CHAPTER-ONE

INTRODUCTION TO FINANCIAL SYSTEMS, FINANCIAL MARKETS AND FINANCIAL

ASSETS
Definition of Financial Institution
An establishment that focuses on dealing with financial transactions, such as investments, loans and
deposits. Conventionally, financial institutions are composed of organizations such as banks, trust
companies, insurance companies and investment dealers. Almost everyone has deal with a financial
institution on a regular basis. Everything from depositing money to taking out loans and exchange
currencies must be done through financial institutions. A financial system or financial sector functions
as intermediary and facilitate the flow of funds from the areas of surplus to the areas of deficit. A
financial system is a composition of various institutions, market, regulations and laws, practices,
money manager, analysts, transactions and claims and liabilities. In a financial system different parties
participate in or perform different functions but the common features of all those functions is the
transfer of money from surplus to deficit economic agents. Transfer of funds from ultimate lenders to
ultimate borrowers can be made through direct lending via trading in organized securities markets or
indirectly through financial intermediaries.
We study money, banking, and financial Markets
1. To examine the role of money in the economy
2. To examine how financial institutions such as banks and insurance companies work
3. To examine how financial markets (such as bond, stock and foreign exchange markets) work
Components of the Financial System
The five components of the current financial system are money; financial institutions (including
banks); financial instruments (including loans, stocks, and bonds); financial markets (like Bahrain
Stock Exchange); and central banks (like the Central Bank of Bahrain (CBB)).
1. Money
 Money is defined as anything that is generally accepted in payment for goods and services or
in the repayment of debt.
 Monetary theory ties changes in the money supply to changes in aggregate economic activity
and the price level
Money and Recession

The periodic but irregular upward and downward movement of aggregate output produced in
the economy is referred to as the business cycle.

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  Sustained (persistent) downward movements in the business cycle are referred to as
recessions

Sustained (persistent) upward movements in the business cycle are referred to as Expansions
Recessions (unemployment) and booms or expansions (inflation) affect all of us.
Evidence from business cycle fluctuations in many countries indicates that recessions may be
caused by steep declines in the growth rate of money.
Money and Inflation
 The aggregate price level is the average price of goods and services in an economy.
 Inflation is a continual rise in the price level. It affects all economic players.
 There is a strong positive association between inflation and growth rate of money over long
periods. A sharp increase in the growth of the money supply is likely followed by an increase
in the inflation rate.
 Countries that experience very high rates of inflation have rapidly growing money supplies.
2. Financial Institutions/intermediaries
Financial Intermediaries are institutions that channel funds from individuals with surplus funds to
those desiring funds but have shortage of it. The role of the intermediary was mostly related to ensure
transfer of funds from the lender to the borrower. Banks, FIs, brokers, and dealers offered this service.
Some of the important intermediaries operating the financial markets include; investment bankers,
underwriters, stock exchanges, portfolio managers, mutual funds, financial advisors, financial
consultants.
Among other services, they allow individuals to earn a decent return on their money while at the same
time avoiding risk; e.g., banks, insurance companies, finance companies, investment banks, mutual
funds, brokerage houses, Banks are financial institutions that accept deposits and make loans. Banks
make the monetary system a lot more efficient by reducing our need to carry many cash. People have
tended to use checks instead of cash for large purchases and bills.
Innovations in banking like debit cards, direct deposit, and automatic bill-paying reduce that
inconvenience even further, and also reduce such bank-related inconveniences of time spent standing
in line at the bank, writing checks, or visiting the ATM.
Financial innovation refers to both technological advances, which facilitate access to information,
trading and means of payment, and to the emergence of new financial instruments and services, new
forms of organization and more developed and complete financial markets. To be successful, financial
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innovation must either reduce costs and risks or provide an improved service that meets the particular
needs of financial system participants. E-finance is a delivery of financial services electronically
Banks are important to the study of money and the economy because they have been a source of rapid
financial innovation.
3. Financial Instruments:-
“Securities” is a name that commonly refers to financial instruments that are traded on financial
markets. A security (financial instrument) is a formal obligation that entitles one party to receive
payments and/or a share of assets from another party; e.g., loans, stocks, bonds. Even an ordinary bank
loan is a financial instrument.
4. Financial Markets
Financial markets are mechanisms that allows people to easily buy and sell (trade or financial assets
are created and sold); financial securities (such as stocks and bonds), commodities (such as precious
metals or agricultural goods), and other fungible items of value at low transaction costs and at prices
that reflect; e.g., Bahrain Stock Exchange, New York Stock Exchange, U.S. Treasury's online auction
site for its bonds.
Financial markets such as stock market and bond market are essential to promote greater economic
efficiency by channeling funds from who do not have productive use of fund (savers) to those who do
(investors). While well-functioning financial markets promote growth, poorly performing financial
markets can be the cause of poverty. Thus, activities in financial markets may increase or decrease
personal wealth. Activities in financial markets affect business cycle.
The role of financial markets: it provides three economic roles:-
 Interaction of buyers and sellers in the financial market determines the price of the traded asset.
 It provides the mechanism for an investor to sale financial instruments
 It reduces the cost of transacting
 Search cost
 Information cost
The Bond Market and Interest Rates
 A bond is a debt security that promises to make specified rate of interest payments periodically
for a specified period, with principal to be repaid when the bond matures.
 An interest rate is the cost of borrowing or the price paid for the rental of borrowed funds
(usually expressed as a percentage of the rental of $100 per year)
 Everything else held constant, a decline in interest rates will cause consumption and
investment to increase; e.g. spending on housing or cars would rise

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  An increase in interest rates might encourage consumers to save more because more can be
earned in interest income but discourage investors from taking loans. Thus, consumption and
investment would decrease.
 The bond markets are important because they are the markets where interest rates are
determined
The Stock Market: A stock (a common stock) represents a share of ownership of a corporation, or a
claim on a firm's earnings/assets. Stocks are part of wealth, and changes in their value affect people's
willingness to spend. Changes in stock prices affect a firm's ability to raise funds, and thus their
investment. The stock market is important because it is the most widely followed financial market
nowadays. A rising stock market index due to higher share prices increases people's wealth and as a
result may increase their willingness to spend. When stock prices fall an individual's wealth
may decrease and their willingness to spend may decrease. Changes in stock prices affect firms'
decisions to sell stock to finance investment spending. Fear of a major recession causes stock prices to
fall, everything else held constant, which in turn causes consumer spending to decrease
The Foreign Exchange Market
 The foreign exchange market is where funds are converted from one currency into another
 The foreign exchange rate is the price of one currency in terms of another currency
 The foreign exchange market determines the foreign exchange rate
 Everything else constant, a stronger dollar will mean that vacationing in England becomes less
expensive. In addition, the country’s goods exported abroad will cost more in foreign
countries, and so foreigners will buy fewer of them.
 Everything else held constant, a stronger dollar benefits the country’s consumers and hurts the
country’s businesses.
 Everything else held constant, a decrease in the value of the dollar relative to all foreign
currencies means that the price of foreign goods purchased by Americans increases
 If the price of a euro (the European currency) increases from $1.00 to $1.10, then, everything
else held constant, a European vacation becomes more expensive.
5. Central Banks
 A central bank is a governmental body that regulates financial institutions, controls the supply
of money and credit in the economy, handles the government’s finances, and serves as the bank
to commercial banks.
 Commercial banks deposit some of their reserves at the central bank, and the central bank is
the "lender of last resort" to commercial banks in times of crisis.

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  Monetary theory relates changes in the quantity of money to changes in aggregate economic
activity and the price level.
Monetary policy is the management of the money supply and interest rates and is conducted by a
nation's central bank
Fiscal policy involves decisions about government spending and taxation
 Budget deficit is the excess of expenditures over revenues for a particular year
 Budget surplus is the excess of revenues over expenditures for a particular year
 Any deficit must be financed by borrowing
 Budgets deficits can be a concern because deficits can result in higher rates of monetary
growth and they might ultimately lead to higher inflation

Global Financial System

A brief definition of the global financial system (GFS) is the financial system consisting
of institutions, their customers, and financial regulators that act on a global level.

The WHO defines it as "...various official and legal arrangements that govern international financial
flows in the form of loan investment, payments for goods and services, interest and profit remittances.
The main elements are the surveillance and monitoring of economic and financial stability, and
provision of multilateral finance to countries with balance of payments difficulties. The organization at
the centre of the system is the International Monetary Fund (IMF), which has the mandate to ensure its
effective running.”

The most prominent public international financial institutions are:

 The International Monetary Fund keeps tabs of international balance of payments accounts of
member states. The IMF acts as a lender of last resort for members in financial distress,
e.g., currency crisis, problems meeting balance of payment when in deficit and debt default.
Membership is based on quota, or the amount of money a country provides to the fund relative
to the size of its role in the international trading system.
 The World Bank aims to provide funding, take up credit risk or offer favorable terms
to development projects mostly in developing countries that could not be obtained by the
private sector. The other multilateral development banks and other international financial
institutions also play specific regional or functional roles.

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  The World Trade Organization settles trade disputes and negotiates international trade
agreements in its rounds of talks (currently the Doha Round).
 The Bank for International Settlements (BIS) in Basel Switzerland, which is both a bank as
well as an intergovernmental organization for central banks worldwide. It has numerous
subsidiary bodies, most importantly the Basel Committee on Banking Supervision,
the Financial Stability Board, and the BIS Joint forum on financial conglomerates. It publishes
global bond market capitalization data.
 The World Economic Forum, a Swiss "non-profit" foundation based in Geneva meeting
annually Davos.

The most prominent private international financial institutions are:

 The Institute of International Finance (IIF), a trade organization of the world's

largest commercial banks and investment banks
 The World Federation of Exchanges (WFE), which publishes global stock capitalization
information in annual reports
 The Global Financial Markets Association(GFMA), which consists of European, Asian and
North American financial market associations: The Association for Financial Markets in
Europe (AFME) in London and Brussels, the Asia Securities Industry & Financial Markets
Association (ASIFMA) in Hong Kong, and the Securities Industry and Financial Markets
Association (SIFMA) in New York and Washington DC.

These global financial institutions are banks, Insurance, or commercial banks, active in
the stock-, bond- foreign exchange-, derivatives- and commodities-markets, investing private equity
including mortgages in hedge funds and pension funds, mutual funds, sovereign wealth funds etc.
International lobbying firms play a role in international financial systems, as they increasingly develop
cross-border lobbying arms to influence international negotiations. For example, Podesta Group, a
Washington lobbying firm, founded "Global Solutions" to influence multilateral free trade agreements,
such as the Trans-Pacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership
(TTIP), and any other issues "at the intersection of trade, economics, politics and diplomacy"
Functions the financial system of money and capital markets
Savings Function: Bonds, stocks, and other financial claims sold in money and capital markets
provide a profitable; relatively low-risk outlet for the public is saving which flow through the financial
markets into investment.

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Wealth Function: A stock of assets (the financial instruments) sold in the money and capital markets
provide an excellent way to store of wealth.
Liquidity Function: Financial markets provide liquidity (immediately spendable cash) for savers who
hold financial instruments but are in need of money.
Credit Function: Global financial markets furnish credit to finance consumption and investment
spending.
Payments Function: The global financial system provides a mechanism for making payments for
goods and services.
Risk Protection Function: The financial markets around the world offer businesses, consumers, and
government protection against life, health, property, and income risks.
Policy Function: The financial markets are a channel through which governments may attempt to
stabilize the economy and avoid inflation.
Functions and Roles of the Financial System in the Global Economy
 To understand the functions performed and the roles played by the system of financial markets
and financial institutions in the global economy and in our daily lives.
 To discover how important the financial system is to increasing our standard of living, generating
new jobs, and building our savings to meet tomorrow is financial needs
 Introduction to the Financial System The financial system is … the collection of markets,
institutions, laws, regulations, and techniques through which bonds, stocks, and other securities
are traded, interest rates are determined, and financial services are produced and delivered around
the world.
 Introduction to the Financial System The primary task of the financial system is … to move
scarce loan able funds from those who save to those who borrow to buy goods and services and to
make investments in new equipment and facilities, so that the global economy can grow and the
standard of living can increase.
 Flows within the Global Economic System The basic function of the economic system are to
allocate scarce resources – land, labor, management skill, and capital-to produce the goods and
services needed by society. The global economy generates a flow of production in return for a
flow of payments. The circular flow of production and income is interdependent and never
ending.
 Circular Flow of Income, Payments, and Production in the Global Economic System Flow of
incomes Flow of expenditures for consumption & taxes Flow of productive services Flow of

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 production of goods & services Producing units (mainly business firms and governments)
Consuming units (mainly households)
 The Role of Markets in the Global Economic System Most economies around the world relies
principally upon markets to carry out the complex task of allocating scarce resources. The
marketplace is dynamic. It determines what goods and services will be produced and in what
quantities through their prices. Markets also distribute income by rewarding superior producers
with increased profits, higher wages, and other economic benefits.
 Types of Markets-there are essentially three types of markets within the global economic system.
The factor markets allocate factors of production (land, labor, skills, and capital) and distribute
income (wages, rent) to the owners of productive resources. Consuming units use most of their
income from factor markets to purchase goods and services in the product markets.
 Types of Markets the financial markets channel savings to those individuals and institutions
needing more funds for spending than are provided by their current incomes.
 Types of Markets Producing units (mainly business firms and governments) Consuming units
(mainly households) Flow of funds (savings) Flow of financial services, income, and financial
claims Financial markets Flow of production Product markets Goods and services Flow of
payments Flow of payments for consumption and taxes Flow of incomes Flow of incomes Factor
markets Productive services Productive services
 The Financial Markets and the Financial System: Channel for Savings and Investment Nature of
savings Households: current income – tax payments – consumption expenditures Businesses:
retained earnings Governments: current revenues – expenditures Nature of investment
Households: purchase of a home Businesses: expenditures on capital goods and inventories
Governments: building/maintaining public facilities
 The Financial Markets and the Financial System: Channel for Savings and Investment the
financial markets enable the exchange of current income for future income and the transformation
of savings into investment so that production, employment, and income can grow, and living
standards can improve.
 The Global Financial System Flow of financial services, incomes, and financial claims
Demanders of funds (mainly business firms and governments) Flow of loan able funds (savings)
Suppliers of funds (mainly households)
 Functions Performed by the Global Financial System and the Financial Markets Savings function.
The global system of financial markets and institutions provides a conduit for the public’s
savings. Wealth function. The financial instruments sold in the money and capital markets
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 provide an excellent way to store wealth. Liquidity function. Financial markets provide liquidity
for savers who hold financial instruments but are in need of money.
 Functions Performed by the Global Financial System and the Financial Markets Credit function.
Global financial markets furnish credit to finance consumption and investment spending.
Payments function. The global financial system provides a mechanism for making payments for
goods and services, in the form of currency, checking accounts, debit cards, credit cards, digital
cash, etc.
 Functions Performed by the Global Financial System and the Financial Markets Risk protection
function. The financial markets offer protection against life, health, property, and income risks, by
permitting individuals and institutions to engage in both risk sharing and risk reduction. Policy
function. The financial markets are a channel through which governments may attempt to stabilize
the economy and avoid inflation.
 Functions Performed by the Global Financial System and the Financial Markets the financial
services that are most widely sought by the public include: Payments services thrift services
Insurance services Credit services hedging services Agency services
 Types of Financial Markets within the Global Financial System The money market is for short-
term (one year or less) loans, while the capital market finances long-term investments by
businesses, governments, and households. In particular, governments borrow from commercial
banks in the money market, while in the capital market, insurance companies, mutual funds,
security dealers, and pension funds supply the funds for businesses.
 Types of Financial Markets within the Global Financial System The money market may be
subdivided into Treasury bills, certificates of deposit (CDs), bankers’ acceptances, commercial
paper, federal funds and Eurocurrencies. The capital market may be subdivided into mortgage
loans, tax-exempt (municipal) bonds, consumer loans, Eurobonds and Euro notes, corporate
stock, and corporate notes and bonds.
 Types of Financial Markets within the Global Financial System In open markets, financial
instruments are sold to the highest bidder, and they can be traded as often as is desirable before
they mature. In negotiated markets, the instruments are sold to one or a few buyers under private
contract.
 Types of Financial Markets within the Global Financial System In the spot market, assets are
traded for immediate delivery (usually within one or two business days). A futures or forward
market is designed to trade contracts calling for the future delivery of financial instruments.

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 Options markets enable contracts that grant the right to buy or sell certain securities at specific
prices within a certain time to be traded.
Types of Financial Markets and Their Roles
A financial market is a broad term describing any marketplace where buyers and sellers participate in
the trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically
defined by having transparent pricing, basic regulations on trading, costs and fees, and market forces
determining the prices of securities that trade. Financial markets can be found in nearly every nation in
the world. Some are very small, with only a few participants, while others - like the New York Stock
Exchange (NYSE) and the forex markets - trade trillions of dollars daily. Investors have access to a
large number of financial markets and exchanges representing a vast array of financial products. Some
of these markets have always been open to private investors; others remained the exclusive domain of
major international banks and financial professionals until the very end of the twentieth century.
Capital Markets: A capital market is one in which individuals and institutions trade financial
securities. Organizations and institutions in the public and private sectors also often sell securities on
the capital markets in order to raise funds. Thus, this type of market is composed of both the primary
and secondary markets. Any government or corporation requires capital (funds) to finance its
operations and to engage in its own long-term investments. To do this, a company raises money
through the sale of securities - stocks and bonds in the company's name. These are bought and sold in
the capital markets.
Stock Markets
Stock markets allow investors to buy and sell shares in publicly traded companies. They are one of the
most vital areas of a market economy as they provide companies with access to capital and investors
with a slice of ownership in the company and the potential of gains based on the company's future
performance. This market can be split into two main sections: the primary market and the secondary
market. The primary market is where new issues are first offered, with any subsequent trading going
on in the secondary market.
Bond Markets
A bond is a debt investment in which an investor loans money to an entity (corporate or
governmental), which borrows the funds for a defined period at a fixed interest rate. Bonds are used by
companies, municipalities, states and U.S. and foreign governments to finance a variety of projects
and activities. Bonds can be bought and sold by investors on credit markets around the world. This
market is alternatively referred to as the debt, credit or fixed-income market.

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Money Market
The money market is a segment of the financial market in which financial instruments with high
liquidity and very short maturities are traded. The money market is used by participants as a means for
borrowing and lending in the short term, from several days to just under a year. Money market
securities consist of negotiable certificates of deposit (CDs), bankers’ acceptances, U.S. Treasury
bills, commercial paper, municipal notes, Eurodollars, federal funds and repurchase agreements
(repos). Money market investments are also called cash investments because of their short maturities.
The money market is used by a wide array of participants, from a company raising money by selling
commercial paper into the market to an investor purchasing CDs as a safe place to park money in the
short term. The money market is typically seen as a safe place to put money due the highly liquid
nature of the securities and short maturities. Because they are extremely conservative, money market
securities offer significantly lower returns than most other securities
Cash or Spot Market
Investing in the cash or "spot" market is highly sophisticated, with opportunities for both big losses
and big gains. In the cash market, goods are sold for cash and are delivered immediately . For the same
reason, contracts bought and sold on the spot market are immediately effective. Prices are settled in
cash "on the spot" at current market prices. This is notably different from other markets, in which
trades are determined at forward prices. The cash market is complex and delicate, and generally not
suitable for inexperienced traders. The cash markets tend to be dominated by so-called institutional
market players such as hedge funds, limited partnerships and corporate investors. The very nature of
the products traded requires access to far-reaching, detailed information and a high level of
macroeconomic analysis and trading skills.
Derivatives Markets
The derivative is named so for a reason: its value is derived from its underlying asset or assets. A
derivative is a contract, but in this case the contract price is determined by the market price of the core
asset. If that sounds complicated, it's because it is. The derivatives market adds yet another layer of
complexity and is therefore not ideal for inexperienced traders looking to speculate. However, it can
be used quite effectively as part of a risk management program.
Examples of common derivatives are forwards, futures, options, swaps and contracts-for-difference
(CFDs). Not only are these instruments complex but so too are the strategies deployed by this market's
participants.
Foreign exchange and the Interbank Market

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The interbank market is the financial system and trading of currencies among banks and financial
institutions, excluding retail investors and smaller trading parties. While some interbank trading is
performed by banks on behalf of large customers, most interbank trading takes place from the banks'
own accounts. The forex market is where currencies are traded. The forex market is the largest, most
liquid market in the world with an average traded value that exceeds $1.9 trillion per day and includes
all of the currencies in the world. The forex is the largest market in the world in terms of the total cash
value traded, and any person, firm or country may participate in this market.
There is no central marketplace for currency exchange; trade is conducted over the counter. The forex
market is open 24 hours a day, five days a week and currencies are traded worldwide among the major
financial centers of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong, Singapore, Paris and
Sydney.
Primary Markets vs. Secondary Markets
A primary market issues new securities on an exchange. Companies, governments and other groups
obtain financing through debt or equity based securities. Primary markets, also known as "new issue
markets," are facilitated by underwriting groups, which consist of investment banks that will set a
beginning price range for a given security and then oversee its sale directly to investors. The primary
markets are where investors have their first chance to participate in a new security issuance. The
issuing company or group receives cash proceeds from the sale, which is then used to fund operations
or expand the business the secondary market is where investors purchase securities or assets from
other investors, rather than from issuing companies themselves. The Securities and Exchange
Commission (SEC) registers securities prior to their primary issuance, then they start trading in
the secondary market on the New York Stock Exchange, Nasda or other venue where the securities
have been accepted for listing and trading.
The secondary market is where the bulk of exchange trading occurs each day. Primary markets can see
increased volatility over secondary markets because it is difficult to accurately gauge investor demand
for a new security until several days of trading have occurred. In the primary market, prices are often
set beforehand, whereas in the secondary market only basic forces like supply and demand determine
the price of the security.
Secondary markets exist for other securities as well, such as when funds, investment banks or entities
such as Fannie Mae purchase mortgages from issuing lenders. In any secondary market trade, the cash
proceeds go to an investor rather than to the underlying company/entity directly.

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