Financial Institutions and Markets Overview of the Financial System

CHAPTER ONE

OVERVIEW OF THE FINANCIAL SYSTEM

1.1 Introduction
This chapter is designed to introduce you to the basic concepts of the Financial Systems. The
first part of this chapter deals with the nature, role and operation of the financial system and the
various types of financial transactions formulated and performed in the financial system.
Properties and roles of the different types of financial assets that are created and traded in the
financial system are also discussed in the second part of this chapter. In addition, it will provide
information regarding the classification and roles of financial markets in the financial system

Definition; A financial system is defined as the collection of markets, individuals, laws, polices,
systems, conventions, techniques and institutions through which bonds, stocks, and other
securities are traded, interest rates are determined and financial services are provided and
delivered.
1.2:Functions of the Financial System

Financial system performs the essential economic function of channeling funds from people who
have saved surplus funds by spending less than their income to people who have a shortage of
funds because they wish to spend more than their income

Why is this channeling of funds from savers to spenders so important to the economy? The
answer is that the people who save are frequently not the same people who have profitable
investment opportunities available to them, the entrepreneur’s. Let’s first think about this on a
personal level. Suppose that you have saved $1,000 this year, but no borrowing or lending is
possible because there are no financial systems. If you don’t have an investment opportunity that
will permit you to earn income with your savings, you will just hold on to the $1000 and will
earn no interest. However, Carl the carpenter has a productive use for your $1,000. He can use it
to purchase anew tool that will shorten the time it takes him to build a house, there by earning an
extra $200 per year. If you could get a touch with Carl, you could lend him the $1,000 at a rental
(interest) of $ 100 per year, and both of you would be better off.

In the absence of financial system, you and Carl the carpenter might never get together. Without
financial system, it is hard to transfer funds from a person who has no investment opportunities
to one who has them; you would both be stuck with the status quo, and both of you would be
worse off. Financial markets are thus essential to promoting economic efficiency.

The existence of financial systems is also beneficial even if someone borrow for a purpose other
than increasing production in a business. Say that you are recently married, have a good job, and
want to buy a house. You can earn a good salary, but because you have just started to work, you
have not yet saved much. Over time you would have no problem saving enough to buy the house
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of your dreams, but by then, you would be too old to get full enjoyment from it. Without
financial system, you are stuck; you can’t buy the house and will continue to live in your tiny
apartment.

If a financial system were set up so that people who had built up savings could lend you the
money to buy the house, you would be more than happy to pay them some interest in order to
own a home while you are still young enough to enjoy it. Then, you had saved up enough funds;
you would pay back your loan. The overall outcome would be such that you would be better off,
as would the persons who made you loan. They would now earn some interest, where as they
would not if the financial system did not exist.

Financial systems have such an important function in allowing funds to move from people who
lack productive investment opportunities to people who have such opportunities. By doing so, a
financial system contributes to higher productive and efficiency in the overall economy. It also
directly improve the well- being of consumers by allowing them to time their purchases better,
they provide funds to young people to buy what they need and can eventually afford without
forcing them to wait until they have saved up the entire purchase price. The Financial system that
is operating efficiently improves the economic welfare of everyone in the society.

1.2: The Flow of Funds in the Financial System (Financial Transactions)

Financial systems are never static; they change constantly in response to shifting demands from
the public, the development of technology and changes in laws and regulations. Competition in
the financial market place forces financial institutions to respond to public need by developing
new, better quality, and more convenient financial services.

Whether simple or complex, all financial systems perform at least one basic function. They move
scarce funds from those who save and lend (surplus-budget units) to those who wish to borrow
and invest (deficit-budget units). In the process, money is exchanged for financial assets however
the transfer of funds from savers to borrowers can be accomplished in at least three different
ways. These are: - direct finance, semi-direct finance, and indirect finance.
1) Direct Finance
Borrowers borrow funds directly from lenders in financial markets by selling them securities
(alsocalled financial instruments).Borrowers and lenders meet each other and exchange funds in
return for financial assets. It is the simplest method of carrying financial transactions. You
engage in direct finance when you borrow money from a friend and give him or her IOU (a
promise to pay) or when you purchase stocks or bonds directly from the company issuing them.
We usually call the claims arising from direct finance primary securities because they flow
directly from the lender to the ultimate users of funds.

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Direct Finance

Borrower-spenders Funds Saver-Lenders

(Deficit budget units) (Surplus budget
units)
Primary securities (stocks, bonds,
notes, etc)

Primary Secondary
Securities Financial securities
intermediaries

Loan able funds Loan able funds

Indirect Finance

Figure 1; the flow of funds in the financial system (direct and indirect finance)

The principal lender- savers are households, but business enterprises and the government
(particularly state and local government), as well as foreigners and their governments, sometimes
also find themselves with excess funds and so lend them out. The most important borrower-
spenders are business and the government (particularly the federal government) but households
and foreigners also borrow to finance their purchases of cars, furniture, and houses.

 The following can be visible draw backs of this system:

i) Both borrower and lender must desire to exchange the same amount of funds at the
same time.
ii) The lender must be willing to accept the borrower’s IOUs (a promise to pay), which
may be quite risky, illiquid or slow to mature.
iii) There must be a coincidence of wants between surplus and deficit – budget units in
terms of the amount and form of a loan. Without that fundamentals coincidence, direct
finance breaks down.
iv) Both lender and borrower must frequently incur substantial information costs simply to
find each other.
v) The borrower may have to contact many lenders before finding the one surplus – budget
unit with just the right amount of funds and willingness to take on the borrower’s IOU.

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2) Semi direct Finance

Early in the history of most financial systems, a new form of financial transaction appears which
we call semi direct finance.
Borrower- Primary Saver-Lenders
Primary
Spenders Securities Security brokers (Surplus
Securities
(Deficit Budget and dealers Budget Units)
Units) Proceeds of security
sales (less fees and Flow of
commission) funds

Figure 2; the flow of funds in the financial system (semi-direct finance)

Here, some individuals and business firms become securities brokers and dealers whose essential
function is to bring surplus and deficit budget units together – thereby reducing information
costs.

Broker: An individual or institution that provides information concerning possible purchases

and sales of securities. Either a buyer or a seller of securities may contact a broker, whose job is
simply to bring buyers and sellers together.

Dealer: Also serves as a middle man between buyers and sellers, but the dealer actually acquires
the seller’s securities in the hope of marketing them at a more favorable price.Dealers take a
position of risk because by purchasing securities outright for their own portfolios, they are
subject to risk of loss if those securities decline in value.

3) Indirect Finance/Financial Intermediation

The limitations of both direct and semi direct finance stimulated the development of indirect
finance carried out with the help of financial intermediaries.The process of indirect finance using
financial intermediaries (institutions), called financial intermediation, is the primary route for
channeling funds from lenders to borrowers, (see figure 1 above)

Financial intermediaries issue securities of their own or buy securities issued by corporations and
then sell those securities to investors.

Examples of such securities include: checking and saving accounts, health, life and accident
insurance policies, retirement plan and shares in mutual fund.
1) They generally carry low risk of default
2) The majority can be acquired in small denominations
3) They are liquid (for most) and can be easily converted into cash with little risk of
significant loss for the purchaser.
4) Reduced transaction costs

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Financial Intermediaries /Institutions

The principal financial institutions /intermediaries fall in to three categories; depository
institutions (banks), contractual and savings institutions, and investment institutions
1 Depository institutions (banks)
These are financial institutions that accept deposit from individuals and institutions and makes
loans. They include commercial banks and thrift institutions (savings and loan associations,
mutual savings banks, and credit unions.)
2 Contractual savings institutions
These are financial institution such as insurance companies and pension funds, which acquire
funds at periodic intervals on contractual basis

Since they can predict with reasonable accuracy how much they will have to pay out in benefits
in the coming years, they don’t have to worry as much as depository institutions about losing
funds.
3 Investment intermediaries
These are financial institutions which sale shares to individuals and use these funds to invest n a
pool of assets. Example: mutual funds, investment banks, money market mutual funds etc.

Why are Financial Intermediaries and Indirect Finance so Important in Financial System?
To answer this question we need to understand the following core ideas.
I. Transaction cost
The time and money spent in carrying out financial transactions are major problems for people
who have excess funds to lend. Financial intermediaries (institutions) reduce transaction costs
because of two main reasons.
A Economies of scale; one solution to the problem of high transaction cost is to bundle (bring
together) the funds of many investors so that they can take advantage of economies of scale , the
reduction in transaction cost per dollar of investment as the size or scale of transaction
increases. By bundling together investors' funds, transaction costs for each individual investor
are far smaller. Economies of scale exist because the total cost of carrying out transaction in
financial markets increases only a little as the size of transaction grows. For example, the cost of
arranging a purchase of 10,000 shares of stock is not much greater than the cost of arranging a
purchase of 50 shares of stock.

The presence of economies of scale in financial markets helps explain why financial
intermediaries developed and are such an important part of our financial structure. The clearest
example of a financial intermediary that arose because of economies of scale is a mutual fund. A
mutual fund is a financial intermediary that sells shares to individuals and then invests the
proceeds in bonds or stocks. Because it buys large blocks of stocks or bonds, a mutual fund can
take advantage of lower transaction costs.

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B Expertise; financial intermediaries also arise because they are better able to develop expertise
to lower transaction costs. They develop experts for convenient service which can be used for
huge number of transactions at a lower cost per transaction.

An important outcome of a financial intermediary's low transaction costs is that they allow a
financial intermediary to provide its customers with liquidity services, services that make it
easier for customers to conduct transactions.

The presence of transaction costs in financial markets explains in part why financial
intermediaries and indirect finance play such an important role in financial markets. To
understand financial structure more fully, however, we turn to the role of information in financial
markets.
II. Asymmetric Information
One party having insufficient knowledge about the other party involved in a transaction to make
accurate decisions- is an important aspect of financial markets. If one party often doesn’t know
enough about the other party to make accurate decisions, we call there is asymmetric
information. It creates two major problems; adverse selection and moral hazard

A Adverse selection ; this is the problem created by asymmetric information before the
transaction occurs. Potential bad credit risks are the ones who most actively seek out loans. Due
to lack of information parties who are most likely to produce an undesirable (adverse) outcome
may be selected , who are unlikely to pay back the loan .This leads to ‘’credit risk ‘’or ‘’risk of
default ‘’. Because adverse selection increases the chances that a loan might be made to a bad
credit risk, lenders may decide not to make any loans even though there are good credit risks in
the market place.

B Moral hazard ;this problem is created by asymmetric information after the transaction occurs
.This means after taking the loan ,the borrower might engage in activities that are undesirable or
immoral. This makes again the probability of the loan to be paid back less. For example, once
borrowers have obtained a loan, they may take on big risks (which have high possible returns but
also a greater risk of default) because they are playing with someone else's money. Because
moral hazard lowers the probability that the loan will be repaid, lenders may decide that they
would rather not make a loan.

The problems created by adverse selection and moral hazard can be minimized by financial
intermediaries. They can screen out good from bad credit risk thereby reduce losses due to
adverse selection. They develop experts in monitoring and evaluating the parties they lend to,
thus reduce risks associated with moral hazard.

Techniques to Solve the Problem of Adverse Selection

If purchasers of securities can distinguish good firms from bad, they will pay the full value of
securities issued by good firms, and good firms will sell their securities in the market. The
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securities market will then be able to move funds to the good firms that have the most productive
investment opportunities.
A. Private production and sale of information
The solution to the adverse selection problem in financial market is to eliminate asymmetric
information by furnishing people supplying funds with full details about the individuals or firms
seeking to finance their investment activities .One way to get this material to saver- lender is to
have private companies which collect and produce information, distinguishes good from bad
firms and then sell it to purchasers of securities. The system of private production and sale of
information doesn't completely solve this problem of adverse selection in securities markets,
because of the so called ‘’free rider problem ‘’, this occurs when people who don’t have paid
for takes advantage of information that other people have paid. This discourages the private
production and sale of information.
B. Government regulation
The free rider problem prevents the private market from producing enough information to
eliminate all the asymmetric information that leads to adverse selection. Government could
produce information to help investors distinguish good from bad firms and provides it to the
public free of charge. This solution, however, would involve in releasing negative information
about firms, a practice that might be politically difficult.
The second possibility is for the government to regulate financial markets in a way that
encourages firms to reveal honest information about themselves so that investors can determine
how good or bad the firms are. This can be achieved by enforcing firms to adhere to standard
accounting principles and to disclose information about their sales, assets, and earnings.

Although government regulation lessens the adverse selection problem, it does not eliminate it.
Even when firms provide information to the public about their sales, assets, or earnings they still
have more information than investors. There is a lot more to knowing the quality of a firm than
statistics can provide. Furthermore, bad firms have an incentive to make themselves look like
good firms because this would enable them to fetch a higher price for their securities. Bad firms
will slant the information they are required to transmit to the public, thus making it harder for
investors to sort out the good firms from the bad.
C. Financial intermediaries
Financial intermediaries such as banks become an expert on the production of information about
firms so that it can sort out good credit risk from bad ones then it can acquire funds from
depositors and lend to potential investors. Then it can acquire funds from depositors and lend
them to the good firms. Because the bank is able to lend mostly to good firms, it is able to earn a
higher return on its loans than the interest it has to pay to its depositors. As a result, the bank
earns a profit, which allows it to engage in this information production activity.

An important element in the ability of banks to profit from the information it produces is that it
avoids the free-rider problem by primarily making private loans rather than by purchasing
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securities that are traded in the open market. Because a private loan is not traded, other investors
cannot watch what the bank is doing and bid up the loan's price to the point that the bank
receives no compensation for the information it has produced. The bank's role as an
intermediary that holds mostly non-traded loans is the key to its success in reducing asymmetric
information in financial markets.

D. Collateral and net worth

Adverse selection interferes with the functioning of financial markets only if a lender suffers a
loss when a borrower is unable to make loan payments and thereby defaults. Collateral, property
promised to the lender if the borrower defaults reduces the consequences of adverse selection
because it reduces the lenders losses in the event of a default. In case of default, the lender can
sell the collateral and use the proceeds to make up for the losses on the loan. For example, if you
fail to make your mortgage payments, the lender can take title to your house, auction it off, and
use the receipts to pay off the loan. Lenders are thus more willing to make loans secured by
collateral, and borrowers are willing to supply to collateral because the reduced risk for the
lender makes it more likely they will get the loan in the first place and perhaps at a better loan
rate. The presence of adverse selection in credit markets thus provides an explanation for why
collateral is an important feature of debt contracts.

Net worth also called equity capital, the difference between a firm's assets (what it owns or is
owed) and its liabilities(what it owes) can perform a similar role as collateral. If a firm has high
net worth, even if it engages in investments that cause it to have negative profit and so defaults
on its debt payments, the lender can take title to the firms net worth, sell it off and use the
proceeds to recoup some of the losses from the loan. In addition, the more net worth a firm has in
the first place, the less likely it is to default because the firm has a cushion of assets it can use to
pay off its loans. Hence when firms seeking credit have high net worth, the consequences of
adverse selection are important and lenders are more willing to make loans.

Techniques Used to Solve the Problem of Moral Hazard

The following are the major tools in solving the problems associated with moral hazard
A. Production of information and monitoring
The creditor can be engaged in a particular type of information production, the monitoring of
the firm’s activities: auditing the firm frequently and checking on what the firm is generally
doing. The problem is that the monitoring process can be expensive in terms of time and money
As with adverse selection, the free rider problem decreases the amount of information production
that would reduce the moral hazard problem. In this example, the free rider problem decreases
monitoring. If you that other stockholders are paying to monitor the activities of of the company
you hold shares in, you can take a free ride on their activities.

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B. Government regulations to increase information

As with adverse selection, the government has an incentive to reduce moral hazard problem
created by asymmetric information, which provides another reason why the financial system is
heavily regulated. Governments everywhere has laws to force firms to adhere to standard
accounting principles that make profit verification easier. They also pass laws to impose criminal
penalties on people who commit the fraud of hiding and stealing profits. However, these
measures can only be partly effective
C. Net worth
When the borrowers have more at stake because their net worth (the difference between their
assets and liabilities) is high, the risk of moral hazard- the temptation to act in a manner that
lenders find objectionable- will be greatly reduced because the borrowers themselves have a lot
to lose net worth is higher, the risk of moral hazard will be greatly reduced because the
borrowers themselves have a lot to lose.

One way of describing the solution that high net worth provides to the moral hazard problem is
to say that it makes the debt contract incentive-compatible; i.e. it aligns the incentives of the
borrower with those of the lender. The greater the borrower's net worth, the greater the borrowers
incentive to behave in such a way that the lender expects and desires, the smaller the moral
hazard problem in the debt contract is, and the easier it is for the firm to borrow. Conversely,
when the borrower's net worth is lower, the moral hazard problem is greater, and it is harder for
the firm to borrow.
D. Monitoring and enforcement of restrictive covenants
A lender can insure that the borrower uses the money for the purpose intended by writing
provisions (restrictive covenants) into the debt contract that restrict the firm’s activities.

Restrictive covenants can encourage the borrowers to engage in desirable activities that makes
the more likely to be paid back. It also requires a borrowing firm to provide information about its
activity periodically in the form of reports. Because verification of earnings and profits is so
important in eliminating moral hazard, venture capital firms usually insist on having several of
their own people participate as members of the managing body of the firm, the board of
directors, so that they can keep a close watch on the firm's activities.

There are four types of restrictive covenants that achieve this objective:

1. Covenants to discourage undesirable behavior: keeping the borrower from engaging in the
undesirable behavior of undertaking risky investment projects.
2. Covenants to discourage undesirable behavior: Restrictive covenants can encourage the
borrower to engage in desirable activities that make it more likely that the loan will be paid
off.

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3. Covenants to keep collateral more valuable: Because collateral is an important protection

for the lender, restrictive covenants can encourage the borrower to keep the collateral in good
condition and make sure that it stays in the possession of the borrower.
4. Covenants to provide information: Restrictive covenants also require a borrowing firm t
provide information about its activities periodically in the form of quarterly accounting
income report; thereby making it easier for the lender to monitor the firm and reduce moral
hazard.
E. Financial intermediation
Although restrictive covenants help reduce the moral hazard problem, they do not eliminate it
completely. it is almost impossible to write covenants that rule out every risky activities.
Furthermore, Borrowers may be clever enough to find loopholes in restrictive covenants that
make them ineffective.

Another problem with restrictive covenants is that they must be monitored and enforced. A
restrictive covenant is meaningless if the borrower can violate it knowing that the lender won't
check up or is unwilling to pay for legal recourse. Because monitoring and enforcement of
restrictive covenants are costly, the free-rider problem arises in the debt securities market just as
it does in the stock market. If you know that other debt security holders are monitoring and
enforcing the restrictive covenants you can free-ride on their monitoring and enforcement. But
other debt security holders can do the same thing, so the likely outcome is that not enough
resources are devoted to monitoring and enforcing the restrictive covenants. Moral hazard
therefore continues to be a severe problem for marketable debt.

As we have seen before, financial intermediaries, particularly banks, have the ability to avoid the
free-rider problem as long as they primarily make private loans. Private loans are not traded, so
no one else can free-ride on the intermediary's monitoring and enforcement of the restrictive
covenants. The intermediary making private loans thus receives the benefits of monitoring and
enforcement and will work to shrink the moral hazard problem inherent in debt contracts. The
concept of moral hazard has provided us with additional reasons why financial intermediaries
play a more important role in channeling funds from savers to borrowers than marketable
securities do.

1.3 Financial Assets

Asset: - Any possession that has value in an exchange.
Asset: - Tangible  its value depends on particular physical properties, example: - buildings
- Intangible represents legal claims to some future benefit.
- Their value bears no relation to the form, physical or otherwise in which the
claims are recorded.
What is a financial asset?
It is a claim against the income or wealth of a business firm, household, or unit of
government represented usually by a certificate of receipt or other legal document and
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usually created by the lending of money,example: - Stocks,Bonds, Insurance policies

Deposits held in a commercial bank, credit union or saving banks.
A. Financial Assets/Instruments vs. Physical Assets
1. Physical assets
Physical assets have a physical characteristics or location such as buildings, equipment,
inventories etc. Physical assets provide continuous stream of services. Physical assets wear out
or subject to depreciation. Their physical condition is relevant for the determination of market
value
2. Financial assets
Financial assets represent a financial claim with a right to some cash. They represent a claim
against the income or wealth of business, household, or unit of Government. They are usually
created by or related to the lending of money (credit transactions).
1.3.1: Properties of Financial Assets
Financial assets have certain properties which help to determine the intention of investors on
financial assets being traded in financial market. Some of them are:
b) Moneyness-some of the financial assets are used as a medium of exchange to settle
transactions and they termed /serve as money. This characteristic is a clearly desirable one
for investors in the market.
c) Divisibility and denomination-divisibility relates to the minimum size in which a financial
asset can be liquidated and exchanged for money. The smaller the size, the more the
financial asset is divisible. Financial assets have varying degree of divisibility depending
on their denomination.
d) Reversibility- is the cost of investing in financial securities and then getting out of it and
back in to cash again. This property also called round trip cost.eg:deposits at bank
e) Term to maturity-is the length of the interval until the date when the instrument is
scheduled to make its final payment, or the owner is entitled to demand liquidation.
f) Liquidity; it is the degree in which financial assets can easily be liquidated (sold) withouta
loss in value. For this term most scholars argued that there is no uniformly accepted
definition, but according to Professor James Tobin liquidity is defined in terms of “How
much sellers stand to lose if they wish to sell immediately as against engaging in a costly
and time-consuming search”. Any financial asset which takes more time to convert in to
cash is termed as illiquid asset. E.g. Pension funds. Whereas the less the time taken to
convert in to cash is a liquid one. e.g.: Deposits in banks.
g) Convertibility; is the ability of the financial assets to be convertible in to other financial
assets. E.g. a corporate convertible bond is a bond that the bond holder can change in to
equity shares.
h) Currency: Most financial assets are denominated in one currency, such as US dollar or
Yen, and investors must choose them with that feature in mind.

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i) Cash flow and return predictability: A return that an investor will realize by holding a
financial asset depends on the cash flow that is expected to be received. This includes
dividend payments on stocks and interest payments on debt instruments.
j) Complexity; some financial assets are complex in the sense that they are actually
combinations of two or more simpler assets. To find the true value of such an asset,one
must decompose it in to its component parts and price each component separately.
k) Tax status: Investors are more concerned with income after taxes than before after taxes of
financial assets. All other properties of financial assets remain the same; taxable securities
would have to offer a higher before tax yields to investors than tax exempt securities to be
preferred. But, investors with in high tax brackets benefit most from tax-exempt securities.
The yield/income after tax can be determined using the following formula:

Yat = Ybt(1-T)................................Where: Yat-yield after tax

Ybt-yield before tax
T -Tax rate
Generally, the yield after tax depends on the existing Tax rates

1.2.2 Role of Financial Assets in the Financial System

Financial assets play a vital role in the economic performance of financial institutions. And they
have two principal economic functions:
A) Mobilizing/transferring funds from those who have surplus of funds to deficit units who
need to invest in financial assets.
B) Redistributing unavoidable risk associated with the cash flow generated by tangible
assets.
Example: To understand the two economic functions of financial assets in the financial system
see the following illustration:

A) Mr. X has got a license to open a manufacturing business organization. Mr. X has estimated
he needs 3 million Br. to operate his business. Actually he has 200,000 Br from his life
saving.
B) Mr. Y has 800,000 Br. from this total amount he plans to spend 100,000 Br. for his personal
consumption. The remaining 700,000 Br is planned for investment.
C) Mr. Z has got a bonus fund worth of Br 300,000 and he plans to spend Br 100,000 and to
invest the remaining 200,000 Br.

By accident Mr.X,Y,and Z meet in New York City. Sometime during their conversation, they
discuss their financial plans. By the end of the evening, they agree to deal on it. Mr. X agrees to
invest Br.100, 000of his savings in the business and sell a 50% share to Mr. Y for 700,000 Br.
Mr. Z agrees to lend Mr. X Br 200,000 for four years interest rate of 20% per year. Mr. X will be
responsible for operating the business without the assistance of Mr. Y and Z.

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Two financial claims came out of this agreement. The first is the equityinstrument issued by Mr.
X and purchased by Mr. Y for Br 700,000.the other is a debt instrument issued by Mr. X and
purchased from Mr. Z for Br200, 000.Thus, two financial assets allowed funds to be transferred
from Mr. Y & Z who has a surplus of funds to Mr. X, who needed to invest in tangible assets.

1.3 Financial Markets

It is a market in which financial assets(securities) such as stocks and bonds can be bought and
sold. Or it is a market in which funds are transferred or mobilized from people (transfer units)
having an excess of available funds to those people (deficit) units with a shortage of funds to
invest. As a market for financial claims, the main actors are households, business (including
financial institutions), and government units that purchase/sell financial asset. In short those
participants are broadly categorized in to surplus and deficit units.
1.3.1 Classification of Financial Markets
Financial markets are classified under different bases to trade financial assets:
1. Classification on the bases of origin/issuance of an asset
a. Primary market-is a market in which newly issued securities are traded.
b. Secondary market-is a market in which previously issued/second hand securities are
traded. Also called after market
2. Classification on the bases of maturity/ term of claims
a) Money market-a market with shortly matured(less than a year) financial securities are
being traded.
b) Capital market- a market with long period matured(greater than a year) financial
securities are being traded.
3. Classification on the bases of type/ownership of financial claims
a) Equity market-is the financial market for residual claims (equity instruments). Example
stock market.
b) Debt market–the financial market for fixed claims (debt instruments). It is a market in
which securities that require the issuer (the borrower) to pay the holder (the lender)
certain fixed dollar amounts at regularly scheduled intervals until specified time (the
maturity date) is reached, regardless of the success or failure of any investment projects
for which the borrowed funds are used are going to be traded.

4. Classification on the bases of organizational structure of the market

a) Organized exchange market (auction)-is an organized and regulated financial market
where securities are bought and sold at a price governed by demand and supply forces.
It is a market where buyers and sellers of securities (or their agents or brokers) meet in
one central location to conduct trades. Example New York and American stock exchange
b) Over the counter market (OTC) –is a market made through brokers or dealers called
market makers using a negotiation over telephone or computer based networking system.
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Financial Institutions and Markets Overview of the Financial System

5. Classification on the basis timing of delivery

a) Spot/cash market; the market where the delivery occurs immediately the transaction
occurs
b) Futures/forward market; is the market where the delivery occurs at a pre determined time
in the future.
1.3.2 Role of the Financial Market in the Financial System
We have defined a financial market as a market for creation and exchange of financial assets. If
you buy or sell financial assets, you will participate in financial markets in some way or the
other.
Financial markets play a pivotal role in allocating resources in an economy by performing three
important functions:

a) Financial markets facilitate price discovery. The continual interaction among numerous
buyers and sellers who use financial markets helps in establishing the prices of financial
assets. Well organized financial markets seem to be remarkably efficient in price discovery.
That is why financial economists say” if you want to know what the value of a financial asset
is, simply look at its price in the financial market”.
b) Financial markets provide liquidity to financial assets. Investors can readily sell their
financial assets through the mechanism of financial markets. In the absence of financial
markets which provide such liquidity, the motivation of investors to hold financial assets will
be considerably diminished. Thanks to transferability and negotiability of securities through
the financial markets, it is possible for companies and other entities to raise long term funds
from investors with short term and medium term horizons. While one investor is substituted
by another when a security is transacted, the company is assured of long term availability of
funds.
c) Financial markets considerably reduce transaction costs. The two major costs associated
with transacting are search costs and information costs. Search costs comprise of explicit
costs such as the expenses incurred on advertizing when one wants to buy or sell an asset and
implicit costs such as the effort and time one has to put to locate a customer. Information
costs refer to costs incurred in evaluating the investment merits of financial assets.

Besides, in line to the above functions the market can help participants to facilitate:
 the raising of capital/fund (in the capital market)
 international trade (currency /foreign exchange market)
 transfer of risks (in the derivative market)

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DMU, CBE
Department of Banking and Finance