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Lecture 1: An Overview of the Financial System Financial Markets Why study Financial Markets? Markets in which funds are transferred from people who have a surplus / an excess of available funds to people who have a shortage of available funds are called financial markets. Bond is traded in the bond market in which interest rates are determined. Stock is a security that is a claim on the earnings and assets of the corporation. It can be traded in the stock market. Conversion of different currencies takes places in the foreign exchange market. Direct Finance

Lender-Savers Borrower-Spenders 1. Households (securities) (securities) 1. Business Firms 2. Business firms 2. Government 3. Government (funds) (funds) 3. Households 4. Foreigners 4. Foreigners

Financial Intermediaries Institutions (such as banks, insurance companies, mutual funds, pension funds, and financial companies) that borrow funds from people who have saved and then make loans to others. Indirect finance and financial intermediaries is also important. Financial Intermediation is the process of indirect finance whereby financial intermediaries link lenders-savers and borrower-spenders, providers and users of capital.

Flows of Funds through the Financial System Types of Financial Intermediaries Depository institutions issue receipts for money deposited with it. Investment intermediaries such as finance companies, investment trust sells mutual funds or unit

trusts which are pro-rata claims on a portfolio of securities managed by the trust. Contractual saving institutions such as insurance company, pension funds

Financial Markets

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Functions of Financial Markets 1. Channel savings to investments. It is a resource allocation. 2. Financial markets can improve economic efficiency through the price discovery.

e.g. Funds can be transferred from a person who has no investment opportunities or lacks productive investment opportunities to one who has them.

3. Activities in financial markets have direct effects on personal wealth and on the behaviour of

business. Financial markets can improve the welfare of the economy. e.g. You can borrow money from a bank to purchase a house (mortgage).

4. Transfer and manage risk. 5. Corporate governance. Structure of Financial Markets 1. Type of transaction

It includes direct transactions, in which lender and borrower deal with each other directly (perhaps with the assistance of a broker or agent) and indirect transactions, which go through a financial intermediary.

2. The way of fund raising

i. Debt market is the most common fund raising market. Debt instrument is a contractual

agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date.

ii. Equity market allows the holder of equities such as common stock, which are claims to share in the net income and the asset of a business.

3. Selling and reselling

i. A primary market is one in which assets are sold for the first time; the assets traded in the

primary financial market are newly issued securities or shares. Investment banks specialize in this market. They might also underwrite the issue, contracting to buy it at a set price and assuming the risk of reselling it to the public.

ii. A secondary market is one in which the same assets are resold (e.g., stock exchanges). Brokers are agents of investors who match buyers with sellers of securities. Dealers link buyers and sellers by buying and selling securities at stated prices.

Secondary market can be organized in two ways. Exchange: buyers and sellers meet in a central location to conduct trades. Over-the-counter (OTC) market: dealers who are dispersed geographically have an inventory of

securities stand ready to buy and sell over the counter to anyone who comes to them and is willing to accept their prices.

4. Duration or Maturity: short term vs. long term

i. Term to maturity (length of time until the loan must be repaid): A debt instrument is short

term if its maturity is less than a year and long term if its maturity is ten years or longer. Intermediate term is for those between 1 year and 10 years.

ii. Markets: The money market is for the trading of short-term instruments those with maturities of less than a year. The capital market is for transactions in longer-term instruments, those with maturities of more than a year.

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Financial Market Instruments (Securities) 1. Money Market Instruments i. Treasury (T) Bills is a short-term financial instrument issued by the government (debt obligation

backed by the U.S. government) with a maturity of less than one year. Possibility of default is nearly zero. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 m.

The T-bills are usually one month (four weeks), three months (13 weeks) or six months (26 weeks), or one-year securities. Exchange Fund Bills and Notes, debt instruments issued by the HKMA for the account of the Exchange Fund It was introduced in March 1990in Hong Kong. The benchmarks for fixings are 1-week, 1-month, 3-month, 6-month, 9-month and 12-month.

ii. Interbank Loans are loans between banks and “Interest Rate = Interbank rate” The London Interbank Offered Rate (LIBOR) is a daily reference rate based on the interest rates

at which banks borrow unsecured funds from banks in the London wholesale money market (or interbank market). Federal Fund Rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight in the United States. It is the interest rate banks charge each other for loans.

Hong Kong Interbank Offered Rate ( HIBOR) is the rate of interest offered on Hong Kong dollar loans by banks in the interbank market for a specified period ranging from overnight to one year.

iii. Negotiable Bank Certificates of Deposits (NCDs) is a debt instrument sold by a bank to

depositors that pays annual interest of a given amount and at maturity pays back the original purchase price.

iv. Commercial Paper is a short-term instrument issued by large banks and well-known corporation

(good credit rating). e.g, the first issue of commercial paper in H.K was in 1977 by the MTRC.

v. Banker’s Acceptance is a bank draft issued by a firm, payable at some future date, and guaranteed for a fee by the bank that stamps it ”accepted” (stamp fee).

vi. Repurchase Agreements (Repos) are effectively short-term loans (usually with a maturity of less

than two weeks) in which treasury bonds serve as collateral, an asset that the lender receives if the borrower does not pay back the loan.

2. Capital Market Instruments

i. Stocks are equity claims on the net income and assets of a corporation. Owner of common stock, or ordinary shares are entitled to a portion of the corporation’s profits in the form of dividend.

ii. Mortgages are loans to individuals or firms to buy housing, land or other real structures, where

the structure, or land, then in turn serves as collateral for the loans. Mortgage-backed securities are issued as mortgages are not sufficiently liquid because of different terms and interest rates.

iii. Corporate Bonds are long-term bonds issued by corporations with very strong credit ratings. The

typical corporate bond sends the holder an interest payment and pay off the face value when the bond matures. Some corporate bonds, called convertible bonds, also have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date.

iv. Government Securities are long-term debt instruments are issued by the government to finance

the government deficit (e.g., bonds).

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Functions of Financial Intermediaries Main reasons for importance of financial intermediaries and indirect finance in financial markets: 1. Reduce transaction costs in provision of safekeeping, accounting and payments mechanisms for

funds. 2. Diversifying and sharing risk by pooling financial resources from providers. 3. Asymmetric information usually increases as market is large even though it has been on the decline

as a result of more and more people being able to easily access all types of information. Existence of intermediaries can solve some problems created by asymmetric information: adverse selection & moral hazard by collecting and processing information.

4. Facilitate investments for real economic growth by providing liquidity between providers and users

of capital. Transaction costs include the time and money spent trying to exchange financial assets, goods or services. e.g. Ann has money ($1 mil.) & Ben wants to borrow money ($1 mil.) to start a business with interest

rate, 4%; the corresponding interest payment is $40,000. Then, Ann and Ben need a lawyer Chan to write up a contract but the fee is $50,000. “Interest payment < lawyer’s fee”. It’s not a good deal!

With financial intermediaries, a bank knows how to find a good lawyer to produce an airtight contract, and this contract can be used over and over again in its loan transactions, thus lowering the legal cost per transaction. Financial intermediaries can reduce the transaction costs substantially because they have developed expertise and they also take the advantage of economies of scale. Risk Sharing is possible because low transaction costs allow financial intermediaries to reduce the risk exposure of investors by pooling a collection of asserts into a new asset. Adverse Selection is the problem created by asymmetric information, before the transaction occurs. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome are the ones who most actively seek out a loan and thus most likely to be selected. e.g.: Suppose both Big Big Wolf (Wolffy) and Lufsig want to borrow money from you. If information is

symmetric, you are likely to lend money to hard-working Big Big Wolf because of his strong survival skill. If information is asymmetric, you are likely to lend money to Lufsig because of his wonderful presentation skill and elegant outlook!

To avoid Adverse Selection, you just don’t lend any money to either of them. Moral Hazard is the problem created by asymmetric information after the transaction occurs. Moral Hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view because they make it less likely that the loan will be paid back. e.g.: Suppose that you made a loan to your good friend who wants to develop his agriculture business in

China. However, he may spend your money to support Greenpeace activity in the mainland. It is likely that he may not return any money. Because of the risk of moral hazard, you may not lend any money to this person.