1. Chapter 2 Financial Intermediation and Financial Markets
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

2. Learning Objectives
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

3. Financial Intermediation
Financial intermediation is the process of transferring sums of money from economic agents with surplus funds to economic agents that would like to utilize those funds.
The key to understanding the process and the range of financial instruments available lies in recognizing that economic agents are a heterogeneous bunch, having very different financial positions, investment, business and financial needs. For this reason, there are a wide range of financial intermediaries and financial instruments servicing these needs.
Financial intermediaries play a very important economic role in facilitating the transfer of funds between deficit and surplus economic agents, in large part because they are able to reconcile the often-conflicting needs of the two types of agent.
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

4. Surplus and Deficit Agents
At any moment of time, in an economy, one can observe two distinct groups of economic agents: those that have surplus funds due to their expenditure being less than their income, and those that require funds to finance expenditure which exceeds their income. The former are referred to as surplus agents and the latter are deficit agents.
Surplus Agents have surplus funds due to their expenditure being less than their income.
The aim: Firms save funds to meet unforeseen contingencies, to finance future investments ; individuals save a deposit for house purchase and so on.
Deficit Agents require funds to finance expenditure which exceeds their income.
The aim: Individuals borrow to buy a car, a house; Firms borrow to finance investment and so on.
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

5. Financial Security
A financial security is simply a legal claim to a future cash flow.
Each financial security has an issuer that agrees to make future cash payments to the legal owner of the asset (investor/holder).
Example: A $200 million issue of 10-year government bonds by the US treasury.
The issuer (US treasury) will pay investors in the bond issue the principal and interest.
Example: A $ loan by Bank of America to Mr. Jackson.
The issuer: Mr. Jackson
The legal owner of the security: Bank of America
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

6. Debt & Equity
Debt: An amount of money borrowed by one party from another
Government debt is borrowed by via the issue of Treasury bonds and bills.
Corporate debt is borrowed from financial institutions via the issue of corporate bonds or commercial paper.
Equity: A share representing an ownership stake in a company. The holder is entitled to periodic dividends and can sell the shares to other parties at the prevailing market price
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

7. Types of Financial Liabilities
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

8. Examples of Different Financial Liabilities
Type I: Deposit of a bank that has to be paid with fixed interest payment of 8% one year from now.
Type II: Life assurance policy
Type III: Deposits of bank on which interest has to be paid every six months with a variable rate
Type IV: Health, housing or motoring insurance
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

9. The Role of Financial Intermediaries
Financial Intermediation is the process of transferring sums of money from economic agents with surplus funds to economic agents that would like to utilize those funds
Financial Market: A market where financial assets are traded and exchanged.
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

10. The Role of Financial Intermediaries
Assisting in the transfer of funds from surplus agents to deficit agents
The provision of payments mechanism
Maturity transformation
Risk transformation
Liquidity provision
Reduction of transaction, information and search costs
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

11. Types of Financial Markets
Primary Market: This market deals in issues of new securities, which include government bonds, local authority bonds, and shares in new public corporations
The most active market participants: Investment and commercial banks and investment firms
Secondary Market : The market for buying and selling a security that has already been issued on the primary market
Market-makers are important in the operation of secondary markets
Market-maker: A broker or dealer that will quote bid-offer prices on securities
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

12. The Classification of Financial Markets
Type of the asset
Maturity of the asset
The date of issue of the assets traded
The means of settlement
The type of financial asset traded.
The organizational structure of the market
The method of sale/pricing
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

13. Participants in Financial Markets
Brokers and Market-Makers
A broker acts as an intermediary on behalf of investors wishing to conduct a trade. The broker is the legal agent of the investors. They obtain a commission for their service.
Market makers act as a dealer in a financial security , quoting both a price at which he is willing to buy the security (bid price) and a higher price at which he is willing to sell the security (ask price).
Gross Profit Margin: Ask Price-Bid Price
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

14. Participants in Financial Markets
Arbitrageurs: exploit pricing anomalies in order to make riskless guaranteed profits.
Example: If security A trades at a higher price on market 1 than market 2, arbitrageurs will buy the asset in market 2 at the cheap price and immediately sell it in market 1 at higher price. Prices then adjust until the anomaly is eliminated.
Hedgers: seek to buy or sell financial assets to reduce or eliminate an existing risk.
Speculators: undertake long or short position in the financial markets in the hope of making a profit.
Keith Pilbeam ©: Finance and Financial Markets 4th Edition