Introduction to Financial Systems and Financial Markets

Financial System

a densely interconnected network of all financial intermediaries. financial markets and regulators and their relations with respect to the flow of funds and from households, governments, business firms, and foreigners, as well as the financial infrastructure.

Importance of FInancial System

• Transforms household savings into funds available for investment by firms. It diverts savings to productive uses, it helps to increase output of the economy.

• Facilitates economic activity and growth.

Direct Finance

It occurs if a sector in need of funds borrows from another sector via a financial market.

Indirect Finance

financial intermediary obtains funds from savers and uses these savings to make loans to a sector in need of finance.

Financial Markets

which facilitate the flow of funds in order to finance investments by corporations, governments and individuals.

refers to channels or places where funds and financials instruments such as stocks, bonds, and other securities are exchanged between willing individuals or entities.

Financial Institutions

who are the key players in the financial markets as they perform the function of intermediation and thus determine the flow of funds.

Financial Regulators

who perform the role of monitoring and regulating th eparticipants in the financial system.

Financial Intermediaries

acts as the middleman for joining two unrelated parties in investing and growth. Most frequently, this process is completed through a financial institution.

engaged in process of indirect finance and exist because of:

• lenders and borrowers have conflicting needs

• transaction costs

• asymmentric of information

• to allow risk sharing

Depository

consists of traditional banks, credit unions, and savings and loan depositories. they accept deposit and make loans acting as intermediaries in matching lenders and borrowers.

Non-depository

are made up of financial advisors and brokers, insurance companies, life insurance companies, mutual funds, and pension funds.

Conflicting Needs

most lenders prefer lending short-term, most borrowers prefer borrowing long-term. that is why most intermediation is done indirectly, where intermediaries understand and reconcile the different needs of lenders and borrowers.

Transaction Costs

financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them, and because their large size allows them to take advantage of economies of scale, the reduction in transaction costs per peso of transactions as the size (scale) of transactions increases.

Asymmetry of Information

refers to a situation where one party to a market transaction has much more information about a product or service than the other. this leads to problems of moral hazard and adverse selection.

Adverse Selection

information known by the first party to a contract is unknown to the second and, as a result, the second party incurs major costs.

Moral Hazard

tendency of one party to a contract to alter his/her behavior in ways the are costly to the other party.

Risk Sharing

financial intermediaries create and sell assets with low risk characteristics and then use the funds to purchase other assets that may have far more risk. this process of risk sharing is called asset-liability transformation. another way of this provided by financial intermediaries is through diversification. financial intermediaries invest in a collection of assets whose return do not always move together, with the result that overall risk is lower than for individual assets.

Money Markets

this is the sector of the financial market where financial instruments that will mature or be redeemed in one year or less from issuance date are traded.

consists of buyers and sellers who purchase and sell short-term marketable securities, such as certificates of deposit, commercial paper, and treasury bills. these securities are traded as a means of short-term borrowing and lending.

Capital Markets

this is the sector in the financial market where financial instruments issues by government and corporations that will mature beyond one year from issuance date are traded.

it is a financial market where buyers and sellers trade long-term securities, such as stocks and bonds.

Primary Market

this is where fund demanders like corporation or government agencies raise funds through new issuances (first-hand or original issuance) of financial insturments (bonds or stocks).

Secondary Market

this is where securities issued in the primary market are subsequently traded (resold and repurchased-second hand)

trading previously issued securities

no new funds for issuer

provides liquidity for seller

Domestic Market

if the transaction is perfected within the same national boundary, this is called

International or Foreign Market

if the transaction is perfected beyond the national boundary, this is called