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ALOMAR_212_3 1 Chapter 2 The Financial System

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Page 1: ALOMAR_212_31 Chapter 2 The Financial System. ALOMAR_212_32 Intermediaries, instruments, and regulations. Financial markets: bond and stock markets Financial

ALOMAR_212_3 1

Chapter 2 The Financial System

Page 2: ALOMAR_212_31 Chapter 2 The Financial System. ALOMAR_212_32 Intermediaries, instruments, and regulations. Financial markets: bond and stock markets Financial

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• Intermediaries, instruments, and regulations.

• Financial markets: bond and stock markets

• Financial intermediaries: banks, insurance companies, pension funds

• Moving funds from those who have a surplus of funds to those who have a shortage of funds.

 

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1 -Functions of the Financial Markets:

• Financial markets channel funds: surplus of funds to shortage of funds.

• Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities (financial instruments) which are claims on the borrower’s future income or assets.

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• Securities are assets for the person who buy them but liabilities (IOU, debts) that (sell, issue) them.

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1 -Functions of the Financial Markets:

• With no lending or borrowing opportunities, an individual who saved KD1000 will remain the same

• But giving the KD(1000) to another person with productive use of it (earning KD200/year) sharing the KD200 (100/100).

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• Using financial markets for: increasing/improving production, personal uses (house), therefore:

• Financial markets allow funds to move from people who lack productive investment opportunities to people who have such opportunities.

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2 -The Structure of the Financial Market:

• Debt and Equity Markets: can obtain funds in financial markets in two ways:

A. Issue a debt instrument: bond, mortgage:

a contractual agreementcontractual agreement by the borrower to pay the holder of the instrument fixed amountfixed amount at regular intervalsregular intervals (interest and principle payment) until specific datespecific date (maturity date).

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• Maturity: the time that a debt instrument expires.

• If maturity is less than a year: Short-Term debt instrument

• if the maturity is ten years or longer: Long-Term debt instrument

• in between: Intermediate-Term.

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2 -The Structure of the Financial Market:

• B. Issuing Equities:

such as common stock, which are claims to share in the net income and assets of a business.

• Equities usually make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date.

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• An equity holder is a residual claimantresidual claimant:

the corporation must pay all its debt holders before it pays its equity holders

(disadvantage of owing a firm’s equity).

• The Advantage: the holder can benefit directly from any increase in profits or asset value.

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Primary and Secondary Markets :

• Primary market: a financial market in which new issues of a security (bond or stock) are sold to initial buyers.

• Secondary market: a financial market in which securities that have been previously issued are resold.

• Broker: an agent of investors who match buyers with sellers of securities.

• Dealer: link buyers and sellers by buying and selling securities at stated prices.   

   

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• A corporation acquires new funds only when its securities are first sold in the primary market.

• Secondary markets serve 2 functions:   

• Easier to sell financial instruments to raise cash; they make financial instrument more liquid

• Determine the price of the security (pay for the issuing corporation no more than what you think it will be sold at the secondary market).     

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• Exchanges and over-the-counter markets: (to organize secondary markets)

• Exchanges; a central location where buyers and sellers of securities meet.

• Over the counter market (OTC): dealers in different locations with inventory of securities stand ready to buy and sell securities “over the counter” to anyone accept their price.

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• Money and capital markets: depends on the maturity of the securities traded in each market;

• Money market:

only short-term debt instrument are traded.  

• Capital market:

the market in which longer term debt and equity instrument are traded.

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3 -Financial Market Instrument :

• Money market instrument: Short-term to maturity, least price fluctuations, least risky investments.

• US Treasury bills, Negotiable bank certificates of deposits, Commercial paper, Banker’s acceptances, Repurchase agreements, Federal funds.

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• Capital market instrument:

• Stocks, Mortgages, Corporate bonds, US government securities, US government agency securities, State and Local government bonds, Consumer and Bank commercial loans.

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• 4- Function of Financial Intermediaries

- Transaction Costs: economies of scale

- Asymmetric information:

Adverse Selection and Moral Hazard.

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5- Financial Intermediaries

A. Depositary Institutions.

- Commercial Banks.

- Savings and Loan Association

- Mutual Savings Banks

- Credit Unions.

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5- Financial Intermediaries

B. Contractual Savings Institutions:

- Life insurance companies

- Fire and Casualty insurance companies.

- Pension funds and government retirement funds.

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5- Financial Intermediaries

C. Investment Intermediaries:

- Finance companies

- Mutual funds

- Money market mutual funds.

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6 -Regulations of the Financial System:

A. Increasing information available to investors.

B. Improving control of monetary policy

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6 -Regulations of the Financial System:

C. Ensuring the soundness of financial intermediaries:

- Restrictions on entry,

- Disclosure,

- Restrictions on assets and activities,

- Deposit insurance,

- Limits on competition,

- Restrictions on interest rates