PBF

• Main functions of financial systems

  • Economic function
  • Monetary function
• Economic function

  1. Channel funds from surplus units (lender-savers) to shortage units (borrower-spenders) through

  2. Direct financing

  3. Indirect financing
• Direct financing

  Borrowers borrow directly from lenders in financial markets (e.g. stock market, bond market) by selling financial instruments (e.g. stocks, bonds)
• Indirect financing

  Borrowers borrow indirectly from lenders via financial intermediaries (e.g. banks)
• Differences between direct and indirect financing

  • Channelling of funds
  • Risk

  
• Monetary function

  • Facilitate lending & borrowing
  • Provide payment mechanism
  • Adjust portfolio composition, transfer risk

  
• The monetary function is important for an economy because it facilitates mobilising savings, increasing funds available to fund capital investments, and increasing efficiency of economic activity
• Bonds

  Debt instruments owed by the issuer (or borrower) to the bondholder
• Government bonds

  • Default risk free
  • Pay lower interest rates than municipal and corporate bonds
• Treasury bills (T-bills)

  Short term US government bonds with maturity less than 1 year
• Municipal bonds

  Bonds issued by local government, county or state governments to finance public interest projects
• Corporate bonds

  Have higher risk of default than municipal and government bonds, therefore pay higher coupon interest
• Types of corporate bonds


  • Zero coupon bond
  • Perpetual bonds
  • Floating rate bonds
  • Index-linked bonds
  • Callable bonds
  • Puttable bonds
  • Convertible bonds
  • Foreign bonds
  • Eurobonds

  
• Common stocks (ordinary shares)

  Represent ownership in a firm, shareholders have voting and control rights, returns include dividends and capital gains
• Preferred stocks (preference shares)

  Represent equity claims with limited ownership rights, receive fixed constant preferred dividends
• Yield curve

  Plots the yields (interest rates) of bonds with different maturity but the same risk
• Types of yield curves

  • Upward sloping
  • Flat
  • Downward sloping
• Theories explaining the shape of the yield curve

  • Expectation theory
  • Liquidity premium theory
  • Market segmentation theory

  
• Primary market


  Where new/old financial securities (bonds & stocks) are traded
• Secondary market

  Where previously issued financial securities are resold
• Market segmentation theory

  The bond market is actually made up of a number of separate markets distinguished by time to maturity, each with their own supply and demand conditions
• Different classes of investors and issuers will have a strong preference for certain segments of the yield curve and, therefore, the curve will not necessarily move up, or down, over its entire range
• Primary market


  Where new/old financial securities (bonds & stocks) are traded and sold from the issuer to the initial buyers, facilitating new capital/financing
• Secondary market

  Where previously issued financial securities are resold among investors, does not facilitate new financing but improves liquidity

  
• Secondary market makes financial securities more liquid

  Makes the primary issue more attractive to investors, easier for the firm to sell securities in the primary market
• Price determined by trading in the secondary market

  Sets the price for new issues into the primary market
• Exchange market

  Securities are traded by brokers in one central location with more rules governing trading
• Over-the-counter (OTC) market


  Securities are traded by dealers at different locations with fewer rules, more competitive as dealers use technology to link prices
• Financial markets

  • Money markets
  • Capital markets (include stock market & bond market)
• Money markets


  Financial market where short-term securities (maturity <1 year) are issued and traded, for shortage units to facilitate short term liquidity need and for surplus units to earn interest
• Capital markets


  Financial market where long-term securities (maturity > 1 year) are issued and traded, to provide longer-term (more stable) sources of finance for the issuer
• Financial instruments in money markets


  • Treasury bills or certificates of deposit (CD)
• Financial instruments in capital markets


  • Stocks, government bonds, corporate bonds
• Market-based financial system


  Equity markets are more important than banks, financial markets play a greater role in providing finance to firms
• Bank-based financial system


  Banks are the primary source of funds to firms, more important than markets
• USA & UK have market-based financial systems, Germany & Japan (& Italy, Spain) have bank-based financial systems, France has both banks and markets as equally important
• Characteristics of market-based vs bank-based financial systems


  • No integration of banking & commerce, low integration of bank & non-bank financial services in market-based
  • Integration of banking & commerce, high integration of bank services (universal banks) in bank-based
• Implications of financial system


  • Firms' financing
  • Households' asset allocation
  • Role of financial intermediation

  
• Trend is towards market-based financial systems, suggesting its superiority in terms of capital allocation due to discredited government intervention and effectiveness of financial markets emphasised by economic theory
• Causes of the Global Financial Crisis 2007/08


  • Capital flows resulting from the growth of global macro-imbalances
  • Financial innovations (e.g. securitization)
  • Inadequate regulation
  • Inadequate capital/liquidity held by banks
  • Increase in demand for and supply of credit
  • Relaxation of credit supply conditions especially sub-prime lending in US
  • Bubble in US (and other European) housing markets linked to growth in credit
  • Long period of moderation - changed risk appetite