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Financial system
Introduction
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A set of sub systems of nancial institutions,markets, instruments and services.Intermediates with the ow of funds betweensavers and borrowers.Facilitates transfer and allocation of scarceresources eciently and eectively.
Meanin of Financial
!ystem
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Formal nancial system" #rani$ed, institutional and reulated
Informal financial system: Advantaes" %ow transaction costs
Minimum default risk &rans'arency of
'rocedures
(isadvantaes" )ide rane of interestrates
*iher rates of interest +nreulated
&y'es of Financial !ystem
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Financial InstitutionsFinancial Markets
Financial InstrumentsFinancial !ervices
om'onents of the Financial
!ystem
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Types of Financial Institutions
Banking and Non Banking
Banking: creators and purveyors ofcredit. Types: Commercial Banks
Cooperative Banks Non-Banking:purveyors of credit Types: evelopmental !nancial institutions" #utual Funds"
Insurance companies"
NBFCs
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Functions of FinancialInstitutions
$rovide t%ree transformation services:
&ia'ility( asset and si)e transformation
#aturity transformation
*isk transformation
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Financial MarketsTypes:
#oney #arket + market for s%ort -term de't
instruments.
Capital #arket - + market for long
-term e,uity and de't instruments
egments:
$rimary #arket + market for ne issues
econdary #arket + market for trading outstanding
issues
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&ink Beteen $rimary / econdaryCapital markets
+ 'uoyant secondary marketindispensa'le for t%e presence of a
vi'rant primary market econdary market provides a 'asis
for t%e determination of prices of
ne issues ept% of t%e secondary market
depends on t%e primary market
Bunc%ing of ne issues a0ects
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Financial Instruments
Types: $rimary econdary
istinct Features: #arketa'le Tradea'le Tailor-made
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Financial !ervices
#a1or categories: Funds
Intermediation $ayments
#ec%anism $rovision of
li,uidity *isk
#anagement Financial
2ngineering
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Functions of Financial system
#o'ilise and allocate savings
#onitor corporate performance
$rovide payment and settlement systems
3ptimum allocation of risk 'earing and reduction
isseminate price related information
30er portfolio ad1ustment facility
&oer t%e cost of transactions
$romote t%e process of !nancial deepening and'roadening
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-ey elements of a well functionin nancialsystem
+ strong legal and regulatory environment
ta'le money
ound pu'lic !nances and pu'lic de't
management + central 'ank
ound 'anking system
Information system 4ell -functioning securities market
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Financial system designs
Types : Bank 'ased
#arket 'ased
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#arket -'ased Financialystem
+dvantages:$rovide attractive terms to 'ot% investors and 'orroers
Facilitate diversi!cation
+llo risk s%aring
+llo !nancing of ne tec%nologies
ra'acks:$rone to insta'ility
25posure to market risk
Free rider pro'lem
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Bank 'ased Financialystem
+dvantages: Close relations%ips it% parties
$rovide tailor made contracts
26cient inter-temporal risk s%aring
No free rider pro'lem
ra'acks: *etards innovation and grot%
Impedes competition
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Functions of Financial#arkets
2na'ling economic units to e5ercise t%eir time preference
eparation( distri'ution( diversi!cation and reduction of risk
26cient payment mec%anism
$roviding information
2n%ancing li,uidity $roviding portfolio management services.
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The main function of a financial system is thecollection of savings and their distribution for
investment, thereby stimulating capital formationand, to that extent, accelerating the process ofeconomic growth. The financial system is a linkbetween the savers (savings-surplus economic
units) and the investors (saving-deficit economicunits). It is made up of all those channelsthrough which savings become available forinvestment.
Functions
78
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3rganisation
The organisation of the financial systemcomprises of three inter-related components,namely, financial intermediaries, financialmarkets and financial assetsinstruments(securities).
79
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!inancial intermediaries (!Is) represent a significantchange in the whole process of a transfer of choice ofinvestment from an individual saver to an institutional
agent. They convert primary securities with a given set ofcharacteristics, into indirect securities with very differentfeatures. " primary security is a security issued by a non-financial economic unit. " security issued by a financialintermediary is an indirect security. The ability of !Is to
transform a primary security into an indirect securitymakes it more attractive to both the borrowers and thelenders. The pooling of funds by an !I leads to anumber
Financial Intermediaries
7
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of indirect and derived benefits that add greatly to theeffectiveness and efficiency of the savings-investment
process. The benefitsservices associated with thetailoring of financial assets according to the desires ofthe savers and investors are# (i) convenience in terms ofdenomination and li$uidity, (ii) lower risk due todiversification of the portfolio, (iii) expert management of
the portfolio and (iv) lower cost resulting from economiesof scale. " diversified structure of !Is in a matured andsophisticated financial system consists of banks, %&!'s,mutual funds, insurance organisations and so on. ith avariegated structure, these are able to mobilise savingsfrom the widest section of the investing public andchannelise them to a cross-section of economicindustrialenterprises.
;
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" primary security is a security issued by a non-financial economic unit, such as ordinary
preference shares, debenturesbonds andinnovative debt instruments includingparticipating, convertibles, warrants and so on.
0rimary !ecurity
;?
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"n indirect security is a security issued by an !Isuch as units of mutual funds. It is based on an
underlying primary security. The pooling of fundsby an !I and converting a primary security into anindirect security is associated with a number ofbenefits, namely, convenience, diversification,
expert management and lower cost.
Indirect !ecurity
;@
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" derivative instrument includes# (i) a securityderived from a debt instrument, share, secured or
unsecured loan, risk instrument, contract fordifferences or any other form of security and (ii) acontract which derives its value from thepricesindex of prices of the underlying
securities. It is an instrument of riskmanagement. The most commonly usedderivative contracts are forwards, futures andoptions.
(erivative Instruments
;8
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A forward contractis an agreement to exchange an
asset for cash, at a predetermined future datespecified today. "t the end of the contract, onecan enter into an offsetting transaction by payingin the difference in the price. It is settled by the
delivery of the asset on the expiration date.
;9
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!uture contracts are transferable specified
delivery forward contracts. They are agreementsbetween two counterparties to fix forward theterm of an exchangelock-in the price today, of anexchange that will take place between them at
some fixed future date, ranging between / to 01months. epending on the underlying asset,future contracts could be stock futures or indexfutures.
;
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2ptions give the holder the right (but not the
obligation) to buy (call option) or sell (put option)securities at a predetermined price(strikeexercise price) withinat the end of aspecified period. In order to ac$uire the right of
option, the buyer pays to the seller, an optionpremium as the price for the right. 3e can lose nomore than the option premium paid but hispossible gain is unlimited. The sellers4 possible
loss is unlimited but his maximum gain isrestricted to the option premium charged by him.
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