Fiduciary or paper money is issued by the Central Bank on the basis of computation of estimated demand for cash. Monetary policy guides the Central Bank’s supply of money in order to achieve the objectives of price stability (or low inflation rate), full employment, and growth in aggregate income.

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COURSE OBJECTIVES:
AFTER READING THIS COURSE, PARTICIPANTS ARE EXPECTED:
TO UNDERSTAND FINANCIAL MARKET AND ITS PLACE IN AN
ECONOMY
TO EXPLAIN THE MAIN PLAYERS IN THE FINANCIAL MARKET
TO DESCRIBE THE WIDE RANGE OF INSTRUMENTS OF FINANCING
AVAILABLE IN FINANCIAL MARKET
TO UNDERSTAND OF RISKS ENCOUNTERED BY MULTINATIONAL
COMPANIES AND THE PROCESS OF MANAGING THESE RISKS;
TO DESCRIBE FINANCIAL INSTITUTIONS & THEIR OPERATIONS
 TO UNDERSTAND THE FINANCIAL REGULATORY ENVIRONMENT OF
FINANCIAL MARKET

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4. INTRODUCTION
 A well-organized, efficient, smoothly functioning financial system is an important component of a
modern, highly specialized economy.
 The financial system provides a mechanism whereby a firm or household that is a net lender may
conveniently make funds available to net borrowers who intend to spend more than their current
income.
 It provides the means to collect money from the people who have it and distribute it to those
who can use it best.
 So, the financial system connects lenders (surplus units) and borrowers(deficit units) either
directly through financial markets or indirectly through financial institutions.

5. • So, the financial system, which is composed of the financial markets and financial institutions, transfer
funds between lenders and borrowers directly or indirectly.
• If it is in the financial market, borrowers have to issue financial claims/ Financial assets/ which is
considered as an asset by the holder and liabilities by the issuer.
• A financial market is a market in which those financial assets (securities) such as stocks and bonds
can be purchased or sold.
• They include the organized exchanges for stocks and futures, and the over-the-counter (OTC) market for
bonds, foreign exchange, and derivatives.

6. • Financial institutions are organizations that process monetary transactions, including business and
private loans, customer deposits, and investments.
• They're key to the financial intermediation process, whereby financial institutions transfer funds from
those who save money to those who borrow money.
• It includes banks, insurance companies, pension funds, organized exchanges, and the many other
companies that serve to facilitate economic transactions.
• They create financial instruments, such as stocks and bonds, pay interest on deposits, lend money to
creditworthy borrowers, and create and maintain the payment systems of modern economies.
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7.  This process, called financial intermediation, is actually the primary means of moving
funds from lenders to borrowers.
 Why are financial institutions so important than financial markets?
 Why do people goes for financial institutions rather than financial market, where they
can directly make transaction?
To answer this question, we need to understand the role of
Transaction costs
Risk sharing and
Information costs in financial markets.
WHY FINANCIAL INSTITUTIONS?

8. TRANSACTION COSTS
 Financial intermediaries make profits by reducing transactions costs
 They reduce transactions costs by developing expertise and taking advantage of economies of
scale
• A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity
services
1. Banks provide depositors with checking accounts that enable them to pay their bills easily
2. Depositors can earn interest on savings accounts and yet still convert them into goods and
services whenever necessary.

9. RISK SHARING
• Financial institution’s low transaction costs allow them to reduce the exposure of investors to risk,
through a process known as risk sharing
They do this by providing the means to diversify customer asset.
Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the
diversified pool to individuals.
•Again financial institutions create and sell assets with lesser risk to one party in order to buy
assets with greater risk from another party
 This process is referred to as asset transformation, because in a sense risky assets are turned
into safer assets for investors.

10. Information asymmetry
oAnother reason financial institutions exist is to reduce the impact of asymmetric information.
oOne party lacks crucial information about another party, impacting decision-making.
For example, a borrower who takes out a loan usually has better information about the potential returns and
risk associated with the investment projects for which the funds are earmarked than the lender does.
oAsymmetric information in financial markets means that investors may be subject to adverse selection
and moral hazard problems that may hinder the efficient operation of financial markets and may also
keep investors away from financial markets

11.  Adverse selection: Before transaction occurs
 Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan
 Similar problems occur with insurance where unhealthy people want their known medical problems covered
• Moral hazard:- After transaction occurs
 Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that
won’t pay loan back
 Again, with insurance, people may engage in risky activities only after being insured
o Because of their expertise in screening and monitoring, financial intermediaries reduce adverse selection and
moral hazard problems which enable them to make profits.

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A financial asset is a non-physical asset whose value is
derived from a contractual claim

13. The role of financial resource/Assets
Transfer funds from surplus units to deficit units
Redistribute the unavoidable risk associated with the cash flow generated by
tangible assets among the deficit units and surplus units.

14. Characteristics of financial assets
Moneyness-Financial assets can be used as a medium of exchange or can be converted into money
at little cost or risk
Divisibility & Denomination-Refers to the minimum amount or size in which assets can be traded.
For instance, Bonds are generally sold in $ 1,000 denominations, commercial paper in $25,000 units
and deposits are infinitely divisible.
Reversibility-ability to be converted back to cash at a lower cost(low round trip cost). It indicates the
cost of buying an asset and then re-selling it. Also referred to as turnaround cost or round-trip cost.
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15. Term to maturity-Is the length of the period until the final repayment date or the date at
which the owner can demand the asset liquidation.
 In different cases the financial assets may terminate before the stated maturity (in
presence of call provisions, bankruptcy of the issuer...) Or can be also extend on
demand of both counterparties.
 Instruments may be issued with the term of a few days to so many years. Eg.
T.Bill vs bonds.

16. Liquidity-Can be resold without substantial loss of value.
 The degree of liquidity of an instrument can be determined based on the degree of
market capitalization /financial market/ and it can be determined by means of
contractual obligations/ the issuer‘s identity/.
 An example of agreement that can determine the degree of liquidity of an instrument is the
claim of a private pension fund.
 In this case, the asset is clearly considered illiquid in that the claim can be satisfied
not before the retirement date.

17. Convertibility-Relates to the possibility to convert the financial assets into another type of
asset.
 This is the case of convertible bonds and preferred stocks.
 Currency- Refers to the currency in which the asset’s cash flow is denominated.
 There are some assets denominated in one currency that allow to earn cash flow in a
different currency (dual currency securities), created to reduce the exchange rate risk.
 For example, some types of Eurobonds can pay interest in one currency and principal in a
second currency.

18. Complexity- A financial asset can be also regarded as a combination of
two or more simpler financial instruments whose value is the sum of the
price of its component parts.
 For instance, the price of a callable bond corresponds to the price
of a similar non-callable bond less the value of the option that
allows the issuer to redeem the bond early.

19. Tax status-Financial assets have different tax status which depends on the
governmental regulations applying to the asset.
 The tax treatment generally varies according to the issuer and owner nature,
the asset maturity, the country’s legislation, and so on.
 All of the above properties are important to determine the pricing of the
financial asset.

20. Additional characteristics
They do not depreciate like physical goods,
Their physical condition or form is usually not relevant in
determining their market value.
They have little or no value as a commodity
Their cost of transportation and storage is low.

21. THE ROLE AND TYPE OF FINANCIAL MARKETS
•Financial markets perform the essential economic function of
channeling funds from those that have saved surplus funds by
spending less than their income to those that have a shortage of
funds because they wish to spend more than their income.

22. Financial markets has the following role in an economy
 Eliminate arbitrage:-Arbitrage is a purchase of asset in one market at a given price and
simultaneously sale it in another market at a higher price. However, with advancements in
technology, it has become extremely difficult to profit from pricing errors in the market.
 Raising capital
 Commercial transactions- Financial markets provide the grease that makes many commercial
transactions possible.
 Investing- Provide an opportunity to earn a return on funds that are not immediately needed
 Risk management- Futures, options and other derivatives contracts can provide protection against
many types of risk.
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TYPE OF FINANCIAL
MARKETS
Financial markets can be classified as
follows
• Money markets and capital
markets
• Primary and secondary market
•Equity market and Debt market
•Cash market and Future market

24. THE ROLE AND TYPE OF FINANCIAL
INSTITUTIONS
The role of financial institutions
 Maturity intermediation- They create loans of long term maturity out of deposits that mature in the
short term.
 Risk reduction through diversification-They diversify risk by investing in different sectors of the
economy.
 Reducing the cost of contracting and information processing-They are better equipped in completing
contracts and processing information
 Providing a payment mechanism-Enable individuals and businesses to effect payments using checks,
credit cards, debit cards, and through electronic transfer.

25. TYPE OF FINANCIAL INSTITUTIONS
Financial institutions are organizations that process monetary transactions,
including business and private loans, customer deposits, and investments.
There are two main types of financial institutions:
 Depository, and
 Non- depository,

26. Depository institutions
• These financial institutions get their funds mostly through public deposits.
In depository institutions, customers deposit money in accounts, and the institutions loan that money to
borrowers.
Their main liabilities are the deposits, and their main assets are loans.
• They are involved in the creation of deposits which is an important component of the money supply.
 Deposit taking institutions
Commercial Banks
Microfinance Institutions (MFIs)
Saving Banks
Credit unions

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Non-depository institutions
• Non-depository institutions are those financial institutions that do not accept deposits or provide traditional
banking services, such as checking accounts.
• However, they provide loans to borrowers
• These institutions receive the public's money because they offer other services than just the payment of interest.
Non-deposit taking institutions
 Insurance companies
 Mutual funds
 Pension funds
 Investment banks
 Finance companies

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