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© 2008 Pearson Education Canada2.1
Chapter 2Chapter 2An Overview of the Financial System
© 2008 Pearson Education Canada2.2
An Overview of the An Overview of the Financial SystemFinancial System
Primary Function of the Financial System is Financial Intermediation
The channeling of funds from households, firms and governments who have surplus funds (savers) to those who have a shortage of funds (borrowers).
© 2008 Pearson Education Canada2.3
An Overview of the Financial An Overview of the Financial SystemSystem
© 2008 Pearson Education Canada2.4
Classifications of Financial Classifications of Financial MarketsMarkets
Debt Markets• Short-term (maturity < 1 year) – the
Money Market
• Long-term (maturity > 10 year) – the Capital Market
• Medium-term (maturity >1 and < 10 years)
© 2008 Pearson Education Canada2.5
Classifications of Financial Classifications of Financial MarketsMarkets
Equity Markets - Common stocks• Primary Market - New security issues sold to
initial buyers• Secondary Market - Securities previously
issued are bought and sold
© 2008 Pearson Education Canada2.6
Classifications of Financial Classifications of Financial Markets Markets (Cont’d)(Cont’d)
Secondary Markets Exchanges• Trades conducted in central locations (e.g.,
Toronto Stock Exchange and New York Stock Exchange)
Over-the-Counter Markets• Dealers at different locations buy and sell
© 2008 Pearson Education Canada2.7
Financial Market InstrumentsFinancial Market Instruments
© 2008 Pearson Education Canada2.8
Financial Market Instruments Financial Market Instruments (Cont’d)(Cont’d)
Other Money Market Instruments• Certificates of deposit• Repurchase agreements• Overnight funds
© 2008 Pearson Education Canada2.9
Financial Market Instruments Financial Market Instruments (Cont’d)(Cont’d)
© 2008 Pearson Education Canada2.10
Financial Market Instruments Financial Market Instruments (Cont’d)(Cont’d)
Other Capital Market Instruments• Canada savings bonds• Provincial and municipal bonds
• Government agencies securities
© 2008 Pearson Education Canada2.11
Internationalization of Internationalization of Financial MarketsFinancial Markets
International Bond Market• Foreign bonds - sold in a foreign country and
denominated in that country• Eurobonds – denominated in a currency other than
the country in which it is sold • Eurocurrencies – foreign currencies deposited in
banks outside the home country
© 2008 Pearson Education Canada2.12
World Stock MarketsWorld Stock Markets
© 2008 Pearson Education Canada2.13
Function of Financial Function of Financial IntermediariesIntermediaries
Financial Intermediaries• Engage in process of indirect finance• Are needed because of transactions costs and
asymmetric information
© 2008 Pearson Education Canada2.14
Function of Financial Function of Financial Intermediaries Intermediaries (Cont’d)(Cont’d)
Transactions Costs1. Financial intermediaries make profits by
reducing transactions costs.
2. They reduce transactions costs by developing
expertise and taking advantage of
economies of scale.
© 2008 Pearson Education Canada2.15
Function of Financial Function of Financial Intermediaries Intermediaries (Cont’d)(Cont’d)
Risk Sharing• Create and sell assets with low risk characteristics
and then use the funds to buy assets with more risk (also called asset transformation)
• Lower risk by helping people to diversify portfolios
© 2008 Pearson Education Canada2.16
Asymmetric Information Asymmetric Information
Adverse Selection• Before transaction occurs• Potential borrowers most likely to produce adverse
outcomes are ones most likely to seek loans and be selected
© 2008 Pearson Education Canada2.17
Asymmetric InformationAsymmetric Information (Cont’d) (Cont’d)
Moral Hazard• After transaction occurs• Hazard that borrower has incentives to engage in
undesirable activities making it more likely that loan won’t be paid back
© 2008 Pearson Education Canada2.18
Financial IntermediariesFinancial Intermediaries
© 2008 Pearson Education Canada2.19
Size of Financial Size of Financial IntermediariesIntermediaries
© 2008 Pearson Education Canada2.20
Regulation of Financial Regulation of Financial MarketsMarkets
© 2008 Pearson Education Canada2.21
Regulation of Financial Regulation of Financial MarketsMarkets
Primary Reasons for Regulation1. Increase information to investors
- Decreases adverse selection and moral hazard problems
- Securities commissions force corporations to disclose information
© 2008 Pearson Education Canada2.22
Regulation of Financial Regulation of Financial Markets Markets (Cont’d)(Cont’d)
Primary Reasons for Regulation (continued)
2. Ensuring the soundness of intermediaries- Prevents financial panics- Restrictions on entry/assets/activities, disclosure,
deposit insurance, limits on competition