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  • Chapter 2An Overview of the Financial System

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    Function of Financial MarketsPerform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of fundsDirect finance: borrowers borrow funds directly from lenders in financial markets by selling them securities

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    Function of Financial Markets (contd)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 MarketsDebt and Equity MarketsDebt instruments (maturity)Equities (dividends)Primary and Secondary MarketsInvestment Banks underwrite securities in primary marketsBrokers and dealers work in secondary markets

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    Structure of Financial Markets (contd)Exchanges and Over-the-Counter (OTC) MarketsExchanges: NYSE, Chicago Board of TradeOTC Markets: Foreign exchange, Federal fundsMoney and Capital MarketsMoney markets deal in short-term debt instrumentsCapital 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 MarketsForeign Bonds: sold in a foreign country and denominated in that countrys currencyEurobond: bond denominated in a currency other than that of the country in which it is soldEurocurrencies: foreign currencies deposited in banks outside the home countryEurodollars: 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 FinanceLower transaction costs (time and money spent in carrying out financial transactions) Economies of scaleLiquidity servicesReduce the exposure of investors to riskRisk Sharing (Asset Transformation)Diversification

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    Function of Financial Intermediaries: Indirect Finance (contd)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 (contd)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 SystemTo increase the information available to investors:Reduce adverse selection and moral hazard problemsReduce insider trading (SEC).

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    Supplementary Notes:Investment BanksNYSE HKExOTCOTC Markets: CMU in Hong Kong

    Copyright 2010 Pearson Addison-Wesley. All rights reserved.2-*

    Copyright 2009 Pearson Prentice Hall. All rights reserved.2-*Internationalization of Financial MarketsThe number of international stock market indexes is quite large. Dow () S&P 500 (500) Nikkei 225 (225) FTSE 100 (100) Hang Seng Index ()

    Copyright 2009 Pearson Prentice Hall. All rights reserved.

    Copyright 2010 Pearson Addison-Wesley. All rights reserved.2-*

    GlossaryFederal (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.

    Copyright 2010 Pearson Addison-Wesley. All rights reserved.2-*

    Copyright 2010 Pearson Addison-Wesley. All rights reserved.2-*

    GlossaryRisk 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.

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