Chapter 2 - Financial Market (Part 1) PDF

TOPIC 2: FINANCIAL MARKETS (PART 1) 2.1 INTRODUCTION 2.2 FINANCIAL SYSTEMS 2.2.1 DEFINITION OF FINANCIAL SYSTEMS 2.2.2 FLOW OF FUNDS MECHANISM 2.3 BASIC COMPONENTS OF THE FINANCIAL SYSTEMS 2.3.1 FINANCIAL INSTITUTIONS 2.3.2 FINANCIALMARKETS 2.3.2.1 THE ROLE OF FINANCIAL MARKETS 2.3.2.2 TYPES OF F...

TOPIC 2: FINANCIAL MARKETS (PART 1) 2.1 INTRODUCTION 2.2 FINANCIAL SYSTEMS 2.2.1 DEFINITION OF FINANCIAL SYSTEMS 2.2.2 FLOW OF FUNDS MECHANISM 2.3 BASIC COMPONENTS OF THE FINANCIAL SYSTEMS 2.3.1 FINANCIAL INSTITUTIONS 2.3.2 FINANCIALMARKETS 2.3.2.1 THE ROLE OF FINANCIAL MARKETS 2.3.2.2 TYPES OF FINANCIAL MARKETS 2.4 FINANCIAL ASSETS: INSTRUMENTS TRADED IN FINANCIAL MARKETS 2.4.1 DEFINITION OF ASSETS 2.4.2 TYPES OF FINANCIAL ASSETS 2.4.3 PROPERTIES OF FINANCIAL ASSETS Learning outcomes: 1. Understanding the structure and components of financial systems. 2. Explain the role of financial markets in capital allocation and resource mobilization. 3. Identifying the different types of financial markets and their characteristics. 4. Learning about the properties and features of financial assets to make informed investment decisions. 1|Page 2.1 INTRODUCTION Governmental bodies, business firms, non-profitable and charitable organizations (NGO) are often in need of external capital. Other than borrowing from financial intermediaries such as commercial banks, these entities can also seek funds from financial markets. Financial markets serve as avenues (a way of access) for demanders and suppliers of funds to meet for transfer of capital. 2.2 FINANCIAL SYSTEMS 2.2.1 DEFINITION OF FINANCIAL SYSTEMS Financial system is defined in economics and finance studies as: “A system that provides efficient flow of funds from saving to investment by bringing savers and borrowers together via financial markets and financial institutions.” 2.2.2 FLOW OF FUNDS MECHANISM Based on the illustration in Figure 2.1, its shows the flow of funds mechanism from surplus spending units to deficit spending units. The flow of funds mechanism start when a group of people (known as ‘surplus spending units’) have investible funds. These surplus spending units people obtain surplus monies that require to be invested somewhere to earn additional returns. Meanwhile, there exists another group known as ‘deficit spending units’. These group consumes monies and are currently in need to raise additional funding. Therefore, the financial system plays an important role in facilitating the flow and efficient allocation of funds from one group (surplus spending units) to another group that require funds (deficit spending units). The greater the flow of funds, the greater shall be the accommodation of individual’s preference for spending and saving. 2|Page 2.3 BASIC COMPONENTS OF THE FINANCIAL SYSTEM There are TWO basic components of financial system – Financial Institutions and Financial Markets. 2.3.1 FINANCIAL INSTITUTIONS  Financial Institutions serve as intermediaries that channel the deposits of individuals, business and government into loans or investments.  These are institutions that facilitate the flow of funds from savers to borrowers. They include:  Commercial banks, (e.g: Maybank, CIMB Bank)  Savings institutions, (e.g: Bank Simpanan Nasional, Bank Rakyat)  Insurance companies, (e.g: Takaful Insurance, AIA Insurance)  Pension funds, (e.g: KWSP, SOCSO)  Finance companies ( e.g: Aeon Credit Service (M) Berhad)  Mutual funds (e.g: Kenanga Investors berhad) 2.3.2 FINANCIAL MARKETS  Financial Markets are represents location where important parties such as investors, firms and government agencies can meet and perform transaction and facilitate the flow of funds.  Also refers as markets for financial instruments Below are the summary of Financial Institutions and Financial Markets. Financial Institutions Financial Market  Intermediaries that channel the deposits of  Location where important parties individuals, business and government into such as investors, firms and loans or investments. government agencies can meet and perform transaction and facilitate the flow of funds.  Involved indirect financing  Involved direct financing  Consist of:  Consists of:  Commercial banks  Money markets  Saving institutions  Capital markets  Insurance companies  Pension funds  Finance companies  Mutual funds 3|Page 2.3.2.1 THE ROLE OF FINANCIAL MARKETS Financial markets exist to help in the transaction of financial assets. They are able to do so through the following ways. i. Price ❖ Financial markets serve as a platform where buyers and sellers Discovery express their views on the value of an asset by stating the prices at which they are willing to transact. ❖ A clearing price can be determined when the demand and the supply schedule meet. ii. Provision of ❖ Provision of liquidity refers to the ability of ensuring that financial Liquidity markets or institutions have sufficient funds available to facilitate transactions and meet immediate demands. ❖ Financial markets provide a place whereby willing buyers and sellers can gather to transact, via physically or electronically. iii. Reduction of ❖ Financial markets reduce transaction cost in TWO ways: Transaction o Reduction of search costs. Costs - Financial markets provide a convenient venue where willing sellers can find suitable and willing buyers to facilitate asset transactions. - Without financial markets, a willing seller would need to spend significant time, effort and cost to find a willing buyer. o Reduction of contracting costs. - When buyers and sellers need to draft their own contracts for exchange, significant time and money would be spent for reaching an agreement on the terms and conditions. - Through financial markets, the terms and conditions of contracts are standardized and implicit in every trade, making them completely transparent to traders. - This helps buyers and sellers minimize contracting costs during asset transactions. 4|Page 2.3.2.2 TYPES OF FINANCIAL MARKETS (A) Primary Market Vs Secondary Market Primary market Secondary market  Market where new securities are bought  Market where the holder of existing and sold for the first time. securities sells the security concerned to another investor.  The issuer is directly involved in the transaction and receives the proceeds  Provide the means for transferring from the sale of securities. ownership of a security (debt/equity)  TWO types of primary market activities:  The issuer of the securities is not  Public Offerings involved in the transactions and does  Private Placements not receive the proceeds from the sale.  Example 1:  Example 2: TNB issued and sold directly new Based on example 1, the share price later shares to the public at RM5 per share. rises to RM6 each and the current This transaction is occur in primary investor sell the share to another market. investor. This transaction can be done through broker and it occur in secondary market. (B) Money Market Vs Capital Market Money Market Capital Market Buying and selling the of short term Buying and selling the of long-term instruments (Less than one year) instruments (More than one year) Issued by firms and government. Issued by firms and government. Low risk High risk Low return High return High liquidity Low liquidity Example: Example:  Commercial paper  Equity securities  Government Paper  Long-term debt securities 5|Page 2.4 FINANCIAL ASSETS: INTRUMENTS TRADED IN FINANCIAL MARKETS 2.4.1 DEFINITION  Asset is: “Any possession that has value in an exchange.”  Assets can be tangible or intangible. 2.4.2 TYPES OF ASSETS There are TWO types of assets – Tangible Assets and Intangible Assets. Tangible Assets Intangible Assets  Assets that we can see and  Legal claims to future benefits, and touch. financial assets fall under this category.  The value of the assets will  Example: depend on their physical  Shares give legal claim to properties. future dividends & liquidation  Example: value  Size of land  Bonds give legal claim to  Age of building coupon payments &  Make of car repayment of the par value at maturity 2.4.3 PROPERTIES OF FINANCIAL ASSETS Financial assets have many properties. These properties are important as they affect the value of the assets and the way they are traded and exchanged. Properties Explanation (Characteristics) Moneyness  Money is a medium of exchange.  Example: i. Cash  Can be used directly in exchange for goods and services. ii. Cheques  Can be used as a near cash substitute, and hence can be considered as near money. iii. Saving deposits  Can also be considered as near money as they can be quickly and easily converted into cash or money 6|Page Divisibility  Divisibility is the minimum size of the assets in an exchange.  Example: (Ability to divide the  Bank deposits are almost infinitely divisible as one can particular assets into deposit or withdraw up to the nearest cent. smaller units)  Treasury bills and bonds for most countries are traded in a denomination of $1,000.  Shares are traded in lot sizes, for example, one round lot contains 1,000 shares. Reversibility  Reversibility is the ease of reversing on a deal.  For example, if one purchases the shares, how easy would it be (Ability to undo or for him to sell those shares? reverse a particular  Such ease of reversibility can be measured by the round-trip action or operation) cost.  The most common round-trip cost is the bid-offer spread. o The bid price is the price that the market is willing to buy from the investors. o The offer price is the price that the market is willing to sell to him.  Other types of round-trip costs include the commission or brokerage fees that one has to pay to the middleman, such as a broker or a brokerage firm, for the transaction. Maturity  Maturity is a particular time when the asset will cease to exist.  Time deposits have maturity dates.  Example:  Banks normally accept time deposits of 3, 6, 9, 12 and 24 months.  Treasury bills have shorter time to maturity  Corporate bonds have longer time to maturity. Liquidity  Liquidity is generally a function of how much one would lose if he/she were to liquidate the asset immediately.  If there are many ready buyers and sellers willing to buy or sell a particular asset and the price of the asset can be efficiently determined, we say that the asset is liquid.  A good measure of the liquidity of the assets is the size of the bid and offer spread.  Generally speaking, the smaller the spread, the more liquid is the asset is. 7|Page Currency  Assets are normally denominated in a particular currency.  Example:  Malaysian Ringgit (MYR)  US dollars (USD),  Singapore dollars (SGD Risk  There are TWO risk that an asset is exposed to.  Credit risk - Risk of the counterparty defaulting on his financial obligation. - For example, an investor investing in the bond of a firm will stand to lose if the firm goes into bankruptcy and cannot meet its obligation to service the interest (coupon) payment or the par value at maturity.  Price risk - Risk that refers to the fluctuation of the price of the asset. - A common measure of price risk is the volatility of the price or returns of the asset computed as the variance or standard deviation of the price or returns. 8|Page