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Lectures 1-2:

Chapter 2

An Overview of
the Financial
System
1. Function of the Financial System
Channel funds from those who have surplus funds to
those who need the funds
(Indirect Finance)

Financial
Intermediates

Lenders Financial Borrowers


Savers Markets Spenders

(Direct Finance)

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1. Function of the Financial System
Entities who save  entities with profitable I
  economic efficiency

Without the financial system, cannot finance


profitable but huge I project from individual savings

 no railway or MRT, no telecommunication and


airline companies;
(neither can you buy a flat for marriage before you
save enough money)

 the financial system is one of the major innovation


in human history
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2. Structure of Financial Markets
A. Debt and Equity Markets
Debt market: fixed payment at regular interval until
a specified date (maturity date)
• short-term (< 1 year)
• intermediate-term (1-10 years) <bonds>
• long term (>10 years) <bonds>

Equity market: dividend (more volatile, risk


sharing, last claimer) – capital gain

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A. Debt and Equity Markets

US (outstanding Amount):
size of debt market > share market
(US$41 trillion) (US$18 trillion) end 2005
(US$35 trillion) (US$19.5 trillion) end 2008
(US$43 trillion) (US$17.2 trillion) end 2010
(US$42 trillion) (US$21.3 trillion) end 2013
(new) funds raised in bond market is even more
important
not the case in many other countries including
Singapore (bank loans and share market fund raising
tend to dominate that of the bond market)

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A. Debt and Equity Markets

Why important to develop the debt market?


• as another effective source of company finance,
especially important if there were bank crises
 liquidity crunch, company may not have enough
funds to finance their operations
 real economic activity severely hampered
(e.g. US: South American debt crisis in the early
1980; real estate crisis in the late 1980s; the Asian
Financial Crisis)

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Why important to develop the bond market?

• alternative investment instrument, can help


prevent a crisis from developing
e.g., US stock market correction, very often funds
withdrawn from the US stock market was invested
in the US bond market.
Without the US bond market, funds flow out of the
US and affect the US exchange rate

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2. Structure of Financial Markets
B. Primary and Secondary Markets
Primary: e.g. IPOs, investment bank underwrite
(bargain with issuer), guarantee a price and sell to
public (also distribution set-ups/channels, e.g. to
institutional investors and small brokerage)

Secondary: e.g. stock exchange (Singapore Stock


Exchange, New York Stock Exchange, Hong Kong
Stock Exchange)
Brokers: match buyers with sellers of securities
Dealers: buying & selling securities at stated P
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B. Primary and Secondary Markets

Role of secondary market:


• make the asset more liquid (easier to issue: if can’t
sell, won’t buy)
• determine the securities price (will only buy if they
think they can sell at this price in the secondary
market)

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C. Exchanges & Over-the-Counter Markets

Secondary markets are organized in two ways:


• exchanges: buyers & sellers (or their brokers)
meet in one central location to conduct trades (use
hand and finger signals, e.g. US Stock Exchange,
SIMEX …)

• over-the-counter: dealers at different locations


who have an inventory of securities stand ready to
buy & sell to anyone who comes to them and is
willing to accept their price (e.g. foreign exchange,
US bonds, NCDs …)

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3. Internationalization of Financial
Markets
Before the 1980s, US financial market >> rest of
the world
Since then, fast growth of FM outside the US,
Now: many firms raise funds from the FM outside
their economies, many individuals invest in the
world FM
 internationalization

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3. Internationalization of Financial
Markets
A. International bond market
Foreign bonds: issued in a foreign country
denominated in that country’s currency
e.g. Singapore company issue a HK$ bond in HK, A$
bond in Australia,

Euro bonds: issued in a country denominated in a


currency other than that of the country in which it is
issued

Eurocurrencies: Eurodollar, Euroyen, …

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3. Internationalization of Financial
Markets
B. World Sock market
• Japanese stock market (once > US)
• Nikkei 225, Financial Time Index,
• mutual funds or unit trusts specialize in foreign
stock market,
• Index funds

Foreigners not only providing foreign funds to US


corporates, but also help finance federal government
expenditure (low saving rate in the US, supplement
by foreign investment)

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4. Function of Financial Intermediaries
e.g.: banks (savings & loans associations, credit union)
insurance companies (life, fire & casualty);
mutual funds; pension funds & government
retirement funds

• Financial intermediaries are far more important


source of corporation financing than securities
market (even more in other countries, e.g., SP)

• reduce transaction costs (e.g., reduce cost of


contracts through economies of scale)
Smaller savers ($1000), problem of investing in
financial market: high transaction costs (per $ of
I), cannot diversity
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4. Function of Financial Intermediaries
Financial intermediaries  transaction costs (by
economies of scale):
• banks’ mortgage loans, lawyer to design good loan
contracts  standard form, very low legal cost per
$ of loans
• bundle funds of many investors   tran. costs per
$ of I (e.g., mutual funds, but high management
fees)
-  risk through pooling of funds & diversification
- liquidity services (e.g., check account, deposit,
ATM by banks)

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4. Function of Financial Intermediaries
- reduce search costs: matching the different needs
between surplus units and deficit units on the size
of funds, time horizon and liquidity

- can better deal with problems arising from


asymmetric information
• adverse selection (before transaction)
• moral hazard (after transaction)

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Supplement: Financial Market Instruments
A. Money Market Instruments
Treasury Bill: most liquid, most actively traded
(held by banks)

NCD (Negotiable Certificate of Deposit): Deposit note


sold by a bank to depositors
• large denomination, higher interest
• negotiable: can be sold in the secondary market
(previously neither negotiable nor redeemable
without penalty, innovation by City Bank in 1961,
save billion $ of interest costs

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Supplement: Financial Market Instruments
Commercial Paper: short-term debt instruments
issued by large corporation
• company not only borrow from bank, but also
borrow directly from market
• large corporation relies more on that

Repurchase Agreements: short-term loans with


Treasury Bill as a collateral

e.g. big company with idle funds for two weeks,


lend money to a bank by buying Treasury Bill from
the bank, which agree to buy the Treasury Bill back
at a slightly higher price

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Supplement: Financial Market Instruments
Federal Funds: lending federal deposits among
banks  federal funds rate
If a bank does not have enough deposits at the Fed
to meet the required reserve, can borrow from
another bank with excess deposit

Euro dollar: US$ deposit outside US, including


foreign branch of US banks

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Supplement: Financial Market Instruments
B. Capital Market Instruments
Stock: new issue << amt outstanding (<1%) or
market capitalization
In the US, individuals hold about half of the value of
stocks, the rest are held by pension funds, mutual
funds and insurance companies
Mortgages: loans to households or firms to purchase
housing, land or other real structures, with the latter
served as a collateral for the loans (mostly residential
mortgage)
• Singpaore: mostly done by banks
• US: a lot done by savings and loans associations,
mutual saving banks
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Supplement: Financial Market Instruments
Mortgage Backed Securities: government agencies
(e.g. Fannie Mae, Ginnie Mae and Freddie Mae in the
US and HKMC in HK) issue bonds and use the
proceeds to buy mortgages.

• In the 1970s, 80% of the mortgage loans financed


by financial intermediaries. Now, only 1/3 are
owned by these intermediaries
• Help to reduce the banks’ maturity mis-match
• Investors get more investment instruments
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Supplement: Financial Market Instruments
• Banks and the mortgage corporation acting only as
agent between the holders of the securities and the
mortgager
(but principal-agent problem; risk of property bubble
& its bursting)

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Supplement: Financial Market Instruments
Corporate bonds: long-term bonds issued by firms
with strong credit rating
• pay interest regularly and the face value when the
bond mature
• convertible bond: option to convert it into a
specified amt of shares  chance of capital gains
for its holders (lower interest cost for the company)

• outstanding amt of corporate B < 1/5 of stocks, but


new corporate B issued each yr > new issues in the
stock mkt, more important source of corporate fin;
can alleviate real impact of bank crises

• Principal buyers are life insurance companies,


pension funds and households.
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Supplement: Financial Market Instruments
US government securities: US Treasury use to
finance federal deficit
• US government bonds, most liquid security traded
in the capital market
State and local government bonds: municipal
bonds, long-term debt instruments issued by local
government to finance expenditure on schools, roads,
and other large programs.
• interest income exempted from federal income tax
and generally from state taxes in the issuing state
• commercial banks, with their high income tax rate,
are the biggest buyers of these securities, owning
half the total amount outstanding
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Supplement: Financial Market Instruments
Consumer and commercial loans: loans by bank
and finance companies, no secondary market  least
liquid, but secondary market are developing

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