Chapter 2: The Financial
System
Objective
Understanding the workings of
the financial system
Determining rates
of return
Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc.
1
Chapter 2 Contents
1.
2.
3.
4.
5.
6.
What is a Financial
System
The Flow of Funds
The Functional
Perspective
Financial
Innovation & the
“Invisible Hand”
Financial Markets
Financial Market
Rates
7.
8.
9.
Financial
Intermediaries
Financial
Infrastructure
and Regulation
Governmental &
QuasiGovernmental
Organizations
2
The Flow of Funds Diagram
Markets
Surplus Units
Deficit Units
Intermediaries
3
Fund Flows via Market
Markets
Surplus Units
Deficit Units
Intermediaries
4
Fund Flows via Intermediary
Markets
Surplus Units
Deficit Units
Intermediaries
6
Fund Flows via Intermediary and
Market
Markets
Surplus Units
Deficit Units
Intermediaries
8
Funds Flow via Markets and
Intermediaries
Markets
Surplus Units
Deficit Units
Intermediaries
10
Funds Flow: Disintermediation
Markets
Surplus Units
Deficit Units
Intermediaries
12
Six Key Financial Functions:






Transferring Resources Across Time &
Space
Managing Risk
Clearing and Settling Payments
Pooling Resources and Subdividing
Shares
Providing Information
Dealing with Incentive Problems
13
Incentive Problems



Moral Hazard
Adverse Selection
Principal-Agent Problem
19
Moral Hazard


When having insurance against
some risk causes the insured party
to greater risk or to take less care.
Example: If a warehouse owner
buys fire insurance, his incentive to
spend money to prevent a fire is
reduced.
20
Adverse Selection


Those who purchase insurance
against risk are more likely than the
general population to be at risk.
Example:
A
firm
selling
life
annuities cannot assume that the
people who buy them will have the
same expected length of life as the
general population.
21
Principal-Agent Problem

Agents may not make the same
decisions that the principals would
have made if the principals knew
what the agents know and were
making the decisions themselves.
22
Financial Assets



Debt: Bonds
Equity: Stocks
Derivatives: Options, Forward
Contracts
26
Debt


Corporate bonds, government
bonds, residential and commercial
mortgages, consumer loans.
Fixed-income instruments
27
Debt



Money Market: Short-term Debt
Capital Market: Long-term Debt
Money market instruments are
mostly interest-earning securities.
Money markets are globally
integrated and liquid.
28
Equity


The claim of the owners of a firm.
Common stocks or shares are
bought and sold in the stock
market.
Common stock represents a residual
claim on the assets of a corporation.
Has the feature of limited liability.
29
Derivatives


Financial instruments that derive
their value from the prices of one or
more other assets such as equity
securities, fixed-income securities,
foreign currencies, or commodities.
They serve as tools for managing
exposures to the risks associated
with the underlying assets.
30
Derivatives

o
o

Options: call options, put options
Call option: gives its holder the
right to buy some asset at a
specified price on or before some
specified expiration date.
Put option: the right to sell.
Forward contracts: oblige one party
to the contract to buy, and the
other party to sell.
31
Financial Market Rates
1.
2.
Interest Rates
Rates of Return on Risky Assets
32
Interest Rates



A promised rate of return.
Mortgage rate: the interest rate
that home buyers pay on the loans
they take to finance their homes.
Commercial loan rate: the rate
charged by banks on loans made to
businesses.
33
Interest Rates
Depend on:
 Unit of account: the medium in
which payments are denominated.
A currency, a commodity such as
gold, or some standard “basket” of
goods and services.
 Maturity: the length of time until
repayment of the entire amount
borrowed.
34
Interest Rates
Depend on:
 Default risk: the possibility that
some portion of the interest or
principal on a fixed-income
instrument will not be repaid in full.
35
Exchange Rate Example
15000 ¥
•150 ¥/£
3% ¥/¥ (direct)
1.73% ¥/£/£/¥
15260 ¥
15450 ¥
Time
Japan
£100
9%£/£
140 ¥/£
£109
U.K.
37
Exchange Rate Example
15000 ¥
150 ¥/£
3% ¥/¥ (direct)
8.27% ¥/£/£/¥
16241 ¥
15450 ¥
Time
Japan
£100
9%£/£
149 ¥/£
£109
U.K.
38
Effect of Maturity
US Treasury Yiled Curve, Jan 97
7.50
Annualized Yield (% )
7.00
6.50
6.00
5.50
5.00
4.50
0
5
10
15
Years to Maturity
20
25
30
40
Effect of Default Risk
April '95
US
Corporate Corporate
Treasury High Quality Med Quality
1 - 10 Years 6.92%
7.57%
7.86%
10 ++ Years 7.65%
8.15%
8.55%
41
Computation of Return on Stock
Return 
( EndPrice
 StartPrice
)  CashDivide
nd
StartPrice
Return 
($ 105  $ 100 )  $ 5
 0 . 10  10 %
$ 100
42
Market Indexes


Dow Jones Industrial Index (DJI)
Standard and Poor’s 500 (S&P 500)
DJI: Prices of 30 Stocks of Major
Industrial Corporations
S&P 500: 500 Stocks of the largest
public corporations
43
Market Indexes
DJI Index 
Average of Current Stock Pr ices
 100
Average of Stock Pr ices in Base Year
S & P Index  Weight of Stock 1 
Current Pr . of Stock 1

Stock 1 Pr . in B . Y .
Weight of Stock 2 
Current Pr . of Stock 2

Stock 2 Pr . in B . Y .
44
Inflation and Real Interest Rates




Nominal Price: in terms of some
currency
Real price: in terms of purchasing
power over goods and services
Nominal interest rate
Real interest rate: unit of account,
the basket used to compute the
national consumer price index (CPI)
45
Nominal to Real
Nominal
Rate : R
Real Rate :r
Inflation
Consumer
Rate :i
Price Index :CPI
( CPI )
A

C
( CPI )
A

C
1 r 
A (1  R )
C (1  i )
A
(1  r )
C
1 R
1 i
 r 
R i
1 i
46
Determinants of Rates of Return




Productivity of Capital Goods
Degree of Uncertainty about
productivity
Time Preferences of People
Risk Aversion
47
Financial Intermediaries







Banks: Commercial, Investment
Insurance Companies
Pension and Retirement Funds
Mutual Funds
Venture Capital Firms
Asset Management Firms
Information Services
48
Regional and World Organizations



Bank for International Settlements
(BIS)
International Monetary Fund (IMF)
International Bank for
Reconstruction and Development
(World Bank)
49