Financial System Finance (Noun, Verb) The American Heritage® Dictionary of the English Language, Fourth Edition defines the term as under- 1:"The science of the management of money and other assets."; 2: "The management of money, banking, investments, and credit. "; 3: "finances Monetary resources; funds, especially those of a government or corporate body" 4: "The supplying of funds or capital."
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Financial System Finance (Noun, Verb) The American Heritage® Dictionary of the
English Language, Fourth Edition defines the term as under-
1:"The science of the management of money and other assets.";2: "The management of money, banking, investments, and credit. ";3: "finances Monetary resources; funds, especially those of a government or corporate body"4: "The supplying of funds or capital."
Financial System Finance as a function (i.e. verb) is defined
by the same dictionary as under- 1:"To provide or raise the funds or capital
for": financed a new car2: "To supply funds to": financing a daughter through law school.3: "To furnish credit to".
:"the commercial activity of providing funds and capital"4: "the branch of economics that studies the management of money and other assets"5: "the management of money and credit and banking and investments"
Financial System System: Set of complex and closely
connected or interlinked institutions, agents, practices, markets, transactions, claims, and liabilities in the economy
Financial System: Money, Credit, Finance Heart to human body: Important for
Economy A financial system functions as an intermediary
and facilitates the flow of funds from the areas of surplus to the areas of the deficit.
Money Generally accepted as payment for
goods and services and repayment of debts
Functions of money: Medium of Exchange Unit of Account Store of value Standard of deferred payment Money forms: Commodity Money and
Fiat Money
Measures of Money M1:Currency (coins and bills) and
M3: M2 plus time deposits M0: Currency plus deposits of banks
and other institutions at the central bank
Credit Money Loaned A method of paying for goods or
services at a later time, usually paying interest as well as the original money
Finance Activity by which claims to resources
are either assembled from those released by domestic savings, obtained from abroad, or specifically created usually as bank deposits or notes and then placed in the hands of investors.
Investments Activity by which resources are
actually committed to production Volume of capital formation: Intensity
of savings, finance and investment. Conversion of savings to investment:
Transfer Process
Transfer Process Genesis of Financial System: Divorce
between savings and investment Relationship between savings and
investment vary considerably among economic units
Goldsmith’ designated categories of economic units: Savings-surplus units (Savings in excess of investments), Economic Units (Investments exceed their savings) and Neutral units (Savings equal to investments)
Financial System
Function of efficient allocation of funds
Financial innovation Growth of technology Rudimentary Finance Direct Finance Indirect Finance
Rudimentary Finance Financial System of underdeveloped
or traditional economy Per capita output low and declining Absence of an array of financial
assets/ instruments that would stimulate savings
Absence of an array of financial markets that would allocate savings competitively to investment
Direct Finance Improvement over rudimentary
finance by removing the obstacles to efficient capital formation
Improved capital formation under direct finance through: Financial assets/ instruments, Brokers/ Investment Bankers, Secondary Markets/ Stock Exchanges
Financial Assets/ Instruments (Securities)
Financial instrument/ asset is a claim against another economic unit and is held as a store of value and for the return that is expected.
Examples: Shares, Debentures, etc. Financial assets stimulate capital
formation and speedy economic development
Brokers/ Investment Bankers
Find savers and bring them with economic units needing funds
Brokerage function, Underwriting function
Secondary Markets/ Stock Exchanges/ Markets
Provide savers with ability/ facility to dispose of their investment portfolio and realise cash to finance their current consumption
Provide liquidity and marketability
Indirect Finance Flow of savings from savers to entrepreneurs
through intermediary financial institutions like mutual funds, insurance companies, etc.
Services offered by financial intermediaries: Convenience (Divisibility, Flexibility, Maturity) Lower risk Expert Management Economies of Scale Channelisation of savings (Encouraging,
Sponsoring, Discriminating between various industries)
Financial System Functions
Saving FunctionLiquidity FunctionPayment FunctionRisk FunctionPolicy Function
Saving Function Public saving find their way into the
hands of those in production through the financial system. Financial claims are issued in the money and capital markets which promise future income flows. The funds with the producers result in production of goods and services thereby increasing society living standards.
Liquidity Function The financial markets provide the
investor with the opportunity to liquidate investments like stocks, bonds, debentures, etc. whenever they need the fund.
Payment Function The financial system offers a very
convenient mode for payment of goods and services. Cheque system, credit card system etc are the easiest methods of payments. The cost and time of transactions are drastically reduced.
Risk Function The financial markets provide protection
against life, health and income risks. These are accomplished through the sale of life and health insurance and property insurance policies. The financial markets provide immense opportunities for the investor to hedge himself against or reduce the possible risks involved in various investments
Policy Function The government intervenes in the
financial system to influence macroeconomic variables like interest rates or inflation so if country needs more money government would cut rate of interest through various financial instruments and if inflation is high and too much money is there in the system then government would increase rate of interest.
Financial System: Composition
Financial System: Intermediary
Intermediary Market Role
Stock Exchange Capital MarketSecondary Market to
securities
Investment BankersCapital Market,
Credit Market
Corporate advisory services, Issue of securities
UnderwritersCapital Market,
Money Market
Subscribe to unsubscribed portion of securities
Registrars, Depositories, Custodians Capital Market
Issue securities to the investors on behalf of the company and handle share transfer activity
Primary Dealers Satellite Dealers Money Market
Market making in government securities
Forex Dealers Forex MarketEnsure exchange ink
currencies
Indian Financial System Phases
Upto 1951 !951 to the mid-eighties After early nineties
Defined as the market in which financial assets are created or transferred.
These assets represent a claim to the payment of a sum of money sometime in the future and/or periodic payment in the form of interest or dividend.
Classification
Money market(Short term instrument)
Capital markets(Long term instrument)
The most important distinction between the two:
The difference in the period of maturity.
Main Function To channelize savings into short term productive investments like working capital .
Instruments in Money MarketCall money marketTreasury bills marketMarkets for commercial paperCertificate of depositsBills of ExchangeMoney market mutual fundsPromissory Note
Part of the national money market
Day-to day surplus funds mainly of banks are traded
Short term in nature
Maturity of these loans vary from 1 to 15 days
Lent for 1 day: Call money
Lent for more than 1 day but less than 15 days: Notice money
Convenient interest rate
Highly liquid loan repayable on demand
Unsecured Promissory note.
Issued by well known companies with strong and high credit rating.
Sold directly by the issuers to investors or through agents like merchant banks and security houses.
Flexible Maturity
Low interest rates with compared to banks.
Imparts a degree of financial stability to the system.
Referred as note payable in accounting
It is a contract detailing the terms of a promise by one party (the maker) to pay a sum of money to the other (the payee).
The obligation may arise from the repayment of a loan or from another form of debt.
For example, in the sale of a business, the purchase price might be a combination of an immediate cash payment and one or more promissory notes for the balance.
Defined as short term deposit by way of usance promissory notes.
Greater flexibility to investors in the deployment of surplus funds.
Permitted by the RBI to banks
Maturity of not less than 3 months and upto 1 year.
Transferable in nature
Free negotiability and limited flexibility
Invest primarily in money market instruments of very high quality.
RBI and public financial institution can set it either directly or through its existing subsidiaries.
MMMFOpen EndedClose Ended
Provided resources needed by medium and large scale industries.
Purpose for these resourcesExpansionCapacity ExpansionInvestmentsMergers and Acquisitions
Deals in long term instruments and sources of funds
Main Activity
Functioning as an institutional mechanism to channelize funds from those who save to those who needed for productive purpose.
Provides opportunities to various class of individuals and entities.
Primary Markets Secondary MarketsWhen companies need financial resources for its expansion, they borrow money from investors through issue of securities.
The place where such securities are traded by these investors is known as the secondary market.
Financial Markets Foreign Exchange and Eurocurrency market
Domestic and International Bond Market
Domestic and International Stock Markets
Derivatives Markets
Important Characteristic of Financial Markets
Liquidity: The ease of capturing an asset’s value
Reflects a market’s operational efficiency
Impacts a market’s informational and allocational efficiency
The inter bank foreign exchange market for large transactions is the world’s most liquid market
Other Market Characteristics
Maturity: Short-term: Money market Long-term: Capital market Regulatory Jurisdiction: Single-country internal markets Multi-country external markets Middlemen Intermediated through a commercial bank Non-intermediated or direct to the public,
through a broker or investor bank
Foreign Exchange Markets conducted through commercial
banks
Spot Market Cash market with delivery in two
business days Forward Market Trade at a prearranged date and
price
Intermediated Markets in bank deposits and loans
Money Markets Capital Markets
Internal Markets
Short term accounts with domestic clients
Long term accounts with domestic clients
External markets
Eurocurrency deposits and loans
Long term accounts with foreign clients
Non-intermediated (Direct) markets
Money Markets Capital markets
Internal Markets
Short term Commercial Paper
Stocks and bonds issued in the domestic market
External markets Eurocommercial paper
Global equity, foreign bonds and Euro bonds
Eurocurrency Markets Eurocurrencies: Bank deposits and loans
residing outside any single country Floating rate pricing usually with
maturities less than five years Few regulatory restrictions because
they are outside the jurisdiction of any single government
Competitive pricing – outstanding in 2.5 trillion dollars
Few regulations in eurocurrency market
Typically there are No reserve requirement No interest rate regulations or caps No with holding taxes No deposit insurance requirements No credit allocation regulations Less stringent disclosure
requirements
Floating rate pricing in eurocurrency market
Low interest rate risk: Interest rates tied to a variable rate base such as the LIBOR
Low default risk: Traded between large commercial banks, investment banks and multinational corporations
Relatively short maturities: Typically less than five years
Global Equity offerings Cross listing of shares: Increase
demand and enhance share price, Improves image of the firm, Gets more customer and investor base
Cross listing benefits the firm in improving transparency and disclosure, reduces opportunity for hostile takeover.
Dominant: 56 per cent
International Bond Market
Domestic Bonds Foreign Bonds Euro Bonds: Samurai, Bull dog, Yankee