Chapter one: Overview of financial system

1Definition and Component of financial

system
Definition
• Financial system is a system that aims at
establishing and providing smooth, regular,
efficient and effective linkage between savers
(depositors) and investors (borrowers).
• It is a set of complex and closely connected
instructions, practices, agents and claims
related to the financial aspects of the
economy.
 The role of financial system in the economy
The following are the roles of financial system in the
economic development of a country.

1. Savings-investment relationship
• To attain economic development, a country needs more
investment and production. This can happen only when
there is a facility for savings. As, such savings are
channelized to productive resources in the form of
investment. Here, the role of financial institutions is
important, since they induce the public to save by
offering attractive interest rates. These savings are
channelized by lending to various business concerns
which are involved in production and distribution.
 Cont,d
2. Financial systems help in growth of capital
market
• Any business requires two types of capital
namely, fixed capital and working capital. Fixed
capital is used for investment in fixed assets,
like plant and machinery. While working capital
is used for the day-to-day running of business.
It is also used for purchase of raw materials
and converting them into finished products.
 Con,d
• Fixed capital is raised through capital market by
the issue of debentures and shares. Public and
other financial institutions invest in them in
order to get a good return with minimized risks.
• For working capital, we have money market,
where short-term loans could be raised by the
businessmen through the issue of various credit
instruments such as bills, promissory notes, etc.
 Con,d
3. Financial system helps in Infrastructure and
Growth
• Economic development of any country depends
on the infrastructure facility available in the
country. In the absence of key industries like coal,
power and oil, development of other industries
will be hampered. It is here that the
financial services play a crucial role by providing
funds for the growth of infrastructure industries.
 Cont,d
4. Financial system helps in development of Trade
• The financial system helps in the promotion of both
domestic and foreign trade.
• The financial institutions finance traders and the
financial market helps in discounting financial
instruments such as bills.
• Foreign trade is promoted due to per-shipment and
post-shipment finance by commercial banks. They
also issue Letter of Credit in favor of the importer.
 Cont,d
5. Employment Growth is boosted by financial system
• The presence of financial system will generate more
employment opportunities in the country.
• The money market which is a part of financial system
provides working capital to the businessmen and
manufacturers due to which production increases,
resulting in generating more employment opportunities.
• With competition picking up in various sectors, the
service sector such as sales, marketing, advertisement,
etc., also pick up, leading to more employment
opportunities
 Cont,d
6. Financial system ensures balanced growth
• Economic development requires a balanced growth
which means growth in all the sectors simultaneously.
• Primary sector, secondary sector and tertiary sector
require adequate funds for their growth.
• The financial system in the country will be geared up
by the authorities in such a way that the available
funds will be distributed to all the sectors in such a
manner, that there will be a balanced growth in
industries, agriculture and service sectors.
 Cont,d

7. Financial system’s role in balanced regional

development
• Through the financial system, backward areas
could be developed by providing various
concessions or sop. This ensures a balanced
development throughout the country and this
will mitigate political or any other kind of
disturbances in the country.
• It will also check migration of rural population
towards towns and cities.
 Cont,d
8. Role of financial system in attracting foreign
capital
• Financial system promotes capital market. A
dynamic capital market is capable of attracting
funds both from domestic and abroad. With
more capital, investment will expand and this
will speed up the economic development of a
country
 Cont,d
9. Financial system’s role in Economic Integration
• Financial systems of different countries are capable of
promoting economic integration.

• This means that in all those countries, there will be

common economic policies, such as common investment,
trade, commerce, commercial law, employment
legislation, old age pension, transport co-ordination, etc.

• We have a standing example of European Common

Market which has gone to the extent of creating a
common currency, representing several countries in
Western Europe.
 Cont,d
10. Political stability
• The political conditions in all the countries
with a developed financial system will be
stable. Unstable political environment will not
only affect their financial system but also their
economic development.
 Financial Assets
• In any financial transaction, there should be a creation
or transfer of financial asset. Hence, the basic product
of any financial system is the financial asset. Financial
assets are intangible assets where typically the future
benefits come in the form of a claim to future cash.

• Another term used for a financial asset is a financial

instrument. Certain types of financial instruments are
referred to as securities and generally include stocks
and bonds.
 Cont,d
• For every financial instrument there is a
minimum of two parties.
• The party that has agreed to make future cash
payments is called the issuer; and
• The party that owns the financial instrument
and therefore the right to receive the
payments made by the issuer is referred to as
the investor
Distinction between real assets and financial assets

Real assets are income-generating assets,

whereas financial assets are the allocation of
income or wealth among investors.

Real assets appear only on the asset side of

the balance sheet, whereas financial assets
appear on both sides of balance sheets.
• i.e. Your financial claim on a firm is an asset, but
the firm's issuance of that claim is the firm's
liability.
 Cont,d
Financial assets are created and destroyed in
the ordinary course of doing business. For
example, when a loan is paid off, both the
creditor's claim (a financial asset) and the
debtor's obligation (a financial liability) cease
to exist.
• Whereas real assets are destroyed only by
accident or by wearing out over time.
 Role and Properties of Financial Assets
• The following are the properties of Financial Assets, which
distinguish them from Physical and Intangible Assets:
1. Currency:
• Financial Assets are exchange documents with an attached
value. Their values are dominated in currency units determined
by the government of an economy.
2. Divisibility
• Financial Instruments are divisible into smaller units. The total
value is represented in terms of divisions that can be handled
in a trade. The divisibility characteristic of Financial Assets
enables all players, small or big, to participate in the market.
 Cont,d
3. Convertibility
• Financial Assets are convertible into any other type of
asset. This characteristic of convertibility gives flexibility
to financial instruments. Financial Instruments need not
necessary be converted into another form of Financial
Asset; they can also be converted into Physical/Tangible
and Intangible Assets.
4. Reversibility
• This implies that a financial instrument can be exchanged
for any other asset and logically, the so formed asset
may be transferred back into the original financial
instrument.
 Cont,d
5. Liquidity /Marketability/
• The financial asset can be exchanged for currency with another
market participant who does not have immediate cash need, but
expects future benefits.
6. Cash Flow
• The holding of the financial instrument results in a stream of cash
flows that are the benefits accruing to the holder of the financial
instrument. However, a financial instrument by itself does not
create a cash flow.
7. Information Availability
• In many cases, information concerning financial assets is more
readily available than for real assets
 Financial Markets

• A financial market is a market where financial instruments

are exchanged. The more popular term used for the
exchanging of financial instruments is that they are
“traded.” They are markets where people buy and sell
financial instruments like stocks, bonds and future
contracts.
Financial markets provide the following three major
economic functions:
 Price discovery
 Liquidity
 Reduced transaction costs
 Price discovery

• Price discovery means that the interactions of

buyers and sellers in a financial market
determine the price of the traded asset.
• Equivalently, they determine the required
return that participants in a financial market
demand in order to buy a financial instrument.
 Liquidity

• Financial markets provide a forum for

investors to sell a financial instrument and is
said to offer investors “liquidity”. This is an
appealing to sell a financial instrument.
• All financial markets provide some form of
liquidity. However, the degree of liquidity is
one of the factors that characterize different
financial markets.
 Reduces the cost of transacting
• Transacting cost can be classified into two types:
search costs and information costs.
• Search costs in turn fall into two categories: explicit
costs and implicit costs.
• Explicit costs include expenses that may be needed
to advertise one’s intention to sell or purchase a
financial instrument;
• implicit costs include the value of time spent in
locating counterparty to the transaction.
 Cont,d
• The presence of some form of organized
financial market reduces search costs.

• Information costs are costs associated with

assessing a financial instrument’s investment
attribute. In a price efficient market, prices
reflect the aggregate information collected by
all market participants.
 Financial markets structure

 Financial instruments
• There is a great variety of financial instrument
in the financial marketplace.
• The use of these instruments by major market
participants depends upon their offered risk
and return characteristics, as well as
availability in retail or wholesale markets.
 Table 1. Financial instrument categories

Category Risk determinants Expected returns Main participants

Non tradable and non- In wholesale money In wholesale money markets: In wholesale money
transferable markets: transaction low markets: banks
volumes
In retail markets: low In credit markets: low In retail markets: banks and
transparency, lack of non-bank firms and
standardization, low households
creditworthiness
In foreign exchange In foreign In foreign exchange
markets: high volatility, exchange markets: high markets: financial institutions,
change of currency companies
Securities Market volatility, Comparably high Banks and non-bank firms,
individual risks and individuals
failures
Derivatives Market volatility, leverage Very high Banks and non-bank firms,
individuals
 Cont,d

• A financial instrument can be classified by the type

of claims that the investor has on the issuer.
• A financial instrument in which the issuer agrees to
pay the investor interest plus repay the amount
borrowed is a debt instrument.

• A debt instrument also referred to as an instrument

of indebtedness, can be in the form of a note, bond,
or loan. The interest payments that must be made by
the issuer are fixed contractually.
 Cont,d
• The investor in a debt instrument can realize
no more than the contractual amount. For this
reason, debt instruments are often called
fixed income instruments.
 Table 2: Fixed-income market
Market Features Issuers

Long term Bonds Long-term obligations to Governments, firms

make a series of fixed
payments
Convertibles Bonds that can be swapped Firms
for equity at pre-specified
conditions
Asset-backed securities Securitised Financial institutions, firms
“receivables” presenting
future streams of
payments
Preferred stock, subordinated Debt and equity hybrids Firms
debt
Medium term Notes Medium-term obligations Governments

Floating-rate notes Medium-term instruments Firms

with interest rates based on
London Interbank
Offered Rate(LIBOR )or
another index
Short term Bills Short-term obligations Governments

Commercial paper Short-term debt instruments Firms

Certificates of deposit Short-term debt instruments Banks

 Equity instrument
• Equity instrument specifies that the issuer pays the
investor an amount based on earnings, if any, after
the obligations that the issuer is required to make
to investors of the firm’s debt instruments have
been paid.
 Cont,d
• Common stock is an example of equity
instruments. Some financial instruments due
to their characteristics can be viewed as a mix
of debt and equity.
 Cont,d
• Preferred stock is a financial instrument,
which has the attribute of a debt because
typically the investor is only entitled to receive
a fixed contractual amount.
• However, it is similar to an equity instrument
because the payment is only made after
payments to the investors in the firm’s debt
instruments are satisfied.
 Classification of financial markets

• They are classified according to

 the financial instruments they are trading,
 features of services they provide,
 trading procedures,
 key market participants, as well as the
 origin of the markets.
 Cont,d
• From the perspective of country origin, its financial market can
be broken down into an internal market and an external
market.

• The internal market, also called the national market, consists

of two parts: the domestic market and the foreign market. The
domestic market is where issuers domiciled in the country
issue securities and where those securities are subsequently
traded.

• The foreign market is where securities are sold and traded

outside the country of issuers.
 Cont,d
• External market is the market where securities
with the following two distinguishing features are
trading:
• 1) at issuance they are offered simultaneously to
investors in a number of countries; and
• 2) they are issued outside the jurisdiction of any
single country. The external market is also referred
to as the international market, offshore market,
and the Euromarket (despite the fact that this
market is not limited to Europe).
 Cont,d
• Money market is the sector of the financial
market that includes financial instruments
that have a maturity or redemption date that
is one year or less at the time of issuance.
These are mainly wholesale markets.
 Cont,d
• The capital market is the sector of the financial
market where long-term financial instruments issued
by corporations and governments trade. Here “long-
term” refers to a financial instrument with an original
maturity greater than one year and perpetual
securities (those with no maturity).

• There are two types of capital market securities:

1. Those that represent shares of ownership interest,
also called equity, issued by corporations, and
2. Those that represent indebtedness, or debt issued by
corporations and by the state and local governments.
 Cont,d
• Financial markets can be classified in terms of
cash market and derivative markets.
• The cash market, also referred to as the spot
market, is the market for the immediate
purchase and sale of a financial instrument.
 Primary market and Secondary markets

o Primary markets
o Secondary markets
Types of secondary markets
 organized stock exchanges
 over-the- counter (OTC) markets.
• Stock exchanges are central trading locations
where financial instruments are traded. In
contrast, an OTC market is generally where
unlisted financial instruments are traded.
 Function of Financial Markets
1. Channels funds from person or business without
investment opportunities (i.e., “Lender-Savers”) to
one who has them (i.e., “Borrower-Spenders”)
2. Improves economic efficiency
3. Critical for producing an efficient allocation of
capital, which contributes to higher production and
efficiency of overall economy
 Function of Financial Markets
4. Well-functioning markets improve the well being of
consumers by allowing them to time their purchases
better
 Financial Markets Funds Transferees

Lender-Savers Borrower-Spenders
1. Households 5. Business firms
2. Business firms 6. Government
3. Government 7. Households
4. Foreigners 8. Foreigners
 Methods of funds transfer

• 1. Direct financing
• 2. Indirect financing
 Direct financing
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are
claims on the borrower’s future income or assets
• Securities are assets for the person who buys them
• They are liabilities for the individual or firm that
issues them
 Indirect finance
• Borrowers borrow indirectly from lenders via
financial intermediaries (established to source
both loanable funds and loan opportunities) by
issuing financial instruments which are claims on
the borrower’s future income or assets
Exhibit 1.1 Transfer of Funds From Surplus
to Deficit Units
END OF CHAPTER ONE