SU,CBE,ACFN

DEPARTMENT OF ACCOUNTING AND

FINANCE

COURSE NAME: FINANCIAL INSTITUTION

AND MARKET

COURSE CODE: ACFN3081

By: Dagnachew T. 2024
 CHAPTER ONE
AN OVERVIEW OF THE FINANCIAL SYSTEM
• OUTLINES…..
The Role of financial system in the economy

Provision of liquidity

Transformation of the risk characteristics of assets

Financial assets: role and properties

Financial markets: role, classifications and participants

Lending and borrowing in the financial system

 The Role of financial system in the economy
• A financial system (within the scope of finance) is a system that allows the exchange
of funds between lenders, investors, and borrowers. Financial systems operate at
national, global, and firm-specific levels. They consist of complex, closely related
services, markets, and institutions used to provide an efficient and regular linkage
between investors and depositors.
• A modern financial system may include banks (operated by the government or private
sector), financial markets, financial instruments, and financial services. Financial
systems allow funds to be allocated, invested, or moved between economic sectors.
Financial systems, i.e. financial intermediaries and financial markets, channel funds
from those who have savings to those who have more productive uses for them.
They perform two main types of financial service that reduce the costs of moving
funds between borrowers and lenders, leading to a more efficient allocation of
resources and faster economic growth.
• These are the provision of liquidity and the transformation of the risk characteristics
of assets.
 Provision of liquidity
• The link between liquidity and economic performance arises because many high
return investment projects require long-term commitments of capital, but risk
adverse lenders (savers) are generally unwilling to delegate control over their
savings to borrowers (investors) for long periods. Financial systems mobilize
savings by agglomerating and pooling funds from disparate sources and creating
small denomination instruments. These instruments provide opportunities for
individuals to hold diversified portfolios. Without pooling individuals and
households would have to buy and sell entire firms.
• Financial markets can also transform illiquid assets (long-term capital
investments in illiquid production processes) into liquid liabilities (financial
instrument). With liquid financial markets savers/lenders can hold assets like
equity or bonds, which can be quickly and easily converted into purchasing
power, if they need to access their savings.
 Transformation of the risk characteristics of assets
The second main service financial intermediaries and markets provide is the transformation of
the risk characteristics of assets. Financial systems perform this function in at least two ways.
First, they can enhance risk diversification and
Second, they resolve an information asymmetry problem that may otherwise prevent the
exchange of goods and services.
Financial systems facilitate risk-sharing by reducing information and transactions costs. If
there are costs associated with the channeling of funds between borrowers and lenders,
financial systems can reduce the costs of holding a diversified portfolio of assets.
Intermediaries perform this role by taking advantage of economies of scale; markets do so by
facilitating the broad offer and trade of assets comprising investors’ portfolios.
 Financial assets: role and properties
• An asset is defined as any resource that is expected to provide future
benefits and, hence, has economic value. Assets can be divided into two
categories: tangible assets (real assets) and intangible assets (financial
assets).
• The value of a tangible asset (real assets) depends on its physical
properties. Buildings, aircraft, land, and machinery are examples of tangible
assets.
• An intangible asset represents a legal claim to some future economic
benefits. The value of an intangible asset bears no relation to the form,
physical or otherwise, in which the claims are recorded.
 CONT’D….
• Financial assets (intangible): Another term used for a financial asset is a financial instrument. Certain

types of financial instruments are referred to as securities and generally include stocks and bonds. For

every financial instrument there is a minimum of two parties. The party that has agreed to make future

cash payments is called the issuer; the party that owns the financial instrument and therefore the right to

receive the payments made by the issuer is referred to as the investor.

Familiar examples include:
• Money: any financial asset that is generally accepted in payment for purchases of goods and
services. Thus, checkable accounts and currency are financial assets servings as payment media
and therefore are forms of money.
• Equity/stocks: represent ownership shares in a business firm and as such, are claims against the
firm’s profits and against proceeds from the sale of its assets.
• Debt securities: include such familiar instruments as bonds, notes, and accounts payable.
• Insurance policies, contracts, etc…
 Properties or Characteristics of Financial Assets

• Financial asset do not provide a containing stream of services to their owners

as a home, an automobile or a washing machine would do. These assets are
sought after because.

• They promise, future returns to their owners and serve as a store of value
(Purchasing power). A number of other features make financial assets unique.
They cannot be depreciated because they do not wear out like physical goods,
moreover, their physical condition or form usually is not relevant in
determining their market value (price).
 CONT’D….
• Generally, financial assets have the following properties:
• Moneyness: some financial asset used as a medium of exchange or in settlement of
transactions. Could be cash or near money, such as time & savings deposits.
• Reversibility: the cost of investing in a financial asset and then getting out of it and
back into cash again.
• Cash flow,
• Term to maturity,
• Convertibility,
• Currency,
• Liquidity,
• Return predictability,
• etc
 The roles of financial assets
• Financial assets serve two principal economic roles or functions.
• First, they allow the transference of funds from those entities that have
surplus funds to invest to those who need funds.
• Second, they permit the transference of funds in such a way as to redistribute
the unavoidable risk associated with the cash flow generated by tangible
assets among those seeking and those providing the funds. However, the
claims held by the final wealth holders generally differ from the liabilities
issued by those entities that are the final demanders of funds because of the
activity of entities operating in financial systems, called financial
intermediaries, who seek to transform the final liabilities into different
financial assets preferred by the public.
 Financial markets: role, classifications and participants
• A financial market is a market in which people trade financial securities,
commodities, and other tangible items of value at low transaction costs and at
prices that reflect supply and demand. Securities include stocks and bonds, and
commodities include precious metals or agricultural products.
• In economics, typically, the term market means the aggregate of possible buyers
and sellers of a certain good or service and the transactions between them.
• The term "market" is sometimes used for what are more strictly exchanges,
organizations that facilitate the trade in financial securities, e.g., a stock exchange or
commodity exchange. This may be a physical location (like NYSE (New York stock
exchange) or an electronic system.
• Much trading of stocks takes place on an exchange; still, corporate actions (e.g.,
merger) are outside an exchange, while any two companies or people, for whatever
reason, may agree to sell stock from the one to the other without using an
exchange.
 Role of financial markets
• One of the important sustainability requisite for the accelerated development
of an economy is the existence of a dynamic financial market. A financial
market helps the economy in the following manner.
• Saving mobilization: Obtaining funds from the savers or surplus units such as
household individuals, business firms, public sector units, central government, state
governments etc. is an important role played by financial markets.
• Investment: Financial markets play a crucial role in arranging to invest funds thus
collected in those units which are in need of the same.
• National Growth: An important role played by financial market is that, they contribute
to a nation's growth by ensuring unfettered flow of surplus funds to deficit units. Flow
of funds for productive purposes is also made possible.
• Entrepreneurship growth: Financial markets contribute to the development of the
entrepreneurial claw by making available the necessary financial resources.
• Industrial development: The different components of financial markets help an
accelerated growth of industrial and economic development of a country, thus
contributing to raising the standard of living and the society of well-being.
 Types or Classification of Financial Markets
• Financial markets can be divided in the following ways:
1. Based on the nature of the claim
2. Based on the maturity of the claims
3. Based on the newly issued or not
4. Based on the Cash versus derivative instruments…
 1. On the basis of the nature of claims
• The claims traded in a financial market may be either for a fixed dollar
amount or a residual amount and financial markets can be classified
according to the nature of the claim. The former financial assets are
referred to as debt instruments and, and the financial market in which such
instruments are traded is referred to as the debt market.
• The latter financial assets are called equity instruments and the financial
market where such instruments are traded is referred to as the equity
market or stock market. Preferred stock represents an equity claim that
entitles the investor to receive a fixed dollar amount. Consequently,
preferred stock has in common characteristics of instruments classified as
part of the debt market the equity market. Generally, debt instruments and
preferred stock are classified as part of the fixed income market.
 2. On the basis of maturity of the claims
• On the basis of this, financial market is classified as money market and
capital market.
 Money market: is a market where short-term funds are borrowed and
lent. It is a market for short-term financial assets, which are near
substitute for money. The instruments dealt within the money market
are liquid and can be turned over quickly at low transaction cost and
without loss. Generally, a financial asset with a maturity of one year or
less is considered short-term and therefore part of the money markets.
 CONT’D….
 Capital market: is a market in which firms and other institutions that
require funds to finance their long term operations come together with
individuals and institutions that have money to invest. Capital market makes
long term debt financing and capital possible. The capital market can be
divided into bond market and stock market. The traditional cutoff between
short term and long term is one year.
A financial asset with a maturity of more than one year is part of the capital
market.
3. On the basis of whether the financial claims
are newly issued or not
• A third way to classify financial markets is by whether the financial
claims are newly issued. When an issuer sells a new financial asset to
the public, it is said to be “issue” the financial asset. The market for
newly issued financial assets is called the primary market.

• After a certain period of time, the financial asset is bought and sold
(i.e., exchanged or traded) among investors. The market where this
activity takes place is referred to as the secondary market.
 4. On the basis of cash versus derivative
instruments
• Some financial assets are contracts that either obligates the investor to buy or
sell another financial asset or grant the investor the choice to buy or sell
another financial asset. Such contracts derive their value from the price of the
financial asset that may be bought or sold.

• These contracts are called derivative instruments and the markets in which
they trade are referred to as derivative markets.
 Financial markets also can be divided as follows:
• Open versus negotiated Markets
• Another distinction between market in the global financial system focuses on
open market versus negotiated markets.
• For example, some corporate bonds are sold in the open market to the
highest bidder and are bought and sold any number of times before they
mature and are paid off. In contrast, in the negotiated market for corporate
bonds, securities generally oversold to one or a few buyers under private
contract.
E.g. An individual who goes to his or her local banker to secure a loan for new
furniture enters the negotiated market for personal loans. In the market for
corporate stocks there are the major stock exchanges which represent the
open market.
 CONT’D….
• Spot vs. forward market

• A spot market is any market where buyers and sellers contract for
immediate payment and delivery at the moment of contractual
agreement.

• A forward market is any market where the buyer and seller enter into a
contractual agreement today for payment and delivery at specific dates in
the future. A contract is a legal agreement between the parties to perform
specific actions at a specified date.
 Financial market participants
• There are three basic financial market participant categories.
• Action in financial markets by central banks is usually regarded as
intervention rather than participation.
I) Supply side vs. demand side
• A market participant may either be coming from the Supply Side, hence
supplying excess money (in the form of investments) in favor of the demand
side; or coming from the Demand Side, hence demanding excess money (in
the form of borrowed equity) in favor of the Supply Side.
• The demand side consists of: those in need of cash flows (daily operational
needs).
• The supply side consists of: those who have aggregate savings .
 II) Investor vs. Speculator
• An investor is any party that makes an Investment. However, the term has
taken on a specific meaning in finance to describe the particular types of
people and companies that regularly purchase equity or debt securities for
financial gain in exchange for funding an expanding company.
• Speculation, in the narrow sense of financial speculation, involves the
buying, holding, selling, and short-selling of stocks, bonds, commodities,
currencies, collectibles, real estate, derivatives or any valuable
financial instrument to profit from fluctuations in its price as opposed to
buying it for use or for income via methods such as dividends or interest.
Speculator is any party undertakes speculation activity.
 III) Institutional investor vs. Retail investor
• An institutional investor is an investor, such as a bank, insurance company,
retirement fund, or mutual fund that is financially sophisticated and makes
large investments, often held in very large portfolios of investments.
• A retail investor is an individual investor possessing shares of a given
security.
 Lending and borrowing in the financial system
• The following table illustrates where financial system [financial markets&
financial institutions] fit in the relationship between lenders {lending party}
and borrowers {borrowing party}:
Relationship between lenders and borrowers

Lenders Financial Intermediarie Financial Markets Borrowers

s

Stock Exchange Individuals

Banks
Money Market Companies
Individuals Insurance Companies
Bond/Capital Market Central Government
Companies Pension Funds
Foreign Exchange Municipalities
Mutual Funds
market Public Corporations