Armour Chapter 2 Flashcards
Revision of Chapter 2 of Module 1
Why is the financial system so large and complex?
- Every individual, company needs finance in some form or the other.
- The needs of individuals and companies differ significantly.
- complexity multiplied by the need to relate the future to the present.
- financial system keeps capital flowing around the economy.
- Links the economy of today with the economy of tomorrow.
What is the distinction between the financial system and the so-called real economy?
real economy refers to the part of the economy which deals with production, transportation and selling of goods and services. (Outcome based: manufactures goods and services).
The significance of the financial system lies in the functions it performs in relation to the real economy.
This it does by intermediating between the personal sector of real economy and the household sector of real economy.
Personal Sector of Real Economy.
Individuals and Households.
Corporate Sector of Real Economy.
Start-Ups, small entrepreneurial firms, medium-sized enterprises, and large corporations.
5 Fundamental Roles of Financial Systems
- Providing a secure mechanism for payments at a distance.
- Mobilizing capital from savers who have more financial resources than uses for the resources.
- Selecting projects from among those who seek investment to capital.
- monitoring the performance of those executing projects in which investment has been made.
- managing risk.
The Traditional Components of a Financial system.
A. Direct Intermediaries’: Banks
1. commercial banks act as intermediaries between savers and borrowers.
2. lenders deposit money in banks and checking deposits and time accounts.
3. Borrowers are lent this money for a variety of terms.
B. FINANCIAL MARKETS:
Allow savers and borrowers to directly connect with one another.
C. MARKET-FACILITATING INSTITUTIONS
D. ASSET MANAGERS
E. OTHER FINANCIAL INTERMIDIARIES
Functions of a Bank
- Banks lend and borrow money @ fixed and variable rates (literal commodification of trust).
- Banks hand out loans to the household and corporate sectors.
- In doing this, Banks perform the functions of a financial system for the Real Economy (i.e. Payment Service over distances).
- Banks mobilize capital by providing depositors with both a return on their investment and liquidity.
- Conversion of Illiquid assets to Liquid assets (savers want to be able to convert some part of their investments to cash at a short notice in the off-chance they suffer financial shock or decide to change their consumption patterns. However, many investments are illiquid, wherein the investors won’t get back their funds at short notice. By pooling savings from different households, Bank intermediation enables savers to get access to higher returns offered by illiquid investments BUT still have access to liquid funds.)
- PROJECT SELECTION AND MONITORING FUNCTION: Banking personnel have considerable expertise in accessing the quality of credit decisions and monitoring borrower’s performance. Banks that can do this have immense value, as when a bank refinances a loan, other investors become more willing to advance funds.
If a bank fails at this, corporate borrowers suffer a loss in value, making it costly for another lender to acquire the same private knowledge about its business that its original lender did, making it MORE costly for the firm to raise capital in the short-run. - MANAGEMENT OF RISK: Associated with investment at lower cost than the investor’s themselves: derive diversification benefits from investing in a large array of assets, which would be very costly for individuals to hold themselves.
FINANCIAL MARKETS AND THEIR TYPES
Financial markets allow savers and borrowers to directly connect with one another.
1. Equity Markets
a. Primary Markets
b. Secondary markets
2. Bond Markets
3. Commodities Markets
4. Derivatives Markets
In both, Equity and Bond Markets, the investors are a mix of private individuals and institutional investors.
EQUITY MARKETS
An equity market is a market in which shares are issued and traded, either through exchanges or over-the-counter markets.
These are of the following two types:
PRIMARY MARKETS: Raising Equity Capitals, where companies sell their shares to investors.
SECONDARY MARKETS: Where the investors trade their shares on the stock exchange.
BOND MARKETS
A bond market is a marketplace for debt securities. This market covers both government-issued and corporate-issued debt securities.
DERIVATIVES MARKETS
These are markets on which financial instruments based on other financial instruments are traded.
They are called ‘Derivatives’ to indicate that their pay-offs are derived from movements in other-financial securities and assets (aka the underlying).
WHAT ARE THE ADANTAGES OF TRADING DERIVATIES AS AGAINST UNDERLYING SECURITIES?
a. Possible to produce a richer array of financial profiles than what the underlying securities themselves offer.
b. Allows investors to earn returns from securities @ low cost.
c. Markets in derivatives are more liquid than the underlying securities, in the sense that there is an active market in them which allows investors to buy and sell them easily.
Examples of Derivatives Market
FUTURES MARKETS: Where contracts are traded under which parties agree to exchange securities, commodities or currencies at a future date for a pre-set price.
Commodities Market
These are markets for trading a range of primary commodities. Typically, for countries rich in natural resources.
Two types of Banks
- Commercial Banks: primarily concerned with taking and investing deposits and the other funds which they raise.
- Investment Banks: that provide similar services as commercial banks in addition to services other than deposits.
Functions of a Financial Market.
a. allow savers and borrowers to directly connect with one another.
b. Perform project screening and monitoring functions: they do this via a price mechanism.
c. in a well-functioning capital market, the prize serves to aggregate information about the expected value of activities of securities issuers.
In the making of Investment Decisions: Savers and Speculators are making assumptions about the likely prospect for economies, firms and markets.
MARKET FACILITATING INSTITUTIONS
Markets are generally complimented by a number of institutions that assist their functioning.
Credit-rating institutions evaluate the financial soundness of companies, financial institutions, and governments that issue bonds and other fixed income securities.
Equity analysts evaluate the likely future prospects of shares of individual companies and make recommendations of whether investors should buy or sell the shares.
ASSET MANAGERS
Some intermediaries specialize in the management of retail investors financial assets by investing in publicly traded securities on their behalf, also qualifying market-facilitating institutions.
What are the ways in which Market-Facilitating Institutions facilitate retail investors access to securities market?
- They let them benefit from diversification, it does not matter how small the amount invested is.
- MFIs choose investments on behalf of the retail investors based on their ‘supposedly’ superior expertise.
- They execute investment decisions at a lower cost given their size.
OTHER FINANCIAL INTERMIDIARIES
1 PENSION FUNDS invest for the long term in assets that benefit employees on retirement.
2. INSURANCE COMPANIES offer protection to the insured against risks of loss sustained on their property and themselves.
Q: If markets serve to aggregate information for the investor, what role do these institutes play in the monitoring and screening of investments?
This depends on how well a financial market functions.
1. For highly liquid markets, Asset managers expertise adds very little.
2. For less Liquid markets, specialist asset managers can add value for the investors.
Why are Financial Systems so complex?
- INTERNATIONAL DIFFERENCE IN FINNANCIAL SYSTEMS: striking feature of financial systems across the world–Extent to which they differ across countries and the reason for pronounced variation in size and nature of financial system is the different functions that a financial system performs.
The ways in which corporate sectors finance themselves varies significantly across nations
