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Chapter Seven
Money, Banking &Financial Market
Financial Market &Financial Intermediation
Lecture 7
Financial Market
A Model of the Economy
The Economics of Financial
Intermediation
Main Concepts
Part I:
Financial Market
Part II:
Financing Methods on financial markets
Part III:
The Economics of Financial Intermediation
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Overview of the Course
Financial Market
Financing Methods on financial markets
The Economics of Financial
Intermediation
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Market
Financial markets function, a vital and
important in the economy through transferring
financial economic resources saved to
invested economic units.
Financial markets, including:
Financial intermediation institutions its:
1. Banks
2. Mutual funds
3. Non-bank financial institutions.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Market
Definition the General Secretariat Council of
Economic Unity:
A regulated market, Carefully structured for
trading stocks and bonds.
Definition financial markets
Markets, which accommodate Financial
Resource Flows from savers to investors,
through trading directly and indirectly (through
intermediaries), leading forwarded the savings to
various types of investment.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Markets Characteristics
1. Major market for any economic activity in the
community.
2. The financial markets One component of the
financial sector to the financial market such as:
A. Stock market /Bourse.
B. Financial instruments (stocks, bonds).
C. Financial institutions (banks, funds, insurance
companies, etc...).
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Markets Characteristics
3. Financial markets are financial credit market to
finance investment in several ways, including:
A. Issuance the shares and offered for trading in
the market.
B. Issue the shares through participation in
company's assets and net income achieved in
the future.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Markets Characteristics
4. Credit Role has not been at once, but was
a result of development different stages
was affected by the nature relationship
between savers and investors (lenders and
borrowers).
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Markets Characteristics
5. Distinction between two main stages
have passed with them financial markets.
A. Integration phase between savers and
investors.
B. Separation Phase between savers and
investors.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Distinction between main stages have
passed with them financial markets
1. Integration phase between savers and
investors.
Financial Resource Flows had being
directly between savers and investors, an
investor is the saver is due to limited their
numbers who was facing three options:
A. Spend the full incomes, and thus there is no
income surplus, to recruited into investment.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Distinction between main stages have
passed with them financial markets
B. Hoarding savings and thereby disrupting
income surplus.
C. Income Surplus doing invest directly (best
choice).
Direct funding style and the direct flow
Combined with integration phase between
savers and investors.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Distinction between main stages have
passed with them financial markets
2. Separation Phase between savers and
investors.
This stage style combined with, the
financial institutions intermediate
emergence between savers and investors.
1. Indirect flow.
2. Increase the number of savers and
differences their preferences and desires of
the investment.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Distinction between main stages have
passed with them financial markets
3. Emergence Credit Markets starting
from:
Work Cashiers.
Banks as institutions and intermediary
between lenders and borrowers.
Central banks role in the process credit
organize and control..
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Overview of the Course
Financial Market
Financing Methods on financial markets
The Economics of Financial
Intermediation
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Mrs. Shefa Sagga Money, Banking,&Financial Market
A Model of the Economy
As in Principles of Macro, divide the
economy into different sectors and see
how those sectors interact:
“Agents” in the Economy.
Markets where Agents Interact.
Equilibrium.
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1. The Agents in the System…
There are four agents that we will focus
on when constructing a model of the
economy:
Households.
Firms.
Government.
“The Rest of the World” (ROW).
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Mrs. Shefa Sagga Money, Banking,&Financial Market
2. Markets
There are three markets that we typically focus
on in macroeconomics:
The Factor Market
The Goods Market
The Financial Market (we examine in detail in
this course).
There are three standards that define forms and
types (Classifications) financial markets, namely:
1. Standard Issue.
2. Standard trading site.
3. Standard maturity.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
The Map of the Economy
That is: Y = C + I + G + (X – M)
)ميزان الدخل القومي= االستهالك + االستثمار +مصاريف الحكومة + (الصادرات – الواردات
Y=Equilibrium level of national income.
C=Consumption of goods and services.
I= Investments.
G=Government spending.
X=Exports of goods and services.
M=Import of goods and services from other countries.
That is: Y = C + I + G +( X – M).
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Mrs. Shefa Sagga Money, Banking,&Financial Market
The Map of the Economy
That is: Y = C + I + G + (X – M)
)ميزان الدخل القومي= االستهالك + االستثمار +مصاريف الحكومة + (الصادرات – الواردات
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Methods in financial markets
There are two Financial Methods in
financial markets that we typically focus on
in macroeconomics:
1. Direct Financing
2. Indirect Financing
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Overview of the Course
GOVERNMENT
HOUSEHOLDS Financial Markets:
Central Banking &
-Interest Rates
-Risk
Monetary Policy
-Expectations
FIRMS Financial Institutions
- Financial Intermediaries
The Economy
REST OF THE
WORLD
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Markets
Why Study Financial Markets?.
Channel funds from savers to investors,
thereby promoting economic efficiency.
Affect personal wealth and behavior of
business firms.
Brief Introduction to:
Bond Market.
Stock Market.
Foreign Exchange Market.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Function of Financial Markets: Flow of Funds
Indirect Finance
Financial
Intermediaries
Lender-Savers Borrowers-Spenders
• Households Financial • Business-Firms
• Firms Markets • Government
• Government • Households
• Foreigners • Foreigners
Direct Finance
Allows transfers funds from person Or business without investment
opportunities to one who has them.
Improves economic efficiency.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Some Basic Definitions
Debt Instrument:
1. Debt Instrument: Contractual agreement by
borrower to pay holder of the instrument a
fixed dollar amount at regular intervals
(principal + interest), until a specified date.
Example: Car loan.
2. The maturity of a debt instrument is the
number of years (term) until the instrument
expires.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Classifications of Financial Markets
First: According to Standard Issue, the financial
markets structure component of:
Primary Major Markets (Market Issue).
Secondary Market (Trading Markets).
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Classifications of Financial Markets
1. Primary Market
New security issues sold to initial
buyers (often behind closed doors).
Investment banks typically underwrite
securities (guarantees a price for the
security and then sells it to the public).
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Classifications of Financial Markets
2. Secondary Market
Securities previously issued are bought
and sold.
E.g.: NASDAQ, Futures, Foreign Exchange.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Classifications of Financial Markets
Second: According to Standard trading site,
financial markets structure consists of:
Stock Market /Bourse (Regulated markets).
Unregulated Markets/ Over-the-Counter
Markets.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Classifications of Financial Markets
1. Stock Market /Bourse (Regulated
markets).
Exchanges
Trades conducted in central locations (e.g.,
New York Stock .Exchange, NYSE;
London Stock Exchange, LSE).
2. Unregulated Markets.
Over-the-Counter Markets
Dealers at different locations buy and
sell.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Market Instruments
Third: According to the standard securities
maturity financial markets structure
component of:
1. Debt Markets.
2. Money /Equity market.
3. And capital market.
In addition to the above mentioned there are:
4. Future markets.
5. And Spot markets.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Methods of Raising Private Sector Funds
1. Debt Markets.
2. Equity /Money Markets.
3. Capital Market.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Methods of Raising Private Sector Funds
1. Debt Markets
Short-term (maturity < 1 year): Money
Market.
Intermediate-term (1year < maturity <
10 years).
Long-term (maturity > 10 years).
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Methods of Raising Private Sector Funds
2. Equity /Money Markets
Common stocks: claims to share in
assets and net income.
No maturity date; periodic payments
known as dividends.
3. Capital Market:
Intermediate + Long Term Debt +
Equity.
Examples: Bonds, mortgages.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Market Instruments
What are the kinds of securities traded in
financial markets?.
1.Money Market Instruments
2.Capital Market Instruments
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Market Instruments
What are the kinds of securities traded in
financial markets?.
1.Money Market Instruments
Because of short term to maturity, debt
instruments traded in the money market
don't have much fluctuation in their
prices, and hence are least risky.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Market Instruments
2.Capital Market Instruments
Debt and equity instruments with
maturities greater than a year; these
have much greater fluctuations in their
prices (compared to money market
instruments) and as such are considered
more risky.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Function of Financial Markets: Flow of Funds
Indirect Finance
Financial
Intermediaries
Lender-Savers Borrowers-Spenders
• Households Financial • Business-Firms
• Firms Markets • Government
• Government • Households
• Foreigners • Foreigners
Direct Finance
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Function of Financial Intermediaries
Financial Intermediaries:
1. Engage in process of indirect finance.
2. More important source of finance than
securities markets.
3. Needed because of transactions costs
and asymmetric information.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Role of Financial Intermediaries
1. Transaction Costs.
2. Risk Sharing.
3. Asymmetric Information.
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Banking and Financial Institutions
1. Financial Intermediation
Helps get funds from savers to
investors through bond/equity/foreign
exchange markets.
2. Banks and Money Supply
Crucial role in creation of money.
3. Financial Innovation
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Mrs. Shefa Sagga Money, Banking,&Financial Market
5 Parts of the Financial System
1. Money
To pay for purchases and store wealth
2. Financial Instruments
To transfer wealth from savers to investors
and to transfer risk to those best equipped
to bear it.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
5 Parts of the Financial System
3. Financial Markets
Buy and sell financial instruments.
4. Financial Institutions.
Provide access to financial markets.
5. Central Banks
Monitor financial Institutions and
stabilize the Economy.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Overview of the Course
Financial Market
Financing Methods on financial markets
The Economics of Financial
Intermediation
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Mrs. Shefa Sagga Money, Banking,&Financial Market
11-44
A Summary of the Role of Financial
Intermediaries
1. Pooling Savings.
2.Safekeeping and Accounting.
3.Providing Liquidity.
4.Risk sharing.
5.Information Services.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
A Summary of the Role of Financial
Intermediaries
1. Pooling Savings: Accepting resources from a
large number of small savers/lenders in order
to provide large loans to borrowers.
2.Safekeeping and Accounting: Keeping
depositors’ savings safe, giving them access to
the payments system, and providing them with
accounting statements that help them to track
their income and expenditures.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
A Summary of the Role of Financial
Intermediaries
3. Providing Liquidity: Allowing depositors to
transform their financial assets into money
quickly, easily, and at low cost.
3. Risk sharing: Providing investors with the
ability to diversify even small investments.
4. Information Services: Collecting and
processing large amounts of standardized
financial information.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Asymmetries Information and Information
Costs
1. Asymmetric information.
2. Adverse Selection.
3. Moral Hazard.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Asymmetries Information &Information
Costs
1. Asymmetric information
issuers of financial instruments –
borrowers who want to issue bonds
and firms that want to issue stock–
know much more about their business
prospects and their willingness to work
than potential lenders Or investors
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Asymmetries Information and Information
Costs
2. Adverse Selection
Potential borrowers know more about
the projects they wish to finance than
prospective lenders.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Asymmetries Information and Information
Costs
The Adverse Selection Problem
1. If you can’t tell the difference between the two
firms’ prospects, you will be willing to pay a price
based only on the firms’ average quality.
2. The result is that the stock of the good company
will be undervalued.
3. Since the managers know their stock is worth
more than the average price, they won’t issue
the stock in the first place.
4. That leaves only the firm with bad prospects in
the market.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Asymmetries Information and Information
Costs
Solving the Adverse Selection Problem
Disclosure of Information.
Collateral and Net Worth.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Asymmetries Information and Information
Costs
3. Moral Hazard
Moral hazard arises when we cannot observe
people’s actions, and so cannot judge
whether a poor outcome was intentional Or
just a result of bad luck.
principal-agent problem
The separation of ownership from control.
When the managers of a company are the
owners, the problem of moral hazard in equity
financing disappears.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Asymmetries Information and Information
Costs
Moral Hazard in Debt Finance
Because debt contracts allow owners to keep
all the profits in excess of the loan payments,
they encourage risk taking.
a good legal contract can solve the moral
hazard problem that is inherent in debt finance.
Bonds and loans often carry restrictive
covenants
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Mrs. Shefa Sagga Money, Banking,&Financial Market
The Negative Consequences of
Information Costs
1. Adverse Selection: Lenders can’t distinguish
good from bad credit risks, which discourages
transactions from taking place.
Solutions include
Government-required information disclosure.
Private collection of information.
The pledging of collateral to insure lenders
against the borrower’s default.
Requiring borrowers to invest substantial
resources of their own.
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The Negative Consequences of
Information Costs
2. Moral Hazard: Lenders can’t tell whether
borrowers will do what they claim they will
do with the borrowed resources; borrowers
may take too many risks.
Solutions include
Forced reporting of managers to owners.
Requiring managers to invest substantial
resources of their own.
Covenants that restrict what borrowers can do
with borrowed funds.
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Financial Intermediaries and Information
Costs
The problems of adverse selection and
moral hazard make direct finance
expensive and difficult to get.
These drawbacks lead us immediately to
indirect finance and the role of financial
institutions.
Much of the information that financial
intermediaries collect is used to reduce
information costs and minimize the effects
of adverse selection and moral hazard.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Financial Intermediaries and Information
Costs
Screening and Certifying to Reduce
Adverse Selection.
Monitoring to Reduce Moral Hazard.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Review Chapter
1. “Bull Market” vs. “Bear Market”
(Possibility Answer :
A bull market:
Prices of a certain group of securities are
rising Or are expected to rise.
When the market is bullish a prolonged
period where investment prices rise faster
than their historical average.
In such times, investors have faith that the
market will continue to rise in the long
term.
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Mrs. Shefa Sagga Money, Banking,&Financial Market
Review Chapter
A bear market:
An opposite of bull market; its
characterized by falling prices and an
expectation that they will continue falling.
When the market is bearish, it leads to a
slow down of economy together with a
rise in unemployment and inflation.
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