Chapter two: An overview of the financial system

• Characteristics of financial Instruments

• Function of financial Markets

• Structure of financial Markets

• Function of financial intermediaries

• Classification of financial Intermediaries

1. Characteristics of financial Instruments

• Liquidity

• Risk

• yield

liquidity

• Liquidity refers to the ease & willingness with which an asset may be converted into money on short notice.

• There are 3 prerequisites for a financial instrument to be considered highly liquid

1- the instrument must be easily converted to cash2- the transaction costs of doing so must be low3- the principle must remain relatively stable over time

Risk

• The possibility of not recovering the full value of original funds invested.

A) Default Risk• refer to the possibility of not receiving the contractual

interest payments or of not recovering the principle due to the insolvency of the instrument’s issuer.

B) Market RiskRefer to risk of fluctuation in the price or market value of the

financial instrument

yield

The yield :is the rate of return on an assets , expressed as a percentage per year.

Computed as: the yearly return on the instrument divided by the price or initial principal (current yield)

The yield to Maturity takes into consideration any capital gain or loss realized at maturity.

Relationship between liquidity, Risk and yield

• Investors will normally accept a lower yield in order to obtain increased liquidity

• Risk & yield are positively related, because most investors are risk averse and must be compensated with higher returns for accepting a higher degree of risk

• Risk & liquidity are also related. More liquid financial instruments are less risky, because they may be cased in a short time, at a price not significantly lower than the original purchase price

2. Function of financial Markets

• The basic function of financial markets is to channel funds from people who have an excess of available funds to people who have a shortage.

• Financial markets are important in channelling funds from people who do not have a productive use for them to those who do, a process that results in greater economic efficiency

• Financial markets can do this either through

A) Direct finance: in which borrowers borrow funds directly from lenders by selling them financial instrument

B) Indirect finance: which involves a financial intermediary who stands between the lender savers and the borrower spenders and helps transfer funds from one to the other.

3. Structural classification of financial Markets

• Debt and Equity markets

• Primary and secondary markets

• Exchanges and over the counter markets

• Money and capital markets

a) Debt and Equity Markets• Debt instrument (such as bond or mortgage) which

is a contractual agreement by the borrower to pay the holder of the instrument fixed amount of money at regular intervals until a specified date

• Equity (such as shares) which are claims to share in the net income and the assets of a business. Long term securities because they have no maturity date.

• The main disadvantage of owning a corporation’s equity is that: the corporation must pay all its debt holders before it pays its equity holder

• The advantage of holding equities is that: they benefit directly from any increases in the corporation’s profitability or asset value.

b)Primary and secondary Markets

• Primary market is a financial market in which new issues of a security are sold to initial buyers by the corporation or government agency borrowing the funds.

• A secondary Market is a financial market in which securities that have been previously issued can be resold.

• ex: Newyork stock exchange & NASDAQ

c) Exchange and over the counter Markets

• Exchange Market: where buyers and sellers of securities meet in one central location to conduct trades.(organized exchanges)

• Over the counter market : in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices.

d) Money and capital Markets• The Money Market is one in which short term

debt instruments are traded (less than year)

• The capital Market is one in which long term debt and equity instruments are traded

4. Function of Financial Intermediaries

• Financial intermediaries are financial institutions that acquire funds from lenders savers by issuing liabilities and use the funds to make loans to borrowers spenders.

• Financial intermediation benefits both surplus and deficit spending units.

From the point of view of surplus units (savers)

• Financial intermediaries can overcome the obstacles that stop savers from purchasing primary claims directly.

• Some of these obstacles are: 1- lack of information 2- lack of financial expertise 3- limited access to financial markets

From the point of view of deficit spenders

• Financial intermediaries broader the range of instruments, and maturities an institution can issue, which significantly reduce transactions costs.

• For example, a bank can give a loan to General Motors or buy a GM bond from the primary financial market .

• The ultimate result from this is that funds have been transferred from the public (the lenders-savers) to GM (the borrower- spender) with the help of the financial intermediary (the bank).

• By charging a higher interest rate on loans than they pay on the funds they acquire (the interest differential), financial intermediaries make profit

Problems associated with asymmetric information between lender and borrower

• Adverse selection

• Moral Hazard

• Transaction costs

Adverse selection

• Is the problem created by asymmetric information before the transaction occurs .

• Adverse selection is a problem associated with equity and debt contracts arising from the lender's relative lack of information about the borrower's potential returns and risks of his investment activities.

• Adverse selection is the tendency for those persons with the highest probability of experiencing financial problems to seek out and be granted loans

• Financial intermediaries face the problem of Adverse selection If bad credit risks are the ones who most actively seek loans and, therefore, receive them from financial intermediaries.

Moral Hazard

• Occurs after a loan is made. Moral hazard in financial markets occurs when borrowers have incentives to engage in activities that are undesirable (immoral from the lender point of view)

• Moral hazard arises because the debt contract allows the borrower to keep any and all returns that exceed the fixed payments in the loan agreement.

Transactions costs

• Involves the money & time spent carrying out financial transactions

• Financial intermediaries make profits by reducing transactions costs. (reducing transactions cost by developing expertise and taking advantage of economies of scale.

Question

• Because there is an imbalance of information in a lending situation, we must deal with the problems of adverse selection and moral hazard.

• Define these terms and explain how financial intermediaries can reduce these problems.

• Adverse selection is the asymmetric information problem that exists before the transaction occurs.

For lenders, it is the difficulty in judging a good credit risk from a bad credit risk. • Moral hazard is the asymmetric information problem that

exists after the transaction occurs. For lenders, it is the difficulty in making sure the borrower uses the funds appropriately. • Financial intermediaries can reduce adverse selection

through intensive screening and can reduce moral hazard by monitoring the borrower.

• Financial intermediaries improve the efficiency of financial markets. The reasons are the following:

• 1) People’s small savings can get a higher interest rate when they are marketed as a part of a larger loan.

• 2) Households and small firms, for which it would be impossible to get funds as direct finance, can get relatively large loans from banks.

• 3) Financial intermediaries reduce the costs of collecting information of all borrowers and lenders. It would be very expensive for lenders to identify all potential borrowers, and for borrowers to identify all potential lenders.

• 4) Once a lender finds a potential borrower, he/she has the problem of finding out whether the borrower is likely to repay his debts. Financial intermediaries, on the other hand, have regular information of the financial situation and credibility of their clients by following the movements on their accounts. This gives them superior information as compared with outsiders in evaluating the risk related to a certain client.

• 5) Financial intermediaries reduce the transaction costs which would have to be paid if every lender and borrower himself writes an appropriate loan contract, or pays the brokerage commission for the transaction. Smaller transaction costs related to one client do not threaten the existence of the whole bank, which might happen in the case of a small financial unit.

• large loan as compared with many small loans creates economies of scale (lower unit costs at a larger scale of operation) into the lending business.

• 6) Financial intermediaries can create maturity transformations between financial agreements. From a continuous inflow of small short-term deposits from various sources with varying interest rates, a bank can issue large long- term loans with a fixed interest rate.

• 7) The expertise and education of the personnel in banks allows them to make better investment decisions as compared with small savers with less information. The investing of large sums of money may though create large losses in the case banks make unsuccessful investment decisions.

• 8) If a bank has enough independent depositors and borrowers, the risks related to one

5. Classification of financial Intermediaries

Financial intermediaries may be classified into three categories:

• Depository institution (banks)

• Contractual saving institutions

• Investment intermediaries

Depository Institutions

1- commercial Banks: 2- savings & loan Associations

3- credit unions

1- commercial banks:

Are financial intermediaries that raise funds by issuing checkable deposits( deposits on which checks can be written),

saving deposits (deposits that are payable on demand but do not allow their owner to write checks),

and time deposits (deposits with fixed terms to maturity)

2- savings& loan association:

Obtain funds primarily through savings deposits( often called shares), and time & checkable deposits

3- credit union:These financial institutions are very small cooperative

lending institutions organized around a particular group: union members, employees of a particular firm

Contractual savings institutions

1-Life insurance companies

2- fire and causality insurance

3- pension funds

1- life insurance companies:

• Insure people against financial hazards following a death.

• They acquire funds from the premiums that people pay to keep their policies in force& use them mainly to buy corporate bonds.

2- fire and casualty insurance companies:• These companies insure their policyholders against

loss from theft, fire and accidents.

• They receive funds through premiums for their policies, but they have a greater possibility of loss of funds

• For this reason, they use their funds to buy more liquid assets than life insurance companies do.

3- pension funds:Provide retirement income to employees who

are covered by a pension plan. Funds are acquired by contributions from employers or from employees.

Investment intermediaries

1- finance companies

2- Mutual funds

3- money market mutual funds

1- finance companies:

Raise funds by selling commercial paper (short term debt instrument) & by issuing stocks and bonds

2- Mutual Funds:These financial intermediaries acquire funds by selling

shares to many individuals & use the proceeds to purchase diversified portfolios of stock & bonds

3- Money market mutual funds:

These financial institutions have the characteristics of a mutual fund, but also function to some extent as a depository institution because they offer deposit type accounts