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Financial system

Introduction

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A set of sub systems of nancial institutions,markets, instruments and services.Intermediates with the ow of funds betweensavers and borrowers.Facilitates transfer and allocation of scarceresources eciently and eectively.

Meanin of Financial

!ystem

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Formal nancial system" #rani$ed, institutional and reulated

Informal financial system: Advantaes" %ow transaction costs

Minimum default risk &rans'arency of

'rocedures

(isadvantaes" )ide rane of interestrates

*iher rates of interest +nreulated

&y'es of Financial !ystem

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Financial InstitutionsFinancial Markets

Financial InstrumentsFinancial !ervices

om'onents of the Financial

!ystem

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Types of Financial Institutions

Banking and Non Banking

Banking: creators and purveyors ofcredit. Types: Commercial Banks

Cooperative Banks Non-Banking:purveyors of credit Types: evelopmental !nancial institutions" #utual Funds"

Insurance companies"

NBFCs

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Functions of FinancialInstitutions

$rovide t%ree transformation services:

&ia'ility( asset and si)e transformation

#aturity transformation

*isk transformation

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Financial MarketsTypes:

#oney #arket + market for s%ort -term de't

instruments.

Capital #arket - + market for long

-term e,uity and de't instruments

egments:

$rimary #arket + market for ne issues

econdary #arket + market for trading outstanding

issues

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&ink Beteen $rimary / econdaryCapital markets

+ 'uoyant secondary marketindispensa'le for t%e presence of a

vi'rant primary market econdary market provides a 'asis

for t%e determination of prices of

ne issues ept% of t%e secondary market

depends on t%e primary market

Bunc%ing of ne issues a0ects

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Financial Instruments

Types: $rimary econdary

istinct Features: #arketa'le Tradea'le Tailor-made

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Financial !ervices

#a1or categories: Funds

Intermediation $ayments

#ec%anism $rovision of

li,uidity *isk

#anagement Financial

2ngineering

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Functions of Financial system

#o'ilise and allocate savings

#onitor corporate performance

$rovide payment and settlement systems

3ptimum allocation of risk 'earing and reduction

isseminate price related information

30er portfolio ad1ustment facility

&oer t%e cost of transactions

$romote t%e process of !nancial deepening and'roadening

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-ey elements of a well functionin nancialsystem

+ strong legal and regulatory environment

ta'le money

ound pu'lic !nances and pu'lic de't

management + central 'ank

ound 'anking system

Information system 4ell -functioning securities market

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Financial system designs

Types : Bank 'ased

#arket 'ased

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#arket -'ased Financialystem

+dvantages:$rovide attractive terms to 'ot% investors and 'orroers

Facilitate diversi!cation

+llo risk s%aring

+llo !nancing of ne tec%nologies

ra'acks:$rone to insta'ility

25posure to market risk

Free rider pro'lem

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Bank 'ased Financialystem

+dvantages: Close relations%ips it% parties

$rovide tailor made contracts

26cient inter-temporal risk s%aring

No free rider pro'lem

ra'acks: *etards innovation and grot%

Impedes competition

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Functions of Financial#arkets

2na'ling economic units to e5ercise t%eir time preference

eparation( distri'ution( diversi!cation and reduction of risk

26cient payment mec%anism

$roviding information

2n%ancing li,uidity $roviding portfolio management services.

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The main function of a financial system is thecollection of savings and their distribution for

investment, thereby stimulating capital formationand, to that extent, accelerating the process ofeconomic growth. The financial system is a linkbetween the savers (savings-surplus economic

units) and the investors (saving-deficit economicunits). It is made up of all those channelsthrough which savings become available forinvestment.

Functions

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3rganisation

The organisation of the financial systemcomprises of three inter-related components,namely, financial intermediaries, financialmarkets and financial assetsinstruments(securities).

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!inancial intermediaries (!Is) represent a significantchange in the whole process of a transfer of choice ofinvestment from an individual saver to an institutional

agent. They convert primary securities with a given set ofcharacteristics, into indirect securities with very differentfeatures. " primary security is a security issued by a non-financial economic unit. " security issued by a financialintermediary is an indirect security. The ability of !Is to

transform a primary security into an indirect securitymakes it more attractive to both the borrowers and thelenders. The pooling of funds by an !I leads to anumber

Financial Intermediaries

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of indirect and derived benefits that add greatly to theeffectiveness and efficiency of the savings-investment

process. The benefitsservices associated with thetailoring of financial assets according to the desires ofthe savers and investors are# (i) convenience in terms ofdenomination and li$uidity, (ii) lower risk due todiversification of the portfolio, (iii) expert management of

the portfolio and (iv) lower cost resulting from economiesof scale. " diversified structure of !Is in a matured andsophisticated financial system consists of banks, %&!'s,mutual funds, insurance organisations and so on. ith avariegated structure, these are able to mobilise savingsfrom the widest section of the investing public andchannelise them to a cross-section of economicindustrialenterprises.

;

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" primary security is a security issued by a non-financial economic unit, such as ordinary

preference shares, debenturesbonds andinnovative debt instruments includingparticipating, convertibles, warrants and so on.

0rimary !ecurity

;?

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"n indirect security is a security issued by an !Isuch as units of mutual funds. It is based on an

underlying primary security. The pooling of fundsby an !I and converting a primary security into anindirect security is associated with a number ofbenefits, namely, convenience, diversification,

expert management and lower cost.

Indirect !ecurity

;@

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" derivative instrument includes# (i) a securityderived from a debt instrument, share, secured or

unsecured loan, risk instrument, contract fordifferences or any other form of security and (ii) acontract which derives its value from thepricesindex of prices of the underlying

securities. It is an instrument of riskmanagement. The most commonly usedderivative contracts are forwards, futures andoptions.

(erivative Instruments

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A forward contractis an agreement to exchange an

asset for cash, at a predetermined future datespecified today. "t the end of the contract, onecan enter into an offsetting transaction by payingin the difference in the price. It is settled by the

delivery of the asset on the expiration date.

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!uture contracts are transferable specified

delivery forward contracts. They are agreementsbetween two counterparties to fix forward theterm of an exchangelock-in the price today, of anexchange that will take place between them at

some fixed future date, ranging between / to 01months. epending on the underlying asset,future contracts could be stock futures or indexfutures.

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2ptions give the holder the right (but not the

obligation) to buy (call option) or sell (put option)securities at a predetermined price(strikeexercise price) withinat the end of aspecified period. In order to ac$uire the right of

option, the buyer pays to the seller, an optionpremium as the price for the right. 3e can lose nomore than the option premium paid but hispossible gain is unlimited. The sellers4 possible

loss is unlimited but his maximum gain isrestricted to the option premium charged by him.

=