FMI

Chap1
Financial system
A framework for describing set of markets,
organizations, and individuals that engage in the
transaction of financial instruments (securities), as well
as regulatory institution.
The basic role of Financial System is channeling of
funds within the different units of the economy from
surplus units to deficit units for productive purposes
Assets
Resources owned by business
Fixed Assets
1. Tangible- (real ) (physical appearance)—building
2. Intangible (No physical value,
Legal Claim to future benefit)– financial asset (security)

A financial asset is a non-physical asset whose value is derived

from a contractual future claim.

Financial assets and tangible assets are linked because the ownership
of tangible assets in financed by issuance of financial assets
either equity and debt instruments
Types of Cash flows
Interest Payment (Coupon Payment) ---The rate
charged for using the funds
Dividend---a sum of money paid regularly (typically
annually) by a company to its shareholders out of its
profits
Types of Financial Assets
1. Debt--- an obligation that requires to pay money to
creditors (principal amount + Interest)
2. Equity– money invested in exchange of ownership
3. Preferred Stock: Dual characteristics of debt and
equity (hybrid )
Fixed cumulative dividend like interest payment
Ownership as equity
Preference over common stock holders
No voting rights
Pricing of Financial Assets
1.The price or value of a financial asset is equal to the
present value of all expected future cash flows.
Bonds (Coupon/Interest payment )
Equity (dividend)

2. Expected rate of return (The expected return is the

profit or loss an investor anticipates on an investment)
3. Risk of expected cash flow(chance that an outcome)
Role of Financial Assets
Channelization of funds---Transfer funds from surplus
units to deficit units.
Redistribution of Risk – transfer unavoidable risk
associated with cash flows generated from both
tangible and intangible assets.
Common Dividend Vs Preferred Dividend
1.Preferred Dividend
A dividend that is accrued and paid on a company's 
preferred shares.
Cumulative nature

2. Common Dividend
A common stock dividend is the dividend paid
to common stock owners from the profits of the
company.
Risk Involved in Financial Assets
Purchasing power risk or inflation risk—Risk attached
to purchasing power of expected cash flows
Default or credit risk---the risk associated that
borrower will unable the obligation ( principal amount
+ Interest)
Exchange rate or currency risk—risk attached to cash
flow due to adverse change in exchange rates
Direct finance
The first one is direct finance, in which lenders and
borrowers meet directly to exchange securities.
•Securities are claims on the borrower’s future income
or assets. Common examples are stock, bonds or
foreign exchange
Indirect finance
The second type of financial trade occurs with the help
of financial intermediaries and is known as indirect
finance. In this scenario borrowers and lenders never
meet directly, but lenders provide funds to a financial
intermediary such as a bank and those intermediaries
independently pass these funds on to borrowers.
Asset Transformation
Process of creating a new asset (loan) from liabilities
(deposits) with different characteristics by converting
small denomination into loans of large
denomination or vice versa
Financial markets
A market where financial assets are traded.
Why financial markets are important
1. Channelization of funds
2. Redistribution of Risk
3. Price discovery
 Determine the price of financial assets due to direct interaction of buyer
and seller.
 Determine required rate of return that shows how the funds are allocated
4. Liquidity--- easily convertible in to cash which motivates the security
holder to sell, otherwise to hold incase of no liquidity
5. Save search cost
External cost – money spent to advertise the financial assets for trading
internal cost – value of time spent in final the right customer
6. Save information cost– cost associated the assessment of investment
criteria for financial assets
Classification of Financial Markets
By Nature (Debt Vs Equity)
By Maturity (Money Vs Capital )
By Seasoning (Primary Vs Secondary Market)
By immediate and Future Delivery ( Spot vs
Derivative)
By Location (Auction Vs OTC Vs Organized Vs
Intermediated)
By Nature
Equity market 
market for trading equity instruments
Debt market 
 market where debt instruments are traded.
By Maturity
• Money Market
market for Short-Term securities , < 1 Year
• Capital Market
Market for Long-Term securities, >1Yr
By Seasoning
• Primary Market
Market for Issuance of new Securities offered by company
• Secondary Market
Market for Trading of Previously Issued Securities
By immediate and Future
Spot Market:
-The market in which financial assets traded for
immediate delivery.
 Derivative Market:
financial market for derivatives, financial instruments
like futures contracts or options
Derivatives : A derivative is a contract between two or
more parties whose value is based on
underlying financial asset (like a security)
By location
1. Auction Market(bidding): A trade occurs when the buyer and
seller agree on a price at a central location. A buyer is willing to
pay the highest price and seller is willing to accept the lowest
price
2. Over The counter Market-- Network of Dealers, no central
location--- market where buyer and seller transact directly at pre
quoted price without supervision of any exchange (third party).
there is negotiations between two parties
3. Organized Market– Central location where buyer and seller
traded securities (stock Exchange)
4. Intermediated Market--- A financial market in which some
financial institution stands between counterparties to financial
transactions.
Financial Market Globalization
Globalization means the integration of financial
markets throughout the world into international
financial markets.
Factors
Liberation of markets – so financial enterprise
compete effectively around world.
Technological advances
institutionalization of financial markets
Liberation of markets
Liberation (deregulation) of markets – so financial
enterprise compete effectively around world.
Technological advances
Technological advances for monitoring world markets,
executing orders and analyzing financial opportunities-
allow transmission of real time information on security
prices- in order to identify the arbitrage opportunity.
Market participants are linked worldwide
Arbitrage –
Practice of taking advantage of a price difference
between two or more market
Simultaneous purchase and sale of an asset to profit
from an imbalance in the price
institutionalization of financial markets
Increased institutionalization of financial markets..
The shifting of financial markets from dominance by
retail investors to institutional investors referred to
institutionalization of financial markets–
To improve portfolio diversification
 Avoid perceived mispricing of financial assets in
foreign countries
Motivations for global market
Increased international funds flow
Increased disclosure of information
Reduced transaction costs
Reduced foreign regulation on capital flows
Reduced reliance on domestic markets
Asymmetric Vs Symmetric information
Asymmetric information --happens when one party
to a transaction has greater material knowledge than
the other party.
 Symmetric information is when both parties have
equal knowledge.
Classification of Global Financial Markets
1. Internal – national market
Domestic market– trading of financial assets denominated
in local currency
Foreign market-- trading of financial assets denominated
in other foreign currency but it is regulated by country
‘s laws in which they are traded
External Market—issuance of securities that are offered
simultaneously to investors in number of country
They are issued outside the jurisdiction of any single
country– off shore market or euro market
Market Efficiency and Forms
The degree to which market prices reflect all available,
relevant information is called market efficiency .
Securities are normally in equilibrium
and are “fairly priced.
Weak form -- –(All past available information is reflected
in stock prices)
Semi Strong form –(Only publicly available information
is reflected in stock prices)
Strong form -- All information ( public and private) and
is embedded in stock prices.