Chapt 1-Introduction to F.System (Flash).pptx

Overview of financial system

1. Chapter One Overview of the Financial System

2. Outline: The Financial System Purpose of the Financial System Functions of Financial System Role of Financial System in Economic Development Real Assets and Financial Assets Classification of Financial Markets

3. 1.1 The Financial System A financial system is an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. Financial system includes: Financial markets:- Markets where financial instruments are traded. e.g capital market, money market,foreign exchange.. Financial institutions (banks, insurance companies, mutual funds, finance companies, and investment banks) , Financial instruments:- The various assets or contracts traded in financial markets, such as stocks, bonds, derivatives, and loans Financial services Regulatory bodies etc.

4. Flows of Funds Through the Financial System

5. cont... Direct financing - through the issuance of financial instruments like stocks or bonds. Indirect financing - through financial intermediaries such as banks.

6. 1.2. Purpose of Financial System The purpose of financial system is: To allocate savings efficiently in an economy to ultimate users either for investment in real assets or for consumption. To facilitates the flow of funds from the areas of surplus to the areas of deficit.

7. 1.3. Functions of Financial System Saving Function. Liquidity Function- Monetary assets Payment Function- Mode of payments Risk Function- Protect against life, health, income risks Information Function- Price-related information Transfer Function - Transfer resources across geographical boundaries Other Functions. It assists in the selection of projects to be financed and also reviews performance of such projects periodically.

8. 1.4. Role of Financial System in Economic Development It links the savers and investors. Reduce the exposure of investor to risk: reduce risk by investing in less risky assets. Reduces the transaction costs Reduce asymmetric Information: Adverse Selection and Moral Hazard It helps in promoting the process of financial deepening and broadening. It provides a mechanism for the transfer of resources across geographical boundaries, etc.

9. 1.5. Real Assets and Financial Assets Real (Physical) Assets A tangible (Real) asset is one whose value depends on particular physical properties. For Example: Building, Machinery, Equipment. 2. Financial Assets Intangible (Financial) assets represent legal claims to some future benefits. Their value bears no relation to the form, physical or otherwise, in which the claims are recorded. For example, Bond, stock, T-bill etc. Both assets are expected to generate future cash flows for thrie owner.

10. 1.6. Classification of Financial Markets 1. Classification on the basis of the type of financial claim A. Debt market Fixed claims Maturity date. B. Equity market Residual claims Dividends No maturity date.

11. Cont… 2. Classification on the basis of maturity of claims Money markets Short-term (less than a year) Highly liquid securities. Example: T-bills B. Capital markets Long-term (a year and above). Example: Bond and Stocks

12. Cont… 3. Classification on the basis of seasoning of claim 1. Primary markets called new issue market. Raise new capital. Issued for the first time. Issued directly by the companies. Not well known to the public 2. Secondary markets Already outstanding, securities are traded among investors. Company does not receive any funds from such a sale. More liquid.

13. Cont… 4. Classification on the basis of structure or arrangements Organized markets. Financial transactions take place within the well established exchanges or in the systematic and orderly structure. B. Unorganized markets. Financial transactions take place outside the well established exchange or without systematic and orderly structure or arrangements.

14. Cont… 5. Classification on the basis of timing of delivery Cash/Spot market. Securities are delivered immediately after the purchase or sale of commodities or securities. B. Forward/Future market. Contracts and the delivery of commodities or securities occurs at a pre-determined time in future.

15. Questions If I can buy a car today for birr, 500,000 and it is worth $1,000,000 in extra income next year to me because it enables me to get a job as a travelling anvil seller, should I take out a loan from Tolla the loan shark at a 90% interest rate if no one else will give me a loan? Will I be better or worse off as a result of taking out this loan? “Because corporations do not actually raise any funds in secondary markets, they are less important to the economy than primary markets.” Comment. If you suspect that a company will go bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why? How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger? If there were no asymmetry in the information that a borrower and a lender had, could there still be a moral hazard problem? Why might you be willing to make a loan to your neighbor by putting funds in a savings account earning a 5% interest rate at the bank and having the bank lend her the funds at a 10% interest rate rather than lend her the funds yourself?

16. Answers To determine whether you should take out a loan from Tolla the loan shark at a 90% interest rate, we need to analyze the costs and benefits of the loan. i. Loan Amount and Interest Costs Loan Amount: Birr 500,000 Interest Rate: 90% The interest cost for one year would be: Interest Cost=Loan Amount×Interest Rate=500,000×0.90=450,000 Birr Interest Cost=Loan Amount×Interest Rate=500,000×0.90= 450,000 Birr ii. Total Repayment After One Year Total Repayment: Loan Amount+Interest Cost=500,000+450,000=950,000 Birr Loan Amount+Interest Cost=500,000+450,000=950,000 Birr

17. iii. Income Generated by the Car The car enables you to earn Br. 1,000,000 next year. To compare this amount with the loan repayment 950,000 Br. Net gain = Income - Loan Repayment = 1,000,000 - 950,000 = 50,000 Br Conclusion Since the income generated by the car exceeds the total loan repayment, you would be much better off by taking out the loan, even at a 90% interest rate. The net gain of 50,000 Birr shows that the benefits of taking the loan and purchasing the car outweigh the costs.

18. Q2. While corporations do not directly raise funds in secondary markets, these markets play a vital role in supporting the overall economy by providing liquidity, facilitating price discovery, promoting efficient resource allocation, and indirectly lowering the cost of capital for companies. Therefore, secondary markets are just as important as primary markets in a well-functioning financial system. The argument that secondary markets are less important to the economy is therefore not well-founded. Both primary and secondary markets are interdependent and crucial for economic growth and stability. Q3. Given the higher priority in the claims process and the greater likelihood of recovering some value in bankruptcy, it is generally preferable to hold bonds rather than equities if you suspect a company will go bankrupt next year. Holding bonds offers better protection against the risk of total loss compared to holding stocks.

19. Q4. The adverse selection problem, rooted in information asymmetry, explains why you are more likely to make a loan to a family member than to a stranger. With a family member, you have better information, trust, and the ability to monitor and enforce the loan, reducing the risk of adverse selection. In contrast, lending to a stranger involves greater uncertainty and a higher risk of adverse selection, making you less likely to offer the loan. Q5. Yes, even if there were no asymmetry in the information that a borrower and a lender had, a moral hazard problem could still exist. Moral hazard is primarily about how incentives and behaviors change after a transaction, rather than just about the initial information available to the parties. Even in a scenario where there is no asymmetry in information, moral hazard can still arise because the borrower may change their behavior in ways that increase risk, knowing that the consequences will be partly borne by the lender.

20. Q6. By placing your money in a savings account and letting the bank lend to your neighbor, you benefit from reduced risk, convenience, professional credit assessment, legal protections, and liquidity, all while earning a relatively safe return on your investment. Lending directly to your neighbor, while potentially more profitable, would expose you to significant risks and responsibilities that most individuals are not equipped or willing to handle.

21. Assignment -1 1. Contemporary issues of Financial intermediaries and markets in Ethiopia , for example, related to: Establishment Accounting reports Restrictions on Assets and Activities Insurance to safeguard their customers Interest rate etc. Assignment -2 2. Articles review related to Financial Markets and Institutions, 3 articles.

22. End of Chapter one