FMI - Chapter 1, Overview of The Financial System PDF

Chapter One Overview of the Financial System Asamnew T Department of Accounting and Finance, Addis Ababa University  Chapter Objectives  Understanding the role of financial system in the economy  Understanding financial assets: its characteristics and roles  Understanding what a financial...

Chapter One Overview of the Financial System Asamnew T Department of Accounting and Finance, Addis Ababa University  Chapter Objectives  Understanding the role of financial system in the economy  Understanding financial assets: its characteristics and roles  Understanding what a financial market is, its classifications, its actors  Understanding function of financial intermediaries: Lending and borrowing in the financial system Financial System  What is a financial system?  An economic arrangement wherein financial institutions facilitate the transfer of funds and assets between borrowers, lenders, and investors.  Financial System  The financial system has six parts, each of which plays a fundamental role in our economy. Those parts are:  money,  financial instruments,  financial markets,  financial institutions,  government regulatory agencies, and  central banks.  Financial System…  We use money to pay for our purchases and to store our wealth.  We use financial instruments, to transfer resources from savers to investors and to transfer risk to those who are best equipped to bear it. Stocks, mortgages, and insurance policies are examples of financial instruments.  financial markets allows us to buy and sell financial instruments quickly and cheaply  Financial System…  Financial institutions provide a myriad of services, including access to the financial markets and collection of information about prospective borrowers to ensure they are creditworthy.  Government regulatory agencies are responsible for making sure that the elements of the financial system—including its instruments, markets, and institutions—operate in a safe and reliable manner.  central banks monitor and stabilize the economy. National bank of Ethiopia is our central bank  Core Functions OF A Financial System 1. The investment chain 2. Risk Management 3. Payment systems 4. Providing information  1. The investment chain  Through the investment chain, savers and borrowers are brought together.  Savers provide financing to businesses, and businesses that wish to grow offer opportunities for savers to take part in the growth and resulting potential returns.  The efficiency of this chain is critical to allocating what would otherwise be uninvested capital to businesses ………….that can use it to grow their enterprises  1. The investment chain…..  Pooling resources and subdividing shares Financial systems enable multiple investors to contribute to projects that no one of them alone could afford.  Transferring resources across time and space. Firms in one industry, or in one location, may seek to invest surplus funds in other industries or at other locations.  2. Managing Risk  Financial systems provide ways for investors to exchange, and thereby to control, risks. For example,  insurance enables the pooling of risks,  hedging enables the transfer of risk to speculators,  diversification exploits low correlations that may exist among risky projects  3. Payment systems  Financial systems provide mechanisms that facilitate exchanges of goods and services, as well as assets, followed by settlement, transferring ownership in return for the agreed remuneration.  It is an essential requirement for commercial activities to take place and for participation in international trade and investment.  4. Providing information  One of the most prominent friction in the financial market is asymmetric information  Financial markets, institutions and intermediaries produce useful information of potential borrowers to investors.  Financial systems enable price discovery – that is, for those who wish to trade to observe the prices (rates of exchange) at which agreements can be made. – other information, for example about expectations of future asset price volatility, can be inferred from market prices.  Financial Assets  An asset, broadly speaking, is any possession that has value in an exchange.  Assets can be classified as tangible or intangible. A tangible asset is one whose value depends on particular physical properties—examples are buildings, land, or machinery. Intangible assets, by contrast, represent legal claims to some future benefit.  Their value bears no relation to the form, physical or otherwise, in which these claims are recorded.  Financial assets are intangible assets. For financial assets, the typical benefit or value is a claim to future cash.  Real Assets Vs Financial Assets Real Assets: - are assets used in the process of production in the economy, i.e. item such as factories machinery , patents, humans capital, , , knowledge. Financial assets: - are claims to the output of the production process. In other words, they are legal contract representing the right to receive future financial benefits under a stated set of conditions. E.g. equity bonds (corporate/ deposit with banks shares, government), mutual fund shares, insurance policies, and derivative , instruments  Financial Assets…  The claim that the holder of a financial asset has may be either a fixed dollar amount or a varying, or residual, amount. In the former case, the financial asset is referred to as a debt instrument. An equity instrument (also called a residual claim) obligates the issuer of the financial asset to pay the holder an amount based on earnings, if any, after holders of debt instruments have been paid. Some securities fall into both categories….Preferred stock Both debt and preferred stock that pay fixed dollar amounts are called fixed-income instruments.  The Price of a Financial Asset and Risk  A basic economic principle is that the price of any financial asset is equal to the present value of its expected cash flow, even if the cash flow is not known with certainty. By cash flow, we mean the stream of cash payments over time.  Financial Assets versus Tangible Assets  Both are expected to generate future cash flow for their owner  Financial assets and tangible assets are linked. Ownership of tangible assets is financed by the issuance of some type of financial asset—either debt instruments or equity instruments Ultimately, the cash flow for a financial asset is generated by some tangible asset.  PROPERTIES OF FINANCIAL ASSETS  Moneyness  Divisibility and Denomination  reversibility,  cash flow,  term to maturity,  convertibility,  currency,  liquidity,  return predictability, and  complexity Financial Systems - Approaches ◼ Faced with end users desire (lend or borrow), there are three approaches: ◼ First, they may decide to deal directly with one another. ◼ Second, they may decide to deal via markets ◼ Third, they may decide to deal via intermediaries. L B Markets Intermediaries  Financial Markets  In a market economy, the allocation of economic resources is driven by the outcome of many private decisions Prices are signals that direct economic resources to their best use  Financial Markets…  Two types of markets in an economy: 1. The market for products (manufactured goods and services) 2. The market for factors of production( labor and capital)  Our focus is one part of the factor market, the market for financial assets……financial market  Financial Markets….  A financial market is a market where financial assets are exchanged (i.e.» traded).  Financial markets are markets in which funds are transferred from people and firms who have an excess of available funds to people and firms who have a need of funds. Financial Markets…  Financial markets, such as bond and stock markets, are crucial in an economy.  These markets channel funds from savers to investors, thereby promoting economic efficiency.  Well functioning financial markets, such as the bond market, stock market, and foreign exchange market, are key factors in producing high economic growth.  Financial Markets…  Debt markets, or bond markets, allow governments, corporations, and individuals to borrow to finance activities.  In this market, borrowers issue a security, called a bond, that promises the timely payment of interest and principal over some specific time horizon.  The interest rate is the cost of borrowing.  There are many different types of market interest rates, including mortgage rates, car loan rates, credit card rates, etc.  Financial Markets…  The stock market is the market where common stock (or just stock), representing ownership in a company, are traded.  Companies initially sell stock (in the primary market) to raise money. But after that, the stock is traded among investors (secondary market).  The foreign exchange market is where international currencies trade and exchange rates are set.  Foreign exchange (FX) markets are the largest of all financial markets, with average daily turnover in excess of US$5 trillion.  Financial Markets…  Exercise: Of all the active markets, the stock market receives the most attention from the media. Why? Functions of Financial Market Financial markets provide the following three major ◼ economic functions: ❑ Price discovery ❑ Liquidity ❑ Reduced transaction costs ◼ Price discovery: ◼ Since the interactions of buyers and sellers in a Financial market determine the price of the traded asset, they determine the required return that participants in a financial market demand in order to buy a financial instrument. Functions of Financial Market Functions of Financial Market  Functions of Financial Market Reduced Transaction Costs: ◼ This is performed when Financial Market participants are charged and /or bear the costs of trading a financial instruments. Functions of Financial Market Functions of Financial Market  Classification of Financial Markets  There are many ways to classify financial markets.   Financial Intermediaries  Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman: The intermediary obtains funds from savers The intermediary then makes loans/investments with borrowers  This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers.  More important source of finance than securities markets (such as stocks).  Financial Intermediaries…  Financial intermediary needed because of transactions costs, risk sharing, and asymmetric information 1. Transactions Costs Financial intermediaries make profits by reducing transactions costs. Reduce transactions costs by developing expertise and taking advantage of economies of scale. Financial Intermediaries… 2. Risk Sharing Financial Intermediaries low transaction costs allow them to reduce the exposure of investors to risk, through a process known as risk sharing. Financial Intermediaries create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party.  This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors.  Financial Intermediaries…  Financial intermediaries also help by providing the means for individuals and businesses to diversify their asset holdings.  Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.  Financial Intermediaries… 3. Asymmetric Information Another reason Financial intermediaries exist is to reduce the impact of asymmetric information. One party lacks crucial information about another party, impacting decision-making. We usually discuss this problem along two fronts: adverse selection and moral hazard.  Financial Intermediaries…  Adverse Selection Before transaction occurs Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan Similar problems occur with insurance where unhealthy people want their known medical problems covered Financial Intermediaries…  Moral Hazard After transaction occurs Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back Again, with insurance, people may engage in risky activities only after being insured  Another view is a conflict of interest Financial Intermediaries…  Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits.  Because of their expertise in screening and monitoring, they minimize their losses, earning a higher return on lending and paying higher yields to savers.  41 Types of Financial Intermediaries