Financial system
Financial system mean
A financial system consists of institutional units and markets that interact, typically in a complex manner, for the purpose
of mobilizing funds for investment, and providing facilities, including payment systems, for the financing of commercial
activity.
Or financial environment
The financial environment refers to the system and conditions in which financial transactions, activities, and institutions
operate within a particular economy. It encompasses a broad range of elements that influence the flow of funds,
investments, and the overall functioning of financial markets. The components of the financial environment include:
1. Financial Institutions: These are organizations that facilitate the flow of funds in the economy. They include
banks, credit unions, insurance companies, mutual funds, pension funds, and other entities that provide financial
services.
2. Financial Markets: These are platforms where financial assets like stocks, bonds, commodities, currencies, and
derivatives are bought and sold. Financial markets can be categorized into primary markets (where new securities are
issued) and secondary markets (where existing securities are traded among investors).
3. Regulatory Authorities: These are government bodies responsible for overseeing and regulating the financial
system. They establish rules and guidelines to ensure fair and transparent financial operations, protect investors, and
maintain stability in the financial markets.
4. Monetary Policy: This refers to the measures implemented by a central bank (such as the Federal Reserve in the
United States) to control the money supply, interest rates, and inflation. It plays a critical role in influencing economic
activity and financial conditions.
5. Fiscal Policy: This involves the use of government spending, taxation, and borrowing to influence the economy. It
aims to achieve specific economic objectives like promoting growth, controlling inflation, and managing public debt.
6. Financial Instruments: These are tradable assets that represent a claim on some form of cash flow. They include
stocks, bonds, options, futures, commodities, and various other types of securities and derivatives.
7. Investors and Savers: These are individuals, institutions, and entities that allocate their funds in various financial
instruments with the aim of generating returns or preserving wealth. They can be categorized into retail investors
(individuals) and institutional investors (organizations).
8. Borrowers and Issuers: These are entities, such as governments, corporations, and individuals, that seek to raise
funds through the issuance of financial instruments like bonds or stocks. They borrow capital from lenders or investors
in exchange for a promise of repayment with interest or dividends.
9. Technology and Infrastructure: This includes the systems, platforms, and technologies that facilitate financial
transactions and operations. It encompasses electronic trading platforms, payment systems, information networks, and
cybersecurity measures.
10. Economic Conditions: The broader economic environment, including factors like inflation rates, interest rates,
unemployment levels, and GDP growth, significantly influences the behavior of financial markets and the decisions of
investors and borrowers.
11. Global Factors and Events: Events and conditions in the global economy, including international trade dynamics,
geopolitical events, and global financial crises, can have a profound impact on the financial environment.
12. Information and Communication: The availability and dissemination of financial information through various
channels, including news outlets, financial reports, and digital platforms, play a crucial role in shaping market sentiment
and investor behavior.
13. Cultural and Legal Considerations: Cultural norms, legal frameworks, and regulatory environments specific
to a country or region can greatly influence how financial transactions are conducted and regulated.
Financial Institutions:
1. Banks
2. Credit Unions

Commercial Banks

Savings and Loan Associations

Investment Banks

Building Societies

Central Banks

Cooperative Banks
2. 3. Insurance Companies
3. 4. Mutual Funds

Life Insurance Companies

Property
and
Casualty
Companies

Insurance

Equity Mutual Funds

Fixed-Income Mutual Funds

Money Market Mutual Funds
Reinsurance Companies
4. 5. Pension Funds
5. 6. Brokerage Firms

Public Pension Funds

Full-Service Brokerage Firms

Private Pension Funds

Discount Brokerage Firms

6. 7. Hedge Funds
Online Brokerage Firms
7. 8. Private Equity Firms

Equity Hedge Funds

Venture Capital Firms

Fixed-Income Hedge Funds

Buyout Firms

Event-Driven Hedge Funds
8. 9. Payment Processors
9. 10. Finance Companies

Credit Card Companies

Consumer Finance Companies

Payment Service Providers

Commercial Finance Companies
10. Microfinance Institutions
11. Stock Exchanges
12. Real Estate Investment Trusts (REITs)
13. Mortgage Lenders
Financial Markets:
1. Stock Market
2. Bond Market

Equity Market

Government Bond Market

Preferred Stock Market

Corporate Bond Market
3. Commodity Market
4. Derivatives Market

Agricultural Commodities

Futures Market

Energy Commodities

Options Market

Metals and Minerals
Regulatory Authorities:
1. Securities and Exchange Commission (SEC)
2. Federal Reserve (or Central Bank of the respective country)
3. Commodity Futures Trading Commission (CFTC)
4. Financial Industry Regulatory Authority (FINRA)
5. Prudential Regulation Authority (PRA) [in the UK]
Technology and Infrastructure:
1. Electronic Trading Platforms
3. Information Networks
2. Payment Systems
4. Cybersecurity Measures
Cultural and Legal Considerations:
1. Legal Frameworks
2. Regulatory Environments
3. Cultural Norms
Questions:
What type of financial markets and which type of securities are traded in which type of market
Types of Financial markets:
There are two type of financial markets.
1) Money market and
2) Capital market
1. Money market:

Money market refers to financial market in which individuals or firm traded the short term securities.

Securities are traded for short time period (less than one year).

It helps in fulfilling the short-term fund requirements of the borrowers. And it provides the lenders with liquidity.
Short term securities
1) T-bills
2) Interbank loans
3) Commercial papers
4) Certificates of deposits
5) Money market mutual funds
6) Bills of exchange
7) Commercial bills
8) Call money
1. T-bills

A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation backed by the Treasury Department with a
maturity of one year or less.

T-bills issued by the Government of the country when they need short term funds.

It is issued by short time period
 1-month T-bills
 3-month T-bills
 4-month T-bills
 6-month T-bills
 9-month T-bills
 12-month T-bills

T-bills are secured because it issued by the Government

Treasury Bills or T-Bills are issued by the government, usually through the Reserve Bank of country.

They are instruments of short-term borrowing. T-bills are sold to commercial banks and to the public as well.

T-Bills are generally considered to be an extremely safe investment, as the government is unlikely to default.

T-bills are also in the form of promissory notes. They have a maturity period between 14 days and 364 days.

T-bills are highly liquid and freely endorsable. These are also issued at lower than face value and redeemed at face
value. The difference in amounts is the interest known as the discount.
2. Interbank loans

The interbank lending market is a market in which banks lend funds to one another for a specified term.

Most interbank loans are for maturities of one week or less, the majority being over day.

Interbank loans are traded in money market because it is issued for short time period.
3. Commercial papers

Commercial paper is an unsecured, short-term debt instrument issued by corporations.

It's typically used to the finance short-term liabilities.

Sometimes large corporates and companies will issue commercial papers to raise short term funds.

These commercial papers are promissory notes that are unsecured, short-term, negotiable, transferable (via
endorsement) with a fixed maturity period of less than 365 days.

The companies prefer commercial papers than borrowing funds because they can get funds at lower rates than the
prevailing market rate of interest. And large credit-worthy companies will have no trouble collecting funds via
commercial papers. They are issued at a discount and redeemed at par.
4. Call Money

Most banks have to maintain some minimum cash balance as per the instructions of the RBP (Reserve bank Pakistan),
known as the cash reserve ratio (CRR). This ratio changes from time to time as per the liquidity in the economy.

So banks sometimes borrow money from each other for a short duration to maintain their CRR. This is known as the
call money market. The interest rate on such call money is known as the call rate.
5. Short term Certificates of deposits

A certificate of deposit (CD) is a savings account that holds a fixed amount of money for a fixed period of time, such
as six months the issuing bank pays interest.

These are instruments of the money market that can only be issued by banks and financial institutes.

And they are negotiable and unsecured and usually in bearer form. Banks issue these in times where funds are low but
the demand for credit is high. They help channel savings into investment. They are usually issued for 90 to 365 days.
Banks cannot discount certificate of deposits.
6. Money market mutual funds

A money market mutual fund is a type of fixed income mutual fund that invests in debt securities characterized by their
short maturities and minimal credit risk.

Money market mutual funds are among the lowest-volatility types of investments.
7. Commercial Bills

Commercial bills or bills of exchange are the most common negotiable instruments used in the world of trade. These
negotiable instruments are used to fulfill the working capital requirements of businesses. They have a short-term
maturity (usually 60 or 90 days) and are easily transferable.

The drawer of the bill can wait until the due date, i.e. the date o which the drawee will honor the bill. Or if he doesn’t
wish to wait he can discount the trade bill with a bank before the maturity period is over. This makes the bills very
flexible and easily marketable.
8. Bills of exchange

Bill of exchange, also called draft.

It is a short-term negotiable financial instrument consisting of an order in writing addressed by one person (the seller
of goods) to another (the buyer) requiring the latter to pay on demand (a sight draft).
2. Capital market

Capital market is a place where buyers and sellers indulge in trade (buying/selling) of financial securities like bonds,
stocks, etc.

Securities are traded for long term (more than one year, 2,5,7,9,10,20, 30 years)

The trading is undertaken by participants such as individuals and institutions.

Long-term investments are any securities that are held for more than a year, generally
Long term securities
1) Bonds of corporation
2) Stocks
3) T-bonds
4) Real estate
5) Exchange traded funds (EFTS)
1. Bonds

Bonds are long-term debt obligations issued by corporations and government units.

Proceeds from a bond issue are used to raise funds to support long-term operations of the issuer (e.g., for capital
expenditure projects).

In return for the investor's funds, bond issuers promise to pay a specified amount in the future on the maturity of
the bond (the face value) plus coupon interest on the borrowed funds (the coupon rate times the face value of the
bond).

If the terms of the repayment are not met by the bond issuer, the bond holder (investor) has a claim on the assets of
the bond issuer.
Types of bonds
1. Treasury bonds

Treasury bonds are issued by the U.S. Treasury to finance the national debt and other federal government expenditures.

No default risk

T-bond prices decline when interest rates rise, so they are not free of all risks.
2. Corporate bonds

Corporate bonds are all long-term bonds issued by corporations.

It is exposed to default risk (credit risk- the risk of loss due to a debtor's non-payment of a loan or other line of credit (either
the principal or interest (coupon) or both).)

The larger the default risk, the higher the interest rate the issuer must pay
3. Municipal bonds

Municipal securities issued by state and local (e.g., counties, cities, schools) governments to fund either temporary
imbalances between operating expenditures and receipts or to finance long-term capital outlays for activities such as school
construction, public utility construction, or transportation systems.

Tax receipts or revenues generated from a project are the source of repayment on municipal bonds.

Munis are exempt from federal and state taxes.
4. Foreign bonds

long-term bonds issued by firms and governments outside of the issuer's home country and are usually denominated in the
currency of the country in which they are issued rather than in their own domestic currency

Eurobonds, Yankee bonds, Samurai bonds.
5. Callable bonds

Callable or redeemable bonds are bonds that can be redeemed or paid off by the issuer prior to the bonds' maturity date.
When an issuer calls its bonds, it pays investors the call price (usually the face value of the bonds) together with accrued
interest to date and, at that point, stops making interest payments.
6. Convertible Bonds

A convertible bond is a fixed-income corporate debt security that yields interest payments, but can be converted into a
predetermined number of common stock or equity shares.

The conversion from the bond to stock can be done at certain times during the bond's life and is usually at the discretion of
the bondholder.
7. Non-convertible bonds

Non-convertible bonds or debentures are a type of debenture that cannot be converted into equity shares or stocks, hence
called non-convertible.

The interest rate on non-convertible debentures can be paid either monthly, quarterly, or annually.
Stocks

A stock, also known as equity, is a security that represents the ownership of a fraction of the issuing corporation.
1. Growth stocks

Company’s main focused in reinvestment so in growth stocks companies do not give the more ratio of dividends to
the shareholders.

Growth stocks are those companies expected to grow sales and earnings at a faster rate than the market average.

Growth stocks typically don't pay dividends.

Growth stocks often look expensive, trading at a high P/E ratio, but such valuations could actually be cheap if the
company continues to grow rapidly which will drive the share price up.
2. Volatility stocks
Volatility is the rate at which the price of a stock increases or decreases over a particular period. Higher stock price volatility
often means higher risk and helps an investor to estimate the fluctuations that may happen in the future.
3. Blue chip stocks
Blue-chip stocks are large companies with strong brands, financially sound businesses and consistent earnings and cash
flows. They also often pay sizable dividends. Blue-chip companies are typically leaders within their given market sectors
and have successfully navigated economic downturns in the past.
For example
4. Small stocks

Stocks of companies which have the share outstanding value is below from the average.

Small-cap stocks are shares of companies with total market capitalization in the range of about $300 million to $2
billion. Small-cap companies have the potential for high rates of growth, making them appealing investments,
though their stocks may experience more volatility and pose higher risks to investors.
5. Cumulative stocks
6. Non-cumulative stocks
Cumulative preferred stock is entitled to It is a type of preferred stock that does not pay
receive at a later date those dividends that stockholders
any
unpaid
or
omitted
accumulate during profitless years (dividends dividends.
in arrears).
7. Default stocks
The failure to make timely payment of interest or principal on a debt security or to otherwise comply with the provisions
of a bond indenture.
8. Momentum stocks (profitable stocks)
9. Reverse stocks (Loss gain stocks)
Stocks of companies which have the positive profit figure of Stocks of companies which have the negative
many years continuously.
loss figure of many years continuously.
Financial markets serve several important purposes in the economy. Here are some of the key purposes:
1. Price Determination: Financial markets provide a platform where buyers and sellers can come together to
determine the prices of financial assets (such as stocks, bonds, commodities, etc.). The prices are determined
based on supply and demand dynamics, as well as various other factors like economic conditions, interest
rates, and geopolitical events.
2. Allocation of Capital: They facilitate the flow of capital from investors (savers) to entities that need capital
(businesses, governments, etc.) for various purposes like investment, expansion, or debt repayment. This helps
in the efficient allocation of resources within the economy.
3. Risk Management: Financial markets offer various instruments like derivatives, options, and futures that allow
participants to hedge against various types of risks, including market risk, interest rate risk, currency risk, and
more. This helps in reducing uncertainty and stabilizing financial outcomes.
4. Liquidity and Accessibility: Financial markets provide a high degree of liquidity, meaning that assets can be
bought or sold quickly without significantly affecting their price. This makes it easier for investors to convert
their investments into cash when needed.
5. Information Dissemination: Financial markets serve as a mechanism for the dissemination of information
about companies, governments, and economic conditions. This information helps investors make informed
decisions about where to allocate their capital.
6. Capital Formation: Companies and governments can raise capital by issuing various financial instruments like
stocks and bonds. This allows them to finance their operations, invest in new projects, and grow.
7. Price Efficiency and Transparency: Well-functioning financial markets contribute to price efficiency, which
means that the prices of assets accurately reflect all available information. This helps prevent significant
mispricing and speculative bubbles.
8. Monetary Policy Transmission: Financial markets play a crucial role in the transmission of monetary policy.
Central banks use various tools (like interest rates) to influence financial markets, which in turn affects
borrowing costs, spending, and investment decisions in the broader economy.
9. Wealth Creation and Redistribution: Successful investments in financial markets can lead to wealth creation
for individuals and organizations. Conversely, they can also be a mechanism for wealth redistribution, as
profits and losses are distributed among participants.
10. Facilitating Economic Growth: By providing a mechanism for efficient allocation of capital, risk management,
and wealth creation, financial markets play a vital role in supporting economic growth and development.
Overall, financial markets are a cornerstone of modern economies, enabling the efficient allocation of capital
and resources, which in turn contributes to economic growth and stability.
Difference between money market and financial market
Bases of allocation of funds in financial markets
Capital budgeting / capital rationing
Capital Budgeting refers to the process of evaluating and selecting long-term investment projects or
expenditures that involve significant outlays of capital. These projects typically have a lifespan of several years
and are expected to generate future cash flows. The objective of capital budgeting is to determine whether an
investment is financially viable and will contribute positively to the value of the firm.
There are several types of capital budgeting techniques used to evaluate investment projects:
NPV
IRR and MIRR
PBP and discounted PBP
Accounting rate of return
Profitability index
Cash
TVM
Reason
base
PBP
Yes
No
Less

weaker
Payback period consider the cash base but does not consider the time value of
money, but
than
ARR
Discounted PBP
Yes

No
Discounted cash flows consider the time value of money but does not consider
all cash flow streams. It just consider the only at investment.
ARR
No
No
Most

Weaker
NPV
Yes
Yes
Most
money. So it is a weaker method.

strongest
IRR
Yes
Yes
Less
Accounting rate of return does not consider the cash base and the time value of
Net present value consider the cash base and the time value of money. So it is
a strongest method.

Net present value consider the cash base and the time value of money. So it is
strongest
a strong method. But NPV is stronger than IRR due to many reasons. Reasons
than
are discussed below.
NPV
MIRR
Payback Period: This method calculates the time it takes for the initial investment to be recovered from the cash inflows
generated by the project. It is relatively simple but does not account for the time value of money.