2. Chapter one
An overview of financial system
The role of financial systems in the economy
As we know, financial system is very important
for the economic and all round development of any
country, its major role can be explained as
following:
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3. 1. Promotion of Liquidity
The major function of the financial system is the
provision of money and monetary assets for the
production of goods and services. In financial
language, the money and monetary assets are
referred to as liquidity. In other words, the liquidity
refers to cash or money and other assets which can
be converted into cash readily without loss.
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4. Cont’d
• Hence, all activities in a financial system are related
to liquidity – either provision of liquidity or trading
in liquidity.
2. Mobilizations of Savings
Another important activity of the financial system is
to mobilize savings and channelize them into
productive activities.
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5. Cont’d
The financial system should offer appropriate
incentives to attract savings and make them
available for more productive ventures.
• Thus, the financial system facilitates the
transformation of savings into investment and
consumption. The financial intermediaries have to
play a dominant role in this activity.
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6. Cont’d
3. Provides financial services
We assume that most people are risk-averse. That is,
they are prepared to make a payment (or sacrifice
some income) in order to avoid uncertainty,
especially if the uncertainty may mean the
possibility of a serious loss.
• Among the non-deposit taking institutions, this
service is carried out by insurance companies.
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7. Cont’d
4. Offer portfolio adjustment facilities
Lastly, it should always be remembered that
while savers may be building up a portfolio of
wealth by acquiring financial assets, they want to
be able to rearrange that portfolio from time to
time as they observe changes in the risk/return
characteristics of the assets which they hold.
If we use the phrase ‘net acquisition’ to describe
the additional assets that a household is able to
add to its portfolio each year,
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8. Cont’d
• we must remember that total purchases of
assets may be much larger because some
assets already in the portfolio may have been
sold as part of the portfolio adjustment
process.
• A Financial system must provide people with
the means to make cheap and frequent
adjustments to their portfolio of assets (and
liabilities).
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9. Financial assets
In any financial transaction, there should be a
creation or transfer of financial asset. Hence, the
basic product of any financial system is the financial
asset.
• Financial assets are intangible assets where typically
the future benefits come in the form of a claim to
future cash. Another term used for a financial asset
is a financial instrument.
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10. Cont’d
• Thus, a financial asset is one, which is used for
production or consumption or for further creation of
assets. For instance, a buys equity shares and these
shares are financial assets since they earn income in
future.
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11. Role of financial assets in financial system
Financial assets serve two principal economic
functions. First, financial assets transfer funds from those
parties who have surplus funds to invest to those who
need funds to invest in tangible assets.
• As their second function, they transfer funds in such a way
as to redistribute the unavoidable risk associated with the
cash flow generated by tangible assets among those seeking
and those providing funds.
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12. Cont’d
• However, the claims held by the final wealth
holders generally differ from the liabilities issued by
the final demanders of funds because of the activity
of entities operating in financial markets,
called financial intermediaries,
• who seek to transform the final liabilities into
different financial assets offered by the public.
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13. Properties of Financial Assets
• The following are the properties of Financial Assets,
which distinguish them from Physical and Intangible
Assets:
1. Currency:
• Financial Assets are exchange documents with an
attached value. Their values are dominated in
currency units determined by the government of an
economy.
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14. Cont’d
2. Divisibility
• Financial Instruments are divisible into smaller units. The
total value is represented in terms of divisions that can be
handled in a trade. The divisibility characteristic of
Financial Assets enables all players, small or big, to
participate in the market.
3. Convertibility
• Financial Assets are convertible into any other type of asset.
This characteristic of convertibility gives flexibility to
financial instruments.
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15. Cont’d
• Financial Instruments need not necessary be
converted into another form of Financial Asset; they
can also be converted into Physical/Tangible and
Intangible Assets.
4. Reversibility
• This implies that a financial instrument can be
exchanged for any other asset and logically, the so
formed asset may be transferred back into the
original financial instrument.
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16. Cont’d
5. Liquidity
• The financial asset can be exchanged for currency
with another market participant who does not have
immediate cash need, but expects future benefits.
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17. Cont’d
6. Cash Flow
• The holding of the financial instrument results in a stream
of cash flows that are the benefits accruing to the holder of
the financial instrument. However, a financial instrument by
itself does not create a cash flow.
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18. FINANCIAL MARKETS
In economics a financial market is a mechanism
that allows people to easily buy and sell (trade)
financial securities (such as stocks and bonds),
commodities (such as precious metals or
agricultural goods), and other fungible items of
value at low transaction costs and at prices that
reflect the efficient market hypothesis.
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19. Cont’d
In Finance, Financial markets facilitate:
• The raising of capital (in the capital markets);
• The transfer of risk (in the derivatives markets); and
• International trade (in the currency markets).
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20. Cont’d
Definition
• The term financial markets can be a cause of much
confusion.
• Financial markets could mean:
1. Organizations that facilitate the trade in financial
products. i.e. Stock exchanges facilitate the trade in
stocks, and bonds.
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21. Cont’d
2.The coming together of buyers and sellers to
trade financial products. i.e. stocks and shares
are traded between buyers and sellers in a
number of ways including: the use of stock
exchanges; directly between buyers and sellers .
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22. Cont’d
• In academia, students of finance will use both
meanings but students of economics will only use
the second meaning.
Role of financial market
Financial markets provide the following three major
economic role :
Price discovery
Liquidity
Reduced transaction costs
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23. Cont’d
• Price discovery means that the interactions of
buyers and sellers in a financial market determine
the price of the traded asset. Equivalently, they
determine the required return that participants in a
financial market demand in order to buy a financial
instrument.
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24. Cont’d
Liquidity
• Second, financial markets provide a forum for
investors to sell a financial instrument and is said to
offer investors “liquidity.” This is an appealing to
sell a financial instrument.
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25. Cont’d
Reduced transaction costs:
The third economic function of a financial market is that it
reduces the cost of transacting when parties want to trade a
financial instrument.
• In general, one can classify the costs associated with
transacting into two types: search costs and information
costs. Search costs in turn fall into categories: explicit costs
and implicit costs.
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26. Cont’d
• Explicit costs include expenses that may be needed to
advertise one’s intention to sell or purchase a financial
instrument; implicit costs include the value of time spent in
locating counterparty to the transaction. The presence of
some form of organized financial market reduces search
costs.
• Information costs are costs associated with assessing a
financial instrument’s investment attributes.
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27. Cont’d
• In a price efficient market, prices reflect the aggregate
information collected by all market participants.
• Classification of Financial Markets
There are many ways to classify financial markets. One way
is by the type of financial claim, such as debt markets and
equity markets.
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28. Cont’d
• Another is by the maturity of the claim. For example, the
money market is a financial market for short-term debt
instruments; the market for debt instruments with a maturity
greater than one year and equity instruments is called the
capital market.
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29. Cont’d
• Financial markets can be categorized as those dealing with
financial claims that are newly issued, called the primary
market, and those for exchanging financial claims
previously issued, called the secondary market or the
market for seasoned instruments.
• Markets are classified as either cash markets or
derivative markets. The latter is described later in chapter
three .
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30. Cont’d
• A market can be classified by its organizational structure: It
may be an auction market or an over-the-counter market.
Lending and borrowing in the financial system
• Lenders and borrowers
In this section, we want to discuss people’s reasons for
lending and borrowing and the differing needs of lenders
and borrowers that financial intermediaries have to try to
meet.
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31. Cont’d
• Ultimate lenders: Agents whose excess of income
over expenditure creates a financial surplus which
they are willing to lend.
• Ultimate borrowers: Agents whose excess of
expenditure over income creates a financial deficit
which they wish to meet by borrowing.
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32. Saving and lending
In any developed economy there will be people and
organisations whose incomes are greater than they need to
finance their current consumption. The difference between
current income and consumption we call saving.
• The saving could be used to buy ‘real’ assets, that is to say
machinery, industrial premises and equipment, for example,
in which case as well as saving they would be investing.
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33. Cont’d
• However, many people will be saving at a level which
exceeds their spending on physical investment. Indeed,
in the personal sector there will be people who save
but undertake no physical investment at all.
• The difference between saving and physical
investment is their financial surplus. It is this surplus
that is available for lending.
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34. Borrowing
At the same time as some people have income
which they do not wish to spend entirely upon
current consumption, there will be those firms,
people and public authorities whose expenditure
plans exceed their income.
• These plans can be realized only if their owners
either draw on past savings or engage in borrowing.
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