Chapter # 2
Overview Of The
Financial System
Function of Financial
Markets
Financial markets perform the essential
economic function of channeling funds
from households, firms and
governments that have saved surplus
funds by spending less them their
income to those who have a shortage
of funds because they wish to spend
more then their income.
This function is shown schematically in figure 1.
Indirect Finance
Financial
Intermedi-
Funds
aries Funds
Funds
Lender Savers Borrower Spenders
1. Household 1.Business Firms
2. Business firm Funds Financial Funds 2.Government
3. Government Markets 3.Household
4. Foreigners 4.Foriegners
Direct Finance
Why is this channeling of funds from savers
to spenders so important to the economy ?
In the absence of financial markets, it is hard
to transfer funds from a person who has no
investment opportunities to one who has
them.
The existence of financial markets is also
beneficial even if someone borrows for a
purpose other than increasing production in
a business
Structure of Financial
Markets
Debt and equity markets
Primary and secondary markets
Exchange and over the counter
markets
Money and capital markets
Debt and Equity
Markets
A firm or an individual can obtain
funds in a financial market in two
ways.
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 amount at
regular intervals (Interest and principal
payments), until a specified date (the date)
when a final payment is made.
The second method of raising funds
is by issuing equities such as
common stock (shares), which are
claims to share in the net income and
the assets of a business.
Equities often make periodic
payments (dividends) to their holders
and are considered long term
securities because they have no
maturity date.
Primary and Secondary
Markets
A primary market is a financial
market in which new issues of a
security such as a bond or a stock,
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 (and are
thus secondhand) can be resold.
Exchanges and Over the
Counter Market
Secondary markets can be organized in two
ways.
One is to organize exchange, where buyers and
sellers of securities (or their agents or brokers)
meet in one central location to conduct trade.
The other method of organising a secondary
market is to have an OTC in which dealers at
different locations have an inventory of
securities and stand ready to buy and sell them.
Money and Capital
Market
The money market is a financial market
in which only short term debt-
instruments (maturity of less than one
year) are traded. These securities are
more liquid
The capital market is a financial market
in which long term debt (maturity of one
year or greater) and equity instruments
are traded.
Function of Financial
Intermediaries
Financial Intermediaries stand
between the lender savers and
the borrower- spenders and
help transfer funds from one to
the other.
Importance of
Financial Intermediates
Transaction costs.
Information.
Why are financial
intermediaries so important to
financial markets ?
Financial
Intermediaries
Depository Institutions
Contractual Institutions
Investment Institutions
Depository Institutions
Commercial Banks
Contractual Savings
Institutions
Life insurance companies
Fire and casualty insurance
companies
Pension funds and
government retirement
funds.
Investment
Intermediaries
Mutual funds
Finance companies.
