Chapter 2
An Overview
of the Financial
System
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Preview
• This chapter presents an overview of the
study of financial markets and institutions.
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Learning Objectives
• Compare and contrast direct and indirect
finance.
• Identify the structure and components of
financial markets.
• List and describe the different types of
financial market instruments.
• Recognize the international dimensions of
financial markets.
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Learning Objectives
• Summarize the roles of transaction costs,
risk sharing, and information costs as they
relate to financial intermediaries.
• List and describe the different types of
financial intermediaries.
• Identify the reasons for and list the types of
financial market regulations.
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Function of Financial Markets
• Performs 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
• 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
• 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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Financial Market Instruments
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Financial 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
• World Stock Markets:
– Also help finance the federal government
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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
• Deal with asymmetric information problems:
– Adverse Selection (before the transaction): try
to avoid selecting the risky borrower by gathering
information about them
– Moral Hazard (after the transaction): 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
• Conclusion:
– Financial intermediaries allow “small” savers and
borrowers to benefit from the existence of
financial markets.
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Types of Financial Intermediaries
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Types of Financial Intermediaries
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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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Regulation of the Financial System
• To ensure the soundness of financial
intermediaries:
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control
holding of risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
• Restrictions on Interest Rates
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Regulation of the Financial System
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Examples of Foreign Bonds and Eurobond
in Hong Kong
Foreign Bonds
(Foreign corporation issues bonds in HK$,
Wing Tai Properties (Finance) Ltd,
Virgin Islands, British)
Eurobond
(Foreign corporation issues bonds in USD,
ICICI Bank Ltd, India)
(Foreign corporation issues bonds in CNY,
2007 China Development Bank, China;
2010 McDonald’s, US)
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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)
Shanghai Stock Exchange A Share Index(上海A股
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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Exercise: Adverse selection / Moral hazard
1. A person with a terminal illness purchases several life
insurance policies from a company that does not require
its customers to have a body check. This situation is
subject to the
(A)adverse selection problem (B) moral hazard problem
2. A person with a good driving record has become a
careless driver since he bought an automobile insurance
policy last month. This situation is subject to the
(A)adverse selection problem (B) moral hazard problem
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Chapter 2:Q1
Which of the following statements about the
characteristics of debt and equity is false?
A) They can both be long-term financial
instruments.
B) They both enable a corporation to raise funds.
C) They both involve a claim on the issuer’s
income.
D) They can both be short-term financial
instruments.
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Chapter 2:Q6
A short-term instrument issued by well-known
corporations is called
A) municipal bonds.
B) corporate bonds.
C) commerical paper.
D) commercial mortgages.
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Chapter 2:Q15
Typically, borrowers have superior information
relative to lenders about the potential returns and
risks associated with an investment project. The
difference in information is called
A) risk sharing.
B) asymmetric information.
C) moral selection.
D) adverse hazard
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Chapter 2:Q18
_________ are financial intermediaries that
acquire funds by selling shares to many individuals
and using the proceeds to purchase diversified
portfolios of stocks and bonds.
A) Mutual funds
B) Insurance companies
C) Financial companies
D) Investment banks
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