FM- Financial System- Basic Overview.pdf

This presentation provides a detailed exploration of financial systems and their critical role in economic development. It covers key components like financial institutions, markets, instruments, and payment systems, highlighting their functions in mobilizing savings, allocating capital, and facilitating transactions. Concepts such as risk, interest rates, and financial markets are discussed, showcasing how they impact financial decisions. The presentation also delves into the term structure of interest rates, explaining various theories like the liquidity preference theory and expectations theory, which shape the yield curve. Overall, it emphasizes the importance of a robust financial system in fostering economic growth and stability.

1. FINANCIAL
SYSTEM

2. MEANING
The financial system refers to the network of institutions, such as banks,
insurance companies, markets, and stock exchanges.
The primary function of the financial system is to distribute savings from
individuals and businesses to productive investments, allocate capital
efficiently, and manage risks.
Moreover, it provides a framework for mobilizing and allocating financial
resources, facilitating transactions, and enabling funds transfer
between borrowers and lenders. It is crucial in fostering economic
growth, promoting investment, and supporting an economy’s stability and
functioning.

3. WHAT IS THE ROLE OF THE
FINANCIAL SYSTEM?
The financial system plays a vital role in the economy by mobilizing
savings, allocating capital efficiently, and facilitating productive
investments.
It provides services that enable smooth financial transactions, and
information dissemination, and supports economic stability through risk
management and financial intermediation.
In short, the financial system serves as a crucial intermediary, promoting
economic growth and facilitating the efficient allocation of resources
within an economy.

4. IMPORTANCE
Financial systems are crucial for economies as they promote economic
growth.
They enable individuals and institutions to save, invest, manage risks,
and conduct transactions efficiently. Financial systems also play a role in
price discovery, ensuring fair prices for assets and commodities.
They contribute to economic stability, support monetary policy, and help
regulate financial activities. Overall, financial systems are vital for the
functioning and development of economies.

6. IMPORTANCE
Financial systems are crucial for economies as they promote economic
growth.
They enable individuals and institutions to save, invest, manage risks,
and conduct transactions efficiently. Financial systems also play a role in
price discovery, ensuring fair prices for assets and commodities.
They contribute to economic stability, support monetary policy, and help
regulate financial activities. Overall, financial systems are vital for the
functioning and development of economies.

7. 1. FINANCIAL
INSTITUTION
The entities that provide
financial services, such as
banks, credit unions, insurance
companies, investment banks,
and pension funds, are called
financial institutions.
They act as intermediaries
between savers and borrowers,
channeling funds from savers to
borrowers.

8. 2. FINANCIAL
MARKETS
Financial markets are platforms where
individuals, businesses, and
governments buy and sell financial
assets.
Here are the various types of financial
markets:
Stock markets (for trading shares of
companies), bond markets (for trading
debt securities)
Commodity markets (for trading
commodities like gold, oil, etc.)
Foreign exchange markets (for
trading currencies)

9. 3. FINANCIAL
INSTRUMENTS
Financial instruments are monetary
contracts that can be traded.
Financial instruments include stocks,
bonds, futures contracts,
mortgages.
Financial instruments provide a
means for investors to invest their
funds and for borrowers to raise
capital.

10. 4. PAYMENT AND
SETTLEMENT SYSTEMS
Payment and settlement systems
enable fund transfer between
individuals, businesses, and
financial institutions.
It facilitates the clearing and
settlement of transactions, ensuring
that funds are transferred securely
and efficiently.

11. 5. REGULATORY
AUTHORITIES
Governmental or independent
regulatory bodies regulate all
financial systems.
These authorities establish rules
and regulations to ensure financial
markets and institutions’ stability,
transparency, and fairness.
Additionally, these regulatory
authorities protect consumers and
investors from fraud, misconduct,
and excessive risk-taking.

12. 6. CENTRAL BANKS
Central banks are the monetary
authorities of a country and
sometimes for a group of countries.
They are responsible for formulating
and implementing monetary policy,
controlling the money supply, and
maintaining the financial system’s
stability. The Central banks also act
as lenders of last resort to provide
liquidity during financial stress.

13. 7. FINANCIAL
INFRASTRUCTURE
Financial infrastructure is a
technological system that supports
the financial system’s smooth
functioning.
Some examples of financial
infrastructure include electronic
banking systems, trading platforms,
clearing and settlement systems,
credit card networks, and more.

14. 8. FINANCIAL
SERVICES
The various services offered by
financial institutions, such as loans,
deposits, payment services,
investment services, insurance
services, financial advisory
services, and risk management
services, are termed financial
services.

15. RISK IN
FINANCIAL
MANAGEMENT

16. DEFINITION
Risk in financial management is the potential for an investment's
actual returns to differ from its expected returns. It encompasses
the uncertainty and variability in financial outcomes, which can
impact the value of investments, financial decisions, and overall
financial performance. Risk is inherent in all financial activities due to
factors like market fluctuations, economic changes, and individual
business dynamics.

17. IMPORTANCE
Understanding risk is crucial for financial managers because it
affects the decision-making process. Risk assessment helps
managers evaluate potential gains against potential losses,
determine the viability of projects, and make informed choices
about resource allocation, investment strategies, and financial
planning.

18. TYPES OF RISK
UNSYSTEMATIC RISKSYSTEMATIC RISK CREDIT RISK
OPERATIONAL RISKLIQUIDITY RISK MARKET RISK
CURRENCY RISK
(EXCHANGE RATE RISK)
INTEREST RATE RISK MARKET RISK

19. SYSTEMATIC RISK
Definition: Systematic risk, also known as
market risk or non-diversifiable risk, is the risk
inherent to the entire market or a specific
segment of the market. It cannot be eliminated
through diversification.
Sources: Systematic risk arises from
macroeconomic factors such as inflation,
interest rates, political instability, natural
disasters, and global economic events.
Impact: Since systematic risk affects the entire
market, all investments within the market are
likely to be impacted similarly. This risk is
unavoidable and must be managed through
strategies like hedging or asset allocation.

20. UNSYSTEMATIC RISK
Definition: Unsystematic risk, also known as
specific or diversifiable risk, is associated with a
particular company or industry. Unlike
systematic risk, it can be mitigated through
diversification.
Sources: Unsystematic risk stems from factors
like management decisions, competitive
pressures, labor strikes, product recalls, and
changes in consumer preferences.
Impact: Unsystematic risk affects only a
specific company or industry. Investors can
reduce their exposure to unsystematic risk by
holding a diversified portfolio of investments
across different sectors.

21. CREDIT RISK
Definition: Credit risk is the risk that a borrower
will default on their financial obligations, leading
to a loss for the lender or investor.
Sources: It arises from lending activities, bond
investments, and any other financial
transactions where repayment is expected over
time.
Impact: Credit risk can lead to significant
financial losses, especially in the event of
widespread defaults during economic
downturns. Lenders and investors manage this
risk by conducting thorough credit
assessments and setting appropriate interest
rates.

22. LIQUIDITY RISK
Definition: Liquidity risk refers to the risk of
being unable to quickly buy or sell an
investment without significantly affecting its
price.
Sources: Liquidity risk arises in markets with
low trading volumes or where assets are not
easily convertible to cash.
Impact: High liquidity risk can lead to
substantial losses if an investor is forced to sell
an asset at a significantly lower price. Financial
managers manage liquidity risk by maintaining a
balance between liquid and illiquid assets in
their portfolios.

23. OPERATIONAL RISK
Definition: Operational risk is the risk of loss
resulting from inadequate or failed internal
processes, people, systems, or external events.
Sources: This risk can arise from various
sources, including human error, system failures,
fraud, and natural disasters.
Impact: Operational risk can result in direct
financial losses and reputational damage.
Companies manage operational risk through
robust internal controls, contingency planning,
and risk management frameworks.

24. MARKET RISK
Definition: Market risk is the risk of losses in
investments due to changes in market
conditions, such as fluctuations in asset prices,
interest rates, or currency exchange rates.
Sources: Market risk arises from changes in
economic conditions, investor sentiment, and
geopolitical events.
Impact: Market risk affects the overall value of
an investment portfolio. It is managed through
techniques like diversification, hedging, and the
use of derivatives.

25. INTEREST RATE RISK
Definition: Interest rate risk is the risk of
changes in investment value due to fluctuations
in interest rates.
Sources: This risk primarily affects fixed-
income securities like bonds, where the value of
the investment decreases as interest rates rise.
Impact: Interest rate risk can lead to lower
investment returns or increased borrowing
costs. Financial managers use interest rate
swaps, duration analysis, and bond laddering to
manage this risk.

26. CURRENCY RISK
(EXCHANGE RATE
RISK)
Definition: Currency risk is the risk of loss due
to fluctuations in foreign exchange rates,
affecting investments or financial transactions
denominated in a foreign currency.
Sources: It arises from international
investments, cross-border transactions, and
the global operations of multinational
companies.
Impact: Currency risk can lead to significant
financial losses if exchange rates move
unfavorably. It is managed through currency
hedging, forward contracts, and diversifying
investments across different currencies.

27. MANAGING RISK
HEDGINGDIVERSIFICATION INSURANCE
CONTINGENCY PLANNINGASSET ALLOCATION RISK TRANSFER

28. DIVERSIFICATION
Definition: Diversification involves spreading investments
across different assets, sectors, or geographical regions
to reduce exposure to any single risk factor.
Application: By diversifying, investors can mitigate
unsystematic risk, ensuring that the poor performance of
one investment does not significantly affect the overall
portfolio.
HEDGING
Definition: Hedging is a risk management strategy that
involves using financial instruments, such as options,
futures, or swaps, to offset potential losses in an
investment.
Application: Companies and investors use hedging to
protect against adverse price movements in
currencies, commodities, or interest rates, reducing the
overall risk.

29. INSURANCE
Definition: Insurance involves transferring risk to an
insurer in exchange for a premium, protecting against
potential financial losses from specific risks, such as
property damage or liability.
Application: Businesses use insurance to manage
operational risks, ensuring that they can recover from
unexpected events without significant financial strain.
ASSET ALLOCATION
Definition: Asset allocation is the process of
distributing investments across different asset
classes, such as equities, bonds, and cash, to balance
risk and return.
Application: Financial managers use asset allocation to
create portfolios that align with the investor’s risk
tolerance and investment goals, ensuring a diversified
and risk-managed investment approach.

30. CONTINGENCY
PLANNING
Definition: Contingency planning involves preparing for
unexpected events or crises by developing alternative
plans and strategies to mitigate the impact of those
events.
Application: Companies develop contingency plans to
manage operational risks, such as supply chain disruptions
or financial downturns, ensuring business continuity.
RISK TRANSFER
Definition: Risk transfer involves shifting the risk from
one party to another, typically through contracts,
such as outsourcing, leasing, or purchasing insurance.
Application: Businesses use risk transfer strategies to
manage risks that they are not equipped to handle
internally, reducing potential exposure to financial loss.

31. THE TERM STRUCTURE OF INTEREST RATES
The term structure of interest rates, often
referred to as the yield curve, illustrates
the relationship between the yield
(interest rate) of bonds and their
respective maturities for a specific
issuer, typically government bonds. It
provides insights into the cost of borrowing
over different periods.

33. TYPES OF YIELD CURVE
NORMAL YIELD CURVE
Typically upward-sloping.
Indicates that longer-term
bonds have higher yields
than shorter-term bonds.
Reflects investor
expectations that the
economy will grow, leading
to higher inflation and
interest rates in the future.
INVERTED YIELD CURVE
Downward-sloping curve where
shorter-term bonds have higher
yields than longer-term bonds.
Often signals a potential
economic downturn or recession.
Occurs when investors expect
future interest rates to decline,
often due to expectations of
lower inflation or reduced
economic activity.

34. FLAT OR HUMPED YIELD CURVE
A flat curve indicates that yields across different
maturities are similar, suggesting uncertainty in the
economic outlook.
A humped curve, where medium-term bonds have higher
yields than both short-term and long-term bonds,
indicates that the market expects short-term interest
rates to rise and then fall.

35. THEORIES EXPLAINING THE SHAPE OF THE
YIELD CURVE
01 - LIQUIDITY PREFERENCE THEORY
02 - EXPECTATIONS THEORY
03 - MARKET SEGMENTATION THEORY

36. LIQUIDITY PREFERENCE THEORY
Suggests that investors prefer liquidity, meaning they
favor short-term securities that are less risky and
easier to sell.
To entice investors to hold longer-term securities,
issuers must offer higher yields, leading to an upward-
sloping yield curve.
Explains the typical shape of the yield curve as
investors demand a risk premium for holding less
liquid, long-term securities.

37. EXPECTATIONS THEORY
Proposes that long-term interest rates are
determined by investors’ expectations of future
short-term rates.
If investors expect future short-term rates to
increase, the yield curve will slope upward; if they
expect rates to decrease, the curve will slope
downward.
A normal yield curve suggests that investors expect
future interest rates to rise, while an inverted curve
indicates expectations of falling rates.

38. MARKET SEGMENTATION THEORY
Argues that the bond market is segmented based on
maturity preferences of different investors.
Investors have specific preferences for bonds of
certain maturities, and these preferences determine
the supply and demand for bonds in each segment.
Yield curves are shaped by the supply and demand
within these segments, independent of expectations
about future interest rates.
Explains why yield curves might not always be
smooth or follow expected patterns.

39. In summary, a well-structured financial system is the backbone of
economic growth. By mastering concepts like risk, interest rate theories,
and financial market dynamics, we unlock the tools to drive
development and stability. As we delve deeper, we see how these
elements are not just indicators, but powerful levers shaping the future
of economies.