Welcome to Training on
“Fundamentals of
Financial Markets &
Security Analysis”!
Part I
Introduction to
Financial Systems
• Dakito Alemu, Ph.D, ACCA Candidate
• Tamrat Mengesha, ACCA, MCSI,
CMSA
May 2022
Content
Introduction to Financial Systems
1.1 Definition & Scope of the Financial System
1.2 Role of the Financial System in the Economy
1.3 Direct & Indirect Finance
1.4 Classifications of Financial Institutions & Markets
Brainstorming Questions
What is
1) Finance?
2) Financial system?
3) Investment?
4) Return?
5) Risk?
6) Risk return tradeoff?
What is a financial system?
A financial Financial System
system matches the
needs of savers
a system that directly through
brings savers and financial markets
borrowers in an or indirectly
economy directly through financial
or indirectly. institutions.
The financial system is the process by
which money flows from savers/lender
to users/borrowers.
COMPLIED BY DAKITO ALEMU (PHD)
The Financial System
8
Suppliers and Demanders of Funds
Government Business Individuals
• Federal, state • Investments in • Some need for
and local production of loans (house,
projects & goods and auto)
operations services • Typically, net
• Typically, net • Typically, net suppliers of
demanders of demanders of funds
funds funds
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Financial Markets
A financial market
is mechanism where savers and borrowers transact
directly by exchanging securities with money.
Financial markets channel funds from savers who have
surplus funds to those who have shortage of funds.
Securities are claims on the borrower’s future income or
assets, such as stock, bonds and foreign exchange
With a global size of USD 178 trillion out
of 360.1 trillion (Securities Industry and Financial
Markets Association SIFMA, 2019),capital
Financial markets are one of the most powerful
drivers of economic growth and wealth
creation
market Facts Unfortunately, many emerging markets
and developing economies enjoy only a
small portion of the benefits offered by
capital markets.
Excluding China, only about 11% of
equity and debt issuances were placed
by companies located in emerging
markets in 2019
Financial Institutions
Financial intermediaries that
intermediate between savers and
borrows.
Financial institutions match the
needs of savers and borrowers
indirectly through intermediation
Why Do Financial Institutions Exist?
A healthy and vibrant economy requires a financial system that moves funds from people who
save to people who have productive investment opportunities.
But how does the financial system make sure that your hard-earned savings get channeled to
those with productive investment opportunities?
1) Stocks are not the most important source of external financing for businesses.
2) Issuing marketable debt and equity securities is not the primary way in which businesses
finance their operations
3) Indirect finance, which involves the activities of financial intermediaries, is many times more
important than direct finance, in which businesses raise funds directly from lenders in
financial markets.
4) Financial intermediaries, particularly banks, are the most important source of external funds
used to finance businesses.
5) Only large, well-established corporations have easy access to securities markets to finance
their activities.
6) Financial Intermediaries Reduce Transaction Costs
Sources of External Funds for Nonfinancial Businesses: A Comparison of the United States with
Germany, Japan, and Canada
%
100
United States
90 Germany
80 Japan
Canada
70
60
50
40
30
20
10
0
Bank Loans Nonbank Loans Bonds Stock
Financial Markets: Direct Financing
Scheme
Financial markets: markets where people and firms trade
two kinds of assets
Currencies
Securities – claims on future income flows,
e.g. stocks and bonds
Banks: indirect finance
Financial institutions (financial intermediaries):
firms that help channel funds from savers to investors
Banks: financial institutions that accept deposits and make
loans
Indirect finance channels funds from savers to investors
through banks. Direct finance channels funds through
financial markets.
Bonds
issued by corporations to raise funds for investment, or by the
government
promise predetermined payments to buyers at specified times in the
future
also called fixed-income securities
represent debt: the buyers are lending to the issuers
Stocks
also called equities
shares of ownership in corporations,
who sell them to raise funds for investment
riskier than bonds, because the income comes from corporate
profits, which are unpredictable
Functions of Financial
Markets
Functions of Financial Markets
1) Price Determination
The prices of financial instruments traded in the
financial market are determined by the market
forces, i.e., demand and supply.
Financial market provides the vehicle by which
the prices are set for both financial assets
which are issued newly and for the existing
stock of the financial assets.
2) Funds Mobilization
Funds available from the lenders/investors will get
allocated among the funds demanders through the
financial markets
Businesses raise funds by issuing financial
instruments in the financial market.
So, the financial market helps in the mobilization of
the investors’ savings.
3 ) Liquidity
Financial market provides an opportunity for the
investors to sell their financial instruments
Investors can sell their securities readily and
convert them into cash in the financial market
In the absence of financial market, the investor will
be obligated to hold the financial securities until the
conditions to sell arise
4) Risk sharing
Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
Allows for diversification, the distribution of wealth among many
assets
Losses or low returns on some assets offset by higher returns on
others
An easy way to diversify:
buy shares of mutual funds, financial firms that buy and hold many
different stocks and bonds
5) Easy Access
Financial market platform provides the
potential buyer and seller easily
This helps to save their time and money
in finding the potential buyer and seller.
6) Capital Formation
Financial markets provide the
channel through which the new
investors’ savings flow in the country,
which aids in the country’s capital
formation.
7) Reduction in Transaction Costs and
information asymmetry
The traders require information for
transacting
Financial market provide different types of
information to the traders.
In this way, the financial market reduces the
cost of the transactions.
Asymmetric information:
when one party in a
transaction has more
Asymmetric information than the other
Information party
e.g., a firm selling securities
knows more about its
prospects than the buyers
Two types of asymmetric information:
adverse selection
moral hazard
Importance of Financial
Markets
A) Well-developed financial markets are a
driver of economic growth, and thereby
Importance yield positive effects on employment.
There exists positive correlation between financial market
of Financial development and economic growth.
Markets Financial markets mobilize additional savings into the
economy, making more capital available to companies,
which may then in turn create jobs.
Some evidence exists that capital markets are associated
with higher productivity levels as the allocation of
resources becomes more efficient
Importance of Financial Markets
Financial markets are crucial in our economy.
1. Channel funds from savers to investors, promoting economic
efficiency.
2. Market activity affects: personal wealth, business firms, and
economy
3. Capital markets are one of the most powerful drivers of economic
growth and wealth creation
4. Well functioning financial markets are key factors in producing high
economic growth
B) On a microlevel, well-developed
financial markets constitute an
Importance of important source of financing for
Financial corporations.
Financial markets can provide an attractive alternative
Markets… financing (give companies access to larger volumes of
On a microlevel funding, longer maturities and, potentially, better
economic terms). Thus reducing overall funding costs.
Financial markets allow companies to diversify their
funding sources
Equity markets in particular have been found to
be key to the financing of new businesses
C) From the investors’ perspective,
financial markets offer investment
Importance of
opportunities and risk management
Financial tools.
Markets Financial markets can offer more attractive investing
From the opportunities in terms of their return than bank
deposits, albeit with a higher risk.
investors’ Capital markets can provide investors with a
perspective diversified portfolio, which contributes to risk
management.
Well-developed financial markets also provide risk
management tools through the derivatives markets
Importance of D) Besides economic growth, well-
Financial regulated and supervised capital
markets may enhance financial stability.
Markets… Domestic capital markets provide access to long-
for financial term, local currency financing that helps companies,
governments and investors to manage inflation and
stability foreign exchange risks.
Further, there is empirical evidence that equity
markets can reduce corporate leverage and curb
insolvency risks, while bond markets can serve as a
“spare tire” in times of banking distress.
Types of Financial
Markets
Types of Financial Markets
Criteria Types of Financial Markets
1. Nature of Claims Debt Market Vs Equity Markets
2. Freshness of Claims Primary Vs Secondary Markets
3. Structure or Organization of Claims Exchange Vs Over-the-Counter (OTC)
4. Maturity of Claims Traded Money Market Vs Capital Market
40
COMPLIED BY DAKITO ALEMU (PHD)
Nature of Claim
Debt •
•
Debt securities are traded in debt market
Debt Claims are the most commonly traded security.
• Debt Securities can be short term or long term
Market • Examples are treasury bills, bonds or mortgages
• The most common equity security is stock or
Equity share
• Equity security makes the buyer owner of the
issuer’s enterprise.
Market • Equity securities entitles the holder to earn
dividend, and held primarily to be sold and resold
42
Freshness of Claim
• Securities issued initially
Primary or fresh securities are
Market traded
Secondary • Second hand securities
Market are traded
43
Structure of Market
Securities • In Exchanges, securities are traded in a central
location such as Stock Exchange.
Exchange
Over-the- • In OTCs securities are traded with out an organized
trading location
• OTC is an electronic network over which
Counter transactions are conducted.
44
Maturity of Claims
Money • Markets in which only short-term securities are
traded
Market
Capital • Markets in which longer term debt securities are
traded.
Market
45
Capital markets are:
Financial markets where people buy and
sell long-term debt or equity securities.
Capital Are venues where savings and
Markets investments are channelled between
those who supply and those who
demand capital.
Types of Capital Markets
Types of Capital Markets
Primary Market:
The market for the trading of new securities, for the first time.
Where the financial instruments are sold by their issuers to the investors
In the primary market, the mobilisation of funds takes place through prospectus and private
placement of securities.
Secondary Market:
Are the market for old securities (already-issued securities are traded between investors)
Securities which are previously issued in the primary market are traded here.
It covers both stock exchange and over-the-counter market.
Private placements Vs public offerings
Securities can be issued via private placements or public offerings.
1.Private placements: are restricted to institutional and other
sophisticated investors and have limited price disclosure and
trading activity.
2.Public Offering: securities issued under a public offering are
accessible by all, including retail investors, and are traded on
regulated markets with sufficient pre- and post trade price
transparency
Capital Market
Participants
Capital Market Participants
Main players in the capital market Include:
1) Capital market services providers,
2) Issuers of capital market products,
3) Security exchanges
4) Securities depository & clearing companies
Financial market operation
Financial Crises
Financial Crises
At times, the financial system seizes up and produces financial crises, major
disruptions in financial markets that are characterized by sharp declines in asset
prices and the failures of many financial and nonfinancial firms.
Financial crises have been a feature of capitalist economies for hundreds of years
and are typically followed by the worst business cycle downturns.
From 2007 to 2009, the U.S. economy was hit by the worst financial crisis since
the Great Depression.
Defaults in subprime residential mortgages led to major losses in financial
institutions, producing not only numerous bank failures, but also leading to the
demise of Bear Stearns and Lehman Brothers, two of the largest investment
banks in the United States.
Stage One: Initiation of Financial Crisis
Financial crises can begin in several ways:
1) Mismanagement of financial liberalization or innovation,
2) Asset price booms and busts,
◦ Many nineteenth-century U.S. financial crises were precipitated by increases in interest rates, either when interest rates shot up in
London, which at the time was the world’s financial center, or when bank panics led to a scramble for liquidity in the United States that
produced sharp upward spikes in interest or
3) A general increase in uncertainty caused by failures
of major financial institutions.
◦ U.S. financial crises have usually begun in periods of high uncertainty, such as just after the start of a recession, a crash in
the stock market, or the failure of a major financial institution.
STAGE ONE
Deterioration in
Initiation Asset Price Increase in Increase in
Financial Institutions’
of Financial Decline Interest Rates Uncertainty
Balance Sheets
Crisis
Adverse Selection and Moral
Hazard Problems Worsen
STAGE TWO
Economic Activity
Banking
Declines
Crisis
Banking
Crisis
Adverse Selection and Moral
Hazard Problems Worsen
Economic Activity
Declines
STAGE THREE
Unanticipated Decline
Debt
in Price Level
Deflation
Adverse Selection and Moral
Hazard Problems Worsen
Economic Activity
Declines
Thank you
QUESTIONS?
