UNIVERSITY OF FINANCE-MARKETING The Economics of MBFM Lecture-1 Chapter 2: An overview of financial system Lecturer: Sumit, Ph.D.(in progress), MPA, MFC, NCFM, PGDPM Today’s Lecture • • • • • • • • • Overview Functions of financial markets Flow of fund through financial system Structure of financial markets Financial market instruments Internationalization of financial markets function of financial intermediaries Types of financial intermediaries Regulations of financial system Overview • Financial market(bond and stock) and financial intermediaries have the basic function of getting people together to transfer fund one to another • Well-functions financial markets and financial intermediaries are crucial to economic health • We need to acquire an understanding of their structure and operations Function of 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 • Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities(financial instruments) – • Example: borrow the funds from savers by selling them a bond, a debt security, that promises to make payments periodically for a specified period of time OR stocks, a security that entitles the owner to a share of the company’s profit and losses Why is this channeling of fund from savers to spenders so important to the economy? – People who save are frequently not the same people who have profitable investment opportunities Function of Financial Markets (cont’d) • Without financial market, , its hard to transfer fund from a person who who has not investment opportunities to one who has them – Thus FM 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 Figure Flows of Funds Through the Financial System Lender to saver as loan Borrow by Selling securities Structure of Financial Markets Contractual agreement by the borrower to pay the holder of the instrument fixed dollar • amount at regular intervals until a specified Debt and Equity Markets date, when final payment made – Debt instruments (maturity) – Equities (dividends) • Own portion of firm and right to vote to elect its directors Primary and Secondary Markets – Investment Banks underwrite securities in primary markets – Brokers and dealers work in secondary markets Structure of Financial Markets (cont’d) • • Secondary market can be organized in ways – Exchanges: NYSE, Chicago Board of Trade – OTC Markets: Foreign exchange, Federal funds Another way to distinguishing between markets is on the basis of the maturity of securities traded in each market – Money and Capital Markets • Money markets deal in short-term debt instruments Corporations and banks actively use the money market to each interest on surplus funds • Capital markets deal in longer-term debt and equity instruments Stocks and bonds are often held by financial intermediaries such as insurance companies and pension fund Issues by large banks and corporation such as Microsoft and General motors Financial Markets instruments • Securitas traded in financial markets called financial instruments : – Money market instruments • US treasury bills • Negotiable bank certificates of deposit • Commercial paper • Repurchase agreements • Federal funds Lest price fluctuations so least risky US securities Issued for 1,3,6 month maturities Pay set amount at maturity and have no interest So initially selling at discount Sold by bank to depositors that pay annual interest of giving and amount and at maturity pays back the original purchase price Effectively short term loans (maturity less than weeks) for which TB serve as collateral ,an assets that the lender receives if the borrower does not pay back the loan One bank Borrowing from another bank Issued by US treasury to finance the deficit the federal government Financial Markets instruments – Capital market instruments • Stocks • Mortgages and mortgage backed securities • Corporate bonds • US government securities • US agency securities • State and local government bonds • Consumer and bank commercial loans Too much price fluctuation so More risk securities Issues by corporation with strong credit ratings This bond sends holder interest twice in a year and pays off the face value at maturity Issued by various Govt agencies, Issued by state or local government to finance expenditure on schools, roads and other large programs Table Principal Money Market Instruments Table Principal Capital Market Instruments Internationalization of Financial Markets • Foreign corporations and banks raise funds from US and foreigners have become important investors in the US A look at international bond market and world stock markets will give us a picture of how their globalization of financial markets is taking place – Foreign Bonds: sold in a foreign country and denominated in that country’s currency – Eurobond: bond denominated in a currency other than that of the country in which it is sold Bond dominated in USD sold in London – 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 • Also help finance the federal government Function of Financial Intermediaries: Indirect Finance • Fund can move from lenders to borrowers by a second route, called indirect finance because it involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds form one to the other – Lower transaction costs (time and money spent in carrying out financial transactions) • • – Economies of scale(bank hire one lawyer to make loan at fixed payment) Financial intermediaries can reduce that Liquidity services(online service to pay bills) Reduce the exposure of investors to risk • Risk Sharing at low transaction cost (Asset Transformation): create and sell assets at risk characteristics and from sales money buy another another assets and so on, so risk sharing at low cost • Diversification: pooling a collection of assets into a new asset and then selling it to individuals Function of Financial Intermediaries: Indirect Finance (cont’d) • • Deal with asymmetric information problems (before the transaction) Adverse Selection: try to avoid selecting the risky borrower • • • Gather information about potential borrower Not lend to either customer Moral Hazard(after transaction): ensure borrower will not engage in activities that will prevent him/her to repay the loan • • Sign a contract with restrictive covenants Economic of scope: e.g before loan to coy evaluate credit risk of coy then loan coz later it will be easy for coy to sell bond to public Types of Financial Intermediaries • They fall into categories: – Depository institutions(banks) • • • – Savings and loan associations and mutual saving banks(allow time and checks writing) Credit unions Contractual savings institutions(insurance coy and pension funds) • • • – Commercials banks(fixed deposit and no checks writing) Life insurance companies Fire and casualty insurance companies(more liquid than life) Pension funds and government retirement funds Investment intermediaries(finance companies and MF) • • • Finance companies(selling CP) Mutual funds(get fund by selling stocks and diversified portfolio of stocks ) Investment banks Table Primary Assets and Liabilities of Financial Intermediaries Table 4: Principal Financial Intermediaries and Value of Their Assets Regulation of the Financial System • To increase the information available to investors: – Reduce adverse selection and moral hazard problems – Reduce insider trading (SEC) Regulation of the Financial System (cont’d) • To ensure the soundness of financial intermediaries: – Restrictions on entry (chartering process, hard rules) – Disclosure of information(FS) – Restrictions on Assets and Activities (control holding of risky assets) – Deposit Insurance (avoid bank runs) – Limits on Competition (mostly in the past): • • Branching(not many branches) Restrictions on Interest Rates Table Principal Regulatory Agencies of the U.S Financial System If you have any question, please feel free to ask ... Internationalization of financial markets function of financial intermediaries Types of financial intermediaries Regulations of financial system Overview • Financial market(bond and stock) and financial intermediaries...Today’s Lecture • • • • • • • • • Overview Functions of financial markets Flow of fund through financial system Structure of financial markets Financial market instruments Internationalization of financial. .. insurance companies and pension fund Issues by large banks and corporation such as Microsoft and General motors Financial Markets instruments • Securitas traded in financial markets called financial