment funds, pensions, etc.

Primary vs. secondary

markets
Secondary markets: deal with securities previously issued.
The issuer of the asset does not receive any proceeds from
sale of security.
Secondary market important to original issuer because
price of stock indicate value of company. This indicates
how investors will respond to any rights issue.
Market makers that is those who are prepared to buy and
sell shares at prices they quote ensure liquidity and enable
large trades to be dealt with.
Forms of secondary markets:
Screen-based: dispersed market participants connected via
telecommunications systems
Call market: orders batched together at intervals throughout
day. Market maker holds auctions
Continuous market: prices quoted continuously by market
makers.

Classification of FMs
1. Type of asset traded: can be debt or equity
instruments or a combination of the 2.
2. Maturity of asset traded: if maturity is less than 1
year then its money market. If more than 1 year
then its a capital market
3. Date of issue: if new issue then its primary market,
if previously issued then its secondary market
4. Means of settlement: if settlement for immediate
delivery then its a cash market. If settlement is for
future delivery then its a forward or futures market.
5. Type of financial asset traded: if counterparties
exchange on immediate or future basis then its spot
and forward markets. Options market holder has
right but no obligation to buy or sell in future.

Classification of FMs
6. Organizational structure of the market:
swap markets are known as over-the-counter.
Broker-jobber where a client tells broker what he
wants and the broker looks for the best price.
7. Method of sale/pricing: in London Stock
Exchange market-makers both quote prices and
buy or sell shares. London International Financial
Futures Exchange is based on pit trading
whereby traders trade around a pit. Over-thecounter products are tailor made and pricing
determined directly between buyers and sellers.

Role played by FMs

Pricing of financial assets: FMs provide
continuous prices for buyers and sellers to trade.
Excess supply (demand) suppresses (raises)
prices.
Discipline function: FMs ensure financial
discipline on both corporations and government.
if a decision by government or corporation is
deemed unsound then markets will punish the
entity by raising costs of borrowing.

Participants in FMs
Participants in FMs include individuals,
institutions, brokers and regulators
Brokers and market-makers: broker acts as
intermediary on behalf of investor. He is the legal
agent. He earns a commission. Market-maker acts
as a dealer in financial security quoting a price
she is willing to buy (bid price) a security and a
higher price he is willing to sell (ask price). Profit
margin is the spread between bid-ask prices. They
provide liquidity to the market.

Participants in FMs
Arbitrageurs, hedgers and speculators
Arbitrageur: buys and sells securities to take
advantage of price anomalies in order to make
riskless guaranteed profits. Arbitrageur may buy a
security cheaply in market 1 and sell expensively
in market 2. this has effect of equalizing prices.
Hedgers: buy or sell securities in order to reduce
or eliminate existing risk
Speculators: take risks to make profit. A
speculator may buy a security if he feels it is
underpriced. If the price rises he makes a profit.
But if the price falls instead he loses.