Introduction to Financial Systems

Chapter 1: Introduction to Financial Systems

Chapter Overview

This chapter introduces fundamental concepts related to fund transfers and financial markets, including:

• Fund Transfer: Differentiating between direct and indirect financing.

• Financial Markets: Exploring various market types:

  • Primary vs. Secondary Market

  • Money vs. Capital Market

  • Foreign Exchange Market

  • Derivatives Market

Fund Transfer Mechanisms

Fund transfer addresses the essential question of how to move savers' (suppliers of funds) excess purchasing power to investors (users of funds). This transfer can be achieved in two primary ways:

1. Direct Financing: Savers lend money directly to investors, accepting financial claims in return.

2. Indirect Financing: Financial intermediaries facilitate the transfer between savers and investors.

Direct Financing

In direct financing, users of funds (e.g., corporations) obtain cash directly from suppliers of funds (e.g., households) in exchange for financial claims (e.g., equity and debt instruments).

• Facilitators:

  • Brokers: Act as intermediaries, bringing investors and savers together to facilitate transactions.

  • Dealers: Purchase securities from initial investors and then resell them to savers, effectively taking on market inventory.

  • Investment Bankers: Often act as dealers in direct financial markets, acquiring securities from issuing investors and distributing them to original savers.

• Examples of Direct Financing:

  • Borrowing money from family and friends.

  • Opening an e-brokerage account to trade securities directly.

  • Purchasing stocks of companies like Twitter or Facebook directly from the primary or secondary market without an intermediary transforming the claim.

Indirect Financing

Indirect financing involves financial intermediaries (FIs) acting as asset transformers. Savers provide cash to FIs and receive financial claims (e.g., deposits, insurance policies) from the FIs. The FIs, in turn, provide cash to users of funds and receive financial claims (e.g., equity and debt securities) from them.

• Key Role of FIs: FIs transform the financial claims of users of funds into different financial claims for suppliers of funds, thereby mitigating risks and providing liquidity for savers.

• Examples of Indirect Financing:

  • Buying Certificates of Deposit (CDs) from a bank like Wells Fargo.

  • Purchasing insurance policies from an insurance company like State Farm.

  • Buying shares of a mutual fund, such as the Vanguard $500$ Index, from Vanguard.

  • Contributing to pension funds.

Financial Markets

Financial markets can be categorized along two main dimensions:

1. Primary versus Secondary Markets

2. Money versus Capital Markets

Primary versus Secondary Markets

• Primary Markets:

  • These are markets where users of funds (such as corporations and governments) raise capital by issuing new financial instruments (e.g., stocks and bonds) for the first time.

  • Initial Public Offering (IPO): The first time a company offers its shares to the public. Examples include:

    • Facebook's IPO on May $18$, $2012$, at $38/share.</p></li><li><p>Tesla's IPO on June$29$,$2010$, at$17/share.

    • Nvidia's IPO on January $22$, $1999$, at $12/share.</p></li><li><p>Twitter's IPO on November$15$,$2013$, at$26/share.

    • Lyft's IPO on March $29$, $2019$, at $72/share.</p></li></ul></li><li><p><strong>Seasoned Equity Offering (SEO):</strong> Subsequent offerings of stock by companies that are already publicly traded.</p></li><li><p><strong>Stock Splits:</strong> Events where the number of shares outstanding increases. This includes:</p><ul><li><p>TSLA splits: August$31$,$2020$($3:1$); August$25$,$2022$($5:1$).</p></li><li><p>NVDA splits: June$27$,$2000$($2:1$); September$12$,$2001$($2:1$); April$7$,$2006$($2:1$); September$11$,$2007$($3:2$); July$20$,$2021$($4:1$); June$10$,$2024$($10:1$$).

• Secondary Markets:

  • These are markets where previously issued financial instruments are traded among investors (e.g., the New York Stock Exchange (NYSE) and Nasdaq).

  • In secondary market transactions, the number of shares outstanding of a company does not change; ownership simply transfers between investors.

IPO Underpricing

• Definition: IPO underpricing occurs when the initial public offering price is set below the intrinsic market value of the shares.

• Observation: The closing price on the first trading day for an IPO is typically higher than its original issue price.

• Prominent Scholar: Professor Jay Ritter from the University of Florida is a renowned finance scholar in this area.

Money versus Capital Markets

• Money Markets:

  • These markets facilitate the trading of debt securities with original maturities of one year or less.

  • Examples include Certificates of Deposit (CDs) and U.S. Treasury bills.

• Capital Markets:

  • These markets trade financial instruments, encompassing both debt (bonds) and equity (stock), with maturities exceeding one year.

Foreign Exchange (FX) Markets

• Definition: FX markets are platforms where one currency is traded for another (e.g., exchanging U.S. dollar for Japanese yen).

• Types of FX Transactions:

  • Spot FX: Involves the immediate exchange of currencies at the prevailing current exchange rates.

  • Forward FX: An agreement to exchange currencies on a specific future date at a pre-specified exchange rate, agreed upon today.

Derivative Security Markets

Derivative instruments are financial contracts whose value is derived from an underlying asset, index, or rate. Major derivative instruments include forwards, futures, options, and swaps.

• Forward Contracts:

  • A non-standardized agreement to transact, involving the future exchange of a set amount of assets at a set price.

  • Typically traded over-the-counter (OTC).

• Futures Contracts:

  • A standardized, exchange-traded agreement to transact, involving the future exchange of a set amount of assets for a price that is settled daily.

  • Traded on organized exchanges, providing greater liquidity and reduced counterparty risk compared to forwards.

• Option Markets:

  • Trade contracts that grant the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a specific period.

  • Call Option: Grants the holder the right to buy the underlying asset.

  • Put Option: Grants the holder the right to sell the underlying asset.

  • Option Backdating: A practice where an option is granted with an effective date that precedes the actual date it was approved. This can sometimes be used to set the strike price lower than the market price on the actual grant date, making the option more valuable. Professor Erik Lie of the University of Iowa is a prominent finance scholar in the study of executive stock option backdating.

• Swap Contracts:

  • An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at specified intervals.

  • An example is a Credit Default Swap (CDS), where one party pays another a premium in exchange for protection against a default by a third party.