Lecture 1: An Overview of the Financial System

Financial Markets Why study Financial Markets?

Markets in which funds are transferred from people who have a surplus / an excess of available funds to
people who have a shortage of available funds are called financial markets.
Bond is traded in the bond market in which interest rates are determined.
A stock (also known as equity) is a security that is a claim on the earnings and assets of the corporation. It can
be traded in the stock market.
Conversion of different currencies takes places in the foreign exchange market.

Financial Intermediaries

Institutions (such as banks, insurance companies, mutual funds, pension funds, and financial companies)
borrow funds from people who have saved and then make loans to others. Indirect finance and financial
intermediaries is also important.

Financial Intermediation is the process of indirect finance whereby financial intermediaries link lenders-savers
and borrower-spenders, providers and users of capital.

Flows of Funds through the Financial System

Types of Financial Intermediaries

 Depository institutions issue receipts for money deposited with it.

 Investment intermediaries such as finance companies, investment trust, sells mutual funds or unit trusts
which are pro-rata claims on a portfolio of securities managed by the trust.
 Contractual saving institutions such as insurance company, pension funds

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Structure of Financial Markets

1. Type of transaction
Direct transactions, in which lender and borrower deal with each other directly (perhaps with the
assistance of a broker or agent) and indirect transactions, which go through a financial intermediary.

2. The way of fund raising

i. Debt market is the most common fund raising market. Debt instrument is a contractual agreement by
the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a
specified date.
ii. Equity market allows the holder of equities such as common stock, which are claims to share in the net
income and the asset of a business.

3. Selling and reselling

i. A primary market is one in which assets are sold for the first time; the assets traded in the primary
financial market are newly issued securities or shares. Investment banks specialize in this market.
They might also underwrite the issue, contracting to buy it at a set price and assuming the risk of
reselling it to the public.
ii. A secondary market is one in which the same assets are resold (e.g., stock exchanges). Brokers are
agents of investors who match buyers with sellers of securities. Dealers link buyers and sellers by
buying and selling securities at stated prices.
Secondary market can be organized in two ways.
Exchange: buyers and sellers meet in a central location to conduct trades.
Over-the-counter (OTC) market: dealers who are dispersed geographically have an inventory of
securities stand ready to buy and sell over the counter to anyone who comes to them and is willing to
accept their prices.

4. Duration or Maturity: short term vs. long term

i. Term to maturity (length of time until the loan must be repaid): A debt instrument is short term if its
maturity is less than a year and long term if its maturity is ten years or longer. Intermediate term is for
those between 1 year and 10 years.
ii. Markets: The money market is for the trading of short-term instruments those with maturities of less
than a year. The capital market is for transactions in longer-term instruments, those with maturities of
more than a year.

Functions of Financial Markets

1. Channel savings to investments. It is a resource allocation.

2. Financial markets can improve economic efficiency through the price discovery.
e.g. Funds can be transferred from a person who has no investment opportunities or lacks productive
investment opportunities to one who has them.
3. Activities in financial markets have direct effects on personal wealth and on the behaviour of business.
Financial markets can improve the welfare of the economy.
4. Transfer and manage risk. Financial intermediaries also promote risk sharing by helping individuals to
diversify and thereby lower the amount of risk to which they are exposed. The institutions can help reduce
the exposure of investors to risk through asset transformation.
5. Corporate governance. A “good” firm may easily raise funding in the market.

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Financial Market Instruments (Securities)

1. Money Market Instruments

i. Treasury (T) Bills is a short-term financial instrument issued by the government (debt obligation backed
by the U.S. government) with a maturity of one year or less. It’s considered a conservative & safe
investment Possibility of default is nearly zero. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 m.
The T-bills are usually one month (four weeks), three months (13 weeks) or six months (26
weeks), or one-year securities.
Exchange Fund Bills and Notes, debt instruments issued by the HKMA for the account of the Exchange
Fund It was introduced in March 1990 in Hong Kong. The benchmarks for fixings are 1-week, 1-
month, 3-month, 6-month, 9-month and 12-month.
ii. Interbank Loans are loans between banks and “Interest Rate = Interbank rate”
The London Interbank Offered Rate (LIBOR) is a daily reference rate based on the interest rates at
which banks borrow unsecured funds from banks in the London wholesale money market (or interbank
market).
Federal Fund Rate is the interest rate at which private depository institutions (mostly banks) lend
balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight in the
United States. It is the interest rate banks charge each other for loans.
Hong Kong Interbank Offered Rate (HIBOR) is the rate of interest offered on Hong Kong dollar loans
by banks in the interbank market for a specified period ranging from overnight to one year.
iii. Negotiable Bank Certificate of Deposit (NCD) is a debt instrument sold by a bank to depositors that
pays annual interest of a given amount and at maturity pays back the original purchase price.
iv. Commercial Paper is a short-term instrument issued by large banks and well-known corporation (good
credit rating). e.g, the first issue of commercial paper in H.K was in 1977 by the MTRC.
v. Banker’s Acceptance is a bank draft issued by a firm, payable at some future date, and guaranteed for a
fee by the bank that stamps it “accepted” (stamp fee).
vi. Repurchase Agreements (Repos) are effectively short-term loans (usually with a maturity of less than
two weeks) in which treasury bonds serve as collateral, an asset that the lender receives if the borrower
does not pay back the loan.

2. Capital Market Instruments

i. Stocks are equity claims on the net income and assets of a corporation. This security represents the
ownership of a fraction of a corporation. Owner of common stock, or ordinary shares are entitled to a
portion of the corporation’s profits in the form of dividend.
ii. Mortgages are loans to individuals or firms to buy housing, land or other real structures, where the
structure, or land, then in turn serves as collateral for the loans. Mortgage-backed securities are issued
as mortgages are not sufficiently liquid because of different terms and interest rates.
iii. Corporate Bonds are long-term bonds issued by corporations with very strong credit ratings. The typical
corporate bond sends the holder an interest payment and pay off the face value when the bond matures.
Some corporate bonds, called convertible bonds, also have the additional feature of allowing the holder
to convert them into a specified number of shares of stock at any time up to the maturity date.
iv. Government Securities are long-term debt instruments are issued by the government to finance the
government deficit (e.g., bonds).

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Functions of Financial Intermediaries

Main reasons for importance of financial intermediaries and indirect finance in financial markets:

1. Reduce transaction costs in provision of safekeeping, accounting and payments mechanisms for funds.

2. Diversifying and sharing risk by pooling financial resources from providers.

3. Asymmetric information usually increases as market is large even though it has been on the decline as a
result of more and more people being able to easily access all types of information. Existence of
intermediaries can solve some problems created by asymmetric information: adverse selection & moral
hazard by collecting and processing information.

4. Facilitate investments for real economic growth by providing liquidity between providers and users of
capital.

Transaction costs include the time and money spent trying to exchange financial assets, goods or services.

e.g. Keung has money ($5,000,000) and Anson wants to borrow money ($5,000,000) to buy a house with
interest rate, 0.1%; the corresponding interest payment is $5,000. Then, two persons need a lawyer Fa
to write up a contract but the fee is $5,000, “interest payment ≤ lawyer’s fee”, it’s not a good deal!

With financial intermediaries, a bank knows how to find a good lawyer to produce an airtight contract, and
this contract can be used over and over again in its loan transactions, thus lowering the legal cost per
transaction. Financial intermediaries can reduce the transaction costs substantially because they have
developed expertise and they also take the advantage of economies of scale.

Risk Sharing is possible because low transaction costs allow financial intermediaries to reduce the risk
exposure of investors by pooling a collection of asserts into a new asset.

Adverse Selection is the problem created by asymmetric information, before the transaction occurs.

Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce
an undesirable (adverse) outcome are the ones who most actively seek out a loan and thus most likely to be
selected.

e.g.: Suppose both Big Big Wolf (Wolffy) and Mr. Lufsig want to borrow money from you. If information is
symmetric, you are likely to lend money to hard-working Big Big Wolf because of his strong survival
skill. If information is asymmetric, you may lend money to Mr. Lufsig because of his wonderful
presentation skill and elegant appearance!
To avoid Adverse Selection, you just don’t lend any money to either of them.

Moral Hazard is the problem created by asymmetric information after the transaction occurs.

Moral Hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are
undesirable (immoral) from the lender’s point of view because they make it less likely that the loan will be
paid back.

e.g.: Suppose that you made a loan to your good friend who wants to study space science in the mainland,
however, he may spend your money to buy Star Wars souvenirs. It is likely that he may not return any
money. Because of the risk of moral hazard, you may not lend any money to this person.