Overview of the Financial System

Lecture 1

Main Contents

Function of Financial Markets Structure of Financial Markets

Debt and Equity Primary and Secondary Markets Exchanges and Over-the-Counter Markets Money and Capital Markets Transaction Costs Risk Diversification Asymmetric Information: Adverse Selection and Moral Hazard

Function of Financial Intermediaries

Financial Innovation and Engineering Regulation

1.1 Function of Financial Markets

Function of Financial Markets

Mr. and Mrs. Wong accumulated $1M over the years. They want to find a way to spend all of the savings to make more money for the future life after retirement.

Function of Financial Markets

Mr. Alex, a very brilliant scientist of CUHK, invented a new medicine to cure cancer recently. The new medicine works very well in clinic. So he wants to set up a small pharmaceutical company to produce it. According to his estimate, the total cost would be HK$1M. But he has No Money!

Function of Financial Markets

Financial market can perform as a channel between Mr. & Mrs. Wong and Mr. Alex.

Function of Financial Markets

Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds.

Promotes economic efficiency by producing an efficient allocation of capital, which increases production. Directly improve the well-being of consumers by allowing them to time purchases better.

1.2 Structure of Financial Markets

Direct Finance

In direct finance, borrowers borrow funds directly from lenders in financial markets by selling them securities () or financial instruments ()

Bonds Stocks

Debt and Equity Markets

Debt Market:

Bonds Alex

Financial Market $

Mr. and Mrs. Wong

Debt and Equity Markets

Bond (): An agreement between the borrower and the lender that the borrower will pay fixed amount of money (interest, ) at regular intervals until a specified date (maturity, ). At that date, the borrower returns the principal () to the lender.

Cash Flows of a Bond

Borrower (Mr. Alex)

Maturity

Lender (Mr.& Mrs. Wong)

Debt and Equity Markets

Bond securities suffer from the risk of default, in which the issuer is unable or unwilling to return money he/she promises. The creditor may file a bankrupt petition against the bond issuer in a court to recoup a portion of what they are owed.

Debt and Equity Markets

Equity () Market: The borrower also may raise funds by issuing equities, such as common stock (), to the lender. Now the lender has a claim on the ownership of the borrowers business. He/She has the right to decide any matters of corporate governance. Stocks usually also make periodic payments to the holder (dividends, ).

Debt and Equity Markets

The most important difference between equity and bonds is that stock holder () has the right to participate in the decision of the issuing companys business matters. The stock holders of a company use their shares as votes to elect the members of the board of directors (). This board oversees the daily management on behalf of all equity holders interest.

Debt and Equity Markets

The main disadvantage of owning a corporations equities rather than its debt is that an equity holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays its equity holders. The advantage of holding equities is that equity holders can benefit directly from any increases in the corporations profitability.

Cash Flows of a Stock

Borrower (Mr. Alex)

Lender (Mr.& Mrs. Wong)

Debt and Equity Markets

In summary, financial markets can be categorized mainly into two: bond and stock markets, according to the types of securities. No matter which one, the securities are with high uncertainty in their price. In finance, people call this uncertainty by risk ().

Primary and Secondary Markets

Alex is a medical expert. He knows little about finance and so he needs professional help to issue bonds or stocks to the markets. There is one market for this -----Primary market (,): 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.

Procedure of Primary Markets

An important financial institution, investment bank (), can assist Alex in the primary market for the initial sale of securities to the public. Underwriting () and IPO ():
Investment bank negotiates with the issuer behind closed doors on the terms and prices of new securities and then buy them from the issuer and sell to the public. The issuer pays commission () to investment bank.

Procedure of Primary Markets

Relationship among a company issuing securities, the underwriters and the public:
Issuing Company
Underwriter Syndicate

Lead Underwriter

Investment Banker A

Investment Banker B

Investment Banker C

Investment Banker D

Private Investors

Primary and Secondary Markets

An individual who buys a security in the primary market may want to sell it to someone else later for raising money. He/she can go to secondary market (,
):
A secondary market is a financial market in which securities that have been previously issued can be resold.

Primary and Secondary Markets

The corporation issuing securities acquire no new funds from the secondary markets. However, the secondary markets serve two important functions:

They make the financial instruments more liquid (). They determine the price of the security that the issuing firm sells in the primary market.

Secondary Markets: Exchanges

Secondary markets are organized in two ways:

Exchanges () Buyers and sellers of securities meet in one central location to conduct trading.

Hong Kong Exchanges ()

HKEX launched an electronic Automatic Order Matching and Execution System (AMS) to process trades on stocks of 1,241 listed companies.

Hong Kong Stock Exchange (HKEX)

How the HKEX works:

1 Client places order with Trader 2 Trader enters clients order into the market through AMS workstation 3 Buy/sell orders are matched based on price/time priority on AMS

Client

Trader

AMS

5 Trader can report the executed trade to client immediately

4 Executed trades are transmitted to AMS workstation in real-time

Primary and Secondary Markets

The other way of secondary market is Over-thecounter market (OTC,)

Outside of the exchanges, dealers () at different locations who have an inventory of securities stand ready to sell and buy securities to anyone who approaches to them and is willing to accept their prices.

Typical examples are foreign exchange markets and bond markets

Classification of Financial Markets

In summary, there are several classifications on the financial markets:

Equity and bond markets Primary and secondary markets

1.3 Function of Financial Intermediaries

Financial Intermediaries: Indirect Finance

Indirect finance Financial intermediaries borrow funds from the savers and then use these funds to make loans to spenders.

Reduce transaction cost Risk diversification Reduce the loss due to asymmetric information

Functions of Financial Intermediaries

Reduce transaction cost:

Carrying out financial transactions is time-consuming and expensive. Financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them; and because their large size allows them to take advantage of economies of scale.

Functions of Financial Intermediaries

Risk diversification:

Financial intermediaries can use diversification to transform more risky assets into less risky ones. They create and sell assets with risk characteristics that people are comfortable with.

Functions of Financial Intermediaries

Reduce the loss due to asymmetric information:

Borrower knows much more than lenders. This inequality is called asymmetric information. Moral hazard is one problem caused by asymmetric information after the transaction occurs. It means that the risk that the borrower might engage in activities that are undesirable from the lenders point of view.

Functions of Financial Intermediaries

Reduce the loss due to asymmetric information (cond):

Adverse selection is the problem created by asymmetric information before the transaction occurs. It happens when the potential borrowers who are the most likely to produce an undesirable outcome are the ones who most likely seek out a loan and thus most likely to be selected.

Types of Financial Intermediaries

Type
Depository Institution Commercial banks

Source of Funds
Deposits

Uses of Funds
Loans, mortgages, etc.

Contractual Saving Institution Life insurance companies Pension funds and government retirement funds
Investment Intermediaries Mutual funds Finance companies

Premium from policies Employer and employee contribution

Corporate bonds, mortgages Corporate bonds and stocks

Shares Stocks and bonds

Stocks and bonds Consumer and business loans

1.4 Financial Innovation and Engineering

Financial Innovation and Engineering

Motivation:

Needs for risk reduction Advances in computer and telecommunication technologies Incentives to get around existing regulation and laws

Financial engineering is a process of making new financial products better suited to the circumstances of the customers.

Financial Engineering and Recent Crisis

Lessons from the most recent financial crisis:

Securitization:

Financial Engineering and Recent Crisis

Lessons from the most recent financial crisis:

Encouraged by financial engineering, the behavior of financial institutions changed dramatically. They offered more loans to high-risk borrowers, even without any income statements or employment proofs. In other words, financial institutions exposed themselves to the risk of adverse selection intentionally or unintentionally. Solution? Better regulations!

1.5 Regulations

Regulation of the Financial System

The financial market sometimes cannot maintain all the functions it should have. Thats the necessity for a good regulation from the government. Several ways turn out to be useful for regulating:

Increasing information available to investors Ensuring the soundness of financial intermediaries

Regulation of the Financial System

Increasing information available to investors:

Government should force corporations to disclose more information about such as their sales, assets and earnings to the public. Government also should prohibit trading by the large stockholders in the corporation based on material nonpublic information (insider trading)

Regulation of The Financial System

Ensuring the soundness of financial intermediaries.

Restriction of entry (Chartering processes) Disclosure of information Restrictions on assets and activities (Control holding of risky assets). Deposit insurance (to avoid bank run) Limits on competition