Financial Management with economic model, Lecture notes of Economics

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FINANCIAL MARKET AND INSTITUTION

Introduction

A sound and robust financial system is a key

contributing factor to financial stability in a

country.

Although a definite causal link exists between

real economic stability and financial

stability, sound and robust financial systems

play an important role in reducing the risk

that distortions in the real economy will

develop into a financial crisis and could

even minimize the adverse effects of such a

crisis in the event of it occurring.

Importance of Financial system

• (^) This is important. For example, if you save $10,000, but there are no financial system, then you can earn no return on this—might as well put the money under your mattress.
• (^) However, if a producer could use that money to buy a new machinery (increasing productivity), then she/he be willing to pay you some interest for the use of the funds.

5 Budget positions creating financial needs of economic units: Surplus or deficit.

• (^) S urplus spending units ( SSUs) have

income for the period that exceeds

spending, resulting in savings.

• (^) Other words for “SSU” are saver , lender , or

investor. Most SSUs are households.

• (^) Deficit spending units (DSUs) have

spending for the period that exceeds

income.

• (^) Another word for “DSU” is “borrower”.

Most DSUs are businesses or governments.

Financial systems Financial systems are systems that show the integration of various units operating within the economy of the country including financial markets and financial institution or financial intermediaries using financial assets/securities/. They Provides for efficient flow of funds from saving to investment by bringing savers and borrowers

• (^) Financial assets are an asset that facilitates transactions in financial markets. Many deficit units such as household groups, business firms and government agencies access funds from financial markets by issuing such assets so- called securities.
• (^) A Financial Market is a market in which financial assets (securities) can be purchased or sold. Financial markets facilitate transfers of funds from person or business without investment opportunities (i.e., “Lender-Savers”, or “Surplus Unit”) to those who have investment opportunities (i.e., “Borrower-Spenders”, or “Deficit Unit”).
• (^) Financial institutions are institutions which are established to provide financial services to various units of the economy by accepting deposit from surplus unit and providing funds to deficit units and through making contractual agreements with clients who need certain type of services such insurance protections.

Classification of Financial Markets

There are many ways to classify financial markets.

Among these are:

• (^) Based on the type of financial claim : The

claims traded in a financial market may be either

for a fixed amount or a residual amount.

• (^) As explained earlier, the former financial assets

are referred to as debt instruments, and the

financial market in which such instruments are

traded to as the debt market.

• (^) The latter financial assets are called equity

instruments and the financial market where such

instruments are traded is referred to as the

equity market. Alternatively, this market is

referred to as the stock market.

• (^) Based on the date of issue of the asset traded : this is to classify financial markets whether the financial claims are newly issued or not. When an issuer sells a new financial asset to the public, it is said to "issue" the financial asset. The market for newly-issued financial asset is called the primary market.
• (^) After a certain period of time, the financial asset is bought and sold (i.e., exchanged or traded) amongst investors. The market where this activity takes place is referred to as the secondary market. The second market is where already-issued financial assets are traded.
• (^) The key distinction between a primary market and a secondary market is that in the secondary market the issuer of the asset does not receive funds from the buyer. Rather, the existing issue changes hands in the secondary market and funds flow from the buyer of the asset to the seller

• (^) Based on the organization structure of the market: A market can be classified by its organizational structure. - (^) A visible marketplace for secondary market transactions is an organized exchange - (^) Some transactions occur in the over-the- counter (OTC) market (a telecommunications network)
• (^) Derivative markets Derivatives are financial securities whose values are derived from the values of other underlying instruments, such as bonds. Or a derivative security is a security whose value

FINANCIAL ASSETS Asset : - Any possession that

has value in an exchange.

Asset: - Tangible  its value depends on particular

physical properties.

Example: - buildings

Intangible  represent legal claims to some

future benefit.

Their value bears no relation to

the form, physical or

otherwise in which the claims

are recorded.

Financial assets, financial instruments or

securities are intangible assets.

For financial assets the typical future benefit is a

claim to future cash.

• (^) It is a claim against the income or wealth of a

Kinds of Financial Assets

• (^) Financial assets can be classified in to

two categories: cash instruments and

derivative instruments:

Cash instruments

• (^) Cash instruments are instruments whose

values are determined by the markets.

They include instruments like:

• (^) Money (coins, currency, and checks)
• (^) Common stock, preferred stock,
• (^) Bonds,
• (^) Treasury bill,

Derivative instruments

• (^) Derivative instruments derive value from some other instruments.
• (^) They include instruments like options, spot, forward, bond futures, swaps etc

The major types of depository institutions are:

• (^) Commercial banks referred as banking institutions
• (^) Savings and loans associations and
• (^) Credit unions  Referred as near banking institutions or Thrift institutions

Money and payment system

Money is any thing that is used as a means of facilitating

transaction and exchange in a given community.

a)Barter Economy  (^) Lack of Double Coincidence of Wants  (^) Lack of a Common Measure of Value  (^) Indivisibility of Certain Goods  (^) Difficulty in storing value  (^) Difficulty in making differed payments  (^) Lack of Specialization