Principles of Finance

Lecture 1: Introduction to Financial System and Financial Markets

Definition of the Financial System

The financial system is the place where savers (or, more generally, economic agents with
a surplus of funds relative to their immediate need for those funds) meet investors (or,
more generally, economic agents with a deficit of funds relative to their immediate need
for those funds).

Goals of the Financial System

1. The first goal of the financial system is to facilitate the flow of funds from savers
(entities with a surplus of funds) to investors (entities with a deficit of funds). The
financial system channels funds from savers to investors. In equilibrium, savings
= investment.

Agents can invest using their own money, using indirect finance, or using direct finance.
When agents invest out of their own funds (i.e. by spending past accumulated savings),
they bypass the FS entirely.
When agents use indirect finance, funds come from a financial intermediary, which are
then invested (or spent on consumption goods). A financial intermediary is a firm that
pools the savings of many agents and then passes those funds through to agents that want
to spend them. The intermediary is the middleman, not the ultimate source of funds!
When an agent uses direct finance, funds are provided to the investors directly, without
the use of an intermediary. For example, firms sometimes sell share of stock directly to
the public.
2. The second goal of the financial system is to allow economic agents to share
risks.
3. The third main goal of the financial system is to generate liquidity of financial
assets. The liquidity of an asset (real or financial) is the ease with which it may be
traded.
The following are the key characteristics of a liquid assets:
 Standardized;

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 Value is well understood by all; and

 Many potential buyers and sellers

An alternative definition of liquidity is the ease with which an asset may be converted
into cash, which is the most liquid asset of all. Liquidity is a valuable attribute of an asset.

Definition of Financial Market

A financial market is a market in which financial assets are traded. Financial markets can
be classified into different categories depending on the characteristic of the market or
instrument used to create categories as shown below :

1. Primary and Secondary Markets

The market for instruments (also called securities) issued for the first time, is called the
primary market.   Because of the standardization of these instruments, different needs in
the markets at different times, and different views of economic factors, these instruments
are traded between institutions after they have been issued for the first time. The market
where instruments are traded subsequent to the first issue, is called the secondary market.

The secondary market in some of the securities is a very active market.   Activities in the
secondary market have a strong determining influence on issues in the primary market
as liquidity, tradability, market rates, scale of demand, etc. of specific instruments are
reflected in the secondary market.

2. Money and Capital Market

The capital market is the market for the issue and trade of long-term securities.

The money market is that of short-term securities. Market for short-term debt securities,
such as banker's acceptances, commercial paper, repos, negotiable certificates of deposit,
and Treasury Bills with a maturity of one year or less and often 30 days or less. Money
market securities are generally very safe investments which return a relatively low
interest rate that is most appropriate for temporary cash storage or short-term time

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horizons. Bid and ask spreads are relatively small due to the large size and high liquidity
of the market.

3. Derivative Markets

In the spot market, the closing of the transaction and the delivery of the goods take place
simultaneously or within a short-term time span prescribed by the specific market.
Uncertainty about delivery from the other party is very limited, otherwise no transaction
would take place.

The forward market is the market where a transaction is closed in the present, and the
settlement of the transaction and the delivery of goods are in the future. The delivery
date and the price are determined at the closing of the transaction. Because of the time
lapse between the closing and the settlement of the transaction, the risk that one of the
parties might not be able to deliver at the settlement date is higher than in the spot
market.

The futures market is similar to the forward market, except that in the futures market,
the risks of settlement and quality of the product are addressed. The same transaction as
in the forward market would be closed, with the addition of the standardisation of the
amount of goods, the quality of the goods and guarantee (by an exchange) of the payment
of the price and delivery of goods or cash settlement of the difference.

4. Insurance markets, which facilitates handling of various risks.

5. Foreign exchange markets

The Financial System and the Flow of Funds

The financial system comprises of savers/lenders who provide the finance capital,
investors/borrowers who know what to do with the capital, markets for stocks, bonds,
and other financial instruments, financial intermediaries (such as banks and insurance
companies), financial-services firms (such as financial advisory agencies), and

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regulatory bodies which govern all of these institutions. Funds flow from the surplus
units to the deficit units via financial markets and intermediaries.

The following table illustrates where financial markets fit in the relationship between
lenders and borrowers:

Relationship between lenders and borrowers

Lenders Financial Intermediaries Financial Markets Borrowers

Interbank Individuals
Banks
Stock Exchange Companies
Individuals Insurance Companies
Money Market Central Government
Companies Pension Funds
Bond Market Municipalities
Mutual Funds
Foreign Exchange Public Corporations

Lenders

Individuals do not think of themselves as lenders but they lend to other parties in many
ways. Lending activities may be:

 putting money in a savings account at a bank;

 contributing to a pension plan;
 paying premiums to an insurance company;
 investing in government bonds; or

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 investing in company shares.

Companies tend to be borrowers of capital. When companies have surplus cash that is not
needed for a short period of time, they may seek to make money from their cash surplus
by lending it via short term markets called money markets.

There are a few companies that have very strong cash flows. These companies tend to be
lenders rather than borrowers. Such companies may decide to return cash to lenders (e.g.
via a share buyback.) Alternatively, they may seek to make more money on their cash by
lending it (e.g. investing in bonds and stocks.)

Borrowers

Individuals borrow money via bank loans for short term needs or longer term mortgages
to help finance a house purchase.

Companies borrow money to aid short term or long term cash flows. They also borrow to
fund modernization or future business expansion.

Governments often find their spending requirements exceed their tax revenues. To make
up this difference, they need to borrow. Governments also borrow on behalf of
nationalized industries, municipalities, local authorities and other public sector bodies. In
the UK, the total borrowing requirement is often referred to as the public sector
borrowing requirement (PSBR).

Many borrowers have difficulty raising money locally. They need to borrow
internationally with the aid of foreign exchange markets.

The development of financial markets and instruments

The basic needs in the financial world, are the following:

 the need to invest excess money (supply)

 the need to borrow money (demand) where there is a shortage of money.

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The government of a country might, for instance, need money for certain projects, while
certain private sector companies or individuals might have excess money to invest in
profitable investments.   The “price” paid for money is interest paid on the amount
borrowed, and the interest rate is thus the price mechanism used in financial markets.

To match different financial needs such as the need to borrow and the need to invest,
intermediaries are mostly used, for example:

 where an institution wants to invest a certain sum of money, for a certain time,
giving them a certain yield
 another institution wants to borrow a certain amount of money for a period at the
lowest cost possible, the lender’s and the borrower’s demands might differ.

Functions of the Financial Markets

Any evaluation of the financial system should be founded on an understanding of its

functions within the economic system as a whole, and the means by which these an be
carried out.

Financial markets provide its participants with important benefits.  These benefits can be
classified under the general heading of reducing transaction costs.  Transaction costs
involve the amount of time and money required to buy and sell a good or service.  These
include the costs of gathering and communicating information about price and volume of
trading.   Markets reduce these costs. 

The most fundamental role of the financial system remains that of intermediating
between savers and investors such that efficient resource allocation of the available
resources of the economy is undertaken. From this viewpoint, we can determine the
following six basic or core functions performed by the financial system:

 Function 1: The Mobilization of Capital. Unless financial markets are able to

provide market participants with a variety of instruments of differing maturities
that are traded in markets that have the depth to allow speedy exit, capital

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mobilization will be less than adequate. For example, capital providers desire
liquidity (ability to exit on short notice), risk exposure, while entrepreneurs need
to commit capital for long-term investments. Financial markets resolve this
divergence through provision of alternative instruments to facilitate
diversification, and allow for maturity transformation. These liquidity and
maturity transformation functions of financial systems are very basic functions
that require instrument and market development.
 Function 2: Risk Management and Resource Allocation. In an environment
where uncertainty prevails, risk sharing and insurance are the two most
fundamental functions that a financial system provides. A well-functioning
financial market enables multiple investors to share a project's risk allowing high-
risk, high-return investments to be undertaken. In the absence of such risk-pooling
and risk sharing arrangements, such high-risk, high-return projects may be
rationed out of the market, destroying, rather than creating, value for the
economy. Financial markets, therefore, facilitate allocation efficiency. Risk-
allocation mechanisms supported by well-functioning financial markets allow for
diversification, hedging insurance and leveraging.
 Function 3: Pooling of resources and diversification of ownership. A financial
system provides a mechanism for the pooling of funds to undertake large- scale
indivisible enterprise that may be beyond the scope of anyone individual to
undertake. They also allow individual households to participate in investments
that require large lump sums of money by pooling their funds and then
subdividing shares in the investment. The pooling of funds allows for a
redistribution of risk as well as the separation of ownership and management.
 Function 4: Information Production, Price Discovery and Exchange of
Control. Price signals contain information on quantity, scarcity and value, and
thereby help agents allocate resources to their best use. A well-functioning
financial market processes and aggregates all available information into the value
or price of the commodity. From a welfare point of view, the financial system,
through this price discovery function, allows capital to flow toward its most
productive use and bring about allocation efficiency.

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 Function 5: Facilitating Better Governance and Control. Financial markets

promote efficient governance and control of an organized enterprise (especially
on a public trade corporation) by exerting external pressure and discipline on its
operation. In the presence of uncertainty and informational asymmetries, the
allocation of capital involves the control of capital so that it is efficiently
exchanged to allow it to be put the best use. Inefficient management is typically
removed through takeovers which allow unfriendly raiders to accumulate shares
in the open market and take control of the firm. Often, the very threat of such
takeovers is a powerful mechanism for disciplining management. In its absence,
management becomes entrenched and misallocates or misappropriates resources
from the firm leading to far-reaching economic inefficiencies.
 Function 6: Efficient Clearing and Settling. An important function of the
financial system is to provide an efficient way for people and businesses to make
payments to each other when they wish to buy goods or services. Modern day
complex transactions involve movements of goods, services as well as financial
assets across time, space, and, quite often, across national borders. Efficient
payments and settlement technology allows the speedy completion of such
transactions. If financial markets are to handle large transactions rapidly, clearing
house and depository functions are necessary elements of the enabling
environment. Long delays in intercity check-cashing and lengthy time
requirements for registration of financial assets are serious impediments to market
development. A payments and settlement systems depend on the supervisory and
regulatory system that eventually stands behind the final settlement of all
transactions. In an economy where the such system is not very efficient,
transactions will be primarily cash-based requiring the maintenance of idle cash
balances.
 Function 7: Dealing with Incentive and Agency Problems. Modern finance
theory views the firm as a nexus of contracts: shareholders/owners borrow form
creditors and delegate the task of running the firm to professional managers.
Ownership and control of the firm is, therefore separated. The various
relationships are determined by contractual relationships that are written within

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the regulatory umbrella provided by the government. Financial markets promote

contractual efficiency in an environment characterized by incentive conflicts and
hence lead to allocation efficiency. Incentive contracts for alignment of diverse
interests between management, shareholders, and bondholders can be facilitated
through financial contracts.

Factors influencing the financial markets

Each effective market has a supply of a certain commodity, and a demand for that
commodity. Savings (investments) represent the supply side in the money markets, and
financing needs, as the demand side. Because of the interaction between the various
financial commodities, money and service markets in a country, the simple theory of
supply and demand determining prices cannot be applied in its basic form in these
markets.

The theoretical system would determine that the rate (price for money) would drop if
there is a surplus savings (supply) in the market, but if there are savings in the market
which are not utilized to finance income-making activities, the national income will
eventually decline, probably bringing about a decline in the rate of savings which could
work against the fall in interest rates.

Another factor influencing the financial markets is expectations; for instance, if rates are
high, with the expectation that the rates are going to decline in the future, the demand for
securities and thus the supply of money will be high, pushing interest rates down, and
security prices up.

Expectations of higher inflation could push up interest rates. Prices of goods are
expected to go up, so consumers tend to buy now rather than later, which pushes up the
demand for cash balances and hikes interest rates. Interest rates in turn has an effect on
inflation. The level of savings and spending is to a significant extent determined by
prevailing interest rates.

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Fiscal policy decisions by the government also affect the financial markets. The
decisions by the government also affect the financial markets. The decision on how to
finance the government’s deficits will affect the supply and demand for cash balances,
short and long-term deposits (M3 money supply), and thus influence interest rates. If the
government decides to finance its monetary needs with the issuing of short-term
securities such as treasury bills, the demand for money in the short-term market
increases, exerting upward pressure on interest rates.

FINANCIAL INTERMEDIARY

The term financial intermediary may refer to an institution, firm or individual who
performs intermediation between two or more parties in a financial context. Typically the
first party is a provider of a product or service and the second party is a consumer.

A financial intermediary is typically an institution that facilitates the channelling of

funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an
intermediary institution (such as banks), and then that institution in turn gives those funds
to spenders (borrowers).

Financial intermediaries can be banks; building societies; credit unions; financial adviser;
or broker; insurance companies; life insurance companies; mutual funds; or pension
funds.

Tasks of Financial Intermediaries

The process of intermediation requires something be created by the transformation of

inputs into outputs. Financial intermediaries create assets for lenders and liabilities for
borrowers which are more attractive to each than would be the case if the parties has to
deal with each other directly. The primary monetary task of financial intermediaries is the
creation of money through taking deposits and making loans. Their primary reason to
operate is to earn profits.

Essentially what this means is that intermediaries transform funds which are made
available to them normally for short periods into loans which are made available to

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ultimate borrowers for longer terms. This is sometimes summed up by saying that
intermediaries “borrow short and lend long”.

Their presence in the economy also leads to the following:

 

Financial intermediaries help to channel funds from lenders to

borrowers at a lower cost. For example, a person in need of funds
1. Lower transaction does not have to try to find an individual from whom to borrow the
costs funds. In cases of large sums of money, he does not need to find a
pool of lenders. Such a search would be costly in terms of time and
money.
Financial intermediaries screen borrowers and guarantee the safety of
the deposits up to a certain amount. A potential lender does not have
to spend resources determining the profitability of every project or
2. Lower risk of the reputation of each borrower. Financial intermediaries perform
lending this service and in time, gain the expertise that makes such analysis
cheaper. Consumer credit companies compile reports that lending
agencies can access in seconds. You should check your credit report
annually.
By pooling deposits together, no single depositor is lending to a
3. Diversification of
single borrower. if one firm defaults, that loss is spread over all the
risk
depositors.
A person who stores his wealth in a checking deposit has access to
4. Greater liquidity
that money at all times.

Consequences of Financial Intermediation

The first consequence of financial intermediation is that in the presence of financial
intermediaries, there will be more financial assets and liabilities than there would be
without.
The second is the creation of liquidity. A liquid asset is one that can be turned into money
quickly, cheaply and for a known monetary value. Thus the achievement of a financial

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intermediary must be that lenders can recall their loan either (or both) more quickly or
with a greater certainty of its capital value than would otherwise be the case.
Liquidity has three dimensions:

1. Time – the speed with which an asset can be exchanged for money;
2. Risk – the possibility that the asset may be realizable for value different from that
which is expected; and
3. Cost – the pecuniary and other sacrifices that have to be made in carrying out the
exchange.

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