Chapter_1

Financial Institutions , Markets & Money FIN 221 Chapter 1 Summary Prepared By Al Mannaei

The Role of Financial System

• The financial system consists of:

1. Financial Market: Consists of two sides represent buyers (demand) and sellers (supply)

of financial instruments also called financial claims or securities (stocks, bonds, future

contracts, mortgage ) . ex. of financial market ( Bahrain stock exchange – New York

stock Exchange (NYSE) ). To simplify the definition it’s a market for financial claims .

2. Financial Institutions (financial intermediaries): facilitate the flow of funds from

savers ( SSU , lenders , investors ) to borrowers. Such as Commercial banks, credit

unions, life insurance companies and finance companies. ex of financial institution (

Bahrain Islamic Bank (BISB) , Kuwait Finance House (KFH) , Takaful Insurance .

• Budget Position:

1. A balanced Budget Position ( Income = expenditures)

2. SSU : a Surplus Spending Unit - Position ( income > expenditures)

- SSUs have income for the period that exceeds spending, resulting in savings. Other

words for “SSU” are saver, lender, or investor. Most SSUs are households.

3. DSU : a Deficit Spending Unit - Position ( income < expenditures )

- DSUs have spending for the period that exceeds income. Another word for “DSU” is

“borrower”. Most DSUs are businesses or governments.

Note : Any Unit ( Households , Business Firm & Government ) can be SSU or DSU ,

BUT usually the household represent SSU , and the Business firm & Governments

represent DSU .


Economic Units:

1. Households: Budget Surplus (income , consumption , real investment expenditures)

2. Business firms: Budget constraint ( limited ) : Borrow from SSU in order to expand their

business ( ex. building new factory )

3. Governments (local , state and federal): Budget constraint (limited) : Borrow from SSU

in order to finance infrastructure projects ( building schools , roads …etc)

Financial Claims : it also called IOU1 , Financial instruments , securities . It’s a promise

to pay .The issuer of IOU or the financial claim (ex. government , corporation ) promise to the

buyer that he will pay back the borrowed money with interest. There are three component of

the financial claims : the principle ( the amount of money ) , interest or fees And the maturity (

when the borrower must return the principle to the buyer )

• IOU for DSU is a liability and it’s an asset for SSU. The financial system “balances”-

total financial assets equal total liabilities.

• The ease with which a financial claim can be resold is called marketability.

Direct & Indirect Financing : Regardless of the financing methods the goal is to bring the

parties ( SSU & DSU ) together at least possible cost which is called operational

efficiency.

1- Direct financing : Where the SSU & DSU exchange money and financial claims

directly using direct claims.

a- Private Placement : DSU sells whole security issue to one investor or investor

group.

b- Brokers & Dealers2 :

1 IOU “ I owe you” – If Ali said to Hassan : I owe you 300 BD , it mean that Ali have to pay to Hassan 300 BD. 2 Although dealers & brokers play the middleman role , the finance will consider direct as the financial claims feature ( amount , risk , liquidity , maturity ) will not changed .


o Brokers : Bring SSU & DSU together “ maker”, Broker make profit from

commission fee . Note that the broker will not own the financial claims.

o Dealers : Buy the financial claims at bid price from DSU and resell it to SSU

at ask price , the dealer will make profit from “Ask-Bid” spread , dealers will

make profit as long as Ask price if above bid price, the dealers called “Market

maker” because they affect the market price. Dealers are taking higher amount

of risk as they own the securities before reselling it to the SSU.

c- Investment Bank : Buy entire issues of securities from DSUs then find SSUs to

buy securities at higher price , Investment bank profit from difference -

“underwriting spread”.

For all the three categories of direct finance, in case of default3 the SSU have to refer

to the DSU (the issuer of the financial claims) , WHY ?! because the direct financial

claims is guaranteed by the DSU ( issuer ) not by the dealers , broker or investment

bank.

Test Your Knowledge : True & False

When an SSU owns a financial claim created by financial intermediation, its residual claim is against a DSU. ( ) False , Why ?! Because the financial intermediation will buy direct financial claims and issue indirect financial claims , therefore the SSU will claim against the financial intermediation not the DSU.

Advantages of Direct Financing

o Speed & low cost of the transaction as its one big transaction .

Disadvantages of Direct Financing

1- The amount (denomination) of the direct financial claims is very large , making it

hard to find another party to make the deal.

3 Default : Unable to repay their debt ( loans , bonds..etc)


2- SSU & DSU should have the same preference of maturity , risk & liquidity .If the

preference not match the bargain (deal) will not be done.

Indirect Financing :

Due to the problems of Direct financing , for example the transaction amount (

denomination) are very large , also DSU must find SSU that want direct claims

with precisely ( exactly ) the characteristics or features ( Return , Risk , liquidity ,

maturity ). The financial intermediaries are involved to facilate movement of

fund from SSUs to DSUs . The financial intermediaries transfer financial claims

by making them more attractive . The financial intermediaries purchase direct

financial claims from DSU and transform them into indirect claims with different

set of characteristics or features ( Amount , maturity , liquidity , Return , Risk).

This process is called Financial intermediation .

Many Financial institutes play the role intermediation such as , Retail banks ,

Commercial banks , insurance companies.

Financial intermediaries “transform” claims by raise funds by issuing claims to

SSUs; use funds to buy claims issued by DSUs. Claims can have unmatched

characteristics: SSU has claim against intermediary; Intermediary has claim

against DSU.

In other word the financial intermediaries buy the direct claims issued by DSUs

then the financial intermediary issue their own claims ( indirect financial claims )

which have different features.

Financial intermediaries (institutions) enjoy 3 sources of comparative

Advantages:

1- Economies of scale4

2- Low costs

4 'Economies Of Scale' : The cost advantage that arises with increased output of a product. Economies of scale arise because of the inverse relationship between the quantity produced and per-unit fixed costs; i.e. the greater the quantity of a good produced, the lower the per-unit fixed cost because these costs are shared over a larger number of goods


3- information (reliable)

a. Because financial intermediaries have many transaction with

borrowers , they have idea about borrowers credit . On the other hand ,

in case of direct financing SSU will spend time and money in order to

find a DSU with good credit record .

Transaction cost : All money which paid to do the financial transaction (

search cost , information cost , fees , time ..etc) . The greater the

transaction cost the more likely it is the financial service is provided by

financial intermediary.

Services Provided by Financial Intermediary :

1. Denomination Divisibility – Financial intermediaries are able to

produce a wide range of denomination – from 1$ to 1$ million or even

more by pooling savings of many small SSUs into large investments.

2. Currency Transformation – buy and sell financial claims

denominated in various currencies.

3. Maturity Flexibility – Offer different ranges of maturities to both

DSUs and SSUs – from 1 day to 30 years or more.

4. Credit Risk Diversification – Assume credit risks of DSUs; spread risk

over many different types of DSUs. Financial intermediaries have the

ability to reduce the credit risk ( default risk) because they are linking

between group of SSU ( lenders or savers ) & group of DSU (

borrowers ) in case that one or more from the DSU defaulted the rest

will still able to repay the money.

5. Liquidity5 – Give SSUs and DSUs different choices about when, to

what extent, and for how long to commit to financial relationships.

5 Liquidity means easy to convert into money at low costs


Question : How financial intermediaries provide these services ?

- Because financial intermediaries are purchasing Direct

financial claims from DSU and Issue Indirect financial

claims to SSU , by making these indirect financial claims

suitable with SSU needs .

Question: When DSU & SSU will go for Direct or Indirect financing ?

- Depend on which market best met their needs ( Amount , Return ..) ,

for example for consumer whose transaction are small in amount (

retail transaction ) find intermediation market ( indirect financing ) is

most cost effective.

- SSU & DSU use Indirect financing as long as the cost of doing it less

than providing the services for themselves through the direct credit

market.

Deposit-Type Institutions : Know as intermediaries because most

people use their services on a daily basis.

1. Commercial bank

- Largest & Most diversified intermediaries

- Provide loans in all denomination to consumers , business & government .

- As well as is obtain deposits in all denominations .

- May offer trust or underwriting6 services

2. Thrift Institutions

- Obtain fund by issuing checking account , saving accounts ( short-term)

- They use these funds to purchase real estate loans (long term mortgages)

(different from commercial banks)

6 As mentioned earlier in these notes & during the lecture .


In other word , these institutions borrow small amount for short-term and

lend for long-term ( real-estate )

- Largest provider of residential mortgage loans.

3. Credit Unions

- Small non-profit institute

- Owned & Managed by member

- Member have to pay share of the capital called “ Common Bond”

- Their investment are mainly in short-term loans

- Exemption from Tax because of their cooperative nature.

Second: Contractual Savings Institutions

They obtain funds under long term contractual arrangements and INVEST the

funds in capital market – long-term ( bonds , stock ).

1. Life Insurance Company :

- Obtain fund by selling insurance policies that protect against loss of

income from death or retirement.

- Inflow predictable & Outflow hard to predict

- Invest in long-term asset ( higher yielding7 ) such as corporate bond and

stock

2. Casualty Insurance Companies :

- Obtain fund by selling insurance policies that protect against loss of

property ( home ) caused by almost anything ( fire , hurricane , accident

..etc) , it’s pure –risk protection

- Inflow is predictable but the outflow unpredictable because nobody knows

when the policyholder will claim for insurance benefit.

- Invest in short-term asset & municipal bonds to reduce tax.

7 High return investment


3.Pension Fund :

- Known as retirement fund.

- Obtain fund from employees & employers.

-Provide monthly payment ( retirement salary ).

- Inflow & Outflow is predictable.

-Invest in higher yield , long-term investment.

Investment Fund

- Sell shares to investors and use these fund to purchase direct financial

claims

a. Mutual Fund :

- Obtain fund by selling equity ( shares – stock ) to investors and use these

fund to purchase stock & bonds.

- Provide small investors access to reduce investment risk through

diversification.

- The value of the shares of a mutual fund is not fixed it fluctuates as the

prices of their investments ( portfolio ) change.

2.Money Market Mutual Fund “MMMF”

- Like the mutual fund , the main difference is that the MMMF invest in

money market ( short-term investment ).

Financial Markets are classified in several ways.

1. Primary and Secondary

2. Organized and Over-the-Counter

3. Spot and Futures

4. Options

5. Foreign Exchange

6. International and Domestic


7. Money and Capital

1- Primary & Secondary Markets

• Primary: sell / issue of financial claims for the first time. In the primary market the DSU

receive funds , claims first issued.

• Secondary: are where financial claims “live”—are resold and reprised.

2- Organized & Over –the – counter

• Organized: physical meeting place and communication facilities to exchange securities

under a specific set of rules and regulations on the floor or through the computer system.

• unorganized or over – the – counter market

• available to members of exchange only.

3- Spot and Future Market

• Spot Market: market for current exchange ( Buy now – deliver now )

• Futures or Forward Markets: immediate pricing, promise of future delivery.

“Futures” contracts: standardized as to amounts, forms, and dates; trade on organized

exchanges.

“Forward” contracts: individualized between parties with particular needs.

i. Trade Over the counter

ii. Flexible

4. Option Market : Rights in underlying securities or commodities—writer grants owner

some exclusive right for some certain time

- Buyer of

a. Call option : Right to buy

b. Put option : Right to sell


- Seller of

a. Call option : Has an obligation (Must) to sell if the buyer of the

call option want to exercise his right (option).

b. Put option : Has an obligation (Must) to buy if the buyer of the put

option want to exercise his right (option).

- Option mostly trade on organized market

5. Foreign Exchange Markets

- Any currency is convertible to any other at some exchange rate .

6. International & Domestic Markets

- According to where they are located.

Examples of major international markets:

Eurodollars—US dollars deposited outside U.S.

Eurobonds—bonds issued outside US but denominated in $US

7 . Money market & Capital Market

- Money Market : Short-term maturity

Help participants adjust liquidity—

DSUs borrow short-term to fund current operations

SSUs lend short-term to avoid holding idle cash

Common characteristics of money market instruments—

Short maturities (usually 90 days or less)

High liquidity (active secondary markets)

Low risk (and consequently low yield)

Dealer/OTC more than organized exchange

Example :

Treasury Bills - Negotiable Certificates of Deposit

Commercial Paper - Federal Funds (“Fed Funds”)


Capital Market :

Help participants build wealth

DSUs seek long-term financing for capital projects

SSUs seek highest possible return for given risk

Differences from money markets—

Long maturities (5 to 30 years)

Less liquidity

(secondary markets active but more volatile)

Higher risk in most cases

(with higher potential yield)

Traded “wholesale” and “retail” on organized

exchanges and in OTC markets

Examples :

Bonds – Stocks

Any security maturity above 1 year

Documents

Chapter_1