Financial Institutions and Markets

Jeetendra Dangol, PhD

 Course Outline
1. Introduction
2. Interest rate in financial system
3. The central Bank, monetary policy and interest rates
4. Money markets
5. Bond and mortgage markets
6. Stock market
7. Commercial banking industry
Text:
Financial Markets and Institutions
Anthony Saunders and Marcia Million Cornett

Reference:
Financial Markets and Institutions
Frederic S. Miskin
Financial Markets and Institutions
J. Madura
 Course Objectives

to expose the students to financial

institutions and markets literature and
to give the students practical experience
by conducting a research project in
financial institutions and markets
 Financial System
(Flow of Funds)
Financial system provides a transmission
mechanism between saver-lenders and
borrower-spenders
Savers benefit earn interest
Investors benefit access to money
otherwise not available
Economy benefits efficient means of
bringing savers and borrowers together
Financial System
Financial markets are markets for financial
instruments, also called financial claims or
securities

Financial institutions (also called financial

intermediaries) facilitate flows of funds
from savers to borrowers
 Functions of the Financial System

An efficient financial system

Encourages savings
Savings flow to the most efficient users
Implements the monetary policy of
governments by influencing interest rates
The combination of assets and liabilities
comprising the desired attributes of return,
risk, liquidity and timing of cash flows
 Needs the Financial System

Individuals and businesses gain from the

trading with one another, but there are
obstacles that stand in the way of trade.
The financial system helps to overcome those
obstacles
It facilitates lending, payments and trade in risk
People trade because they differ in what
they have and in what they want
The basis of trade is diversity
Needs the Financial System (contd.)

Lending, insurance and forward transactions are

all forms of trade
As with simple trade in goods and services, the basis
for these forms of trade is diversity, and all involve
gains from trade
Owners of wealth lend to convert their command
over purchasing power today into a stream of
income in the future
Households and businesses accumulate
precautionary reserves to protect themselves
against fluctuations in income or spending
 Needs the Financial System (contd.)
Businesses and households borrow to finance investment
Businesses invest in working capital and fixed capital
Households invest in education, housing and durables
Insurance provides protection against the risk of losses
due to accidents, illnesses and natural disasters
Forward transactions provide protection against adverse
changes in future market prices
Two way of trading goods and services
Credit trading- limited by the need for trust and by large setup
costs
Cash trading- requires no trust or setup costs, but it is limited by
the availability of cash
 Financial Markets
Financial markets are the places where financial assets
and liabilities are traded
Financial markets facilitate the sale and resale of
transferable securities
They are channels through which flows of savings
are allocated to investment
Financial markets establish a pricing mechanism for
financial assets and this pricing mechanism plays a
most important role in allocating saving to
investment
Financial Assets - financial instruments or securities, intangible assets
Economic functions of Financial assets
They allow the transfer of funds from surplus unit to deficit unit
They redistribute the unavoidable risk related to cash generation among
deficit and surplus economic units
 Why Financial Markets?
They provide a mechanism for determining
the price of financial assets
They make assets more liquid
They reduce the costs of exchanging
assets
Transaction costs
Search costs
Information costs
 Financial Markets
The market for government securities
The bond (debt) market
The equity market
The market for derivatives
 Importance of Financial Markets
For example, if you save $1,000, but there are no
financial markets, then you can earn no return on this
might as well put the money under your mattress.
However, if a carpenter could use that money to buy
a new raw wood (increasing productivity), then he will
be willing to pay you some interest for the use of the
funds.

Provide liquidity, making it easy to buy and sell the

securities of the companies

Establish a price for the securities

 Suppose you want to start a business
but you have no start up funds
At the same time, Mr. XYZ has money
to invest for retirement.
If the two of you could get together,
perhaps both of your needs can be
met. But how does that happen?
To make this happening,
There should be

Either
Market
(Financial Markets)

Or
Intermediaries
(Financial Institutions)
 Financial Markets

1. Capital market

2. Bond market

3. Money market
 Indirect vs. Direct Finance
Indirect finance
Borrowers and lenders meet through a financial
intermediary (e.g. bank)
Loan is a liability for borrower, and asset for a bank
Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable
funds and loan opportunities) by issuing financial
instruments which are claims on the borrowers future
income or assets
 Indirect vs. Direct Finance
Direct finance
Borrowers sell securities directly to lenders
e.g. corporate and Treasury bonds

Borrowers borrow directly from lenders in

financial markets by selling financial
instruments which are claims on the
borrowers future income or assets
Flow of Funds in Financial
Markets