Financial System

LEARNING OBJECTIVES

After studying this chapter you should be able to

Summarize the basic function performed by financial system

Describe the principal financial instruments

Explain why financial markets are classified as debt and equity markets, primary and secondary markets, exchanges and over-the-counter markets, and money and capital markets

Describe the principal financial intermediaries

Express why the government regulates financial markets and financial intermediaries

Chapter 2: Financial system

CHAPTER 2.1: FINANCIAL

SYSTEM & FLOWS OF FUNDS

A Model of the Economy

As in Principles of Macro, divide the economy into different sectors and see how those sectors interact:

“Agents” in the Economy

Markets where Agents Interact

Equilibrium

The Agents in the System

There are four agents that we will focus on when constructing a model of the economy:

Households

Firms

Government

“The Rest of the World” (ROW)

Markets

There are three markets that we typically focus on in macroeconomics:

The Factor Market

The Goods Market

The Financial Market (- we examine in detail in this course)

FINANCIAL SYSTEM

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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.

Financial system

The basic function of FS is essentially channelling of funds within the different units of the economy – from surplus units to deficit units for productive purposes.

Surplus economic units have funds left over after spending all they wish to spend

Deficit economic units need to acquire additional funds to sustain their operations

To enable funds to move through the financial system, funds are exchanged for securities.

Securities are documents that represents the right to receive funds in the future.

Securities are traded in financial markets.

Financial intermediaries often help to facilitate this process

THE FLOW OF FUNDS

There are interactions among the various players in the financial system.

Funds flow through the financial system from the entities that have a surplus of funds to those that have a deficit of funds:

Directly

Through markets

Through intermediaries

Surplus UnitsDeficit Units

Markets

Intermediaries

Poor Credit Risk

What Does the Financial System Do?

Economists believe there are three key services that the financial system provides to savers and borrowers: risk sharing, liquidity, and information.

Risk sharing

Risk sharing: A service the financial system provides that allows savers to spread and transfer risk.

The financial system provides risk sharing by allowing savers to hold many assets (diversification).

Diversification: Splitting wealth among many different assets to reduce risk.

Liquidity

The second service that the financial system offers savers and borrowers is liquidity, which is the ease with which an asset can be exchanged for money.

More liquid assets can be quickly and easily exchanged for money, while less liquid—or illiquid—assets can be exchanged for money only after a delay or by incurring costs.

Assets created by the financial system are more liquid than physical assets.

Financial markets and intermediaries help make financial assets more liquid.

Information

Information: Facts about borrowers and about expectations of returns on financial assets.

A third service of the financial system is the collection and communication of information.

Financial markets convey information to both savers and borrowers by determining the prices of stocks, bonds, and other securities.

CHAPTER 2.2: FINANCIAL

INSTRUMENTS

FINANCIAL INSTRUMENTS

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FINANCIAL ASSETS

An asset is anything of value owned by a person or a firm.

A financial asset is a financial claim, which means that if you own a financial asset, you have a claim on someone else to pay you money.

Economists divide financial assets into those that are securities and those that aren’t. A security is tradable, which means that it can be bought and sold in a financial market

NON-MARKETABLE

Characteristics of non-marketable financial assets:

Cannot be traded between or among investors

May be redeemable (a reverse transaction between the borrower and the lender)

Examples:

Savings accounts

Term Deposits

Certificates of Deposits

MARKETABLE

Characteristics of Marketable financial assets:

Can be traded between or among investors after their original issue in public markets and before they mature or expire

Market Capitalization

Is an important term in finance

It is the total market value of a company

It is found by multiplying the number of shares outstanding by the market price per share

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Market Capitalization  Number of shares  Price per share

Market Capitalization  Number of shares  Price per share

Securities

Securities can be:

Short-term or long-term

Debt or equity

Others

SHORT-TERM

Short-term securities:

Maturity of less than 1 year

Least price fluctuation and least risky investments

Common short-term securities:

Treasury bills- Negotiable Bank Certificates of Deposit

Commercial paper- Bankers’ acceptance

Eurodollars

Repurchase Agreement

Federal (Fed) funds/ Overnight funds

Treasury bill

Treasury Bills (T-bill): short‐term securities issued by the treasury to finance the government

bought at a discount and at maturity the investor receives the full face value

after initial sale they have an active secondary market

the most liquid and the safest of all the money market instruments

mainly held by banks, small amounts are held by household, corporations and other financial intermediaries.

Certificate of Deposits

Certificate of Deposits (CDs): a debt instrument sold by a bank to depositors that pay annual interest of a given amount and at maturity pays back the original purchase price

usually have maturities from one day to five years

Small-denomination CDs are very safe investment and they tend to have low interest

Negotiable Bank Certificates of Deposits (NCDs):

CDs that can be traded in secondary markets

have maturities of two weeks to a year

NCDs usually have large-denomination, higher face value and shorter term than CDs

Commercial Paper

Commercial Paper: a short-term debt instrument issued by large banks and well- known corporations with a typical maturity of 30 days

It is similar to an IOU

It is unsecured

It is issued by large corporations with good credit ratings

Companies issue commercial paper to raise cash for current transactions, and many find it costs less than bank loans

Most buyers are large institutions

Banker’s acceptance

A banker’s acceptance: a short-term debt instrument that is guaranteed for payment by a commercial bank (the bank “accepts” the responsibility to pay)

allow businesses to avoid problems associated with collecting payment from reluctant debtors

used to facilitate international transactions

Eurodollars

Eurodollars: dollar-denominated deposits located in non-US banks

Originally, dollar-denominated deposits not subject to U.S. banking regulations were held almost exclusively in Europe; hence the name eurodollars

These deposits are still mostly held in Europe, but they're also held in many other countries

Buyers and sellers are large institutions

Repurchase agreement (repos)

Repurchase Agreement (repos): an agreement in which the borrower agree to sell an amount of government securities (usually