1. Overview of the Financial System
Introduction (Part 1)
Overview of the Financial System

2. Goal of the Lecture Lender-Savers vs Borrower-Spenders
Direct finance vs Indirect finance
Function of financial markets
Debt vs Equity instruments
Primary vs Secondary Markets
Money vs Capital Markets
International Financial management
Introduction to Financial Intermediaries.

3. Financial System Financial markets & Institutions:
Affect our everyday lives
Responsible for the daily smooth flow of funds across individuals, industries and countries.
Involve the flow of trillions of dollars worth of funds throughout our economy
Affect profits, production of goods & services, and our economic well-being.

4. Financial System
Countries with poor performing financial markets usually remain poor.
When the financial system breaks down in a country (as we observed in the past in Russia, East Asia, and Argentina), there is usually severe economic hardship.
Countries that have more efficient and productive financial system tend to have better economic performance.

5. Function of Financial Markets: Lender-Savers vs Borrower-Spenders
A surplus occurs when the amount spent is less than the income received.
Spending < income
Those who have a surplus of funds that they have saved, potentially have funds that they can also lend to those who have a shortage. These entities are called lender-savers.

6. Function of Financial Markets: Lender-Savers vs Borrower-Spenders
A Shortage or deficit occurs when spending exceeds income.
Spending > income
Those who have shortage/deficit may seek to go to those who have surpluses to borrow funds. These entities are called borrower-spenders

7. Function of Financial Markets
Channel funds from entities with saved surplus funds to those with shortage of funds.
i.e. funds flow from lender-savers to borrower-spenders.
Financial markets allow funds to flow from people who lack productive investment opportunities to those who do.
People who save are frequently not the same people who have profitable business or investment opportunities available to them.

8. Examples of Need for Financial Markets
Jean has $1000 saved
No financial markets
No interest earned
Carl is a carpenter needs $1000 to buy a tool to build houses more efficiently. He could earn $200 more per year.
Jean knows Carl and lends him $1000 at 10% interest ($100 per year)
Carl buys the tool and makes $200 more less $100 interest.
Carl & Jean are each $100 richer.
Ed recently graduated from college and got married to Ayeesha.
Ed and Ayeesha have good salaries
They want to buy a new home
They do not yet have the $300,000 saved to buy the home, but will have it in 20 years.
Without a good financial system they will never buy the house in time to have kids.

9. Lessons from the Examples
Without financial markets it is hard to transfer funds from those with surplus to those with investment opportunities.
Financial markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy.
Capital is defined as financial or physical wealth that is employed to produce more wealth.
Well-functioning financial markets improve the well-being of consumers by allowing them to time their purchases better.

10. Flow of Funds Direct Finance Borrower-Spenders Business firms
Government
Households
Foreigners
Lender-Savers
Households
Business firms
Government
Foreigners
Financial
Markets
Funds
Funds

11. Flow of Funds
Direct finance—Borrowers borrow funds directly from lenders in financial markets by selling them securities called financial instruments.
Financial Instruments—claims on the borrower’s future income or assets.
Securities are assets for the person who buys them but liabilities (IOUs) for the individual or firm that sells (issues) them.

12. Structure of Financial Markets: Debt & Equity Markets
An entity can obtain funds in a financial market in two ways:
By issuing debt
By issuing equity
The most common method is the issuance of debt securities such as bonds or mortgages.
Debt instrument—a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specific date, when the final payment is made.

13. Structure of Financial Markets: Debt & Equity Markets
Debt Instruments
Maturity—the number of years until the expiration date.
Short-term—maturity in less than 1 yr
Medium (or intermediate) term—maturity is between 1 to 10 yrs
Long-term—maturity is in 10 or more yrs.

14. Structure of Financial Markets: Debt & Equity Markets
Equity Instruments
Common stock—claims to share in the net income (or profit) and the assets of the business.
No maturity date
Associated with voting rights
Owning 1 share of stock in a firm with 1 million shares outstanding represents ownership of 1 one-millionth of the firm.
Dividends—periodic payments made to equity shareholders.
Residual claimant—corporation must pay all its debt-holders and other stakeholders before paying shareholders.
Equity holders benefit directly from an increase in profit or asset value. Debt holders do not directly benefit.

15. Structure of Financial Markets: Primary & Secondary Markets
IPO
SEO
OTC
Exchange

16. Structure of Financial Markets: Primary Markets
Primary Market—market in which new issues of a security (stock or bond) are sold to initial buyers by the corporation or government agency borrowing the funds.
Transactions usually take place behind closed doors
Investment banks usually assist in primary market activities by underwriting securities.
Underwriting—guaranteeing prices on securities to corporations and then selling the securities to the public.
IPO vs SEO

17. Structure of Financial Markets: Primary & Secondary Markets
IPO
SEO
OTC
Exchange

18. Structure of Financial Markets: Secondary Markets
Secondary Markets—market in which securities that have been previously issued (and are thus secondhand) can be resold.
E.g. NYSE, AMEX, Nasdaq, FX market, etc.
Brokers—agents of investors who match buyers with sellers of securities
Dealers—link buyers and sellers by buying and selling securities at the stated prices

19. Structure of Financial Markets: Secondary Markets
The corporation does not receive any proceeds from the sale of securities in the secondary market
Secondary markets are still important for two reasons:
They make financial instruments more liquid (easier to sell) and thus make issuing the security in the primary market easier.
Gauge the price of the security. The higher the estimated price in the secondary market, the higher the price that the firm will receive in the primary market.
Conditions in the secondary market are most relevant for the issuance of securities in the primary markets.

20. End of Lecture We have discussed Course overview
Lender-saver and borrower-spender
Function of financial markets
Debt and equity securities
Primary and secondary markets
Next
We will complete the discussion of secondary markets, discuss money markets and capital markets, cover international financial markets, and talk a little about stock indexes (or indices).