1. © 2008 Pearson Education Canada
Chapter 2
An Overview of the Financial System
© 2008 Pearson Education Canada

2. An Overview of the Financial System
Primary Function of the Financial System is Financial Intermediation
The channeling of funds from households, firms and governments who have surplus funds (savers) to those who have a shortage of funds (borrowers).
© 2008 Pearson Education Canada

3. An Overview of the Financial System
© 2008 Pearson Education Canada

4. Classifications of Financial Markets
Debt Markets
Short-term (maturity < 1 year) – the Money Market
Long-term (maturity > 10 year) – the Capital Market
Medium-term (maturity >1 and < 10 years)
© 2008 Pearson Education Canada

5. Classifications of Financial Markets
Equity Markets - Common stocks
Primary Market - New security issues sold to initial buyers
Secondary Market - Securities previously issued are bought and sold
© 2008 Pearson Education Canada

6. Classifications of Financial Markets (Cont’d)
Secondary Markets
Exchanges
Trades conducted in central locations (e.g., Toronto Stock Exchange and New York Stock Exchange)
Over-the-Counter Markets
Dealers at different locations buy and sell
© 2008 Pearson Education Canada

7. Financial Market Instruments
© 2008 Pearson Education Canada

8. Financial Market Instruments (Cont’d)
Other Money Market Instruments
Certificates of deposit
Repurchase agreements
Overnight funds
© 2008 Pearson Education Canada

9. Financial Market Instruments (Cont’d)
© 2008 Pearson Education Canada

10. Financial Market Instruments (Cont’d)
Other Capital Market Instruments
Canada savings bonds
Provincial and municipal bonds
Government agencies securities
© 2008 Pearson Education Canada

11. Internationalization of Financial Markets
International Bond Market
Foreign bonds - sold in a foreign country and denominated in that country
Eurobonds – denominated in a currency other than the country in which it is sold
Eurocurrencies – foreign currencies deposited in banks outside the home country
© 2008 Pearson Education Canada

12. © 2008 Pearson Education Canada
World Stock Markets
© 2008 Pearson Education Canada

13. Function of Financial Intermediaries
Engage in process of indirect finance
Are needed because of transactions costs and
asymmetric information
© 2008 Pearson Education Canada

14. Function of Financial Intermediaries (Cont’d)
Transactions Costs
1. Financial intermediaries make profits by
reducing transactions costs.
2. They reduce transactions costs by developing
expertise and taking advantage of
economies of scale.
© 2008 Pearson Education Canada

15. Function of Financial Intermediaries (Cont’d)
Risk Sharing
Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation)
Lower risk by helping people to diversify portfolios
© 2008 Pearson Education Canada

16. Asymmetric Information
Adverse Selection
Before transaction occurs
Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected
© 2008 Pearson Education Canada

17. Asymmetric Information (Cont’d)
Moral Hazard
After transaction occurs
Hazard that borrower has incentives to engage in undesirable activities making it more likely that loan won’t be paid back
© 2008 Pearson Education Canada

18. Financial Intermediaries
© 2008 Pearson Education Canada

19. Size of Financial Intermediaries
© 2008 Pearson Education Canada

20. Regulation of Financial Markets
© 2008 Pearson Education Canada

21. Regulation of Financial Markets
Primary Reasons for Regulation
Increase information to investors
- Decreases adverse selection and moral hazard problems
- Securities commissions force corporations to disclose information
© 2008 Pearson Education Canada

22. Regulation of Financial Markets (Cont’d)
Primary Reasons for Regulation (continued)
2. Ensuring the soundness of intermediaries
Prevents financial panics
Restrictions on entry/assets/activities, disclosure, deposit insurance, limits on competition
© 2008 Pearson Education Canada