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Funds flow form lenders-savers to borrower-spenders via two routes: 1-Direct Finance: Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrowers future income or assets. 2-Indirect Finance: Borrowers borrow indirectly from lenders via financial intermediaries
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The maturity of a debt instrument is the number of years until expiration short tem: claims with maturity of less than one year. long term claims with maturity of 10 years or longer. Intermediate term: maturity between one and ten years
New York Stock Exchange and NASDAQ are the best examples of secondary markets
Over-the-Counter Markets
Internationalization of Financial Markets The growth of foreign financial markets has been a result of: 1. Large increase in the pool of savings in foreign countries 2. Deregulation of foreign financial markets firms in any country seeking to raise funds need not be limited to their Domestic Financial Market. Investors in a country are not limited to the securities issued in their domestic Market.
What are the factors that have lead to the integration of Financial Markets. Deregulation and liberalization of Markets enforced by the global competition Technological advances that linked the Market participants, and make it easier for monitoring world Markets, executing orders, and analyzing financial opportunities. Increased institutionalization of financial Markets. here institutional investors are more willing than retail investor to transfer funds across boarders to improve the risk reward opportunities especially in developing countries (the emerging Markets) .
1-Transactions Costs
The time and money spent in carrying out financial transactions are the major problem for Investors.
Financial intermediaries reduce transactions costs because they have developed expertise in lowering them, and because their large size allows them to take advantage of Economies of Scale, the reduction in transaction costs per dollar of transaction as the size of transaction increases.
A financial intermediarys low transaction costs make it possible to provide customers with liquidity services, services that make it easier for customer to conduct transaction. For Example, (checking account) Banks provide depositors with checking accounts that enable them to pay their bills easily.
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2-Risk sharing
Financial institutions help reduce investors exposure to risk (the uncertainty about the returns investors will earn on assets.) F.I. do this through the process of risk sharing In that they create and sell assets with risk characteristics that people are comfortable with, and then use the fund they acquire to purchase other assets that my have far more risk (This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors)
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Risk sharing
Financial intermediaries also help individuals and businesses to diversify their asset holdings and thereby lower the amount of risk. ( diversification: investing in a portfolio of assets whose returns do not always move together) Low transaction costs allow Financial institutions to buy a range of assets, pool them, and then sell rights of the diversified pool to individuals
3-asymmetric information
A situation in which one party often does not know enough about the other party to make accurate decisions. For example, a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment for which the funds are earmarked than lender does.
Information Asymmetry can lead to two main problems Adverse selection- the problem created by asymmetric information before the transaction. It occurs when the potential borrowers who are most likely to produce an undesirable ( adverse) outcome are the ones who most actively seek out a loan and are thus likely to be selected. because of Adverse selection lenders make decide not to make any loans even though there are good credit risks in the market place.
Moral Hazard- immoral behavior that takes advantage of asymmetric information after a transaction. It is the risk ( hazard) that the borrower might engage in activities that are undesirable ( immoral) for the lenders point of view, because they make it less likely that the loan will be paid back. Another way of describing the moral hazard is that it leads to conflicts of Interest, in which one party in a financial contract has incentive to act in its own interest rather than in the interest of the other party.
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Creating long-term customer relationships. Repeat customers will not require the same effort for screening and monitoring that new customers. Also, customers have an incentive to establish a good repayment record in order to get loans from the same bank in the future.
Collateral. Requiring a potential borrower to pledge assets to be turned over in case of default reduces credit risk in several ways. Obviously, it protects the bank from total financial loss in the event of a default. But it also screens out questionable borrowers (who will not have sufficient collateral) and reduces moral hazard problems since the borrower risks losing his/her property if a default occurs.
Credit rationing. Riskier borrowers will be expected to pay higher interest rates to compensate for this risk. However, ONLY the riskiest borrowers are willing to pay the highest rates. This is an extreme case of adverse selection. In this case, banks may be unwilling to assume the high risk levels and simply refuse to lend to these types of borrowers. Alternatives, banks would lend out only small amounts, giving the borrower the incentive to establish a good payment record to obtain additional loans. Disclosure. Disclosure rules for public companies also mitigate the problems of asymmetric information. The SEC requires companies that sell securities to disclose information in a timely manner. The requirement are not foolproof, the scandals with Enron and WorldCom, among others, demonstrate that financial statements may be manipulated in ways to deceive investors.
Finance Companies
finance companies raise funds by selling commercial paper (a short term debt instrument )and by issuing stocks and bonds .they lend these funds to consumers, who make purchases of such items as furniture, automobiles, and home improvements, and to small businesses. some finance companies are organized by a parent corporation to help sell its product. for example ,ford motor credit company makes loans to consumers who purchase ford automobiles.
Mutual Funds
These financial intermediaries acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds . Shareholders can sell (redeem) shares at any time. Shareholders can sell shares at any time, but the value of the shares will be determined by the value of the MFs holdings of securities.
Investment banks
An investment bank is not a bank or a financial intermediary in the ordinary sense. Its a different type of intermediary that helps a corporation issue securities. First it advises the corporation on which type of securities to issue (stocks or bonds) ;then it helps sell (underwrite) the securities by purchasing them from the corporation at a predetermined price and reselling them in the market. investment banks also act as deal markers by helping corporations acquire other companies through mergers or acquisitions.