Debark University

Department of Economics

Financial Economics

Nature and role of financial system

in economic development
 Introduction
• Market is an institution or arrangement
that facilitates the purchase and sale of
goods, services, and other things.
• A financial market is an institution or
arrangement that facilitates the exchange
of financial assets
– including deposits and loans, Corporate stocks
and bonds, government bonds, and more
exotic instruments such as options and futures
contracts.
 Structure of Financial System
Basic Structure of Financial system are
 Cont’d
A. Financial Institutions
• Financial institutions are the intermediaries who
facilitate smooth functioning of the financial
system by making investors and borrowers
meet.
• Mobilize savings of the surplus units and
allocate them in productive activities promising
a better rate of return.
• Act as financial intermediaries because they act
as middlemen between savers and borrowers.
 Cont’d
• On the basis of the nature of activities, financial
institutions may be classified as:
I. Regulatory and Promotional Institutions
• Financial institutions, financial markets,
financial instruments and financial services are
all regulated by regulators like Ministry of
Finance, NBE, etc.
II. Banking Institutions
• Mobilize the savings of people. They provide a
mechanism for the smooth exchange of goods
and services .
• Three basic categories of banking institutions are:
Commercial Banks, Cooperative Banks and
Developmental Banks.
– Commercial bank is an institution that accepts deposit,
makes loans and offer related services. These institutions
run to make profit.
• Commercial banks provide administrations services such
as
– making business advances, offering fundamental
investment schemes, encouraging saving deposits, fixed
deposits,
– Issuing bank drafts and bank cheques, giving overdraft
facilities, bond investment schemes, cash management,
mortgage loans, debit cards, credit cards, etc.
• Commercial banking can be further divided into
four parts as follows:
– Public Sector Banks (PSBs): are banks where in
the majority stake (i.e. more than 50%) is held by
Government.
– Private Sector Banks: are registered as companies
with limited liability. Private Banks subject to an
essential part of wealth management for high
income groups.
• provide services like: assets management, tax
advisory, financial brokers, offered solitary
relationship manger.
 – Foreign Banks: are registered and have their
headquarters in a foreign country but operate their
branches in the domestic country.
– Regional Rural Banks (RRBs): are playing a
pivotal role in the economic development of rural
countries
• its main objective is to develop rural economy.
III. Non-banking Institutions (NBFIs): also
mobilize financial resources directly or indirectly
from people.
– They lend funds but do not create credit.
• Non-banking financial institutions can be
categorized as
– investment companies, housing companies, leasing
companies, hire purchase companies, specialized
financial institutions, investment institutions, state
level institutions, etc.
– regulations governing these institutions are
relatively lighter as compared to those of banks.
Importance of Financial Institutions
• Financial institutions are important because they
provide a marketplace for money and assets, so
that capital can be efficiently allocated to where
it is most useful.
– For example, a bank takes in deposits from
customers and lends the money to borrowers.
• Without the bank as an intermediary, any one
individual is unlikely to find a qualified
borrower or know how to service the loan.
• Via the bank, the depositor is able to earn
interest as a result.
• Likewise, investment banks find investors to
market a company's shares or bonds to.
Primary and Secondary Markets
• There are several ways to classify financial
markets.
– One obvious method is to classify markets by the
type of asset traded, for example, short-term or long-
term assets.
• The broadest way to categorize markets is to
distinguish between primary and secondary
markets.
• In a primary market, new issues of financial assets
are bought and sold.
– For example, if a certain Corporation issues a new share
of stock, (stock that has never been owned by an
investor before) the stock is sold in the primary market
for new issues of corporate stock.
• In contrast, existing financial assets are bought and
sold in a secondary market.
• The primary market for savings bonds is very
widespread.
• These instruments can be purchased from
commercial banks nationwide, as well as through
payroll deductions.
• There is no central clearinghouse for such
purchases, nor is there a secondary market for
savings bonds.
• You can redeem the bonds, but you cannot sell
them to a third party.
– In contrast, Treasury bonds, which the government
issues to finance the federal debt, have active
primary and secondary markets.
• The primary market for these bonds is an
auction held by the banks, securities dealers,
and other institutional investors bid for new
issues.
• The secondary market for these bonds is an
over-the-counter market that has no precise
physical location.
• The existence of a secondary market for a
financial asset enhances the asset’s liquidity.
• In the absence of a secondary market for a
stock, you would have to personally locate
someone willing to purchase the stock from you.
– Not only could this take considerable time; you
would be unlikely to locate a buyer willing to pay
the highest price for your stock.
• we can classify financial markets according to
the nature of the instruments traded. This
classification consists of debt, equity, and
financial service markets.
Asset Transformation Role of Financial
Institutions
• An asset represents a valued economic resource
belonging to an economic agent - in either
tangible or intangible form - that adds to the
wealth of an individual.
• Most commonly assets are a term commonly
used when referring to financial institutions, as
it appears on the balance sheets of these
institutions.
• A financial institution is a company engaged in
the business of dealing with financial and
monetary transactions such as deposits,
loans, investments, and currency exchange.
– Encompass a broad range of business operations
within the financial services sector including banks,
trust companies, insurance companies, brokerage
firms, and investment dealers.
• The process in which banks convert large
quantities of short-term, low risk, small and
liquid deposits into a small number of much
larger, long-term, riskier and illiquid advances
(loans).
• This is how individual banks make majority of
their profits by transforming assets to meet the
incompatible needs and wants of borrowers and
lenders simultaneously.
• The main risk with this type of approach for banks
is if a large long term loan is funded by a large
number of small short term deposits, the bank may
experience problems meeting the demands of
depositors
– if large numbers decide to withdraw their deposit.
• In this situation the mismatch between the terms of
depositors and borrowers is problematic as the
loans may not be redeemable in the short term
– this creates liquidity issues i.e. there may not be enough
cash immediately available to allow depositors to
withdraw their savings.
• The diagram illustrates how banks take cash
from savers (surplus units - total income
exceeds total expenditure) and
– the bank issues it off to borrowers (deficit
units - total income exceeded by total
expenditure) through loans in exchange for
their debt (to be paid back at a later date).
 Financial Instruments
• Financial instruments are contracts for monetary
assets that can be purchased, traded, created,
modified, or settled for.
– In terms of contracts, there is a contractual
obligation between involved parties during a
financial instrument transaction.
• One company is obligated to provide cash,
while the other is obligated to provide the bond.
– Basic examples of financial instruments are
cheques, bonds, securities.
 Cont’d
• There are typically three types of financial
instruments: cash instruments, derivative
instruments, and foreign exchange instruments.
 A. Cash Instruments
• Cash instruments are financial instruments with
values directly influenced by the condition of
the markets.
– Within cash instruments, there are two types;
securities and deposits, and loans.
• Securities: A security is a financial instrument
that has monetary value and is traded on the
stock market.
– When purchased or traded, a security represents
ownership of a part of a publicly-traded company on
the stock exchange.
• Deposits and Loans: Both deposits and loans are
considered cash instruments because they represent
monetary assets that have some sort of contractual
agreement between parties.
B. Derivative Instruments
• Derivative instruments are financial instruments that
have values determined from underlying assets, such as
resources, currency, bonds, stocks, and stock indexes.
– The five most common examples of derivatives instruments
are synthetic agreements, forwards, futures, options, and
swaps.
– Synthetic Agreement for Foreign Exchange (SAFE): A
SAFE occurs in the over-the-counter market and is an
agreement that guarantees a specified exchange rate during
an agreed period of time.
– A forward is a contract between two parties that
involves customizable derivatives in which the exchange
occurs at the end of the contract at a specific price.
– A future is a derivative transaction that provides the
exchange of derivatives on a determined future date at a
predetermined exchange rate.
– An option is an agreement between two parties in which
the seller grants the buyer the right to purchase or sell a
certain number of derivatives at a predetermined price
for a specific period of time.
– An interest rate swap is a derivative agreement
between two parties that involves the swapping of
interest rates where each party agrees to pay other
interest rates on their loans in different currencies.
 C. Foreign Exchange Instruments
• Foreign exchange instruments are financial
instruments that are represented on the foreign
market and primarily consist of currency
agreements and derivatives.
– In terms of currency agreements, they can be broken
into three categories.
• Spot: A currency agreement in which the actual
exchange of currency is no later than the second
working day after the original date of the
agreement.
– It is termed “spot” because the currency exchange is
done “on the spot” (limited timeframe).
• Outright Forwards: A currency agreement in
which the actual exchange of currency is done
“forwardly” and before the actual date of the
agreed requirement.
– It is beneficial in cases of fluctuating exchange rates
that change often.
• Currency Swap: refers to the act of
simultaneously buying and selling currencies
with different specified value dates.
• Financial instruments can also be categorized into
two asset classes debt-based financial instruments
and equity-based financial instruments.
• 1. Debt-based financial instruments
– are categorized as mechanisms that an entity can use
to increase the amount of capital in a business.
• Examples include bonds, debentures, mortgages
and credit cards.
• They are a critical part of the business environment
because they enable corporations to increase
profitability through growth in capital.
2. Equity-based financial instruments
• are categorized as mechanisms that serve as legal
ownership of an entity.
– Examples include common stock, convertible
debentures, preferred stock, and transferable
subscription rights.
– They help businesses grow capital over a longer period
of time compared to debt-based but benefit in the fact
that the owner is not responsible for paying back any
sort of debt.
• A business that owns an equity-based financial
instrument can choose to either invest further in the
instrument or sell it whenever they deem necessary.
 Risk and Return
• In investing, risk and return are highly
correlated. Increased potential returns on
investment usually go hand-in-hand with
increased risk.
• Different types of risks include project-specific
risk, industry-specific risk, competitive risk,
international risk, and market risk.
• Return refers to either gains or losses made from
trading a security.
 Cont’d
• The return on an investment is expressed as a
percentage and considered a random variable
that takes any value within a given range.
– Several factors influence the type of returns that
investors can expect from trading in the markets.
• Diversification allows investors to reduce the
overall risk associated with their portfolio but
may limit potential returns.
• Making investments in only one market sector
may, if that sector significantly outperforms the
overall market, generate superior returns.
 Cont’d
Diversification Reduces or Eliminates Firm-
Specific Risk
• First, each investment in a diversified
portfolio represents only a small percentage of
that portfolio.
– Thus, any risk that increases or reduces the value
of that particular investment or group of
investments will only have a small impact on the
overall portfolio.
 Cont’d
• Second, the effects of firm-specific actions on
the prices of individual assets in a portfolio
– can be either positive or negative for each
asset for any period.
• Thus, in large portfolios, it can be reasonably
argued that positive and negative factors will
average out so as not to affect the overall risk
level of the total portfolio.
 Comparative Analysis of Risk and Return
Models
 The Capital Asset Pricing Model (CAPM)
 APM
 Multifactor model
 Proxy models
 Accounting and debt-based models
• For investments with equity risk, the risk is best
measured by looking at the variance of actual
returns around the expected return.
• In the CAPM, exposure to market risk is
measured by market beta.
• The APM and the Multifactor model allow for
examining multiple sources of market risk and
estimating betas for an investment relative to
each source.
• Regression or proxy model for risk looks for
firm characteristics, such as size, that have been
correlated with high returns in the past and uses
them to measure market risk.
• On investments with default risk, the risk is
measured by the likelihood that the promised
cash flows might not be delivered.
 Cont’d
• Investments with higher default risk usually
charge higher interest rates, and the premium
that we demand over a riskless rate is called
the default premium.
• Even in the absence of ratings, interest rates will
include a default premium that reflects the
lenders’ assessments of default risk.
• These default risk-adjusted interest rates
represent the cost of borrowing or debt for a
business.
 A. Capital Asset Pricing Model
• describes the relationship between systematic risk
and expected return for assets, particularly stocks.
– is widely used throughout finance for pricing
risky securities and generating expected returns for
assets given the risk of those assets and cost of
capital.
• Investors expect to be compensated for risk and
the time value of money.
• The risk-free rate in the CAPM model accounts
for the time value of money.
• The other components of the CAPM formula
account for the investor taking on additional risk.
 Cont’d
• The goal of the CAPM formula is to evaluate
whether a stock is fairly valued when its risk and
the time value of money are compared to its
expected return.
Limitations of CAPM
– There are several assumptions behind the CAPM
formula that have been shown not to hold in reality.
• Modern financial theory rests on two assumptions:
– One, securities markets are very competitive and
efficient and
– two, these markets are dominated by rational, risk-
averse investors, who seek to maximize satisfaction
from returns on their investments.
 Cont’d
• Despite these issues, the CAPM formula is still
widely used because it is simple and allows for
easy comparisons of investment alternatives.
B. Single Index Model
• To reduce a firm’s specific risk or residual risk a
portfolio should have negative covariance or
rather it should have no variance at all, for large
portfolios
– however calculating variance requires greater
and sophisticated computing power.
 Cont’d
• As such, Index models greatly decrease the
computations needed to calculate the optimum
portfolio.
• The use of such Index models also eliminates
illogical or rather absurd results.
– The Single Index model (SIM) and the Capital
Asset Pricing Model (CAPM) are such models
used to calculate the optimum.
– CAPM makes correct forecast about expected
return.
 Cont’d
Similarities
• Both the SIM and CAPM represent market
movement of stock.
• They both further focus on the balanced
relationship between the risk and expected
return on risky assets.
• Even the functional form for the expected
return is similar for both the two models.
 Cont’d
• The Single Index Model leads to a
simplification of the portfolio choice model
– because of the additional assumption that the
distinctive components of return are independent
across stocks.
• The market portfolio in the CAPM is not the
same as a "market index.
• The Single Index Model also greatly reduces the
computations.
 Capital Allocation
• Capital allocation is about where and how a
corporation's CEO decides to spend the money that
the company has earned.
• means distributing and investing a company's
financial resources in ways that will increase its
efficiency, and maximize its profits.
• A firm's management seeks to allocate its capital in
ways that will generate as much wealth as possible
for its shareholders.
– Allocating capital is complicated, and a company's
success or failure often hinges upon a CEO's capital-
allocation decisions.
 Cont’d
• Greater-than-expected profits and positive cash
flows, however desirable, often present a dilemma
for a CEO, as there may be a great many
investment options to consider.
• Some options for allocating capital could include
returning cash to shareholders
– via dividends, repurchasing shares of stock,
issuing a special dividend, or increasing a
research and development (R&D) budget.
• Alternatively, the company may opt to invest in
growth initiatives, which could include acquisitions
and organic growth expenditures.
 Market efficiency
• Market efficiency is championed in the Efficient
Market Hypothesis (EMH) formulated by
Eugene Fama in 1970
– suggests at any given time, prices fully reflect all
available information about a particular stock
and/or market.
• According to the EMH, no investor has an
advantage in predicting a return on a stock price
– because no one has access to information not
already available to everyone else.
 How Does a Market Become Efficient?
• For a market to become efficient, investors must
notice the market is inefficient and possible to
beat.
– A market has to be large and liquid. Accessibility
and cost information must be widely available
and released to investors at more or less the
same time.
• Transaction costs have to be cheaper than an
investment strategy's expected profits.
– Investors must also have enough funds to take
advantage of inefficiency until, according to the
EMH, it disappears again.
 Degrees of Efficiency
• Strong efficiency: the strongest version, which
states all information in a market, whether public or
private, is accounted for in a stock price.
– Not even insider information could give an investor an
advantage.
• Semi-strong efficiency: implies all public
information is calculated into a stock's current
share price.
– Neither fundamental nor technical analysis can be used
to achieve superior gains.
• Weak efficiency: claims that all past prices of a
stock are reflected in today's stock price. Therefore,
technical analysis cannot be used to predict and
beat the market.
 Equity Valuation
• Equity valuation is a blanket term and is used to
refer to all tools and techniques used by
investors to find out the true value of a
company’s equity.
• It is often seen as the most crucial element of a
successful investment decision.
• Investment Banks typically have a equity
research department, where research
analysts produce equity research reports of
select securities in various industries.
Equity Valuation
 Cont’d
• In equity markets, a financial asset with a
relatively high intrinsic value is expected to
command a high price, and
– a financial asset with a relatively low intrinsic
value is expected to command a low price.
• SR: Financial assets with relatively low intrinsic
value might command a high price and vice-a-
versa, but such distortions are expected to
disappear over time. (Distortions)
• LR: The true value of a stock (and thereby the
market price of that stock) depends only on the
fundamental factors affecting the stock.
 Cont’d
• These factors can be broadly classified into
four categories:
Macroeconomic variables,
Management of the business,
Financial health of the business and
Profits of the business.

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