CH 01

Course Title: Financial Markets and Institutions
Course Code: FIN 421

Reference Books:
1. Capital Markets Institutions and Instruments,
Frank J. Fabozzi and Franco Modigliani
2. Financial Markets and Institutions,
Jeff Madura
1
Overview of financial
System and Financial
markets and Institutions
© 2003 South-Western/Thomson Learning

Overview of Financial System
 Financial System is the collection of markets,

institutions, laws and techniques through which
bonds, stocks and other securities are traded, interest
rates are determined and financial services are
produced and delivered around the world.
 Its primary task is to move scare loan able funds
from those who save to those who borrow to buy
goods and services and to make investments in new
equipment and facilities so that the global economy
can grow and increase the standard of living enjoyed
by its citizens.
Flow of funds in Financial System
Types of market
1. Product Market: The market of manufacturing
goods and services.
2. Factor Market: The market of the factors of
production i.e. labor and capital
3. Financial Market
Overview of Financial Markets
Financial Market: a market in which financial

assets (securities) such as stocks and bonds
can be purchased or sold
 Financial markets provide for financial intermediation--
financial savings (Surplus Units) to investment (Deficit
Units)
 Financial markets provide payments system
 Financial markets provide means to manage risk
Financial asset versus Tangible asset
Tangible asset: A tangible asset is one whose

value depends on particular physical properties
such as buildings, land and machinery.
Financial assets: FA represent legal claims to
some future benefits.
The role of Financial asset
 To transfer funds from those who have surplus

funds to invest to those who need funds to
invest in tangible assets
 To transfer 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.
Properties of financial Asset
1. Moneyness
2. Divisibility: Divisibility relates to the minimum
size at which a financial asset can be liquidated
and exchanged for money. The smaller the size,
the more the financial asset is divisible.
3. Reversibility: refers to the cost of investing in a
financial asset and then getting out of it and
back into cash again. Consecutively reversibility
is also referred to as round-trip cost.
4. Term to maturity: is the length of the interval
until the date when the instrument is scheduled to
make its final payment, or the owner is entitled to
demand liquidation.
5. Liquidity:
6. Convertibility
7. Currency
8. Cash flow and return predictability
9. Complexity
10. Tax status
The value of Financial Asset
 Estimate the cash flow
 Determine the appropriate interest rate for

discounting the cash flow
 Value of financial asset

Overview of Financial Markets
 Broad Classifications of Financial Markets
Money versus Capital Markets
Primary versus Secondary Markets
Organized versus Over-the-Counter Markets

Primary vs. Secondary Markets
 PRIMARY  SECONDARY
 New Issue of Securities  Trading Previously Issued
Securities
  No New Funds for Issuer

Exchange of Funds for
Financial Claim
 Funds for Borrower;  Provides Liquidity for

Seller
Money vs. Capital Markets
 Money  Capital
 Short-Term, < 1 Year  Long-Term, >1Yr
 High Quality Issuers  Range of Issuer Quality
 Debt Only  Debt and Equity
 Primary Market Focus  Secondary Market Focus
 Liquidity Market--Low  Financing Investment--

Returns Higher Returns
Organized vs. Over-the-Counter
Markets
  OTC
Organized
  Wired Network of
Visible Marketplace
Dealers
 Members Trade
 No Central, Physical
Location
 Securities Listed
 All Securities Traded
 New York Stock off the Exchanges
Exchange
Securities Traded in Financial Markets
 Money Market Securities
 Debt securities Only
 Capital market securities

 Debt and equity securities
 Derivative Securities
 Financial contracts whose value is derived from the values of
underlying assets
 Used for hedging (risk reduction) and speculation (risk
seeking)
Debt vs. Equity Securities
Debt Securities: Contractual obligations of Debtor

(borrower) to Creditor (lender)
 Investor receives interest
 Capital gain/loss when sold
 Maturity date
Debt vs. Equity Securities
Equity Securities: Claim with ownership rights and

responsibilities
 Investor receives dividends if declared
 Capital gain/loss when sold
 No maturity date—need market to sell
Role of financial Market
a. The interaction of buyers and sellers in

financial market determine the price of the
traded asset or equivalently the required
return on a financial asset is determined.
b. FM provide a mechanism for an investor to
sell the financial asset.
c. FM reduces the search and information costs
of transacting.
Financial Market Efficiency
 Security prices reflect available information
 New information is quickly included in

security prices
 Investors balance liquidity, risk, and return

needs
Financial Market Regulation
Why Government Regulation?
 To Promote Efficiency
 High level of competition
 Efficient payments mechanism
 Low cost risk management contracts

 To Maintain Financial Market Stability

 Prevent market crashes
 Circuit breakers
 Prevent Inflation--Monetary policy
 Prevent Excessive Risk Taking by Financial Institutions

 To Provide Consumer Protection

 Provide adequate disclosure
 Set rules for business conduct
 To Pursue Social Policies
 Transfer income and wealth
 Allocate saving to socially desirable areas
 Housing
 Student loans
Financial Market Globalization
Globalization of FM means the integration of

financial markets throughout the world into an
international financial market.
 Increased international funds flow
 Increased disclosure of information
 Reduced transaction costs
 Reduced foreign regulation on capital flows
 Increased privatization
Classification of Global Financial Market
1. Internal Market
a. Domestic Market: is where issuers domiciled in the country
issue securities and where those securities are subsequently
traded.
b. Foreign market of a country is where the securities of
issuers not domiciled in the country are sold and traded. For
example, the foreign market in the U.S. is call “Yankee
Market”; in japan is call “ Samurai Market”
2. External Market: also called international market includes
the following features: at issuance they are offered
simultaneously to investors in a number of countries and
they are issued outside the jurisdiction of any single country.
It is also called offshore market.
Role of Financial Institutions in Financial Markets
 Information processing
 Serve special needs of lenders (liabilities) and
borrowers (assets)
 By denomination and term
 By risk and return
 Lower transaction cost

 Serve to resolve problems of market
imperfection
Types of Depository Financial Institutions
Savings Credit Unions

Institutions
Commercial
Banks
Role of Depository Institutions
 They offer deposit accounts that can accommodate the
amount and liquidity characteristics desired by most
surplus units.
 They repackage funds received from deposits to
provide loans of size and maturity desired by deficit
units.
 They accept the risk on the loans provided
 They have more expertise than individual surplus
units in evaluating the credit worthiness of deficit
units.
 The diversify loans among numerous deficit units and
can absorb defaulted loans better than individual
surplus units could. 27
Types of Non-depository Financial
Institutions
 Insurance companies
 Mutual funds
 Pension funds
 Securities companies
 Finance companies
Role of Non-depository Financial
Institutions
 Focused on capital market

 Longer-term, higher risk intermediation
 Less focus on liquidity
 Less regulation
 Greater focus on equity investments
Comparison of Financial Institutions
Financial Main Sources of Funds Main Uses of funds
Institutions
Commercial Deposits from households, Purchases of government and corporate
Banks business and governments securities; loan to businesses and households
Saving Deposits from households, Purchases of government and corporate
Institutions business and government securities; mortgages and other loan to
agencies businesses and households
Credit Unions Deposits from credit union Loan to credit union members
members
Finance Securities sold to Loans to households and businesses
Companies households and businesses
Mutual funds Shares sold to households, Purchases of long term government and
businesses and government corporate securities
agencies
Money market Shares sold to households, Purchases of short term government and
funds businesses and government corporate securities
agencies
30
Financial Institutions Main Sources of Funds Main Uses of funds
Insurance Companies Insurance premiums and Purchases of long term
earnings from investments government and corporate
securities
Pension funds Employer/ employee Purchases of long term
contributions government and corporate
securities
Sessional Report Title
FIN 421
G-A : Impact of Financial Depth on Capital
Market Devlopment in Bangladesh.
G-B : Impact of Financial Access on Capital

G-C : Impact of Market Liqudity on Capital
G-D : Impact of Financial Openness on Capital


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Course Title: Financial Markets and Institutions

Course Code: FIN 421

© 2003 South-Western/Thomson Learning

 Financial System is the collection of markets,

Financial Market: a market in which financial

Tangible asset: A tangible asset is one whose

 To transfer funds from those who have surplus

 Estimate the cash flow

 Determine the appropriate interest rate for

 Value of financial asset

 Broad Classifications of Financial Markets

Money versus Capital Markets

Primary versus Secondary Markets

Organized versus Over-the-Counter Markets

  No New Funds for Issuer

 Funds for Borrower;  Provides Liquidity for

 High Quality Issuers  Range of Issuer Quality

 Debt Only  Debt and Equity

 Primary Market Focus  Secondary Market Focus

 Liquidity Market--Low  Financing Investment--

 Capital market securities

Debt Securities: Contractual obligations of Debtor

Equity Securities: Claim with ownership rights and

a. The interaction of buyers and sellers in

 Security prices reflect available information

 New information is quickly included in

 Investors balance liquidity, risk, and return

Why Government Regulation?

 Efficient payments mechanism

 Low cost risk management contracts

Why Government Regulation?

 To Maintain Financial Market Stability

 Prevent Excessive Risk Taking by Financial Institutions

Why Government Regulation?

 To Provide Consumer Protection

Globalization of FM means the integration of

 Lower transaction cost

Savings Credit Unions

 Focused on capital market

G-B : Impact of Financial Access on Capital

G-D : Impact of Financial Openness on Capital

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