1. finmarkets 3rd a - financial sysytem

7/30/2019 1. FinMarkets 3rd a - Financial Sysytem

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2MBA- Finance

MBA Finance Ashraf Shamseldin

These institutions also provide competition for bank deposits, thereby mobilizing long-term funds

necessary for the development of equity and corporate debt markets, municipal bond markets, mortgage

bond markets, leasing, factoring and venture capital. Collective savings institutions also allow for better

risk management, while helping to reduce the potential for systemic risk through the aggregation of

resources, allocation of risk to those more willing to bear it, and application of portfolio managementtechniques that spread risk across diversified parts of the financial system.

Thus, countries have a lot to gain from deep and broad financial markets and a mature financial services

industry. This development paradigm is increasingly recognized around the world, especially in the

aftermath of repeated emerging market crises in countries with bank-dominated financial systems.

As countries are aiming at achieving high economic rate of growth, they can reap the benefits of financial

system deepening and widening, provided they follow financial sector policies that are conducive to the

further development of both bank and non-bank forms of financial intermediation.

Businesses, institutions, and government units often need to raise funds. They will have to raise thesefunds in the financial markets. In this respect they represent the Demand side on funds. On the other

hand, some other individuals, firms and even governments, have incomes greater than their current

expenditures, so they have savings available to invest so they are looking for an investment opportunity.

Such an opportunity might be those who are looking for finance. In this respect, they as savers/investors

represent the Supply side of funds. People and institutions needing money are brought together with

those having surplus funds in the financial markets.

Financial markets and financial intermediaries (banks, insurance companies, pension funds, etc., ) have

the basic function of getting people together in order to move funds from those who have surplus of funds

(savers/investors) to those who have a shortage of funds (users). For example, when a corporation needs

to form its initial capital or to expand its size and needs to increase its capital, it will need funds toproduce it and bring it to market, or a local government may need funds to build a road or a school, they

will talk to savers/ investors in order to finance their projects.

Well-functioning financial markets and financial intermediaries are needed to improve economic well-

being and are crucial to economic health. They facilitate the provision of finance at a cost effective

manner to companies and this will ultimately increase aggregate output (GDP) thus creating a healthy and

strong economy. On the other hand users of the funds available from investors and offered for finance will

have to be efficient in order to be able to pay expected returns to investors. When all productive units

(companies) are efficient then the economy is obviously efficient. To study the effects of financial

markets and financial intermediaries on the economy, one must first acquire an understanding of their

general structure and operation. One also must learn about the major financial intermediaries and theinstruments that are traded in financial markets as well as how these markets are regulated.

Role of Financial Markets

Financial markets play the essential economic role of channelling funds from people who have saved

surplus funds by spending less than their income to people who have a shortage of funds because they

wish to spend more than their income. In order to play that role, the markets perform two basic functions:

1) Mobilization of the savings of investors; and 2) Allocation of these resources among different users

(producers who are seeking finance). In the money market (banking system) the market first function is

performed by using the interest rate as a tool to mobilize or attract investments, the higher the interest rate

the market offers, the greater is the amount of savings put for investment will be. In the capital market, the

first function is performed by using the rate of return as a tool to mobilize or attract investments, the


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higher the rate of return the market offers, the greater is the amount of savings put for investment will be.

With respect to recourse allocation, while the money market perform this function by measuring the credit

worthiness of the borrower, the capital market insures that the user is efficient enough to pay the expected

return (in case of shares) or insures that the user is properly rated to repay his debts (in case of bonds).

Financial Markets as Source of Finance

Why is this channelling of funds from savers to spenders so important to the economy? The answer is that

the people who save are frequently not the same people who have profitable investment opportunities

available to them, the entrepreneurs. In the absence of financial markets, savers and users might never get

together. Without financial markets, it is hard to transfer funds from a person who has no investment

opportunities to one who has them; Financial markets are thus essential to promoting economic efficiency.

The existence of financial markets is also beneficial even if someone borrows for a purpose other than

increasing production in a business (for example to buy a house you can borrow from lenders).

Financial markets have therefore such an important function in the economy as they allow funds to move

from people who lack productive investment opportunities to people who have such opportunities. Ahealthy economy is dependent on efficient transactions of funds between people. Without efficient

transfers, the economy simply could not function. Obviously, the level of employment and productivity,

hence our standard of living would be much lower.

The most important instruments traded in the various financial markets are the money market instruments

(with the lowest maturities) and capital or securities market instruments (with the highest maturities).

The money market instruments are treasury notes and treasury bonds, government bonds, commercial

papers, certificates of deposits (CDs) and money market investment funds. The securities market

instruments are corporate bonds, common and preferred stocks and financial leasing contracts.

The role of financial markets is shown schematically in Figure 1. Those who have saved and are lendingfunds, the lender-savers, are at the left, and those users who must borrow funds to finance their spending,

the borrower-spenders, are at the right. The principal lender-savers are households, but business

enterprises and the government (particularly state and local government), as well as foreigners and their

governments, sometimes also find themselves with excess funds and so lend them out.

The most important borrower-spenders are businesses and the government, but households and foreigners

also borrow to finance their requirements. The arrows in Fig. 1, show that funds flow from lender-savers

to borrower-spenders via two routes (direct and indirect).

Indirect finance (the route at the bottom of Figure 1), borrowers borrow funds directly from lenders in

financial markets by selling them securities (also called financial instruments), which are claims on the

borrower's future income or assets. Whereas securities are assets for the person who buys them, they are

liabilities (IOUs or debts) for the individual or firm that sells (issues) them. For example, if a company

needs to borrow funds to pay for a new factory to manufacture computerized cars, it might borrow the

funds from a saver by selling the saver a bond, a debt security that promises to make payments

periodically for a specified period of time.


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Savers/lenders

1. Households

2. Firms

3. Governments

4. Foreigners

Spenders-Borrowers

1.Firms

2.Governments

3.Households

4.Foreigners

Financial

Intermed

iaries l Fin

Financial

Markets

Funds

FundsFunds

Note that "markets" is plural. There are different financial markets, each one consisting of many

institutions, in a developed economy. Each market deals with a somewhat different type of financial

instrument in terms of the instrument's maturity and the assets backing it. Also, different markets serve

different types of customers, or operate in different parts of the country. Generally, here are some of the

major types of markets:

1. Physical asset markets (also called tangible or real asset markets) are those for such products andservices.

2. Financial asset markets deal with stocks, bonds, notes, mortgages, and other claims on real assetswith respect to the distribution of future cash flows. These markets are two types:

a. Money markets are the markets for debt instruments with maturities of less than one year

(short term).

b. Capital markets are the markets for long-term debt and corporate stocks.

3. Mortgage markets deal with loans on real estate, and on farmland.

Markets could be world, national, regional, and local markets exist. Thus, depending on an organization's

size and scope of operations, it might be able to raise funds all around the world, or it might be confined

to a strictly local market.

Markets also could be Primary markets in which corporations raise new capital. If a company were to sell

a new issue of common stock to raise capital, this would be a primary market transaction. The

corporation selling the newly created stock receives the proceeds from the sale in a primary market

transaction. The Secondary markets are markets in which existing, already outstanding securities are

traded among investors. The Stock Exchange is a secondary market, because it deals in outstanding, as

opposed to newly issued, stocks and bonds. Secondary markets also exist for various other types of

financial assets. The corporation whose securities are being traded is not involved in a secondary market

transaction and, thus, does not receive any funds from such a sale. Other classifications could be made,

but this breakdown is sufficient to show that there are many types of financial markets.


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Structure of Financial Markets

Money and Capital MarketsAnother way of distinguishing between markets is on the basis of the maturity of the securities traded in

each market. The money market is a financial market in which only short-term debt instruments (maturity

of less than one year) are traded; the capital market is the market in which longer-term debt (maturity ofone year or greater) and equity instruments are traded2. Money market securities are usually more widely

traded than longer-term securities and so tend to be more liquid. In addition, short-term securities have

smaller fluctuations in prices than long-term securities, making them safer investments.

Debt and Equity MarketsA firm can obtain funds in a financial market in two ways. The most common method is to issue a debt

instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the

holder of the instrument fixed dollar amounts at regular intervals (interest payments) until a specified date

(the maturity date), when a final payment is made. The maturity of a debt instrument, is the time (term) to

that instrument's expiration date. 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. Debt instruments with a maturity between one and tenyears are said to be intermediate-term.

The second method of raising funds is by issuing equities, such as common stock, which are claims to

share in the net income (income after expenses and taxes) and the assets of a business. Equities usually

make periodic payments (dividends) to their holders and are considered long-term securities because they

have no maturity date.

The main disadvantage of owning a corporation's equities rather than its debt is that an equity holder is a

residual claimant; that is, the corporation must pay all its debt holders before it pays its equity holders.

The advantage of holding equities is that equity holders benefit directly from any increases in the

corporation's profitability or asset value because equities confer ownership rights on the equity holders.Debt holders do not share in this benefit because their dollar payments are fixed.

Primary and Secondary MarketsA primary market is a financial market in which new issues of a security, such as a bond or a stock, are

sold to initial buyers by the corporation or government agency borrowing the funds. A secondary market

is a financial market in which securities that have been previously issued and sold (and are thus second-

hand) can be resold. An important financial institution that assists in the initial sale of securities in the

primary market is the investment bank. It does this by underwriting securities; that is, it guarantees a price

for a corporation's securities and then sells them to the public.

The stock exchanges, in which previously issued stocks are traded, are the best examples of secondary

markets. Other examples of secondary markets are foreign exchange markets, futures markets, and

options markets. Securities brokers and dealers are crucial to a long-term, well-functioning secondary

market. Brokers are agents of investors who match one buyers with sellers of securities; dealers link

buyers and sellers by buying and selling securities at stated prices. Nonetheless, secondary markets serve

two functions. First, they make the financial instruments more liquid and thus it makes them more

desirable and easier for the issuing firm to sell in the primary market. Second, they determine the price of

the security that the issuing firm sells in the primary market (pricing mechanism).

Secondary markets can be organized in two ways. One is to organize stock exchanges, where buyers and

sellers of securities through their agents/brokers meet in one central location to conduct trades. The other2

In Egypt, money market instruments are not traded.


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method of organizing a secondary market is to have an over-the-counter (OTC) market, in which dealers

at different locations who have an inventory of securities stand ready to buy and sell securities "over the

counter" to anyone who comes to them and is willing to accept their prices.

Financial Institutions

Funds are transferred between those who have funds to invest (savers) and those who need the funds(users) by the three different processes:

1. A direct transfer of money and securities occurs when a business sells its stocks or bonds directlyto savers (investors) without going through any type of financial institution. The business delivers

its securities to savers, who in turn give the firm the money it needs.

2. A transfer also can go through an investment banking house which serves as a middleman andfacilitates the issuance of securities. The company sells its stocks or bonds to the investment bank,

which in turn sells these same securities to savers. The business's securities and the savers' money

merely "pass through" the investment banking house. However, the investment bank does buy and

hold the securities for a period of time, so it is taking a chance it might not be able to resell them to

savers for as much as it paid. Because new securities are involved and the corporation receives

money from the sale, this is a primary market transaction. It should be noted that investmentbanking has nothing to do with the traditional banking process as we know it-investment banking

deals with the issuance of new securities, not deposits and loans.

3. Transfers can also be made through a financial intermediary, such as a bank or a mutual fund.Here the intermediary obtains funds from savers, issuing its own securities or liabilities in

exchange, and then uses the money to lend out or to purchase another business's securities. For

example, a saver might give dollars to a bank, receiving from it a certificate of deposit, and then

the bank might lend the money to a small business in the form of a loan. Thus, intermediaries

literally create new forms of capital-in this case, certificates of deposit, which are both safer and

more liquid than mortgages and thus are better securities for most savers to hold. The existence of

intermediaries greatly increases the efficiency of the financial markets.

Direct transfers of funds from savers to businesses are possible and do occur on occasion, but it is

generally more efficient for a business to enlist the services of an investment banker. Such organizations

(1) help corporations design securities with the features that currently are most attractive to investors, (2)

buy these securities from the corporation, and (3) then resell them to savers. Although the securities are

sold twice, this process really is one primary market transaction, with the investment banker acting as a

middleman as funds are transferred from savers to businesses.

The financial intermediariesdo more than simply transfer money and securities between borrowers and

savers- they literally create new financial products. Because the intermediaries generally are large, they

gain economies of scale in analyzing the creditworthiness of potential borrowers, in processing and

collecting loans, and in pooling risks, and thus helping individual savers diversify-that is, "not put all

their financial eggs in one basket." Further, a system of specialized intermediaries can enable savings to

do more than just draw interest. For example, individuals can put money into banks and get both interest

income and a convenient way of making payments (checking), or put money into life insurance

companies get both interest income and protection for their beneficiaries.

In many developing nations, a large set of specialized, highly efficient financial intermediaries has

evolved. Competition and government policy have created a rapidly changing arena, however, such that

different types of institutions currently perform services formerly reserved for others. This trend, which

will continue, has blurred institutional distinctions. Still, there remains a degree of institutional identity,

and here are the major classes of intermediaries:


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1. Commercial Banks serve a wide variety of customers. Historically, the commercial hankswere the major institutions that handle checking accounts and through which the money supply is

managed by the Central Banks. Conversely, commercial banks in some countries, with very

strong supervision, provide an ever-widening range of services, including trust operations, stock

brokerage services, and insurance. But, in other countries commercial banks are not allowed to do

that because of the conflict of interest. Note that commercial banks are quite different frominvestment banks. Commercial banks lend money, whereas investment banks help companies

raise capital from other parties.

2. Savings and loan associations, which have traditionally served individual savers andresidential and commercial mortgage borrowers, take the funds of many small savers and then

lend this money to home buyers and other types of borrowers.

3. Credit union are cooperative associations whose members have a common bond, such asbeing employees of the: same firm. Members savings are loaned only to other members, generally

for auto purchases, home improvements, and the like. Credit unions often are the cheapest source

of funds available to individual borrowers.

4. Pension funds are retirement plans funded by corporations or government agencies fortheir workers and administered primarily by the trust departments of commercial banks or by lifeinsurance companies. Pension funds invest primarily in bonds, stocks, mortgages, and real estate.

5. Life insurance companies take savings in the form of annual premiums, then invest thesefunds in stocks, bonds, real estate, and mortgages, and finally make payments to the beneficiaries

of the insured parties. In recent years life insurance companies have also offered a variety of tax-

deferred savings plans designed to provide benefits to the participants when they' retire.

6. Mutual funds are investment companies that accept money from savers and then use thesefunds to buy various types of financial assets such as stocks, long-term bonds, and short-term debt

instruments. These organizations pool funds and thus reduce risks through diversification. They

also achieve economies of scale, which lower the costs of analyzing securities, managing port-

folios, and buying and selling securities.

Financial institutions historically have been heavily regulated, with the primary purpose of ensuring the

safety of the institutions and thus protecting depositors. However, these regulations- which have taken

the form of prohibitions on nationwide branch banking, restrictions on the types of assets the institutions

can buy, ceilings on the interest rates they can pay, and limitations on the types of services they can

provide-have tended to impede the free flow of funds from surplus to deficit areas, and thus have hurt the

efficiency of our financial markets.

The Stock MarketThe secondary markets are those in which outstanding, previously issued securities are traded. By far the

most active secondary market, and the most important one to financial managers, is the stock market. It ishere that the prices of firms' stocks are established, and, because the primary goal of managerial finance

is to maximize the firm's stock price, a knowledge of this market is essential for anyone involved in

managing a business.

The Cost of MoneyIn a free economy, funds are allocated through the price system. The interest rate is the price paid to

borrow funds, whereas in the case of equity capital, investors expect to receive dividends and capital

gains. The four most fundamental factors that affect the supply of and demand for investment capital, and

hence the cost of money are: (1) production opportunities, (2) time preferences for consumption, (3)

risk, and (4) inflation. The higher the perceived risk, the higher the required by investors of rate of

return. Further, people use money as a medium of exchange. When money is used, its value in the


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future, which is affected by inflation comes into play: The higher the expected rate of inflation, the larger

the required return.

Thus, we see that the interest rate paid to savers depends in a basic way (1) on the rate of return

producers expect to earn on invested capital. (2) on savers' time preferences for current versus future

consumption, (3) on the riskiness of the loan, and (4) on the expected future rate of inflation. The returnsborrowers expect to earn by investing the funds they borrow set an upper limit on how much they can pay

for savings, while consumers' time preferences for consumption establish how much consumption they

are willing to defer, hence how much they will save at different levels of interest offered by borrowers,

Higher risk and higher inflation also lead to higher interest rates.

1. finmarkets 3rd a - financial sysytem

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