1. 1 Chapter 2: The Financial System Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc. Objective Understanding the workings of the financial system Determining rates of return

2. 2 Chapter 2 Contents 1 What is a Financial System1 What is a Financial System 2 The Flow of Funds2 The Flow of Funds 3 The Functional Perspective3 The Functional Perspective 4 Financial Innovation & the “Invisible Hand”4 Financial Innovation & the “Invisible Hand” 5 Financial Markets5 Financial Markets 6 Financial Market Rates6 Financial Market Rates 7 Financial Intermediaries 8 Financial Infrastructure and Regulation 9 Governmental & Quasi- Governmental Organizations

3. 3 The Flow of Funds Diagram Markets Intermediaries Surplus UnitsDeficit Units

4. 4 Fund Flows via Market Markets Intermediaries Surplus UnitsDeficit Units

5. 5 Fund Flows via Intermediary Markets Intermediaries Surplus UnitsDeficit Units

6. 6 Fund Flows via Intermediary and Market Markets Intermediaries Surplus UnitsDeficit Units

7. 7 Funds Flow via Markets and Intermediaries Markets Intermediaries Surplus UnitsDeficit Units

8. 8 Funds Flow: Disintermediation Markets Intermediaries Surplus UnitsDeficit Units Markets Intermediaries Surplus UnitsDeficit Units

9. 9 Funds Flow: Secured Credit Markets Intermediaries Surplus UnitsDeficit Units Poor Credit Risk

10. 10 Six Key Financial Functions: – –Transferring Resources Across Time & Space – –Managing Risk – –Clearing and Settling Payments – –Pooling Resources and Subdividing Shares – –Providing Information – –Dealing with Incentive Problems

11. 11 Exchange Rate Example 15000 ¥ 15260 ¥ 15450 ¥ £100 £109 Time 3% ¥/¥ (direct) 1.73% ¥/£/£/¥ 150 ¥/£ 9%£/£ 140 ¥/£ JapanU.K.

12. 12 Exchange Rate Example 15000 ¥ 16241 ¥ 15450 ¥ £100 £109 Time 3% ¥/¥ (direct) 8.27% ¥/£/£/¥ 150 ¥/£ 9%£/£ 149 ¥/£ JapanU.K.

13. 13 Exchange Rate Example 15000 ¥ (borrowed) 15450 ¥ Repaid £100 Invested £109 Matures Time 3% ¥/¥ (direct) 3% ¥/£/£/¥ 150 ¥/£ 9%£/£ Forward ¥/£ JapanU.K.

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15. 15 Yield Comparisons

16. 16 Computation of Return

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20. 20 Nominal to Real