Chapter 2

An Overview of the Financial

System

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Function of Financial Markets

• Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds

• Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities

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Function of Financial Markets (cont’d)

• Promotes economic efficiency by producing an efficient allocation of capital, which increases production

• Directly improve the well-being of consumers by allowing them to time purchases better

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Figure 1 Flows of Funds Through the Financial System

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Structure of Financial Markets

• Debt and Equity Markets

– Debt instruments (maturity)

– Equities (dividends)

• Primary and Secondary Markets– Investment Banks underwrite securities in

primary markets– Brokers and dealers work in secondary markets

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Structure of Financial Markets (cont’d)

• Exchanges and Over-the-Counter (OTC) Markets

– Exchanges: NYSE, Chicago Board of Trade

– OTC Markets: Foreign exchange, Federal funds

• Money and Capital Markets– Money markets deal in short-term debt

instruments– Capital markets deal in longer-term debt and

equity instruments

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Table 1 Principal Money Market Instruments

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Table 2 Principal Capital Market Instruments

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Internationalization of Financial Markets

• Foreign Bonds: sold in a foreign country and denominated in that country’s currency

• Eurobond: bond denominated in a currency other than that of the country in which it is sold

• Eurocurrencies: foreign currencies deposited in banks outside the home country– Eurodollars: U.S. dollars deposited in foreign banks outside

the U.S. or in foreign branches of U.S. banks

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Function of Financial Intermediaries: Indirect Finance

• Lower transaction costs (time and money spent in carrying out financial transactions) – Economies of scale– Liquidity services

• Reduce the exposure of investors to risk– Risk Sharing (Asset Transformation)– Diversification

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Function of Financial Intermediaries: Indirect Finance (cont’d)

Deal with asymmetric information problems(before the transaction) Adverse Selection: try to avoid selecting the risky borrower.

Gather information about potential borrower.

(after the transaction) Moral Hazard: ensure borrower will not engage in activities that will prevent him/her to repay the loan.

Sign a contract with restrictive covenants.

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Function of Financial Intermediaries: Indirect Finance (cont’d)

• Conclusion:– Financial intermediaries allow “small” savers

and borrowers to benefit from the existence of financial markets.

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Table 3 Primary Assets and Liabilities of Financial Intermediaries

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Table 4 Principal Financial Intermediaries and Value of Their Assets

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Regulation of the Financial System

• To increase the information available to investors:– Reduce adverse selection and moral hazard

problems– Reduce insider trading (SEC).

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Supplementary Notes:

• Investment Banks• NYSE • HKEx• OTC• OTC Markets: CMU in Hong Kong

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Internationalization of Financial Markets

The number of international stock market indexes is quite large.

Dow (道瓊斯工業平均指數 ) S&P 500 (標準普爾 500指數 ) Nikkei 225 (東京日經 225指數 ) FTSE 100 (倫敦富時 100指數 ) Hang Seng Index (恒生指數 )

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Glossary• Federal (Fed) Funds: These instruments are

typically overnight loans between banks of their deposits at the Federal Reserve.

• Federal funds rate: The interest rate on overnight loans of deposits at the Federal Reserve.

• Repurchase agreement (repo): An arrangement whereby the Fed, or another party, purchases securities with the understanding that the seller will repurchase them in a short period of time, usually less than a week.

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Glossary

• Risk sharing: The process of creating and selling assets with risk characteristics that people are comfortable with and then using the funds acquired by selling these assets to purchase other assets that may have far more risk.

• The process of risk sharing is also sometimes referred to as asset transformation, because in a sense, risky assets are turned into safer assets for investors.