1. An Overview of the Financial System
Chapter 2
An Overview of the Financial System

2. Function of Financial Markets
Perform the essential function of moving funds from economic players that have saved surplus funds to those that have a shortage of funds
Promotes 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
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4. Structure of Financial Markets
Debt and Equity Markets
A company or individual can get funds in 2 ways. The most common is to issue a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal) until a specified date (the maturity date) when a final payment is made.
Short term = less than a year
Intermediate term = 1 to 10 years
Long term = 10 years or longer
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5. Structure of Financial Markets
Debt and Equity Markets (continued)
The second method of getting funds is by issuing equities, such as common stock, which are claims to share in the net income and the assets of a business.
If you own 1 share of a company that has issued 1000 shares you own 1 1/1000 of the company’s assets. Equities often make periodic payments called Dividends.
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6. Structure of Financial Markets
Primary and Secondary Markets
A primary market is a market in which new issues of a security, a bond or stock, are sold to initial buyers by the company or government borrowing the funds.
Investment Banks underwrite securities in primary markets.
A secondary market is a market where securities have already been issued.
Brokers and dealers work in secondary markets.
Secondary markets can be organized in two ways:
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7. Structure of Financial Markets
Exchanges and Over-the-Counter Markets Exchanges are where buyers and sellers meet in a central location like the New York stock exchange. Over-the Counter (OTC) markets are where dealers and brokers sell securities “over the counter”.
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8. Structure of Financial Markets
Money and Capital Markets
Money Markets is a market in which only short-term debt instruments (usually with a maturity debt less than 1 year) are traded.
Capital Market is a market in which longer term debt (with maturity of a year or longer) and equity instruments are traded.
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9. Questions for Discussion
Why is a share of Microsoft common stock an asset for its owner and a liability for Microsoft?
If I buy a car today for $5,000 and it is worth $10,000 in extra income next year to me (I get a better job where I have to travel), should I take out a loan from a “loan shark” at a 90% interest rate if no one else will give me a loan? Will I be better or worse off for taking out this loan? Should we legalize loan –sharking?
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11. Financial Market Instruments
Money Market Instruments
US Treasury Bills are short term debt instruments of the US government issued in one, three and six month maturities to finance the federal government.
Negotiable Bank Certificates of Deposit is a debt instrument sold by banks to depositors that pays an annual interest of a given amount and at maturity pays back the original price.
Commercial Paper is a short term debt instrument issued by large banks and well known corporations, such as Microsoft and General Motors.
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12. Financial Market Instruments
Banker’s Acceptances This is a bank draft (like a check) issued by a company to be paid at a future date and guaranteed for a fee by the bank that stamps it “accepted”. This is mostly used when buying goods overseas as a guarantee that even if the foreign company purchasing the goods goes bankrupt the payment will still be made.
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14. Internationalization of Financial Markets
Foreign Bonds—sold in a foreign country and denominated in that country’s currency. For example, If German automaker Porsche sells a bond in the US denominated in US dollars, it is classified as a foreign bond.
A large percentage of US railroads built in the 1800’s were financed by sales of bonds in Britain.
Eurobond—bond denominated in a currency other than that of the country in which it is sold. For example, a bond in US dollars sold in London.
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15. Internationalization of Financial Markets
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.
Eurodollars have nothing to do with euros, but are instead US dollars deposited in banks outside US.
World Stock Markets
Many countries, like China, now have their own stock market. This is leading the way to a more integrated world economy in which flows of goods between countries is common.
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16. Questions for Discussion in 2’s or 4’s
3. Some economists believe one of the reasons that economies in developing countries grow slowly is that they do not have well developed financial markets. Do you agree or disagree? Why?
4. The US economy borrowed from the British in the 1800’s to build railroads. What debt instrument was used? Why did this help each country?
5. “Because corporations do not raise any funds in secondary markets, they are less important to the economy than primary markets.” What do you think about that statement?
6. If a company goes bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why?
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17. Function of Financial Intermediaries: Indirect Finance
Lower transaction costs
Economies of scale – spreading out the cost of transactions over many transactions.
Liquidity services – services that make it easier for customers to conduct transactions and get cash.
Reduce Risk
Risk Sharing (Asset Transformation). Because of economies of scale, it helps reduce the amount of risk as it is shared among many investors.
Diversification – investing in a collection (portfolio)
of assets to lower the overall risk.
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18. Function of Financial Intermediaries: Indirect Finance
Asymmetric Information
Definition: the unequal knowledge that each party to a transaction has about the other party.
Adverse Selection (before the transaction)—more likely to select risky borrower
Moral Hazard (after the transaction)—less likely borrower will repay loan
We will look at these terms and how they affect us during Monday’s class.
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21. Regulation of the Financial System
To increase the information available to investors:
Reduce adverse selection and moral hazard problems
Reduce insider trading
To ensure the soundness of financial intermediaries:
Restrictions on entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates
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25. Summary
The basic function of financial markets is to direct funds from savers who have an excess of money to spenders who need money.
Directing money helps consumers by allowing them to make purchases when they need them most.
Direct and Indirect Finance is how this is done.
Financial markets can be classified as debt and equity, primary and secondary, exchanges and over-the-counter, and money and capital markets.
The main money market instruments include, US Treasury Bills, Commercial Paper & Eurodollars.
Capital market instruments include stocks & mortgages, corporate bonds
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26. Summary
An important trend in recent years is the growing internationalization of financial markets, such as Eurobonds and Eurodollars.
Financial Intermediaries, such as banks play an important role in the financial system because they reduce transaction costs, allow risk sharing, and solve problems created by adverse selection and moral hazard.
The main financial intermediaries fall into 3 categories:
1. Banks
2. Life Insurance Companies
3. Finance and Mutual Fund Companies
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