Money, Banking and Financial

Markets

Chapter 3

The Financial System

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Chapter Introduction
3.1 Definition and Function
3.2 Structure of Financial Market
3.3 Instruments of Financial Market
3.4 Forms of Financial Market
3.5 Internationalization of Financial Market
3.6 Financial Institutions
 3.1 Definition and Function
3.1.1 Definitions

The financial system is the

process by which money
flows from savers to users.

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 3.1.2 Function of Financial Markets

• Channels funds from person or business

without investment opportunities (i.e.,
“Lender-Savers”) to one who has them
(i.e., “Borrower-Spenders”)
• Improves economic efficiency

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 3.1.3 Importance of Financial Markets
• This is important. For example, if you save $1,000, but there
are no financial markets, then you can earn no return on this-
might as well put the money under your mattress.
• However, if a carpenter could use that money to buy a new
saw (increasing her productivity), then she’d be willing to pay
you some interest for the use of the funds.
▪ Financial markets are critical for producing an efficient
allocation of capital, allowing funds to move from people who
lack productive investment opportunities to people who have
them.
▪ Financial markets also improve the well-being of consumers,
allowing them to time their purchases better.

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 3.2 Structure of Financial Market

3.2.1 Financial Markets Funds Transferees

Lender-Savers Borrower-Spenders
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners

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3.2.2 Segments of Financial Markets

1. Direct Finance
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are
claims on the borrower’s future income or assets
2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable
funds and loan opportunities) by issuing financial
instruments which are claims on the borrower’s future
income or assets

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3.2.3 Flows of Funds through Financial System
Indirect Finance

Financial
FUNDS Intermediaries FUNDS

F
U
N
D
S

Lender-Savers Borrower-Spenders
- Households Financial - Business firms
- Business firms FUNDS Market
FUNDS
- Government
- Government - Households
- Foreigners - Foreigners

Direct Finance

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 3.3 Instruments of Financial Market
Types of Securities:
• Securities
– Financial instruments
– Obligations on the part of the issuer
• Businesses and Governments
– Provide rate of return to purchasers
• Money Market Instruments
• Bonds
• Stock

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 3.3.1 Money Market Instruments

• Short-term Debt Securities

– Issued by governments, financial institutions
and corporations
• Investors are paid interest for the use of
their funds.
• Generally low-risk
• U.S. Treasury bills, commercial paper,
and bank certificates of deposit
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3.3.2 Bonds

• Government Bonds
– Bonds sold by the U.S. Department of the
Treasury.
• Municipal Bonds
– Bonds issued by state or local governments
• Revenue bonds are used toward a project that will
produce revenue, General Obligation Bonds are not.

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3.3.3 Stocks

• Common stock – ownership claims in

corporations.
– Vote on major company decisions
– Cash dividends
– Price appreciation

• Preferred stock – stockholders with

preference in the payment of dividends.

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3.3.4 Convertible Securities

Stockholder has the

right to exchange the
bond or preferred
stock for a fixed
number of shares of
common stock.

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 3.4. Forms of Financial Market
• Debt Markets
─ Short-Term (maturity < 1 year)
─ Long-Term (maturity > 10 year)
─ Intermediate term (maturity in-between)
• Equity Markets
─ Pay dividends, in theory forever
─ Represents an ownership claim in the firm

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• Primary Market – firms and governments issue securities
and sell them initially to the public.
– New security issues sold to initial buyers
– When a firm offers a stock for sale to the general
public for the first time.

• Secondary Market – collection of financial markets in

which previously issued securities are traded among
investors.
- Securities previously issued are bought and sold

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Even though firms don’t get any money from the secondary
market, it serves two important functions:
• Provide liquidity, making it easy to buy and sell the securities
of the companies
• Establish a price for the securities

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• Exchanges
─ Trades conducted in central locations (e.g., New York
Stock Exchange, CBT)
• Over-the-Counter Markets
─ Dealers at different locations buy and sell
─ Best example is the market for Treasury securities

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• Money Market: Short-Term
(maturity <= 1 year)
• Capital Market: Long-Term
(maturity > 1 year) plus equities

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 n d i ng St ock
Understa
Markets

Stock market (exchange) –

market in which common
stocks are traded, such as the
New York Stock Exchange.

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 c h a n g e s
k E x
Stoc
• The New York Stock Exchange – the Big Board is the
most famous and one of the oldest stock markets in the
world. More than 3,000 stocks are listed on NYSE.
• The Nasdaq Stock Market – the second largest stock
market. Over 5,000 companies have their stocks listed on
Nasdaq but many are smaller firms.
• Other U.S. Stock Markets
– The American Stock Exchange/AMEX
– Regional Stock Exchanges
– Foreign Markets
In Vietnam?

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 Investor Participation in the Stock Markets
• Investors use brokerage firms:
1) Establish an account
2) Enter orders
3) Trade stock

• The brokerage firm executes the trade

on behalf of the investor, charging a fee
for the order
– Market Order
– Limit Order

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 3.5 Internationalization of Financial Markets

• Eurocurrency Market
– Foreign currency deposited outside of home country
– Eurodollars are U.S. dollars deposited, say, London.
– Gives U.S. borrows an alternative source for dollars.
• World Stock Markets
– U.S. stock markets are no longer always the largest—
at one point, Japan’s was larger

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 3.6 Financial Institutions
✓ Commercial Banks
✓ Savings Banks and Credit Unions
✓ Non-depository Institutions

✓ Insurance Companies
✓ Pension Funds
✓ Finance Companies

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END OF CHAPTER 3