Chapter 2: An Overview of the Financial System

Function of Financial Markets

Securities are assets for the person who buys them and liabilities for the person or the firm who sells (issues) them.

Structure of Financial Markets

1.       Debt and equity market

Maturity: the maturity of debt instrument is the number of years (terms) until that instrument’s expiration date.

Short-term: maturity is less than 1 year.

Long-term: maturity is 10 years or longer.

Intermediate-term: maturity is between 1 and 10 years.

2.       Primary and secondary markets

Primary market: is a financial market in which new issues of security, such as bonds and stocks, are sold to initial buyers by corporation or government agency borrowing the funds.

Secondary market: is financial market in which securities that have been issued previously can be resold.

Brokers: are agents of investor who match buyers with sellers of securities;

Dealers: link buyers and sellers by buying and selling securities at stated prices.

3.       Exchanges and over-the counter markets

Exchanges: where buyers and sellers of securities (or their agents or brokers) meet in a central location to conduct trades.

Over-the-counter market (OTC): in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices.

4.       Money and capital markets

Money market: is a financial market in which only short-term debt instruments (generally those whose original maturity is less than one year) are traded.

Capital market: is a financial market in which longer-term debt instruments (generally those whose original maturity is one year or greater) and equity instruments are traded.

Financial Market Instruments

1.       Money markets instruments

Negotiable Bank Certificates of Deposit: a certificate of deposit (CD) is a debt instrument sold by bank to depositors than pays annual interest of a given amount and at maturity pays back the original purchase price.

Commercial Paper: is a short-term debt instrument issued by large banks and well-known corporations.

Banker’s Acceptance: is a bank draft issued by a firm, payable at some future date, and guaranteed for a fee by the bank that stamps it “accepted.”

Repurchase Agreement: (repos) are effectively short-term loans (usually with a maturity less than two weeks) for which Treasury bills serves as collateral, an asset that the lender receives if the borrower does not pay back the loans.

2.       Capital Market Instruments

    Capital market instruments are debt and equity instruments with maturities of greater than one year. They have far wider price fluctuations than money market instruments and are considered to fairly risky investments.

Stocks: are equity claims on the net income and assets of a corporation.

Mortgages: are loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans.

Corporate Bonds:are the long-term bonds issued by corporations with strong credit ratings.

Consumer and Bank Commercial loans:these loans to consumers and businesses are made principally by banks but, in the case of consumer loans, also by financial companies.

Internationalization of Financial Markets

1.       International Bond Market, Eurobonds, and Eurocurrencies

Foreign bonds: are sold in a foreign country and are denominated in that country’s currency.

Eurobond: denominated in a currency other than that of the country in which it is sold.

Eurocurrencies: is a variant of Eurobond which is foreign currencies deposited in banks outside the home country. The most important Eurocurrencies are Eurodollars.

Function of Financial Intermediaries: Indirect Finance

    Financial intermediation: the process of indirect finance using financial intermediaries, it is the primary route for moving funds from lenders to borrowers.

1.       Transaction Costs

The time and money spent in carrying out financial transactions are a major problem for people who have excess funds to lend.

2.       Risky Sharing

Diversification: entails investing in a collect (portfolio) of assets whose returns do always not move together, with result that overall risk is lower than for individual risk.

3.       Asymmetric Information: Adverse Selection and Moral Hazard

Adverse selection: is the problem created by asymmetric information beforethe transaction occurs.

Moral Hazard: is the problem created by asymmetric information after the transaction occurs.

Types of Financial Intermediaries

They fall into three categories: depository institutions (banks), contractual saving institutions, and investment intermediaries.

Regulation of Financial System

   The government regulates financial market and intermediaries for two main reasons: to increase the information available to investors and to ensure the soundness of the financial system. Regulations include requiring disclosure of information to the public, restrictions on who can set up a financial intermediary, restrictions on what assets financial intermediaries can hold, the provision of deposit insurance, and reserve requirement.