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TOPIC 1

Introduction
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What is finance?
What is finance?

In what way is finance relevant to you?

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Why Study Financial Markets and

Institutions?
Channeling fund
From those who have fund today (savers)
To those who have productive use of fund but without fund today
(spenders)
Interest rate is
The cost of using fund earlier
The compensation for using fund later
Affect personal wealth
Savings are kept in form of financial instruments, one way or the
other
e.g. stocks, bonds, bank saving, mutual funds, etc..
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Why Study Financial Markets and

Institutions?
The channeling function is achieved by various financial
tools in financial markets
e.g. equity, debt
Financial institutions also perform the functions of pooling
fund.
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Why Study Financial Markets and

Institutions?
They are relevant historically.
A healthy financial system is indispensable for economic
development historically.
e.g. financing Mediterranean trade in ancient time
e.g. financing trans-Atlantic trade starting from 16th century; VOC
They are relevant to you.
Financial planning for long term goals.
Think of one of your long term goals that required financial
resources beyond your current capacity.
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Functions of Financial Markets

Financial markets help to channels funds from
person or business without investment
opportunities (i.e., Lender-Savers) to one who
has opportunities (i.e., Borrower-Spenders).

Some people have funds but have no investment

opportunities; others have investment
opportunities but have no fund .

Who are these people?

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They may be .

Lender-Savers Borrower-Spenders
1. Households 1. Households
2. Business firms 2. Business firms
3. Government 3. Government
4. Foreigners 4. Foreigners
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Functions of Financial Markets

Financial markets also improve the
well-being of consumers, allowing them
to time their purchases better.
For example, a young couple with good
income, but have little saving. They
may not be able to buy their own flat
now.
However, if someone who can lend
his/her saving to them, they do not
need to wait until they save enough.
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Functions of Financial Markets

Another example:
Suppose you want to start a business
and manufacture a household
cleaning robot, but you are lacking of
money (no funds).
At the same time, Peter has money
and he wishes to invest for his
retirement.
Without a financial market, you and
Peter may be stuck with the status
quo.
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Functions of Financial Markets

Still another example:
Purchasing by installment.
e.g. cars, mobile phone, camera, etc..
Buyers of these items borrows money to
purchase now and repaid later
In effect, these purchase are financed by debt.
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Functions of Financial Markets

In short, financial markets
channel fund from lenders-savers to borrowers-spenders
thus helping borrowers-spenders to achieve better timing of their
spending, and
helping lenders-savers to achieve better rate of return.
Better economic efficiency is thus achieved.
How these functions are performed?
Direct financing
Indirect financing
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Direct Finance vs. Indirect Finance

1. Direct Finance
Borrowers borrow directly from lenders in
financial markets by selling financial
instruments (e.g. stocks, bonds) to lenders.
These financial instruments are claims on the
borrowers future income or assets
2. Indirect Finance
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
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Direct Financing
Flow of fund
Flow of financial securities

The interaction of savers and lenders happens in financial

markets by means of different financial tools, which are
what we turn to next.
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Financial Tools and their Markets

Basic tools of financial markets:
Debt
Equity
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Financial Tools and their Markets

1. Debt (Bond) Markets
A bond (a debt instrument) is a contractual
agreement by the borrower to pay the holder of
the instrument fixed amount of money at
regular intervals until a specified date, when a
final payment is made.
a) Short-Term (maturity < 1 year)
money market instruments
b) Intermediate term (maturity between 1
to 10 years)
c) Long-Term (maturity > 10 years)
capital market instruments
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Financial Tools and their Markets

2. Equity (Stock) Markets
An equity is ownership claim in the firm
Represents an claim to share in the net
income and the asset of a business
Equities pay periodic payments (dividends),
in theory forever, so no maturity
Capital market instrument
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Financial Tools and their Markets

From a different angle, financial markets (markets
of financial tools) can be demarcated into
Primary market
Secondary market
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Financial Tools and their Markets

1. Primary Market
The market in which new issues of security
are sold to initial buyers
Typically involves an investment bank who
underwrites the offering
i.e. investment bank act as a middleman.

2. Secondary Market
Securities previously issued are bought
and sold
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Financial Tools and their Markets

Both money market instruments and capital
market instruments have primary and secondary
markets.

Only primary market activities involve channeling

of funds from savers to lenders.

However, secondary market activities are no less

important.
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Financial Tools and their Markets

Functions of secondary maket:

(a) Provide liquidity, making it easy to buy and sell

the securities of the companies
Why it is important?

(b) Establish a price for the securities

Why it is important?
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Indirect Financing
In indirect financing, instead of
savers lending / investing directly
with borrowers, a financial
intermediary (usually an
institution, e.g. a bank) plays a
role as the middleman:
the intermediary obtains funds
from savers
the intermediary then makes
loans/investments with
borrowers
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Indirect Financing
This process is called financial
intermediation.
It is actually the primary means of moving
funds from lenders to borrowers.
More important source of finance than
securities markets, whether it is money
market or capital market.
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Indirect Financing
Functions of financial intermediaries / financial
institutions
a. Dealing with transaction cost
b. Facilitating risk sharing
c. Dealing with the problem of asymmetric
information
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Indirect Financing:
Functions of Financial Intermediaries
(A) Transaction Costs
1. Financial intermediaries make profits by
reducing transaction costs (e.g. The costs to
find the other party, to negotiate, to draw a
contract, etc.)
2. by developing expertise and taking
advantage of economies of scale (e.g. the
same contract can be used in many cases)
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Indirect Financing:
Functions of Financial Intermediaries
(A) Transaction Costs
3. A financial intermediarys low transaction costs
mean that it can provide its customers with liquidity
services, services that make it easier for customers to
conduct transactions
(i) Banks provide depositors with checking
accounts that enable them to pay their bills
easily
(ii) Depositors can earn interest on savings
accounts and yet still convert them into goods
and services whenever necessary
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Indirect Financing:
Functions of Financial Intermediaries
(B) Risk sharing
Financial intermediarires can help reduce the
exposure of investors to risk
FIs create and sell assets with lesser risk to
one party in order to buy assets with greater
risk from another party
This process is referred to as asset
transformation, because in a sense risky
assets are turned into safer assets for
investors (savers). (e.g. commercial banking)
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Indirect Financing:
Functions of Financial Intermediaries
(B) Risk sharing
Financial intermediaries (e.g. mutual fund) also
help by providing the means for individuals and
businesses to diversify their asset holdings.
Why diversify?

Low transaction costs allow them to buy a range

of assets, pool them, and then sell rights to the
diversified pool to individuals.
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Indirect Financing:
Functions of Financial Intermediaries
(C) Problems of asymmetric information
It means one party lacks crucial information
about another party in a transaction, seriously
affect decision-making.
We usually discuss this problem along two
fronts: adverse selection and moral hazard.
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Indirect Financing:
Functions of Financial Intermediaries

(C) Problems of asymmetric information

Adverse Selection
1. Occurs before a transaction
2. e.g. potential borrowers most likely to
produce adverse outcome (fail to repay a
loan, default) are ones most likely to seek a
loan
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Indirect Financing:
Functions of Financial Intermediaries
C) Problems of asymmetric information
Moral Hazard
1. Occurs after a transaction
2. Hazard (bad consequence) that borrower
has incentives to engage in undesirable
(immoral) activities making it more likely that
wont pay loan back
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Indirect Financing:
Functions of Financial Intermediaries
Adverse selection and moral hazard are challenges to any
human organization.
Success or failure to deal with them determines survival
or extinction.
Think of your group projects.
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Indirect Financing:
Functions of Financial Intermediaries
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Indirect Financing:
Functions of Financial Intermediaries
Financial intermediaries reduce
asymmetric information problems,
enabling them to make profits.
Because they are better equipped than
individuals to screen out bad credit risks
from good ones, thus reducing losses
due to adverse selection.
Besides, they develop expertise in
monitoring the parties they lend to, thus
reducing losses due to moral hazard.
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Types of Financial Intermediaries
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Types of Financial Intermediaries
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Main contents of FIN3001

Lets go to the module plan.
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Required Reading
M&E Ch.1 - 2
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END