Chapter One

Overview of the Financial System

Asamnew T

Department of Accounting and Finance,

Addis Ababa University
 Chapter Objectives
 Understanding the role of financial system in the
economy
 Understanding financial assets: its characteristics
and roles
 Understanding what a financial market is, its
classifications, its actors
 Understanding function of financial intermediaries:
 Lending and borrowing in the financial system
Financial System
 What is a financial system?
 An economic arrangement wherein financial
institutions facilitate the transfer of funds and assets
between borrowers, lenders, and investors.
 Financial System
 The financial system has six parts, each of which plays a
fundamental role in our economy.
 Those parts are:
 money,
 financial instruments,
 financial markets,
 financial institutions,
 government regulatory agencies, and
 central banks.
 Financial System…
 We use money to pay for our purchases and to store our
wealth.
 We use financial instruments, to transfer resources from
savers to investors and to transfer risk to those who are best
equipped to bear it.
 Stocks, mortgages, and insurance policies are examples of
financial instruments.
 financial markets allows us to buy and sell financial
instruments quickly and cheaply
 Financial System…
 Financial institutions provide a myriad of services, including
access to the financial markets and collection of
information about prospective borrowers to ensure they are
creditworthy.
 Government regulatory agencies are responsible for making
sure that the elements of the financial system—including its
instruments, markets, and institutions—operate in a safe
and reliable manner.
 central banks monitor and stabilize the economy.
 National bank of Ethiopia is our central bank
 Core Functions OF A Financial
System
1. The investment chain
2. Risk Management
3. Payment systems
4. Providing information
 1. The investment chain
 Through the investment chain, savers and
borrowers are brought together.
 Savers provide financing to businesses,
 and businesses that wish to grow offer opportunities
for savers to take part in the growth and resulting
potential returns.
 The efficiency of this chain is critical to allocating
what would otherwise be uninvested capital to
businesses
………….that can use it to grow their enterprises
 1. The investment chain…..
 Pooling resources and subdividing shares
 Financial systems enable multiple investors to
contribute to projects that no one of them alone
could afford.
 Transferring resources across time and space.
 Firms in one industry, or in one location, may seek to
invest surplus funds in other industries or at other
locations.
 2. Managing Risk
 Financial systems provide ways for investors to
exchange, and thereby to control, risks.
 For example,
 insurance enables the pooling of risks,
 hedging enables the transfer of risk to speculators,
 diversification exploits low correlations that may exist
among risky projects
 3. Payment systems
 Financial systems provide mechanisms that
facilitate exchanges of goods and services, as
well as assets,
 followed by settlement, transferring ownership in
return for the agreed remuneration.
 It is an essential requirement for commercial
activities to take place and for participation in
international trade and investment.
 4. Providing information
 One of the most prominent friction in the financial market is
asymmetric information
 Financial markets, institutions and intermediaries produce
useful information of potential borrowers to investors.
 Financial systems enable price discovery
– that is, for those who wish to trade to observe the prices (rates
of exchange) at which agreements can be made.
– other information, for example about expectations of future
asset price volatility, can be inferred from market prices.
 Financial Assets
 An asset, broadly speaking, is any possession that has value
in an exchange.
 Assets can be classified as tangible or intangible.
 A tangible asset is one whose value depends on particular physical
properties—examples are buildings, land, or machinery.
 Intangible assets, by contrast, represent legal claims to some
future benefit.
 Their value bears no relation to the form, physical or otherwise, in which
these claims are recorded.
 Financial assets are intangible assets.
 For financial assets, the typical benefit or value is a claim to future cash.
 Real Assets Vs Financial Assets
Real Assets:
- are assets used in the process of production in the
economy, i.e., items such as factories, machinery,
patents, human capital, knowledge .

Financial assets:
- are claims to the output of the production process. In other

words, they are legal contract representing the right to receive

future financial benefits
equity bondunder(corporate/
a stated set of conditions.depos
E.g. wit bank
shares, s
mutual fund shares, government),
insurance policies, and it h s,
derivative instruments
 Financial Assets…
 The claim that the holder of a financial asset has may be
either a fixed dollar amount or a varying, or residual, amount.
 In the former case, the financial asset is referred to as a debt
instrument.
 An equity instrument (also called a residual claim) obligates the
issuer of the financial asset to pay the holder an amount based on
earnings, if any, after holders of debt instruments have been paid.
 Some securities fall into both categories….Preferred stock
 Both debt and preferred stock that pay fixed dollar amounts are
called fixed-income instruments.
 The Price of a Financial Asset and
Risk
 A basic economic principle is that the price of any financial
asset is equal to the present value of its expected cash flow,
even if the cash flow is not known with certainty.
 By cash flow, we mean the stream of cash payments over time.
 Financial Assets versus Tangible
Assets
 Both are expected to generate future cash flow for their
owner
 Financial assets and tangible assets are linked.
 Ownership of tangible assets is financed by the issuance of some
type of financial asset—either debt instruments or equity
instruments
 Ultimately, the cash flow for a financial asset is generated by
some tangible asset.
 PROPERTIES OF FINANCIAL ASSETS
 Moneyness
 Divisibility and Denomination
 reversibility,
 cash flow,
 term to maturity,
 convertibility,
 currency,
 liquidity,
 return predictability, and
 complexity
Financial Systems - Approaches
◼ Faced with end users desire (lend or borrow), there are
three approaches:
◼ First, they may decide to deal directly with one another.

◼ Second, they may decide to deal via markets

◼ Third, they may decide to deal via intermediaries.

L B

Markets

Intermediaries
 Financial Markets
 In a market economy, the allocation of economic resources
is driven by the outcome of many private decisions
 Prices are signals that direct economic resources to their best
use
 Financial Markets…
 Two types of markets in an economy:
1. The market for products (manufactured goods
and services)
2. The market for factors of production( labor and
capital)
 Our focus is one part of the factor market,
the market for financial assets……financial
market
 Financial Markets….

 A financial market is a market where financial assets are

exchanged (i.e.» traded).
 Financial markets are markets in which funds are
transferred from people and firms who have an excess of
available funds to people and firms who have a need of
funds.
Financial Markets…
 Financial markets, such as bond and stock
markets, are crucial in an economy.
 These markets channel funds from savers to
investors, thereby promoting economic
efficiency.
 Well functioning financial markets, such as the
bond market, stock market, and foreign exchange
market, are key factors in producing high
economic growth.
 Financial Markets…
 Debt markets, or bond markets, allow governments,
corporations, and individuals to borrow to finance activities.
 In this market, borrowers issue a security, called a bond,
that promises the timely payment of interest and principal
over some specific time horizon.
 The interest rate is the cost of borrowing.
 There are many different types of market interest rates,
including mortgage rates, car loan rates, credit card rates,
etc.
 Financial Markets…
 The stock market is the market where common stock (or
just stock), representing ownership in a company, are traded.
 Companies initially sell stock (in the primary market) to
raise money. But after that, the stock is traded among
investors (secondary market).
 The foreign exchange market is where international
currencies trade and exchange rates are set.
 Foreign exchange (FX) markets are the largest of all
financial markets, with average daily turnover in excess of
US$5 trillion.
 Financial Markets…
 Exercise: Of all the active markets, the stock
market receives the most attention from the
media. Why?
Functions
◼ of Financial Market
Financial markets provide the followin three major
economic functions: g
❑ Price discovery
❑ Liquidity
❑ Reduced transaction costs
◼
Price discovery:
◼ Since the interactions of buyers and sellers in a Financial market
determine the price of the traded asset, they determine the required
return that participants in a financial market demand in order to buy
a financial instrument.
Functions of Financial Market
Functions of Financial Market
 Functions of Financial Market
Reduced Transaction Costs:
◼ This is performed when Financial Market
participants are charged and /or bear the costs of
trading a financial instruments.
Functions of Financial Market
Functions of Financial Market
 Classification of Financial Markets
 There are many ways to classify financial markets.

 Financial Intermediaries
 Instead of savers lending/investing directly with borrowers,
a financial intermediary (such as a bank) plays as the
middleman:
 The intermediary obtains funds from savers
 The intermediary then makes loans/investments with borrowers
 This process, called financial intermediation, is actually the
primary means of moving funds from lenders to borrowers.
 More important source of finance than securities markets
(such as stocks).
 Financial Intermediaries…
 Financial intermediary needed because of transactions costs,
risk sharing, and asymmetric information
1. Transactions Costs
 Financial intermediaries make profits by reducing transactions costs.
 Reduce transactions costs by developing expertise and taking
advantage of economies of scale.
Financial Intermediaries…
2. Risk Sharing
 Financial Intermediaries low transaction costs allow them to
reduce the exposure of investors to risk, through a process
known as risk sharing.
 Financial Intermediaries create and sell assets with lesser
risk to one party in order to buy assets with greater risk from
another party.
 This process is referred to as asset transformation, because in a
sense risky assets are turned into safer assets for investors.
 Financial Intermediaries…
 Financial intermediaries also help by providing the means
for individuals and businesses to diversify their asset
holdings.
 Low transaction costs allow them to buy a range of assets,
pool them, and then sell rights to the diversified pool to
individuals.
 Financial Intermediaries…
3. Asymmetric Information
 Another reason Financial intermediaries exist is to reduce the
impact of asymmetric information.
 One party lacks crucial information about another party, impacting
decision-making.
 We usually discuss this problem along two fronts: adverse
selection and moral hazard.
 Financial Intermediaries…
 Adverse Selection
 Before transaction occurs
 Potential borrowers most likely to produce adverse outcome are
ones most likely to seek a loan
 Similar problems occur with insurance where unhealthy people
want their known medical problems covered
Financial Intermediaries…
 Moral Hazard
 After transaction occurs
 Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more likely that
won’t pay loan back
 Again, with insurance, people may engage in risky activities
only after being insured
 Another view is a conflict of interest
Financial Intermediaries…
 Financial intermediaries reduce adverse selection and
moral hazard problems, enabling them to make profits.
 Because of their expertise in screening and monitoring,
they minimize their losses, earning a higher return on
lending and paying higher yields to savers.
 41

Types of Financial Intermediaries