Chapter 2

Report
Chapter 2
An Overview
of the Financial
System
Function of Financial Markets
• Perform the essential function of channeling
funds from economic players that have saved
surplus funds to those that have a shortage of
funds
• Direct finance: borrowers borrow funds directly
from lenders in financial markets by selling them
securities
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Function of Financial Markets
(cont’d)
• Promotes economic efficiency by
producing an efficient allocation of capital,
which increases production
• Directly improve the well-being of
consumers by allowing them to time
purchases better
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Figure 1 Flows of Funds Through
the Financial System
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Structure of Financial Markets
• Debt and Equity Markets
– Debt instruments (maturity)
– Equities (dividends)
• Primary and Secondary Markets
– Investment Banks underwrite securities in
primary markets
– Brokers and dealers work in secondary markets
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Structure of Financial Markets
(cont’d)
• Exchanges and Over-the-Counter (OTC)
Markets
– Exchanges: NYSE, Chicago Board of Trade
– OTC Markets: Foreign exchange, Federal funds
• Money and Capital Markets
– Money markets deal in short-term debt
instruments
– Capital markets deal in longer-term debt and
equity instruments
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Table 1 Principal Money Market
Instruments
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Table 2 Principal Capital Market
Instruments
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Internationalization of Financial
Markets
• Foreign Bonds: sold in a foreign country and
denominated in that country’s currency
• Eurobond: bond denominated in a currency other
than that of the country in which it is sold
• Eurocurrencies: foreign currencies deposited in
banks outside the home country
– Eurodollars: U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
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Function of Financial
Intermediaries: Indirect Finance
• Lower transaction costs (time and money
spent in carrying out financial transactions)
– Economies of scale
– Liquidity services
• Reduce the exposure of investors to risk
– Risk Sharing (Asset Transformation)
– Diversification
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Function of Financial Intermediaries:
Indirect Finance (cont’d)
Deal with asymmetric information problems
(before the transaction) Adverse Selection: try to avoid
selecting the risky borrower.
Gather information about potential borrower.
(after the transaction) Moral Hazard: ensure borrower will not
engage in activities that will prevent him/her to repay the loan.
Sign a contract with restrictive covenants.
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Function of Financial Intermediaries:
Indirect Finance (cont’d)
• Conclusion:
– Financial intermediaries allow “small” savers
and borrowers to benefit from the existence of
financial markets.
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Table 3 Primary Assets and Liabilities
of Financial Intermediaries
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Table 4 Principal Financial
Intermediaries and Value of Their
Assets
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Regulation of the Financial
System
• To increase the information available to
investors:
– Reduce adverse selection and moral hazard
problems
– Reduce insider trading (SEC).
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Supplementary Notes:
•
•
•
•
•
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Investment Banks
NYSE
HKEx
OTC
OTC Markets: CMU in Hong Kong
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Internationalization of Financial
Markets
The number of international stock market
indexes is quite large.
Dow (道瓊斯工業平均指數)
S&P 500 (標準普爾500指數)
Nikkei 225 (東京日經225指數)
FTSE 100 (倫敦富時100指數)
Hang Seng Index (恒生指數)
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Glossary
• Federal (Fed) Funds: These instruments
are typically overnight loans between banks
of their deposits at the Federal Reserve.
• Federal funds rate: The interest rate on
overnight loans of deposits at the Federal
Reserve.
• Repurchase agreement (repo): An
arrangement whereby the Fed, or another
party, purchases securities with the
understanding that the seller will repurchase
them in a short period of time, usually less
than a week.
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Glossary
• Risk sharing: The process of creating and
selling assets with risk characteristics that
people are comfortable with and then using
the funds acquired by selling these assets to
purchase other assets that may have far
more risk.
• The process of risk sharing is also
sometimes referred to as asset
transformation, because in a sense, risky
assets are turned into safer assets for
investors.
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