1. Chapter Two
An Overview of the financial system

2. Areas covered
• Characteristics of financial Instruments
• Function of financial Markets
• Structure of financial Markets
• Function of financial intermediaries
• Classification of financial Intermediaries

3. 1. Characteristics of financial Instruments
• Liquidity
• Risk
• yield

4. 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 cash
2- the transaction costs of doing so must be low
3- the principle must remain relatively stable over
time

5. 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 Risk
Refer to risk of fluctuation in the price or market value of
the financial instrument

6. 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.

7. Relationship between liquidity, Risk
and yield
• Investors will generally accept a lower yield 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 cashed
in a short time at a price not significantly lower than
the original purchase price

8. 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

9. • 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.
2. Function of financial Markets

11. 3. Structural classification of financial
Markets
• Debt and Equity markets
• Primary and secondary markets
• Exchanges and over the counter markets
• Money and capital markets

12. 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.

13. • 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.
a) Debt and Equity Markets

14. 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

15. 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.

16. 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

17. 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.

18. 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

19. 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.

20. • 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

21. Problems associated with asymmetric
information between lender and
borrower
• Adverse selection
• Moral Hazard
• Transaction costs

22. 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.

23. • 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.

24. 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.

25. 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.

26. 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.

27. • 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.

28. • 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.

29. • 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.

30. • 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.

31. • 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.

32. • 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

33. 5. Classification of financial
Intermediaries
Financial intermediaries may be classified into
three categories:
• Depository institution (banks)
• Contractual saving institutions
• Investment intermediaries

34. Depository Institutions
1- commercial Banks:
2- savings & loan Associations
3- credit unions

35. 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)

36. 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

37. Contractual savings institutions
1-Life insurance companies
2- fire and causality insurance
3- pension funds

38. 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.

39. 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.

40. 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.

41. Investment intermediaries
1- finance companies
2- Mutual funds
3- money market mutual funds

42. 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

43. 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

44. THE END
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