HANDOUT ON FINANCIAL ECONOMICS, CHAPTER ONE

02/24/2022
BY: GETISH B.

Chapter One: Nature and role of Financial system in economic development

1.1. Structure of Financial System

Financial system may be defined as a set of institutions, instruments and markets which promotes
savings and channels them to their most efficient use. It consists of individuals (savers),
intermediaries, market and users of saving or investors.

In the financial system funds flow from those who have surplus funds to those who have a shortage
of funds, either by direct, market-based financing or by indirect, bank-based finance. An important
function of the financial system is to allocate money to the most productive investment projects in
the economy. If the financial system is working properly, only projects with high-risk adjusted
rates of return are funded, and those with low rates are rejected.

In any country a financial system is the engine to development hence it is of paramount importance
in policy implications. In the 1980’s a number of African countries initiated financial policy
reforms as part of structural adjustment programs due to financial liberalization, innovation and
computer technology.

Financial system consists of financial markets, institutions, instruments and financial services. The
basic role of the financial system is to gather money from individuals and businesses that have
more money than they need and route these funds to those who need money now. Businesses need
money to invest in productive assets to expand their business, and consumers have a myriad of
items they buy on credit, such as automobiles, personal computers, and iPhones. Money is the
lubricant that makes an industrial economy run smoothly. Without money, the numerous financial
transactions that businesses and consumers take for granted would grind to a halt.

The financial system is like a huge money maze—funds flow to borrowers from lenders through
many different routes at warp speed. The larger and more efficient the flow, the greater the
economic output and welfare of the economy.
Banks are a critical player in the financial system. Banks provide a place where individuals and
businesses can invest their money to earn interest at low risk.

Banks take these funds and redeploy them by making loans to individuals and businesses. Banks
are singled out for special treatment by regulators and economists because most of what we call

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money in the economy is represented by deposits and checking accounts issued by banks. Thus,
banks are the principal caretaker of the payment system because most purchases are paid by writing
a check or making an online payment against a bank account.

The most powerful institutional player in the financial system is the National Bank (Central Bank)
of the country. Its powers come from its role as the country’s central bank—the institution that
controls the nation’s money supply. The Central Bank’s primary responsibility is to stabilize the
economy by conducting monetary policy by managing the money supply and interest rates.

Finally, the financial system is of great interest to politicians and government officials. Its health
has a major impact on our economic well-being. The collapse of the financial system can be the
harbinger of a recession or worse. A case in point is the 2008 financial crisis and near collapse of
the global financial system that resulted in the most severe economic recession since the Great
Depression of the 1930s.

Financial markets are just like any market you have seen before, where people buy and sell
different types of goods and haggle over prices. Financial markets can be informal, such as a flea
market in your community, or highly organized, such as the gold markets in London or Zurich.
The only difference is that, in financial markets, people buy and sell financial instruments such as
stocks, bonds, and futures contracts rather than pots and pans. Financial market transactions can
involve huge dollar amounts and can be incredibly risky. The dramatic changes in fortunes that
occur from time to time because of large price swings make financial markets newsworthy.
Financial institutions are firms such as commercial banks, credit unions, insurance companies,
pension funds, mutual funds, and finance companies that provide financial services to consumers,
businesses, and government units. The distinguishing feature of these firms is that they invest their
funds in financial assets, such as business loans, stocks, or bonds, rather than in real assets, such
as manufacturing facilities and equipment. Financial institutions dominate the financial system
worldwide, providing an array of financial services to large multinational firms and most of the
financial services used by consumers and small businesses.
Overall, financial institutions are far more important sources of financing than securities markets.

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Funds flow through the financial system: (1) direct financing, where funds flow directly through
financial markets (the route at the top of the diagram), and (2) indirect financing (financial
intermediation), where funds flow indirectly through financial institutions in the financial
intermediation market (the route at the bottom of the diagram). The reason that financial
institutions are often called financial intermediaries is because they are middlemen, facilitating
transactions between SSUs and DSUs.
Financial Markets and Direct Financing

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Financial markets perform the important function of channeling funds from people who have
surplus funds (SSUs) to businesses (DSUs) that need money. The top route in Exhibit 1.1 shows
the flow of funds for direct financing. In direct financing, DSUs borrow money directly from SSUs
in financial markets by selling them securities in exchange for money. Typical financial
instruments bought and sold in the direct financial markets are stocks and bonds. For most large
business firms, direct financial markets are wholesale markets in which the minimum transaction
size is $1 million or more. These markets provide funds at the lowest possible cost. The major
buyers and sellers of securities in the direct financial markets are commercial banks, other financial
institutions, large corporations, the federal government, and some wealthy individuals.
[Link] AND SECONDARY MARKETS
Financial claims are initially sold by DSUs in primary markets. All financial claims have primary
markets. An example of a primary market transaction is IBM Corporation raising external funds
through the sale of new stock or bonds. People are more likely to purchase a primary financial
claim if they believe they will not have to hold it forever (in the case of most common stock) or
until its maturity date (in the case of bonds). Secondary markets are like used-car markets; they
let people exchange “used” or previously issued financial claims for cash at will. Secondary
markets provide liquidity for investors who own primary claims. Securities can be sold only once
in a primary market; all subsequent transactions take place in secondary markets. The New York
Stock Exchange (NYSE) is an example of a well-known secondary market.
EXCHANGE AND OVER-THE-COUNTER MARKETS
Once issued, a financial claim (security) can be traded in the secondary market on an organized
security exchange, such as the NYSE. Trades made through an exchange are usually made on the
floor of the exchange or through its computer system. Organized security exchanges provide a
physical meeting place and communication facilities for members to conduct their transactions
under a specific set of rules and regulations. Only members of the exchange may use the facilities,
and only securities listed on the exchange may be traded. The NYSE is the largest securities
exchange for stocks. The Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange
(CME) are the largest futures exchanges. Securities not listed on an exchange are bought and sold
in the over-the-counter (OTC) market. The OTC market differs from organized exchanges
because the market has no central trading place. Instead, investors can execute OTC transactions

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by visiting or telephoning an OTC dealer or by using a computer-based electronic trading system

linked to the OTC dealer. Traditional stocks traded over the counter have been those of small and
relatively unknown.

Introduction to Financial Instruments

Money Market instruments
The most liquid, short-term debt obligations are traded in the money market.
Commercial Paper: Commercial paper is a form of direct short-term finance by large,
creditworthy companies. If a company such as AT&T needs immediate funds, it can sell
commercial paper (a debt instrument) to another corporation or financial institution. Commercial
paper is a promise to pay back a higher specified amount at a designated time in the immediate
future—say, 30 days. By issuing commercial paper, a corporation avoids the process of applying
for a loan and instead engages in direct finance. To engage in direct finance effectively, the issuing
company must be large and creditworthy enough to find someone willing to accept its commercial
paper, which is sold with the aid of brokers. The growing use of commercial paper has increased
the competitive pressure on banks, which are finding some of their potential loan customers turning
to the commercial paper market.
Negotiable Bank Certificates of Deposit: Certificates of deposit (CDs) are debt instruments sold
by banks and other depository institutions. A CD pays the depositor a specified amount of interest
during the term of the certificate, plus the purchase price of the CD at maturity. For example, a
$1,000, one-year CD paying 5 percent interest would pay $1,000 plus $50 interest at the end of
one year (the term of the CD). Today negotiable CDs are sold in large denominations (over
$100,000) and can be resold in the secondary market. This makes negotiable CDs highly liquid.
The original purchaser need not hold the CD to maturity or pay “a substantial penalty for early
withdrawal” if he or she needs to liquidate the CD. Instead, the person can sell the CD in the
secondary market at a price that will depend on the market interest rate in effect when it is sold.
Treasury Bills: Treasury bills, or T-bills, are short-term debt instruments used by the federal
government to obtain funds. They are issued in 3-, 6-, and 12-month maturities. These instruments
do not pay regular interest payments, but instead are sold at a discount. This means they are sold

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for an amount that is less than what the government promises to pay at maturity, and the difference
between the purchase price and the face value is the return from buying the T-bill. For instance, if
you purchased a one- year Treasury bill in July 1994 for $9,766, in July 1995 (when it matures)
the government would pay you $10,000.
There is a very active secondary market for U.S. Treasury bills. If you purchased the above
Treasury bill but decided to liquidate it for cash before maturity, a simple phone call to a broker
would allow you to sell it to another investor. Furthermore, the likelihood that the U.S. government
will default on its obligation (not pay) is very low. These two factors make U.S. Treasury bills one
of the most liquid of all financial instruments.
It is important to distinguish Treasury bills from other U.S. government securities such as Treasury
bonds. T-bills mature in less than 1 year, T-notes mature in 1 to 10 years, and T-bonds mature in
more than 10 years.
Repurchase Agreements: A repurchase agreement (or simply repo) is an agreement by two
parties in which the borrower sells and agrees to buy back a financial instrument such as a
government bond, note, or T-bill. Suppose a bank needs short-term cash today. The bank can sell
some Treasury bills to a firm such as IBM with the agreement that the bank will repurchase the T-
bills in 30 days at a higher price. In effect, this repurchase agreement is a short-term loan in which
the Treasury bills serve as collateral.
Eurodollars: Eurodollars are U.S. dollars deposited in banks located in other countries. Foreign
banks and offshore branches of U.S. banks hold dollar deposits to service firms engaged in
international trade, as well as for other purposes. U.S. banks sometimes borrow Eurodollars when
they need short-term funds. The growth of the Eurodollar market in the 1970s was spurred by the
relative lack of regulations on these funds, including the absence of regulations requiring banks to
hold reserves against Eurodollar loans.
Banker's Acceptances: A banker’s acceptance is a letter of credit (a bank’s promise to pay on a
specific date) that has been stamped as “accepted” (guaranteed) by another bank. You might think
of a banker’s acceptance as analogous to a post-dated “check” or bank draft. If the party issuing
the check has insufficient funds in the account to cover the draft when it is payable, the bank that
stamped the draft is obligated to pay the amount of the “check” to the party who holds it. Obviously
a banker’s acceptance is more valuable as a medium of exchange than a standard check, since a

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bank guarantees that the banker’s acceptance will be honored. The party issuing a banker’s
acceptance pays a fee to the bank for its guarantee.
Banker’s acceptances are particularly valuable in international transactions, since it is extremely
costly for a firm located in, say, France to recover a bad check from a party located in Egypt. There
is a relatively small secondary market for banker’s acceptances, which essentially operates as a
scaled-down version of the market for Treasury bills.

Federal Funds: Suppose it is 2:50 p.m. and a bank needs $10 million by 3:00 p.m. to meet the
reserve requirements set by the Federal Reserve. Obviously it is too late to attract additional
deposits, and the bank must find a quick way to acquire the funds. One way the bank can obtain
such funds on short notice is to acquire federal funds. Federal funds are simply short-term (usually
overnight) loans between banks. The funds are loaned at an interest rate known as the federal funds
rate. They are called federal funds because they are held in deposit at the Federal Reserve rather
than because they are loaned by the federal government. In fact, the transfer of federal funds is
merely a bookkeeping transfer from the ledger of a bank with an excess of reserves to the ledger
of a bank with deficient reserves.
Capital Market Instruments
In contrast to money market instruments, which have maturities of one year or less, capital market
instruments have maturities of more than one year. The principal capital market instruments are
described next.
Corporate Stock: A share of corporate stock is an equity instrument that represents ownership of
a share of the assets and earnings of a corporation. When a corporation like AT&T needs long-
term funds, it can sell shares of stock to individuals or other investors. AT&T uses the funds
received to purchase assets and run the company; in return, the shareholder owns a share of these
assets and the earnings they generate for AT&T. The profits earned by a corporation and paid to
shareholders are known as dividends. Unlike interest payments, dividends can vary with the health
of the company.
It is important to emphasize that the only time a corporation receives money from stock is the time
at which it issues the stock—the primary market transaction. When the company decides to issue
stock, it offers the shares to underwriters, investment banks that guarantee the firm a certain price
for the issue. Then the investment banker (or bankers, if the issue is large) sells the stock to
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individual investors, with the assistance of brokers, at what they hope is a higher price than the
guaranteed price. Effectively the underwriters provide insurance to the company issuing the new
stock and bear the risk associated with the low price investors pay for the stock.
Once a new issue is in the hands of individual investors, the stock can be sold and purchased by
another investor (with the aid of a broker) in a secondary stock market such as the New York Stock
Exchange or the American Stock Exchange. Notice that the funds transferred in these secondary
markets pass between individual buyers and sellers of the stock rather than to the corporation.
Individuals own the majority of stock in the United States, and pension funds, insurance
companies, and mutual funds own the remainder.
Corporate Bonds: A corporate bond is a debt instrument issued by a corporation that states the
firm will make specified interest payments (typically twice each year) and a principal amount or
“face value” (usually $1,000) at maturity (say, 30 years). The original purchaser of a bond buys
this promise from the firm for an up-front amount, known as the price of the bond. Unlike
stockholders, bondholders own no share of the profits; rather, they are entitled only to the interest
payments and the face value due on maturity. Obviously the firm’s “promise” is valuable to the
purchaser of the bond only if the firm does not go bankrupt. For this reason, only corporations with
strong credit ratings tend to issue bonds. If a company fails to meet its payment obligations, it is
said to be in default.
Corporate bonds, like corporate stock, provide funds to the issuing firm when sold in the primary
market. Like stocks, new bond issues are under¬ written by investment banks, which sell the bonds
to individual investors. When bonds are bought and sold in the secondary bond market (for
example, the New York Bond Exchange), money changes hands among individual investors, and
no funds flow to the corporation that issued the bond.
Mortgages: A mortgage is a debt instrument used to finance the purchase of a home or other form
of real estate when the underlying real estate serves as collateral for the loan. If the borrower
defaults, the lender receives title to the real estate as payment of the debt. Several terms common
to mortgage market transactions are useful not only to students of money and banking but to
anyone who plans to use a mortgage to finance a house.
The two major types of mortgage instruments today are fixed-rate and adjustable-rate mortgages.
Each type of mortgage specifies a term (the length of the mortgage), a down payment (usually

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expressed as the fraction of the house value the buyer must finance personally), and points (the
fraction of the loan value that must be paid up front as prepaid interest). A fixed-rate mortgage
specifies an interest rate that is fixed during the term of the loan, whereas the rate on an adjustable-
rate mortgage (ARM) can change (usually every one or three years). An adjustable-rate mortgage
also stipulates a margin that reflects the premium above some index of interest rates (usually one-
year U.S. Treasury bills) that will be used to adjust the interest rate at specified times during the
term. An adjustable-rate mortgage also stipulates a cap, which is the maximum amount by which
the rate can change at any adjustment point, and a ceiling and floor, or the maximum and minimum
interest rate that will be charged during the life of the mortgage.
Various types of financial institutions issue mortgages, and there is an active secondary market in
which mortgages are bought and sold.
Government Securities: Government securities are debt instruments issued by the U.S. Treasury
and include such instruments as Treasury bonds. The funds obtained from the sale of these bonds
are used to refinance the current federal debt as well as current federal deficits (the amount
Congress spends this year in excess of tax revenues). Because there is an active secondary market
for government securities and the instruments are backed by the full faith and credit of the U.S.
government, government securities are the most liquid of all capital market instruments.
Consumer and Commercial Loans: Consumer loans are loans obtained by individuals for
intermediate-term purchases such as car purchases, as well as merchandise bought with credit
cards. Commercial loans are essentially credit lines issued to businesses. There is a less active
secondary market for consumer and commercial loans, making them the least liquid of all capital
market instruments. However, there has been a growing movement to securitize (convert to
marketable securities) some consumer debt.
Municipal Bonds: State and local governments issue municipal bonds to obtain long-term funds
for such things as highways and schools. The interest payments holders of these bonds receive are
exempt from federal income tax (although some state and local governments do collect income tax
on municipal bond interest earnings). This makes municipal bonds an attractive investment for
lenders in high-income tax brackets.
International Financial instruments

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Tremendous growth has occurred in international financial instruments in recent years. For the
most part, the financial instruments traded in international markets function like the instruments
issued in the United States. The only difference is that the unit of account for these instruments is
the local currency of the country in which they are issued. For instance, bonds issued in Britain
are denominated in British pounds, while bonds issued in Germany are issued in German marks.
Both are foreign bonds to U.S. residents. Eurobonds are an important exception. Eurobonds are
bonds denominated in a currency other than that of the country of origin. For example, a bond
issued in Germany but denominated (paying interest and its face value) in U.S. dollars is a
Eurobond.
The recent surge in activity in world stock and bond markets has broadened the possibilities for
investors and borrowers alike. A borrower no longer has to obtain funds from financial
intermediaries in his or her own country; similarly, a lender need not lend funds only to borrowers
in its own country.
Because of time differences across the globe (when it is 4 a.m. in New York, it is 9 a.m. in London),
international markets allow borrowers and lenders to make financial transactions at virtually any
time of day. This fact has greatly enhanced the liquidity of financial assets that trade on exchanges
around the world.
Risks associated with Investment in Financial Instruments
Financial instruments involve various risks and therefore it is essential to study the nature of the
instrument and the risks it entails before deciding on making an investment. It is important that the
investor does not trade in financial instruments unless he/she is fully aware of the risks involved
in such transactions and that he/she takes into account his/her financial strength and experience in
trading in such investments.

The following shall be kept in mind when assessing whether a financial instrument is suitable for
an investor:

a) The investor must possess sufficient knowledge and experience to evaluate the financial
instrument in question.

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b) The investor must be aware of the risks associated with investing in the financial instrument
in question and the impact that the investment may have on the investor’s assets and financial
capacity.

c) The investor must acquaint him-/herself with and understand the terms which apply to the
financial instrument in question and the markets where the instrument is traded.

d) The investor must be able to assess (either on its own or with the assistance of an advisor) the
impact of external factors such as economic fluctuations, changes in interest rates and other
similar factors which may impact an investment in the financial instrument in question.

General risk factors

Financial instruments involve various risks, but several risk factors apply to any type of financial
instrument and are discussed below:

a) Market risk: The risk that changes in market prices have adverse effect on financial
instruments.

b) Interest rate risk: The risk that changes in interest rates have adverse effect on the value of
a financial instrument.

c) Currency risk: Exchange rates fluctuate and financial instruments that are registered in
foreign currency can entail currency risk. Changes in currency rates can cause profit or loss
although the currency value in which the underlying instrument is registered does not change.

d) Liquidity risk: The risk that an investor cannot easily sell or buy a specific financial
instrument at a certain point in time, or is only able to do so on terms that are considerably
poorer than the norm in an active market at any time. This can be caused by various factors,
such as inactive market with a particular instrument, contract size and other factors that may
affect the supply and demand and market participants’ behaviour.

e) Economic risk: Economic fluctuations often affect the prices of financial instruments. The
fluctuations are variable, they can variate in time and magnitude and can affect different
industries in various ways. When deciding on an investment an investor must be aware of the
general impact of economic fluctuations, including between countries and different
economies, on the value of financial instruments.

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f) Country risk: The risk includes, among other things, political risk, currency risk, economic
risk and risk relating to capital transfers. This refers to the economic factors that could have a
significant impact on the business environment in the country in which the financial
instrument is registered.

g) Legal risk: The risk that the government makes changes to existing laws or regulations that
can have adverse effect on financial instruments, for example changes in tax laws or laws
regarding capital transfers across borders.

h) Inflation risk: When investors assess the yield of a specific financial instrument, it is
necessary to do so with regard to inflation and inflation outlook to estimate the expected real
return on investment and current asset value.

i) Counterparty risk: The risk that a counterparty will not meet his contractual obligations in
full.

j) Settlement risk: The risk related to a counterparty not meeting the contractual obligations on
the settlement date. Settlement loss may occur due to default or due to the different timings of the
settlement between relevant parties.
Risks associated with individual financial instruments

1. Shares
Shares are issued to a shareholder as evidence of the holder’s ownership interest in the limited
company in question. Shares may be issued as written instruments or electronically in a central
securities depositary. A shareholder enjoys the rights provided by law and the company’s Articles
of Association.
Investing in shares may involve the following risks:

a) Company risk: By purchasing shares, the investor contributes funds to the company
concerned and in turn becomes an owner of the company along with other shareholders.
Therefore, the shareholder, as owner, is involved in the development of the company and the
changes which occur to its assets and liabilities. It can be difficult to estimate the return that
the shareholder may expect to receive on the investment. In the event of bankruptcy, the
shareholder may lose the funds that it originally contributed since priority is not given to
shareholders’ claims during bankruptcy proceedings.

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b) Price risk: The price of shares may fall and/or rise without it being possible to predict the
timing or duration of such fluctuations. Price risk must be distinguished from company risk;
however, jointly or separately, these factors influence the price of shares with resultant risks
for investors.

c) Dividend risk: The amount of dividends, if any, which investors receive from their
shareholdings, is determined by the profits of the company in question and its dividend policy.
Dividend payments may cease should the company suffer losses.

2. Bonds
Bonds are written declarations in which the issuer unilaterally and unconditionally accepts its
obligation to pay a certain amount of money at a given time in accordance with the stated terms.
Bonds are generally issued by companies and government bodies. The bond terms, such as interest
and maturity, are always determined in advance. Interest can either be fixed or variable. Bonds can
also be index-linked, in which case the principal of the debt will be adjusted in accordance with a
specific price index, e.g. the consumer price index. The principal of the debt is either paid in one
sum on the final maturity date or on predetermined due dates. The purchaser of a bond (the
creditor) has a claim against the issuer (the debtor) for the payment of money in accordance with
the terms of the bond.

Investing in bonds may involve the following risks:

A) Issuer risk: A bond issuer may become unable to pay its obligations. Such insolvency may
be temporary or permanent. Economic and political developments in the sector and the
countries in which the issuer operates may impact its payment capacity. In the same manner,
the issuer’s credit rating may change as a result of positive and/or negative developments in
the issuer’s operations and influence the market price. Normally there is a connection between
the interest on the issuer’s bonds and its credit rating, the lower the credit rating the higher the
interest rate.

B) Interest rate risk: The market risk factor which has the greatest impact on bond prices are
changes in interest rates in the relevant market. An increase in general interest rates leads to a

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reduction in the market value of the bonds and vice versa. This risk becomes greater as the
maturity of the bond in question is longer.

C) Risk associated with different types of bonds: Risks other than those listed above may be
involved in investments in different types of bonds. Investors are therefore advised to familiarize
themselves with the terms of each individual bond issue as they are presented in the prospectus for
the bond class and not to make a decision to invest until an assessment of all the risk factors
associated with the bonds in question has been carried out.

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