3. 1.1. Introduction
# The Economic System
• The basic function of any economy is to allocate scarce
resources in order to produce the goods and services
needed by society.
• Any economic system must combine inputs (like land and
other natural resources, labour and managerial skills i.e.
entrepreneurs, capital equipment…) in order to produce
outputs (goods and services) to provide to the society.
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4. Fig. Circular flow (interdependent and never ending flow)
The flow of production and payments with in economic
system may be considered to be a circular flow between
producing units and consuming units.
Flow of production
Producing Units /sectarian/ Consuming Units /Household/
• . Business /firms . Individuals
. Gov’t units . Family/
. group in the society
Flow of payment
•
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5. # Financial system
The financial system is the collection of financial
markets, financial institutions, financial instruments,
laws, regulations and techniques through which bonds,
stocks, and other financial instruments are traded,
interest rates determined, and financial services
produced and delivered
FS = f (FM, FI, FIN, IRD, L$ R, Cs, …) 5
6. Function of Financial system
There are seven basic functions of the financial
system in modern society
1.Saving Function:- Financial markets & institutions
provides a conduit/channel for the public’s savings
Bonds, stocks, deposits, and other financial claim
sold in the money and capital markets provide a
profitable, relatively low risk outlet for the publics’
savings. 6
7. The savings flow through the financial markets to the
investment stream is so that more goods and services
can be produced in the future, increasing society’s
standard of living.
When savings flow decline- growth of investment and the
living standards tends to fall.
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8. 8
2. Wealth Function
Businesses and individuals choosing to save, the financial
instruments sold in the money and capital markets provide an
excellent way to store wealth
One might choose to store wealth in real assets (e.g.
authomoble, clothes etc); however, such items are subject to
depreciation
9. 9
Financial instruments like bonds, stocks, and deposits are do
not wear out over time, usually generate income, and
normally, the risk of loss is less than other forms of storing
wealth.
While we might choose to store our wealth in “things”, (e.g.
automobiles & clothes), such items are subject to
depreciation and often carry great risk of loss.
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3. Liquidity Function
Liquidity is related to how soon you can convert your
financial instrument into cash with little cost
The financial markets provide a means of converting
those instruments in to ready cash with little risk of loss.
The financial system provides liquidity for savers holding
financial instruments but in need of money.
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4. Credit Function
Loan of funds in return for a promise of suffer payment.
Consumers frequently need credit to purchase a home, other
consumable commodities & services.
Businesses draw upon their lines of credit to stock their
construct buildings, meet payrolls, and grant dividends to their
stockholders.
Governments (State, local, and federal ) frequently borrow to
construct buildings and other public facilities and cover daily
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5. Payments Function
The financial systems also provide a mechanism for
making payments for goods and services.
Certain financial assets (mainly checking accounts and
Negotiable Order of Withdrawal (NOW)) accounts serve as
a medium of exchange in the making of payments.
Plastic credit cards issued by many banks, credit unions,
and retail stores give the customer instant access to short-
term credit.
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The financial markets offer businesses,
consumers, and government’s protection
against life, health, property, and income risks.
This is accomplished by sale of life & property
insurance policies.
6. Risk Function
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7. Policy Function
The financial markets have been the principal channel through
which governments carried out the policy of attempting to
stabilize the economy and avoid excessive inflation.
By manipulating interest rates and the availability of credit,
governments can affect the borrowing and spending plans of
the public.
This, in turn, influence the growth of the economy, opportunities
for jobs, increase in production, and the rise in prices of goods
& services.
15. 1.2. Financial assets: role and properties
Introduction:- Financial Versus Real Assets
1. Real assets are tangible things owned by persons and
businesses
E.g. Property, automobiles, factories, Machinery,
equipment and etc.
2. Financial assets are what one individual has lent to
another
E.g. Consumer credit, Loans, Mortgages
Financial assets are intangible assets
Usually called financial instruments or securities 15
16. Financial assets (intangible assets) any financial
transaction involve the creation or destruction unique asset.
The entity that has agreed to make future cash payments is
called the issuer of the financial instrument; the owner of the
financial instrument is referred to as the investor.
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17. Types of financial assets
1. Money:- used for purchase goods and services
The most liquid financial asset
2. Common stock (equity):- Gives owner a share of the
firm’s assets and profits. Also have voting rights.
represents the ownership securities in a business.
3. Debt securities (IOUs): Entitles owner to specific
payments on specific dates ( e.g. bills, notes, bonds,
(treasuries)
A. Non-Negotiable:- can be transferred from one parties to
another. E.g. bonds, treasuries bills, corporate notes..
B. Negotiable:- can not transfer to another parties. 17
18. 1.2.1. Role of Financial Assets
To transfer funds from those who have surplus
funds to those who need funds to invest in
tangible assets
Redistribute the unavoidable risk associated
with cash flow generated by tangible assets
among those seeking and those providing the
funds. 18
19. 1.2.2. Properties of Financial Assets
1. Moneyness
Some Financial assets are used as a medium of exchange
or to effect payment
Example: Money, Currency and Demand deposit
Near to cash assets: Treasury bill, saving and time deposits.
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20. 2. Divisibility and Denomination/value:
The minimum size in which a FA can be liquidated and
exchanged for money
The smaller the size, the more the financial asset is divisible
Example: deposit in a bank is typically infinitely divisible
3. Reversibility:
Round-trip cost or turnaround cost (transaction costs)-
cost of buying a security and then selling the security
when circumstances motivate or force you to do so
The lower the round -trip costs, the higher the reversibility of
the assets.
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21. 4. Cash Flow: Every fin’l asset provides a return to the
investor
Example: dividend and capital gain on shares and coupon
rate on debt
5. Term to Maturity: Term to maturity is the length of the
period until the date at which the instrument is scheduled to
make its final payment
6. Convertibility: Some financial assets are convertible into
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22. 7. Currency : The currency in which the financial asset
will make cash flow payments
8. Liquidity : The most important factor affecting the
liquidity of a financial asset is the thickness of the
market
Thick market has many buyers and sellers.
Thin market has few buyers and sellers
Cont’d…
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23. 9. Return Predictability
Return predictability is associated with the uncertainty
of returns of a financial asset
The value of a financial asset depends on the cash
flow expected and on the interest rate used to
discount this cash flow
Cont’d…
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24. 10. Complexity
Callable bond and Putable bond
Callable bond is a bond whose issuer is entitled to repay
the debt prior to the maturity date.
Putable bond - a bond that can be sold back to the issuer
at the option of the investor.
11. Tax Status: Governmental regulations for taxing the income
from the ownership or sale of financial assets vary widely.
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25. 1.3. Financial markets:
role, classifications and participants
1.3.1. Role of Financial Markets
1. The price discovery process ( interaction of buyers and sellers)
Determines the price of the financial assets.
2. Liquidity function : provide a mechanism for an investor to
sell a financial asset when circumstances either force or
motivate him / her to sell.
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26. 3. Reducing the cost of transacting
Search and information costs
Search costs(explicit and implicit) costs
explicit costs include the money spent to advertise one’s
intention to sell or purchase a financial asset.
implicit costs include the value of time spent in locating
counterparty
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27. Information costs are associated with
assessing the investment merits of a financial
asset, that is, the amount and likelihood of the
cash flow expected to be generated from a
financial assets.
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28. 1.3.2. Classification of Financial Markets
There are many ways to classify financial markets
A. By type ( nature) of financial claim
i. Debt market
ii. Equity Market
B. By maturity of financial claim
i. Money market (used to finance short term loans)
ii. Capital market (used to finance long term investment)
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29. C. By seasoning of financial claim
i. Primary market: issuance of new securities
ii. Secondary market: selling or purchasing the existing
securities
D. By immediate delivery or future delivery
i. Cash or spot market ( immediate delivery)
ii. Derivative market (future delivery of financial
instruments),contract
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30. In open markets , financial instruments are sold to the
highest bidder, and they can be traded as often as is
desirable before they mature.
In negotiated markets, the instruments are sold to In
negotiated markets, the instruments are sold to One or a
few buyers under private contract.
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31. E. By globalization
i. Internal ( national) market - Domestic +foreign market
ii. External ( international) – offshore market, and Euro
markets
Are offered to simultaneously to investors in a number
of countries
They are issued outside the jurisdiction of any single
country.
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32. 1.3.3. Market Participants
Market participants are those individuals or entities that
issue, and purchase and sell financial assets.
It includes households, non-financial enterprises,
financial institutions, national governments, government
agencies, local governments, and supranational (such as
the World Bank)
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33. 1.4. Lending and borrowing in the financial system
1.4.1 Lending, Borrowing and Financial Markets
Saving is the difference between income (revenue) and
consumption (expense)
Saving = Income – Consumption
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34. If savings equaled investment in real assets
for all economic units in an economy over all
periods of time, there would be:
no external financing,
no financial assets and
no money and capital markets.
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35. Lending, Borrowing and Financial Markets
A financial asset is created only when:
the investment of an economic unit in real assets exceeds its
savings,
It finances this excess by borrowing or issuing equity securities.
In the economy as a whole, savings-surplus economic unit
(those whose savings exceed their investment in real assets),
provide funds to savings deficit units (those whose investment in
real assets exceeds their savings).
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36. If our investment in real assets exceeds our savings,
we usually make up the difference by:
(1) Liquidating some (all) of financial assets (e.g. Drawing
money out of our savings account
(2) Issuing debt or equity securities
(3) Using some combination of both
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Cont’d…
37. On the other hand, if our savings exceed our
investment in real assets, we can:
(1) Build up our holdings of financial assets (e.g. by placing
money in a savings account or buying a few shares of
stocks);
(2) Pay off some outstanding debt or retire stock previously
issued by our business firm; or
(3) Do some combination of both. 37
38. Savings-surplus economic units are net lenders of funds
and are really a net supplier of funds to the financial system
Such units purchase financial assets, paying off debt, or
retiring equity (stock)
Savings deficit economic units are net borrowers of funds
Such units sell financial assets, issue new debt or sell new
stock.
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