Chapter-01

Overview of financial System and Financial markets and

Institutions

Financial asset:
A financial asset is a non-physical asset whose value is derived from a contractual claim, such
as bank deposits, bonds, and stocks. Financial assets are usually more liquid than other
tangible assets, such as commodities or real estate, and may be traded on financial markets.

Financial asset versus Tangible asset:

A tangible asset is one whose value depends on particular physical properties such as
buildings, land and machinery. Financial assets represent legal claims to some future benefits.

The role of financial asset:

To transfer funds from those who have surplus funds to invest to those who
need funds to invest in tangible assets
To transfer funds in such a way as to redistribute the unavoidable risk
associated with the cash flow generated by tangible assets among those
seeking and those providing the funds.

Properties of financial Asset:

a. Moneyness: Some financial asset used as a medium of exchange or in settlement

of transactions. Could be cash or near money, such as time & savings deposits and
Treasury Bills.
b. Divisibility: Relates to the minimum size in which a financial asset can be
liquidated and exchanged for money.
c. Reversibility: The cost of investing in a financial asset and then getting out of it
and convert into cash again.
d. Term to maturity: the length of the period until the date at which the instrument is
scheduled to make its final payment, or the owner is entitled to demand
liquidation.
e. Liquidity: Liquidity is the term used to describe how easy it is to convert assets to
cash.
f. Convertibility: Convertibility is the quality that allows money or other financial
instruments to be converted into other liquid stores of value.
g. Currency: Currency is a generally accepted form of money, including coins and
paper notes, which is issued by a government and circulated within an economy.

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 Overview of Financial System
Financial System is the collection of markets, institutions, laws and techniques through which
bonds, stocks and other securities are traded, interest rates are determined and financial
services are produced and delivered around the world.
A financial system (within the scope of finance) is a system that allows the exchange of funds
between lenders, investors, and borrowers. Financial systems operate at national, global, and
firm-specific levels.
Money, credit, and finance are used as media of exchange in financial systems. They serve as
a medium of known value for which goods and services can be exchanged as an alternative to
bartering. A modern financial system may include financial institutions, financial markets,
financial instruments, and financial services. Financial systems allow funds to be allocated,
invested, or moved between economic sectors. They enable individuals and companies to
share the associated risks.

Components of financial system:

1. Financial institutions:
a) Banks
b) Non-bank financial institutions
2. Financial markets:
A. Debt security market:
a) Money market
b) Bond market
c) Mortgage market
B. Equity/ Capital market
C. Derivative security market:
a) Forward market
b) Future market
c) Option market
d) SWAP market
3. Financial instruments:
a) Cash instruments
b) Derivative instruments
4. Financial services

1. Financial Institution

A financial institution (FI) is a company engaged in the business of dealing with monetary
transactions, such as deposits, loans, investments and currency exchange. Financial
institutions encompass a broad range of business operations within the financial services
sector, including banks, trust companies, insurance companies, and brokerage firms or
investment dealers.

A financial institution (FI) is a private (shareholder-owned) or public (government-owned)

organizations that, broadly speaking, act as a channel between savers and borrowers of funds
(suppliers and consumers of capital).

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Two main types of financial institutions are:
(1) Banks and credit unions which pay interest on deposits from the interest earned on the
loans
(2) Non-bank financial institutions like insurance companies, mutual funds, investment
banks, underwriters and brokerage firms which collect funds by selling their policies or
shares (units) to the public and provide returns in the form periodic benefits and profit
payouts.

In other points of view, Financial institutions provide services as intermediaries of financial

markets. Broadly speaking, there are three major types of financial institutions:

1. Depository institutions: deposit-taking institutions that accept and manage deposits

and make loans, including banks, building societies, credit unions, trust companies,
and mortgage loan companies;
2. Contractual institutions: insurance companies and pension funds
3. Investment institutions: investment banks, underwriters, brokerage firms.

2. Financial Markets

The financial market is a broad term describing any marketplace where trading of securities
including equities, bonds, currencies and derivatives occurs. Financial market is a market in
which financial assets (securities) such as stocks and bonds can be purchased or sold
Financial markets provide for financial intermediation--financial savings (Surplus
Units) to investment (Deficit Units)
Financial markets provide payments system
Financial markets provide means to manage risk

A. Debt security market: The debt market is the market where debt instruments are traded.
Debt instruments are assets that require a fixed payment to the holder, usually with
interest.
a) Money market: The money market is where financial instruments with high
liquidity and very short maturities are traded.
b) Bond market: A bond market is a debt market or a financial marketplace
where bonds are traded between the issuer and the buyer.
c) Mortgage market: Mortgage market is the market where borrowers and
mortgage originators come together to negotiate terms and effectuate
mortgage transaction.

B. Equity/ Capital market: A capital market is a financial market in which long-term debt
or equity-backed securities are bought and sold. Capital markets are defined as markets in
which money is provided for periods longer than a year.

C. Derivative security market: The derivatives market is the financial market for
derivatives or financial instruments like futures contracts or options, the value of which
are derived from other assets.

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 a) Forward market: Forward Contract is an agreement between parties to buy and
sell the underlying asset at a specified date and agreed rate in future. A forward
contract is a contract whose terms are tailor-made i.e. negotiated between buyer
and seller.
b) Future market: A contract in which the parties agree to exchange the asset for
cash at a fixed price and at a future specified date, is known as future contract.
futures contract is a standardized form of the forward contract.
c) Option market: Medium of exchange for options contracts allowing the holder
the right to sell or buy an underlying commodity on an open market. The option
contracts define the trading limitations of the market, including the option type
and the expiration date. A place where options (rights to buy shares, currencies
etc. at a specified price in the future) are bought and sold.
d) SWAP market: A swap is a derivative contract through which two parties
exchange financial instruments. A market in which a borrower with one type of
loan exchanges it with another borrower with a different type of loan.

Financial Market Globalization:

Globalization of FM means the integration of financial markets throughout the world into an
international financial market.
Increased international funds flow
o Increased disclosure of information
o Reduced transaction costs
o Reduced foreign regulation on capital flows
o Increased privatization
Results: Increased financial integration--capital flows to highest expected risk-adjusted
return

Classification of Global Financial Market:

1. Internal Market
a. Domestic Market: Domestic Market is a market where issuers domiciled in the
country issue securities and where those securities are subsequently traded.
b. Foreign market: Foreign market of a country is where the securities of issuers
not domiciled in the country where securities are sold and traded.
2. External Market: also called international market includes the following features: at
issuance they are offered simultaneously to investors in a number of countries and
they are issued outside the jurisdiction of any single country. It is also called offshore
market.
3. Financial instruments
Financial instrument is a document that has a monetary value or represents a legally
enforceable agreement between two or more parties regarding a right to payment of money.
Financial instruments can be either cash instruments or derivative instruments:

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 Cash instruments: instruments whose value is determined directly by the markets.
They can be securities, which are readily transferable, and instruments such as loans
and deposits, where both borrower and lender have to agree on a transfer.

Derivative instruments: instruments which derive their value from the value and
characteristics of one or more underlying entities such as an asset, index, or interest
rate. They can be exchange-traded derivatives and over-the-counter (OTC)
derivatives.
4. Financial services
Financial services are the economic services provided by the finance industry, which
encompasses a broad range of businesses that manage money, including credit unions, banks,
credit-card companies, insurance companies, accountancy companies, consumer-finance
companies, stock brokerages, investment funds and some government-sponsored enterprises.

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