Untitled Quiz

The Financial System

• Set of frameworks, institutions, and players facilitating financial transactions in an economy.
• Includes financial markets, institutions, economic agents, legal/regulatory frameworks, and transaction execution systems.

Regulation of the Financial System

• Heavily regulated due to its crucial role in economic health.
• Government regulation aims to:
  • Increase information available to investors.
  • Ensure the safety and soundness of the financial system.

Increasing Information Available to Investors

• Asymmetric information in markets can lead to adverse selection and moral hazard, hindering efficiency.
• Risky firms may exploit investors, leading to adverse selection and discouraging investment.
• Borrowers may engage in risky activities or fraud due to moral hazard.

Moral Hazard

• Occurs when a party takes risks knowing they are protected from consequences.
• Motivated by the desire for profits or lack of information about potential losses.

Adverse Selection

• Occurs when one party has more information than the other, leading to skewed decisions.
• Can result in businesses focusing on riskier or less profitable segments due to information asymmetry.

Functions of Financial Markets

• Price Determination: Market forces (demand and supply) determine prices for newly issued and existing financial assets.
• Funds Mobilization: Markets facilitate the mobilization of investors' savings.
• Liquidity: Investors can easily convert securities into cash, providing liquidity.
• Risk Sharing: Financial markets transfer investment risks from those who undertake them to those who provide funds.
• Easy Access: Platforms connect buyers and sellers efficiently, saving time and money.
• Reduced Transaction Costs and Information Provision: Markets provide readily available information to traders.
• Capital Formation: New savings flow into the country, supporting capital formation.

Flow of Funds in a Financial System

• Lender-savers: Primarily households, but can include firms and governments with excess funds.
• Borrower-spenders: Typically businesses and governments, but households can also participate.
• Direct Finance: Borrowers sell securities to lenders in financial markets, creating claims on future income or assets.

Types of Financial Markets

• Money and Capital Markets: Distinguished based on maturity of instruments (short-term vs. long-term).
• Primary and Secondary Markets: Primary markets deal with first-time issuance of securities, while secondary markets handle subsequent trading.
• Debt and Equity Markets: Debt markets involve borrowing and lending of money (bonds), while equity markets represent ownership stakes (stocks).
• Exchanges and Over-the-Counter Markets: Exchanges provide centralized trading platforms, while over-the-counter markets involve direct transactions between parties.
• Internationalization of Financial Markets: Growing interconnectedness and globalization of financial markets.

Money Markets

• Handle short-term, highly marketable debt securities.
• Instruments typically traded in large denominations, not suitable for individual investors.
  • Treasury bills: Highly marketable, short-term government debt.
  • Certificates of deposit: Time deposits with banks, paying interest and principal upon maturity.
  • Commercial paper: Short-term unsecured debt notes issued by large corporations.
  • Eurocurrency: Foreign currency deposits held in local banks (e.g., Eurodollar deposit).
  • Bankers' acceptances: Order to a bank to pay a sum at a future date, similar to a postdated check.

Capital Markets

• Deal with long-term debt and equity securities for long-term financing needs.
  • Treasury (Government) bonds: Issued by governments to borrow from the public.
  • Eurobonds: Bonds issued in foreign currency.
  • Corporate bonds: Issued by companies to raise debt finance, can be unsecured (debentures), secured, callable or convertible.

Primary and Secondary Markets

• Primary Market: Market for new, first-time issuance of financial securities.
• Secondary Market: Market for subsequent trading of existing securities, providing liquidity and supporting primary market operations.

Financial Intermediation

• Intermediation: Financial transactions facilitated by intermediaries (banks, dealers).
• Disintermediation: Transactions directly between parties bypassing intermediaries.

Main Functions of Intermediaries

• Bringing together savers and borrowers: Provide liquidity.
• Risk Pooling and Reduction: Pooling assets and reducing risk through diversification.
• Repackaging Finance: Transform financial instruments to meet specific needs.
• Maturity Transformation: Convert short-term liabilities into long-term assets.
• Efficient Allocation of Information: Provide information and expertise to market participants.
• Provide Clearing Houses: Settle trades efficiently.

Financial Assets

• Financial assets: Claims on income or ownership of real assets.
• Fixed Income Securities (Debt securities): Provide periodic income payments at fixed rates.
  • Short-term debt securities: Money market instruments.
  • Long-term debt securities: Capital market instruments.
• Equity Securities: Represent ownership stake in a business.
  • Value fluctuates with firm performance.
  • Riskier than debt securities.
  • Residual claim on income and assets.