FIN 8202 – Financial Markets and Instruments
Module 1
Key function of the financial system

Allocation of funds for alternative uses

In a deregulated environment, interests rates are the major tools used to accomplish this
allocation
Deficit and Surplus units

Saving = Income – Consumption expenditure

Saving – Investment expenditure = Surplus

Savings could result in surplus economic units – lending funds to other economic units, or

Deficit economic units - net borrow from the financial system
WHAT IS THE IMPACT ON SURPLUS/ DEFICIT UNITS
Saving is the change in household’s net worth (wealth);
-
Can also be negative if: exp > income
Investment refers to acquisition of assets which increases productiveness in economy in the future
Note: difference in normal household investment terminology
Sources of funds available to a household
1. Savings
2. Borrowing
3. Sale of assets – sale of real assets or financial assets
Mean vs. Median Net worth of households – Page 5

Difference between mean and median values reflect unequal distribution of wealth
Do Interest rates have a strong impact on level of saving? Little evidence
Reasons
1. Tax/ Inflation which erodes net saving
2. Target savings – for a specific purpose
3. Life cycle of persons saving
Intermediation and Financial Markets
Intermediation/ Indirect Financing – Advantages
1. Asset Transformation
a. Maturity transformation
b. Quality transformation
c. Denomination transformation
2. Spreading of risk over a large number of depositors
3. Low transaction costs
4. Economies in processing information
a. On loans, and intermediaries monitoring loans to mitigate default
Direct Financing – Advantages
1. Large value transactions
2. High credit ratings
Why is there a growing demand for Direct financing?

On the supply side diversion of savings from intermediaries to fund managers


Are fund managers intermediaries?
On Demand side companies with strong financial fundamentals by pass the banks and raise debt
securities
Primary vs. Secondary markets
Primary markets

Transfer of funds through IPO’s and Private placements

Private placement has lower transaction costs, and greater speed of raising capital

Success depends on investors’ perceptions of ability to subsequently sell their securities to
others: MARKET LIQUIDITY
Secondary market Liquidity
Liquidity – ease of buying and selling securities without large changes in price
Factors affecting Liquidity
1. Volume of trading
2. Market makers
3. Overseas buyers/ sellers
4. Development of Derivatives
5. Short selling