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FINANCIAL MARKETS:

Structure and Role in


the Financial System

Mr. Pol P. Enriquez, CPA


Holy Name University
Accounting 103 Instructor
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Learning Goals
1. Define financial systems
2. Understand the structure and role
in the financial system
3. Define financial instruments
4. Identify the classification of
financial markets
5. Identify the financial market
regulations
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Financial system structure and function

1.1Financial system and structure

 Financialsystems describes collectively


the financial markets, the participants
and the instruments and securities that
are traded in the said market. The
functions of the financial system is to
channel funds from lender to the
borrowers, provide a medium of
exchange, provide a channel through
which the central bank can influence the
economy and the financial system in
particular.
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Financial system structure and function


(cont.)
 The financial system plays the key role in the
economy by stimulating economic growth,
influencing economic performance of the
actors, affecting economic welfare. This is
achieved by financial infrastructure, in which
entities with funds allocate those funds to
those who have potentially more productive
ways to invest those funds. A financial system
makes it possible a more efficient transfer of
funds.
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Financial system structure and function


(cont.)
 As one party of the transaction may possess
superior information than the other party, it
can lead to the information asymmetry
problem and inefficient allocation of financial
resources. By overcoming the information
asymmetry problem the financial system
facilitates balance between those with funds
to invest and those needing funds.
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Financial system structure and function


(cont.)
 E.g of information asymmetry problem
 Purchase or sale of a financial security, asymmetric
information occurs when either the buyer or seller
has more information on the past, present or future
performance of that financial security. If the buyer
has more information, he knows the security is
underpriced relative to its aggregate
performance. If the seller has more information, he
knows the security is overpriced. Asymmetric
information gives either the buyer or seller a better
opportunity to make a profit from the purchase or
sale.
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Financial system structure and function


(cont.)
 E.g of information asymmetry problem
 Borrowing or lending money, asymmetric
information occurs when the borrower has more
information about his financial state than the
lender does. The lender is more unsure whether the
borrower will default on the loan. The lender can
look at a borrower's credit history and salary level,
but this provides limited information compared to
what the borrower knows about his own financial
situation. To account for this asymmetric
information, a lender will charge a risk premium to
compensate for the disparity in information.
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Financial system structure and function


(cont.)
 According to the structural approach, the
financial system of an economy consists of
three main components:
1) financial markets;
2) financial intermediaries (institutions);
3) financial regulators.

Each of the components plays a specific role in


the economy.
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Financial system structure and function


(cont.)
 According to the functional approach,
financial markets facilitate the flow of funds in
order to finance investments by corporations,
governments and individuals.
 Financial institutions are the key players in the
financial markets as they perform the function
of intermediation and thus determine the flow
of funds. The financial regulators perform the
role of monitoring and regulating the
participants in the financial system.
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Financial system structure and function


(cont.)
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Financial system structure and function


(cont.)
Financial instruments
 Any transaction related to financial instrument
includes at least two parties:
1) the party that has agreed to make future
cash payments and is called the issuer;
2) the party that owns the financial instrument,
and therefore the right to receive the payments
made by the issuer, is called the investor.
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Financial system structure and function


(cont.)
Financial instruments
 Financial assets provide the following key
economic functions.
1) they allow the transfer of funds from those
entities, who have surplus funds to invest to those
who need funds to invest in tangible assets;
2) they redistribute the unavoidable risk related
to cash generation among deficit and surplus
economic units.
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Financial system structure and function


(cont.)
1.2 Financial market and their economic functions
What is the 'Financial Market'
The financial market is a broad term describing any
marketplace where trading of securities including equities,
bonds, currencies and derivatives occur. Some financial
markets are small with little activity, while some financial
markets like the New York Stock Exchange (NYSE) trade
trillions of dollars of securities daily.

Financial markets provide the following three major


economic functions:
 1) Price discovery
 2) Liquidity
 3) Reduction of transaction costs
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Financial system structure and function


(cont.)
1) Price discovery
 means that transactions between buyers and sellers
of financial instruments in a financial market
determine the price of the traded asset. The
motivation for those seeking funds (deficit units)
depends on the required return that investors
demand. It is these functions of financial markets that
signal how the funds available from those who want
to lend or invest funds will be allocated among those
needing funds and raise those funds by issuing
financial instruments.
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Financial system structure and function


(cont.)
2) Liquidity function
 provides an opportunity for investors to sell a financial
instrument, since it is referred to as a measure of the
ability to sell an asset at its fair market value at any
time. Without liquidity, an investor would be forced to
hold a financial instrument until conditions arise to sell
it or the issuer is contractually obligated to pay it off.
Debt instrument is liquidated when it matures, and
equity instrument is until the company is either
voluntarily or involuntarily liquidated. All financial
markets provide some form of liquidity. However,
different financial markets are characterized by the
degree of liquidity.
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Financial system structure and function


(cont.)
3) The function of reduction of transaction costs
 is performed, when financial market participants
are charged and/or bear the costs of trading a
financial instrument. In market economies the
economic rationale for the existence of
institutions and instruments is related to
transaction costs, thus the surviving institutions
and instruments are those that have the lowest
transaction costs.
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Financial system structure and function


(cont.)
1.3 Financial intermediaries and their functions

 Financial intermediary is a special financial entity, which


performs the role of efficient allocation of funds, when
there are conditions that make it difficult for lenders or
investors of funds to deal directly with borrowers of funds in
financial markets. Financial intermediaries include
depository institutions, insurance companies, regulated
investment companies, investment banks, pension funds.
 The role of financial intermediaries is to create more
favorable transaction terms than could be realized by
lenders/investors and borrowers dealing directly with each
other in the financial market.
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Financial system structure and function


(cont.)
1.3 Financial intermediaries and their functions
 The financial intermediaries are engaged in:
obtaining funds from lenders or investors and
lending or investing the funds that they borrow to
those who need funds.
 Financial intermediaries are engaged in transformation of
financial assets, which are less desirable for a large part of
the investing public into other financial assets
 Asset transformation provides at least one of three
economic functions:
Maturity intermediation.
Risk reduction via diversification.
Cost reduction for contracting and information
processing
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Financial system structure and function


(cont.)
 These economic
functions are
performed by financial
market participants
while providing the
special financial
services (e.g. the first
and second functions
can be performed by
brokers, dealers and
market makers. The
third function is related
to the service of
underwriting of
securities).
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Financial system structure and function


(cont.)
1.3 Financial intermediaries and their functions
 Other services that can be provided by financial
intermediaries include:
Facilitating the trading of financial assets for the financial
intermediary’s customers through brokering arrangements.
Facilitating the trading of financial assets by using its own
capital to take a position in a financial asset the financial
intermediary’s customer want to transact in.
Assisting in the creation of financial assets for its customers
and then either distributing those financial assets to other
market participants.
Providing investment advice to customers.
Manage the financial assets of customers.
Providing a payment mechanism.
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Financial system structure and function


(cont.)
 1.4. Financial markets structure
 1.4.1. Financial instruments