1. CHAPTER 2 Basics of Finance
FINANCIAL SYSTEM 1. Financial Assets 2. Financial Markets 3. Financial Institutions
Med Jaouad-Principles of Finance, PIIMT 2011

2. Financial System
An institutional framework existing in a country to enable financial transactions
Three main parts
Financial assets (loans, deposits, bonds, equities, etc.)
Financial institutions (banks, mutual funds, insurance companies, etc.)
Financial markets (money market, capital market, forex market, etc.)
Regulation is another aspect of the financial system

3. Basic definition of Financial Assets
An asset is a legal contract between two counterparties.
An asset has a defined maturity.
Any asset is described as a “defined cash flow” expected at a “defined maturity”.
Thus, every asset can be described as a series of (expected cash flow, cash flow-maturity) pairs.
Cash flows can be either fixed or random, positive or negative.
Cash flow-maturity: at what point in time is the cash flow expected.

4. Financial Asset: Definition
It is a financial claim on an asset that is usually documented by some type of legal representation. Examples include bonds and stocks vs physical and tangible assets such as real estate or gold.
 It is non-physical asset. Examples of financial assets include bank accounts and shares in a publicly-traded company.
Financial assets are distinguished from physical assets like real estate and personal property.
They represent a claim to the payment of a sum of money sometime in the future and/or periodic payment in the form of interest or dividend.

5. Financial Assets as sets of (cash flow, maturity) pairs
Based on the asset-maturity, and features of it’s cash flow, financial assets fall into the following broad categories:
Assets with fixed (deterministic) cash flows and fixed maturities: loans, bonds
Assets with fixed cash flows and uncertain maturities: insurance products
Assets with uncertain cash flows and fixed maturities: derivatives (options, swaps, …)
Assets with uncertain cash flows and uncertain maturities: equity

6. Types of financial risk
Financial assets are state–contingent claims:
at time t = 0, there is always a probability of a non-positive payoff at time t = 1.
Each asset has an expected payoff.
Uncertainty about the expected payoff is the risk of a financial asset.
In finance, this risk is captured as fluctuations in the observed value of the asset at every point in time, and is broken down into the following components:
Systemic market risk
Liquidity risk
Credit risk
Legal and institutional risk

7. Financial Markets
Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds
Promote 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

8. Financial Market: Direct finance and Indirect finance
Direct finance – funds are directly transferred from lenders to borrowers
Indirect finance – financial intermediaries receive funds from savers and lend them to borrowers
Securities are assets for the holder and liabilities for the issuer

9. Allows transfers of funds from person or business without investment
opportunities to one who has them
2. Improves economic efficiency

10. Structure of Financial Markets
Debt and Equity Markets
Debt instruments – contractual obligation to pay the holder fixed payments at specified dates (e.g., mortgages, bonds, car loans, student loans)
Short-term debt instruments have a maturity of less than one year
Intermediate-term debt instruments have a maturity between 1 and 10 years
Long-term debt instruments have a maturity of ten or more years
Equity – sale of ownership share (owners are residual claimants).
Owners of stock may receive dividends

11. Structure of Financial Markets
Primary and Secondary Markets
Primary market = financial market in which newly issued securities are sold.
Secondary market = financial market in which previously owned securities are sold.
Investment Banks underwrite securities in primary markets
Brokers and dealers work in secondary markets
Broker – match buyers and sellers
Dealers – buy and sell securities

12. Financial Markets Stocks and Bonds securities Firms Sara Ali money
Primary Market
Secondary Market

13. Structure of Financial Markets
Roles of Secondary Markets
Increase liquidity of financial assets
Determine security prices that help determine the price of securities in primary markets
Exchanges and Over-the-Counter (OTC) Markets
Exchange – buyers and sellers meet in one central location (e.g., NYSE or CSE)
Over-the-counter market – transactions take place in multiple locations through dealers

14. Structure of Financial Markets
Money and Capital Markets
Money markets deal in short-term debt instruments
Capital markets deal in intermediate and longer-term debt and equity instruments

15. Financial Market Instruments
Money Market Instruments
Treasury bonds/bills: 1-, 3-, 6-month maturities, discounted; no default risk
Negotiable bank certificates of deposit (NCD): transferable in the secondary markets, large denominations
Commercial paper (CP): issued by large banks or well-known corporations, direct finance; largest instrument
Banker’s Acceptances: can be resold in the secondary markets, use abroad in international trade
Repurchase Agreements (repos): treasury bills are used to serve as collateral, <2 weeks
Central Bank/Fed funds: overnight loan b/w banks of their deposits at Fed/Central Bank

16. Financial Market Instruments
Capital Market Instruments
Stocks: largest instruments, hold by individuals , pensions, mutual funds, and insurance companies
Mortgages.
Corporate bonds: convertible or non-convertible
Government securities (bonds, bills): issued by the Treasury, most liquid security
State and local government bonds: also called municipal bonds, interest-exemption
Consumer and bank commercial loans

17. The Firm and the Financial Markets
Firm issues securities (A)
Invests in assets (B)
Retained cash flows (F)
Cash flow from firm (C)
Dividends and debt payments (E)
Short-term debt
Long-term debt
Equity shares
Current assets Fixed assets
Taxes (D)
The cash flows from the firm must exceed the cash flows from the financial markets.
Ultimately, the firm must be a cash generating activity.
Government

18. Internationalization of Financial Markets
Foreign Bonds—sold in a foreign country and denominated in that country’s currency
Foreign bonds may be used to avoid exchange-rate risk
Eurobond—bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies—foreign currencies deposited in banks outside the home country
Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
World Stock Markets
Casablanca, London, Tokyo and other foreign stock exchanges have grown in importance

19. Investment Environment

20. Financial Institution: Definition
It is an organization that acts as a channel between savers and borrowers of funds (suppliers and consumers of capital).
It could be Private (shareholder-owned) or Public (government-owned)
Two main types of financial institutions are:
Depository banks and credit unions which pay interest on deposits from the interest earned on the loans, and
Non-depository insurance companies and mutual funds (unit trusts) which collect funds by selling their policies or shares (units) to the public and provide returns in the form of periodic benefits and profit payouts.

21. Function of Financial Intermediaries: Indirect Finance
Lower transaction costs
Economies of scale
Liquidity services
Reduce Risk
Risk Sharing (Asset Transformation)
Diversification
Asymmetric Information
Adverse Selection (before the transaction)—more likely to select risky borrower
Moral Hazard (after the transaction)—less likely borrower will repay loan

22. Function of Financial Intermediaries: Indirect Finance
Adverse Selection: Individuals who are willing to accept a financial (or other) contract are of lower “quality” than a typical individual in the population
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected
Moral Hazard: The existence of a contract causes one party to alter their behavior in a manner detrimental to the other party
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

23. Types of financial intermediaries
Depository institutions
Commercial banks
Savings and Loan Associations
Mutual savings banks
Credit unions
Contractual savings institutions
Life insurance companies
Fire and casualty insurance companies
Pension funds and government retirement funds
Investment intermediaries
Finance companies
Mutual funds
Money market mutual funds
Investment banks

24. Regulation of the Financial System
Two Main Reasons for Regulation
To increase the information available to investors:
Reduce adverse selection and moral hazard problems
Force corporations to disclose information to reduce insider trading
To ensure the soundness of financial intermediaries:
Restrictions on entry
Disclosure Laws
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates

25. Quiz 2
1.Define: Financial Asset, Financial Market and Financial Institution 2. Discuss how these three elements are related 3. Characterize these financial assets : Bonds, Insurance Products, Derivatives and Equity, according to their expected cash flow and asset-maturity