Finance 03

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2.1. Financial System and Financial Markets

Financial System = the set of financial institutions and the relationships between these, which serve to money transfer between persons/ companies/institutions that have excess funds to the persons/ companies/institutions that have deficits of funds

Basic Finance – Financial Systems

LENDERS (SAVERS)

HouseholdsCompaniesGovernmentForeigners

BORROWERS (SPENDERS)Government Companies HouseholdsForeigners

FINANCIAL MARKETS

FUNDS FUNDS

Flows of Funds Through the Financial System

Direct finance

FINANCIAL INTERMEDIARIES

FUNDS

FUNDS FUNDS

FUNDS

FUNDS

Indirect finance

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Participants in the financial systems

Households (including individuals) - L - interested to get a normal return for funds (proportional with the risk)

- B- financing consumption and/or personal investments

Companies - B - financing investments and working capital

- L - interested to invest (temporary) excess cash

Government - B - financing expenditures (temporarily - treasury bills / for long terms (>1 year) – government bonds)

- L - placing temporary excess cash

Foreigners

- L - import loans and foreign investments

- B - export loans and investments of domestic entities abroad


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Issues related to financial investments:

Adverse Selection – the inability of the investors to differentiate between the investment opportunities due to an asymmetry in information

(lack of information at investors level)

Moral Hazard – the possibility that the borrowers to change their behaviour after the investment decision or to provide misleading information about its

assets, liabilities or credit capacity (fraud risk)


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Financial intermediariesDepository Institutions (Commercial Banks, Saving Banks) offer passive interest rate for savers’ deposits. Partly, (except for reserve requirements), from these sources, banks grant loans, charging the active interest.

Active interest rate > Passive interest rate

Bank’s Interest Margin = Active interest rate - Passive interest rate

Investment Intermediaries (Mutual Funds; Investment Funds) – professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities.

Contractual Savings Institutions

- Pension funds - pool of assets forming an independent legal entity that are bought with the contributions to a pension plan for the exclusive purpose of financing pension plan benefits.

- Insurance companies - compensate loss (including death or illness – for life insurance) when these incur from the insurance premiums.


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* Intermediaries in the financial markets (especially in the capital market)

Brokers (Brokerage firms) – trade securities on behalf of their customer , based on brokerage fees charged (to customers).. Dealers - trade securities for their own account.


Financial Markets = the mechanisms that allow individuals, companies and institutions to easily trade financial securities, commodities and other fungible items of

value.

Types of financial markets

Primary Mk.

Secondary Mk.

Organized Mk. (Exchanges)

Over the counter Mk. (OTC)

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Primary mk. vs. Secondary mk.

Primary mk. – the first sale of securities - issuance (usually without any negotiation). Companies, governments or public sector institutions can obtain funds through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is an initial public offering (IPO).

Secondary mk. (aftermarket) – the market of previously issued securities


Exchange mk. vs. Over the counter mk.

Organized mk. (Exchange mk.) - fixed trading rules; established physical location; trading is usually conducted by auction + standardized securities. (NYSE; BSE)

Over the counter mk. (OTC) - directly trade of securities, between two parties, located in a variety of places and a variety of ways (by telephone or by computer ) + unstandardized securities (NASDAQ; former RASDAQ)

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Remember the issues ?

- Moral hazard

- Adverse Selection

2.2. Financial markets

Examples:Money Market– market of short term and highly liquid securities issued by government or banks;Banking System – both market of deposits and market of bank loans for households and companies;Capital Market – market of long term securities;FOREX Market – market of foreign currencies;Government Securities (T-bills) Market – market of government bills (≤1 year) with “zero” default risk (by extension this market refers to the market of any maturities and also to the securities issued by municipalities);Insurance Market;Real Estate and Other Alternative Assets Market.


need of Market Supervisory Authorities

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Supervisory Authorities

Money Market; Banking System & FOREX Market, including Government Securities Market (with maturities < 1 year) - CENTRAL BANK (National Bank of Romania – NBR (BNR));

Capital Market, including Government Securities Market (with maturities ≥1 year) – Securities and Exchange Commission (National Securities Commission (CNVM)) ;

Insurance Market - Insurance Supervisory Commission;


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Financial Securities

- PRIMARY (BASIC)- DERIVATIVES- SYNTHETIC

1. Primary (Basic)• Shares = equity investments (company ownership & associated risks and benefits), (in public or private -unlisted- companies) - common shares - proportional vote in General Shareholders Meetings;

- right to be voted as manager; - right to received the proportional dividends from distributed net profit; - in the case of bankruptcy, the common shareholders are the last ones to benefit from the capital recuperated;

(unlimited risk& unlimited return) - preferred shares - no vote in General Shareholders Meetings;

(fixed income) - right to receive fixed dividends, independent of the company’s result; - in the case of bankruptcy, the preferred equity is redeemed before common equity.

(limited risk& limited return)


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• Bonds (fixed income) = debt securities, in which the issuer owes the holders a debt

(at its par value /face value) and, depending on the terms of the bond, is obliged

to pay fixed interest (the coupon – sometimes variable) and/or to repay the principal at a later date, termed maturity.

- in case of bankruptcy, bond holders have priority in receiving the money, after the liquidation of the bond issuer’s assets;- the coupon and the principal may be indexed with the inflation rate;- the risk of non-payment for coupon or reimbursement price is lower than in the case of stock;- price is inverse correlated with the market interest rate- no decision right.

(limited risk& limited return)

• Money market instruments- Commercial Papers- Negotiable Certificates of Deposit- T - Bills- Municipal Notes


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2. Derivative securities• Convertible bonds – offer the options to choose, at the maturity, between

reimbursement or share conversion• Futures contracts/ Forward contracts - represent standardized (futures) /

unstandardized (forward) contracts between sellers and buyers to transfer a number of securities, at a price established at the moment of the contract signing, traded on exchanges (futures)/on OTC markets (forward).

• Options – standardized contracts that give the right, but not the obligation, of one of the parties (buyer) to buy (CALL opt.) or to sell (PUT opt.) a certain number of securities at an exercise price and at a certain pre-established maturity date. This right is compensated by payment of a premium, which is traded on exchanges. (examples)

3. Synthetic securities• Market index contracts (index futures)

*Types of orders on capital market1. Market orders2. Limit orders3. Short sales – Margin requirements (examples)4. Stop loss


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Main types of financial systems:

I. Anglo-Saxon Financial System- Based on capital markets (capital markets oriented)- Good treatment for shareholders- Investors are protected at the highest level- Information is largely available on the market- Market is considered the best regulator (by the way of the securities market prices)- Competition is very importantMain Goal - maximisation of the shareholders’ wealth

II. Continental European Financial System - Based on banks (banks oriented);- Low number of IPOs- Banks regulate the system- The competition is not so important- Strong labor unionsMain Goal - harmonisation of stakeholders’ interests


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Main types of financial systems:

III. Japanese Financial System- Based on typically business groups (keiretsu), formed by banks, companies; insurance

companies;- This groups are centered on a bank (so mainly this system is a bank oriented system) - Low level of protection for minority shareholders;- Competition between groups.

* Islamic Financial System


Business

Finance 03