Prasanna Chandra

6e

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FUNDAMENTALS OF
FINANCIAL MANAGEMENT
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THE FINANCIAL SYSTEM
Chapter 2
 OUTLINE

▪ Functions of the Financial System

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▪ Financial Assets
▪ Financial Markets
▪ Financial Market Returns
▪ Financial Intermediaries
▪ Regulatory Infrastructure
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THE FINANCIAL SYSTEM
 FUNCTIONS OF
THE FINANCIAL SYSTEM
▪ Payment System

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▪ Pooling of Funds
▪ Transfer of Resources
▪ Risk Management
▪ Price Information for Decentralised
Decision Making
▪ Dealing with Incentive Problem
 FUNCTIONS OF
THE FINANCIAL SYSTEM
Contd
…
▪ Payment System

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Depository financial intermediaries such as banks are the pivot of
the payment system. Credit card companies play a supplementary
role.

▪ Pooling of Funds
Financial markets and intermediaries facilitate the pooling of the
household savings for financing business.

▪ Transfer of Resources
The financial system facilitates the efficient life-cycle allocations of
household consumption, the efficient allocation of physical capital
to its most productive use, and the efficient separation of
ownership from management.
 FUNCTIONS OF
THE FINANCIAL SYSTEM
Contd
…
▪ Risk Management

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A well-developed financial system offers a variety of instruments
that enable economic agents to pool, price, and exchange risk. The
three basic methods of managing risk are : hedging, diversification,
and insurance

▪ Price Information for Decentralised Decision

Making
Interest rates and security prices are used by households in their
consumption-saving-investment decisions and by firms in their
investment and financing decisions
 FUNCTIONS OF
THE FINANCIAL SYSTEM
Contd
…

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▪ Dealing with Incentive Problems
Information asymmetry leads to moral hazard and adverse
selection, which are broadly referred to as agency problems.
Financial intermediaries like banks and venture capital
organizations can solve the problem of informational asymmetry
by handling sensitive information discreetly and developing a
reputation for profitable activity
 FINANCIAL ASSETS

Financial assets are intangible assets that represent claims to

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future cash flows. The terms financial asset, instrument, or
security are used interchangeably.
Examples :
▪ A 10-year bond issued by the GOI carrying an interest rate
of 7 percent.
▪ Equity shares issued by TCS to the general investing public
through an initial public offering.
▪ Call options granted by WIPRO to its employees.
 FINANCIAL MARKETS

A financial market is a market for creation and exchange

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of financial assets.
Financial markets play a very pivotal role in allocating
resources in the economy by performing three important
functions as they:
▪ Facilitate price discovery
▪ Provide liquidity
▪ Reduce the cost of transacting
 FUNCTIONS OF
FINANCIAL MARKETS
▪ FACILITATE PRICE DISCOVERY

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The continual interaction among numerous buyers and sellers who
participate in financial markets helps in establishing the prices of
financial assets

▪ PROVIDE LIQUIDITY
Thanks to the liquidity provided by financial markets, it is possible
for companies (and other entities) to raise long-term funds from
investors with short-term horizons

▪ REDUCE THE COSTS OF TRANSACTING

Financial markets considerably reduce the following costs of
transacting
• Search cost
• Information cost
 CLASSIFICATION OF
FINANCIAL MARKETS
DEBT MARKET

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NATURE OF CLAIM
EQUITY MARKET
MONEY MARKET
MATURITY OF CLAIM
CAPITAL MARKET
PRIMARY MARKET
SEASONING OF CLAIM
SECONDARY MARKET
CASH OR SPOT MARKET
TIMING OF DELIVERY
FORWARD OR FUTURES MARKET
EXCHANGE-TRADED MARKET
ORGANISATIONAL
STRUCTURE OVER-THE-COUNTER MARKET
 FINANCIAL MARKET RETURNS
• Interest Rate
Function of the unit of account, maturity, and default risk

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• Rate of Return on Risky Assets
Cash dividend Ending price – Beginning price
r= +
Beginning price Beginning price

Dividend yield Capital yield

• Inflation and Real Interest Rate

1 + Nominal rate
1 + Real rate =
1 + Inflation rate
 DETERMINANTS OF
RATES OF RETURN

▪ Expected Productivity of Capital

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▪ Degree of Uncertainty about the Productivity
of Capital
▪ Time Preferences of People
▪ Degree of Risk Aversion
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FINANCIAL INTERMEDIARIES
 RATIONALE FOR
FINANCIAL INTERMEDIARIES

▪ Diversification

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▪ Lower Transaction Cost
▪ Economies of Scale
▪ Confidentiality
▪ Signalling
 RATIONALE FOR
FINANCIAL INTERMEDIARIES
▪ DIVERSIFICATION
The pool of funds mobilised by financial intermediaries is invested in a broadly

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diversified portfolio of assets (loans, stocks, bonds and so on).
▪ LOWER TRANSACTION COST
The transaction cost in percentage terms decreases as the transaction size increases.
▪ ECONOMIES OF SCALE
Financial institutions enjoy economies of scale
▪ CONFIDENTIALITY
Information shared with financial intermediaries may be kept confidential whereas
information disclosed to numerous individual investors is in public domain.
▪ SIGNALLING
Financial intermediaries can pick up and interpret signals and cues better. So they
perform a signalling function for the investment community.
 REGULATARY
INFRASTRUCTURE

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▪ RESERVE BANK OF INDIA
▪ SEBI
 KEY TRENDS IN THE
INDIAN FINANCIAL SYSTEM

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▪ Market-determined interest rates and greater
volatility of interest rates
▪ Emergence of universal banks
▪ Emphasis on prudential regulation and supervision
▪ Gradual integration with the global financial system
▪ Increase in financial innovation
 SUMMING UP
▪ The financial system – consisting of a variety of institutions,
markets, and instruments related in a systematic manner –
provides the principal means by which savings are

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transformed into investments.
▪ The financial system provides a payment mechanism, enables
the pooling of funds, facilitates the management of
uncertainty, generates information for decentralised decision
making, and helps in dealing with informational asymmetry.
▪ Financial assets represent claims against the future income
and wealth of others. Financial liabilities, the counterparts of
financial assets, represent promises to pay some portion of
prospective income and wealth to others.
 SUMMING UP
Contd
…
∙ The important financial assets and liabilities in our economy

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are money, demand deposit, short-term debt,
intermediate-term debt, long-term debt, and equity stock.
∙ A financial market is a market for creation and exchange of
financial assets. Financial markets facilitate price discovery,
provide liquidity, and reduce the cost of transacting.