Lecture 1

Financial Markets, Financial Institutions and Money

Financial markets are markets in which funds are transferred from people who have a
surplus of funds to people who have a shortage of funds. The major known markets are
The bond market
The stock market
The foreign exchange market
1) The Bond Market:
A security (also called a financial instrument) is a claim on the issuer's future income or assets
A bond is a debt security that promises to make payments periodically for a specified period
of time.
The bond market is important because:
o It enables governments and businesses to finance their activities.
o It is where interest rate (i) is determined and (i) is important because it is the cost of
borrowing money.
2) The Stock Market
A common stock (usually called stock) represents a share of ownership in a corporation. A
corporation raises funds by issuing and selling stocks.
Stock prices usually fluctuate moving up and down and therefore affect:
o People's wealth:
o The amount of funds that can be raised by businesses;.
3) The Foreign Exchange Market
A foreign exchange market is where:
o The conversion of a currency from the country of origin to the currency of the country
where they are going to takes place.
o The foreign exchange rate is being determined.
Exchange rates fluctuate moving up and down and therefore affect:
o A country's exports
o A country's imports
What are financial institutions?

They are the institutions through which the financial markets work

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Financial institutions include banks, insurance companies, investment banks, etc. all
of which are regulated by the government.
Financial intermediaries are institutions that borrow funds from people and lend them
to others. Banks are the most well-known type of financial intermediaries.

What is money?

Money (or money supply) is defined as anything that is generally accepted in

payments for goods and services or in repayment of debts.

Money and business cycles

o Money plays an important role in generating business cycles
o When aggregate output or total production of goods and services increases,
unemployment decreases and vice versa (unemployment is measured by the
unemployment rate).
o money may be a factor behind business cycles.

Money and inflation

o Money plays an important role in generating inflation.
o Statistics in many countries show that increases in money supply lead to an
increase in the inflation rate. The inflation rate measures the rate of change in
the price level measured as a percentage change per year.
Money and interest rate
Statistics show that money supply affects the behavior of interest rates.

Other important concepts

o Monetary policy: management of money and interest rate by the Central Bank
or the Federal Reserve System (Fed).
o Fiscal Policy: government decisions about government spending and taxation.
o Budget deficit: results when government expenditure is greater than tax
revenues.
o Budget surplus: results when government expenditure is less than tax
revenues.
o A deficit financed by borrowing may lead to
A higher rate of money growth
A higher rate of inflation
A higher interest rate
o Gross domestic product (GDP) or aggregate output is the market value of
all final goods and services produced in the economy during one year
o National Income (NI) - or aggregate income is the total income or earnings
of the factors of production (land, labor and capital) from producing goods and
services during one year i.e. wages + rent + interest + profit. Aggregate income
is equal to aggregate output

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o Nominal GDP: when the total value of goods and services produced is
measured at current prices
o Real GDP: when the total value of goods and services produced is measured at
fixed prices
o The aggregate price level is the average level of prices in an economy.
Measures of the aggregate price is done using several price indexes:
GDP deflator = Nominal GDPt X 100
Real GDPt

PCE deflator = Nominal personal consumption expenditure X 100

Real personal consumption expenditure

CPI (consumer price index) is calculated by pricing a "basket" of

goods and services bought by urban households

How to calculate the growth rate?

To calculate the growth rate between two periods we have to calculate the real GDPs
first of the two periods:
Real GDP = Nominal GDP X 100
Price index
Growth rate of GDP = Real GDP this year Real GDP last year X 100
Real GDP last year
Or

xt xt 1 X 100
xt 1
where x
= real GDP
t
= this year
t 1 = a year earlier

How to calculate the inflation rate?

Price index this year Price index last year X 100
Price index last year
Or

Pt Pt 1
Pt 1

x 100
Where P
= price index
t
= this year
t 1 = a year earlier

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Function and Classification of Financial Markets

Function of Financial Markets

Financial markets channel funds (money) from savers who have an excess of funds to spenders
who have a shortage of funds

Financial markets can do this directly through direct finance in which borrowers borrow funds
directly from lenders by selling them securities. Securities are assets for the person who buys
them but liabilities for the person who sells them.

Financial markets can also channel funds indirectly by making use of financial intermediaries
that stand between lender-savers and borrower spenders.
Indirect Finance
Financial
intermediarie
s

Funds

Funds

Funds

Lender-saver:
1) Households
2) Businesses
3) Government
4) Foreigners

Funds

Financial
markets

Funds

Borrower-spender:
1) Businesses
2) Government
3) Households
4) Foreigners

Direct Finance

Financial markets help in producing an efficient allocation of resources because they

allow funds to move from people who lack investment opportunities to people who have
such opportunities. Therefore, they improve the welfare of everyone in society.

Classification of Financial Markets

1) Debt and equity markets
A firm or an individual can obtain funds in a financial market in two ways:

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A) By issuing a debt instrument such as bond or a mortgage.

A debt instrument is "an agreement by the borrower to pay the holder of the debt
instrument fixed dollar amounts at regular intervals (interest + principal payments) until a
specified date (the maturity date) when the final payment is made.
The maturity of the debt instrument is the number of years until the instrument expiration
date.
o The debt instrument is short term if the maturity is less than one year
o The debt instrument is intermediate term if maturity is between 1 and 10 years.
o The debt instrument is long term if its maturity is 10 years or longer.
B) By issuing equities such as a common stock.

Equities are "claims to share in net income.

Equities make periodic payments to their holders (dividends).

The disadvantage is that the equity holder is paid after all debt holders are paid first
(residual claimant).

The advantage is that the equity holder benefits from any rises in the firm's assets or
profitability unlike the debt holder who receives fixed payments.

2) Primary and Secondary Markets

A) Primary markets
A primary market is a financial market in which new issues of a security such as a bond or
a stock are sold to initial buyers by the corporation or a government agency borrowing the
funds.
These markets are not known to the public An important institution that helps in the initial
sale is the investment bank
B) Secondary markets

A secondary market is a market where securities that have previously been issued are
resold.
Examples of secondary markets are the New York and American stock exchange and
NASDAQ.
Brokers are agents who match buyers and sellers of securities.
Secondary markets are nevertheless important to the corporation because:
o They make it easier to sell these financial instruments to raise cash. Thus their
liquidity makes them desirable and easier for the firm to issue new securities.
o They determine the price of securities in the primary market because the investor
will not pay for new securities more than its price in the secondary market.
Therefore the higher the price in the secondary market, the higher the price of new
securities in the primary market.

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3) Exchange and Over-the-counter (OTC) Markets

Secondary markets are organized in two ways:
A) An exchange market where buyers and sellers of securities (or their agents) meet in one
central location to conduct trades; e.g. NYSE.
B) An over-the-counter (OTC) market in which dealers at different locations who have
securities buy and sell over the counter to anyone who wants to buy and accepts their prices.
4) Money and Capital Markets
This is a classification of market based on the maturity of the securities traded
A) The money market is a market in which only short term debt instruments (generally those
with maturity of less than one year) are traded.
B) The capital market is a market in which longer term debt instruments (generally those with
maturity 1 year and over) and equity instruments are traded.
Function and Classification of Financial Intermediaries
Function of Financial Intermediaries
1) Reducing transaction costs:
2) Reducing risk by risk sharing

Banks do this through risk sharing by creating and then selling assets with moderate risk to
investors and then using the money to purchase assets that have far more risk. This is called
asset transformation.
Financial institutions also promote risk sharing by helping individuals invest in a collection of
assets (portfolio) whose returns do not always move together, thus lowering the overall risk.
This is called diversification.

3) Asymmetric information: adverse selection and moral hazard

Asymmetric information means that each party in a transaction has unequal information about
the other party. This lack of knowledge results in:
o Adverse selection: The problem created by asymmetric information before a transaction
occurs: It means that the people who are the most undesirable from the other party's point
of view are the ones who are most likely to be engaged in a transaction.

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o Moral hazard: The problem created by asymmetric information after the transaction
occurs: It refers to the risk that one party in a transaction will engage in a behavior
that is undesirable from the other party's point of view.
Classification of Financial Intermediaries
US Financial Intermediaries

Depository Institutions
1) Commercial banks
2) Saving & loans inst.
3) Mutual saving banks
4) Credit Unions

Contractual saving inst.

1) Life insurance co.
2) Fire & casualty ins.
3) Pension & government
retirement funds

Investment intermediaries
1) Finance companies
2) Mutual funds
3) Money market mutual
funds

Depository institutions:
1) Commercial banks
These financial intermediaries raise funds (liabilities on banks) by issuing:
o Checkable deposits (deposits on which checks can be written.
o Saving deposits (deposits that are payable on demand but do not allow their owners to
write checks).
o Time deposits (deposits with fixed terms to maturity).
Banks then use these funds to (assets of banks):
o Make commercial consumer and mortgage loans
o Buy government securities and loans
2) Saving and loan associations and mutual saving banks: institutions that were different from
commercial banks in the past but now they are similar to them.
3) Credit unions: center around a group of people such as union members, acquire funds from
depositors called shares and make consumer loans.
Contractual saving institutions
1) Life insurance companies:
Insure people against financial hazards such as those following a death.
They acquire funds from premiums that people pay to keep their policies in force.
They pay back in case of death and sell annuities (annual income payments upon
retirement).
They invest their money in bonds and - to a limited extent in stocks.
2) Fire and casualty institutions
Same as life insurance companies but face a greater risk of losing their money if a major
disaster takes place.

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3) Pension and Retirement Funds

They acquire funds from employers or from employees who either contribute voluntarily
or have their contribution automatically deducted from their salaries.
They pay back in annual incomes in the form of pensions.
They usually invest in long term stocks and bonds as they know how much they will have
to pay each period and have no risk of losing their money.
Investment Intermediaries
1) Finance Companies
They acquire funds by selling a commercial paper (a short term debt instrument), stocks
and bonds.
They lend these funds to consumers to buy furniture, cars, etc.
Some finance companies are organized by a parent company to help sell its products (For
example, Ford Motors Credit Company makes loans to consumers who buy Ford cars.).
2) Mutual Funds: acquire funds by selling shares to many people and use the proceeds to buy
diversified stocks and bonds
3) Money Market Mutual Funds: same as Mutual Funds but also act as a depository institution.
The Egyptian Financial intermediaries: are more or less similar to those existing in the US as
they include commercial banks, saving institutions, credit unions, insurance companies,
investment companies and others. However, the classification may be different as many Egyptian
economists classify intermediaries into two main groups: financial institutions comprising all
types of commercial and non-commercial banks; and non-bank financial institutions comprising
all other types of intermediaries.
The Egyptian Banking System
As banks are the most important type of financial intermediaries, we will briefly review the
structure of the Egyptian banking system. In depth analysis will be conducted through your
projects and research papers.
Structure of the
Egyptian Banking System (July 2005)
Central Bank of Egypt

Private sector banks

(32)

Public sector banks

(7)

Commercial
banks (4)

Specialized
(3)

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9

Foreign branches
(7)

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