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FINANCIAL INSTITUTIONS AND MARKETS

The financial system

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Learning objectives:
 To define the financial system;
 To describe the four elements of the financial system namely lenders and borrowers,
financial institutions, financial instruments and financial markets;
 To explain the functions of the financial system;
 To outline how financial market rates – interest rates, exchange rates and rates of return –
are determined

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The financial system comprises the financial markets, financial intermediaries and other
financial institutions that execute the financial decisions of households, firms/businesses and
governments
...
Extensive international telecommunication
networks link financial markets and intermediaries so that the trading of securities and
transfer of payments can take place 24 hours a day
...




The interaction between the various components of the financial system is shown below:
1
...
Both are non-financial entities and are referred to as surplus economic units (SEUs)
and deficit economic units (DEUs) respectively
...

The household sector consists of individuals and families, private charitable, religious and
non-profit bodies as well as unincorporated businesses such as farmers and professional
partnerships
...

The government sector consists of central and county governments as well as local
authorities
...

Usually the household sector is a net saver and thus a net provider of loanable or investable
funds to the other three sectors
...
For example a business with a
temporary excess of funds will typically lend those funds for a brief period rather than
reduce its indebtedness i
...
, repay its loans
...

Direct financing can only occur if lenders’ requirements in terms of risk, return and liquidity
exactly match borrowers’ needs in terms of cost and term to maturity
...

Financial intermediaries perform indirect financing by making markets in two types of
financial instruments – one for lenders and one for borrowers
...
In turn they acquire claims on borrowers known as primary
securities
...

2
...
Types of financial intermediaries include banks, insurance companies,
pension and provident funds, unit trusts, mutual funds
...
Insurers and
pension and provident funds receive contractual savings from households and re-invest the
funds mainly in shares and other securities such as bonds
...
e
...

A unit trust invests funds subscribed by the public in securities such as shares and bonds and
in return issues units that it may repurchase
...
Both unit trusts and mutual
funds play a risk diversification role in that they are large enough to spread their investments
widely i
...
, they can spread the risk by investing in number of different securities
...
Financial instruments
Financial instruments or claims can be defined as promises to pay money in the future in
exchange for present funds i
...
, money today
...

Financial claims can be categorized as indirect or primary securities
...

Marketable instruments can be traded in secondary markets while non-marketable
instruments cannot
...
Non-marketable claims generally involve the household
sector while marketable claims are usually issued by the corporate and government sectors
4
...
A financial market
is not a single physical place but millions of participants, spread across the world and linked
by vast telecommunications networks that brings together buyers and sellers of financial
instruments and sets prices of those instruments in the process
...

Financial market terminology includes terms such as cash and derivatives markets; spot and
forward markets, primary and secondary markets; financial exchanges and over-the-counter
markets
...


Cash and derivatives markets



The foreign exchange, money, bond and equity markets are all considered cash markets
because transactions executed in these markets will result in physical flows of cash at some
time or another
...


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The foreign exchange market is the international forum for the exchange of currencies
...

The distinction between money and bond markets is mainly on the basis of maturity
...
Both money and bond markets involve interest-bearing debt
instruments
...
Equity and bond markets are grouped together under the term capital market
i
...
, the market in which corporations, financial institutions and governments raise long-term
funds to finance capital investments and expansion projects
...
These variables can be underlying instruments in the cash market
...
However derivatives can be based on almost any
variable
While a distinction has been drawn between foreign exchange, money, bond, equity and
derivatives markets, several financial instruments straddle the division between these
markets
...
For example a convertible bond is a
hybrid of bond and equity securities
...


Spot and forward markets

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A spot market is a market in which financial instruments are traded for immediate delivery
...
The spot market is sometimes referred to as
the cash market
...


Primary and secondary markets

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The primary market is the market for the original sale or new issue of financial instruments
...
e
...


The secondary market is a market in which previously-issued financial instruments are
resold
...
It
is also a primary market where shares are issued for the first time
...
They
are usually governed by law and the exchanges’ rules and regulations
...
OTC dealers stand ready
to buy at the bid price and sell at the (higher) ask or offer price hoping to profit from the
difference between the two prices
...



Channel savings into investment
The financial system operates as a channel through which savings can finance real investment
i
...
, it channels funds from those who wish to save (surplus economic units) to those who
need to borrow (deficit economic units)
...
It
allows savers to convert current income into future spending and borrowers current
spending into future income;
 Across industries and geographical regions: capital resources can be transferred from
where they are available and under-utilized to where they can be most effectively used
...

In addition individual households can participate in investments that require large lump sums
of money by pooling their funds and then sub-dividing shares in the investment
...


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Clearance and settlement of payments
The financial system provides an efficient way to clear and settle payments thereby
facilitating the exchange of goods, services and assets
...


Management of risk

By reducing credit risk and providing liquidity through maturity transformation financial
intermediaries change unacceptable claims on borrowers to acceptable claims on themselves
i
...
, the risky long-term liabilities of deficit units are transformed into less-risky liquid assets
for surplus units
...
However if financial intermediaries do this on behalf of many
small savers, search costs are reduced
...
In addition it enables asset managers to make
investment decisions and household’s savings decisions
...

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Interest rates
An interest rate is the price, levied as a percentage, paid by borrowers for the use of money
they do not own and received by lenders for deferring consumption or giving up liquidity
...
A security is considered to be
liquid if it can be converted into cash at short notice at a reasonable price;
Time preference: lenders require compensation for saving money for use in the future rather
than spending it in the present;
Risk: lenders charge a premium if investment returns are uncertain i
...
, if there is a risk that
the borrower will default
...
Sovereign debt generally has no risk premium within a country
...


Exchange rate
The exchange rate is the price at which one currency is exchanged for another currency
...


Rates of return

Interest rates are promised rates i
...
, they are based on contractual obligation
...
The return from holding these assets comes from two sources:
 Price appreciation (depreciation) i
...
, any gain (loss) in the market price of the asset;
 Cash flow (if any) produced by the asset e
...
, cash dividends paid to shareholders, rental
income from property
...
50
...
2
...
55
...
50
...
2
...
45
...
2,000
...
3,000
...

Scarcity exists when the needs and wants of a society exceed the resources available to
satisfy them
...
e
...

The approach to resource allocation – the assignment of scarce resources to the production
of goods and services - allows a distinction to be made between those economies that are
centrally planned and those that operate predominantly through market forces i
...
economic
systems
The Flows of economic activity



The structure of an economy is often described by a circular flow of income diagram
...
On the resource
side i
...
, real flows: households provide labor to firms and firms produce goods and services
and supply them to households for consumption
...

 In reality the economy is more complicated
...



At the same time as the leakages are taking place, additional forms of spending are
occurring that represent injections into the circular flow:
 Investment spending: firms use capital in the production process
...
g
...
Capital goods have themselves been produced
...
This
generates income for firms producing capital goods;
 Exports: firms sell their production to another country in exchange for foreign exchange
...


Economic Objectives
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The performance of an economy is generally judged in terms of the following economic
objectives:
An acceptably high rate of non-inflationary economic growth;
A high and steady level of employment of the labour force;
A stable general price level i
...
, avoidance of undue inflation and deflation;
A favorable and stable balance of payments; and
Equitable distribution of income
...
e
...

However recognition that market forces alone cannot ensure that an economy will achieve
the economic objectives has resulted in state intervention occurring to some degree in all
countries
...
e
...


Fiscal Policy

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Fiscal policy is the use of government spending and taxation policies to influence the overall
level of economic activity
...
Similarly increases in taxation and/or decreases in government
spending will weaken aggregate demand
...
Higher tax rates or reductions in public expenditure are referred to as the
tightening of fiscal policy
...
A budget surplus exists when taxation and other receipts of the government exceed
its payments for goods and services and debt interest
...
A budget deficit is financed by borrowing
...

National debt incurs interest costs and has to be paid back
...

Monetary policy

 Monetary policy regulates the economy by influencing monetary variables such as:
 The rate of interest: lowering interest rates encourages companies to invest (i
...
invest in
capital expenditure) as the cost of borrowing falls and households to increase consumption
as disposable incomes rise on the back of lower mortgage and overdraft rates
...

 The tools of monetary policy are:
 Reserve requirements;
 Open-market operations; and
 Bank or discount rate policy
...
By changing the reserve
requirement the central bank can influence the money supply and credit extension
...

Open market operations: Open market operations involve the purchase and sale of
government and other securities by the central bank to influence the supply of money in the
economy and thereby interest rates and the volume of credit
...
A sale of securities – contractionary monetary
policy – does the opposite
...
Banks borrow from the central bank
primarily to meet temporary shortfalls of reserves
...
g
...

This will decrease the money supply and reduce credit extension
...

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Economic Indicators
Economic indicators provide insights into how economies and markets are performing
...

The interpretation of economic indicators is important for a number of reasons as this is
dependent on the users including:

 Economists and other market analysts
- Assessment of the performance of the economy
- Judgment of the effectiveness of a government’s economic policy
- Ascertainment of the performance of an unfamiliar economy;
- Comparison of the economic performance of different countries;
- Formation of economic and market forecasts and views
...
GDP is presented as annual or quarterly totals
...

There are three approaches to estimating GDP:

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-

production or output method sums the value added (value of production less input costs) by
all businesses (agriculture, mining, manufacturing, services);

Expenditure method adds all spending:

 private consumption e
...
, food and clothing;
 government consumption e
...
, remuneration of public sector employees;
 investment e
...
, factories, manufacturing plants; and
 exports (foreigners’ spending) less imports (spending abroad)

-

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income method aggregates the total incomes from production and includes employees’
wages and salaries, income from self-employment, businesses’ trading profits, rental
income, trading surpluses of government enterprises and corporations
...
In
practice discrepancies exist due to shortcomings in data collection, timing differences and
the lack of informal sector data
...
For
example, strong economic growth after an economic recession usually indicates the
utilization of idle capacity; during the expansion phase it may suggest the installation of new
and additional capacity to add to future production while at the peak it may imply
inflationary pressures
...
This will lead to rising interest rates as market participants expect the central bank
to raise interest rates to avoid higher inflation
...

(iii) Share prices: High growth leads to higher corporate profits – this supports share prices
...

(iv) Exchange rate: Strong economic growth will tend to appreciate the exchange rate as higher
interest rates are expected
...

It is divided into a number of categories including durable goods (goods expected to last
more than 3 years), non-durable goods (food and clothing) and services
...




Interpretation: A change in private consumption spending has a large effect on total
production as it is the largest component of aggregate demand
...
However if
consumption grows faster than an economy’s productive capacity demand for imports will
increase and inflation will rise
...
Its share of GDP is higher in countries where the state provides
many services
...
It does
not represent total government spending as government investment spending is included
in investment spending
...

Interpretation: Government consumption expenditure tends to be a stable percentage of
GDP
...
A short-term increase in government spending can provide a stabilizing boost to
the economy
...
It
is made up of:
- Gross domestic fixed capital investment that includes spending on residential and nonresidential buildings, construction works and machinery and other equipment;
- Change in inventories
...
It
represents only a small proportion of Investment spending
...
Firms’ investment decisions are
based on expectations of future aggregate demand, corporate profits and interest rates
...


Consumer price index (CPI)

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Definition:
Price indices measure levels of and changes in particular baskets of
prices
...
Price indices provide information on
inflation
...

Presented as: Monthly index numbers
Interpretation: The CPI is used to calculate and monitor inflation
...
e
...


Likely impact on:
Interest rates: Larger than expected increases or an increasing trend in CPI is considered
inflationary
...

Bond prices: Higher interest rates mean falling bond prices
...

Exchange rate: The effect is uncertain
...
However higher inflation typically leads to tighter monetary
policy and higher interest rates, which leads to appreciation
...
Prices of domestically-produced goods / imported
goods are measured when they leave the factory / arrive in the country and not when they
are sold to consumers
...

Interpretation: The PPI and CPI tend to follow the same trend
...


Balance of payments

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Definition: The balance of payments is a tabulation of a country’s transactions with foreign
countries and international institutions over a period – a quarter or year
...
e
...

Balance of payments is presented as monthly money values
...
e
...
g
...

Balance of payments
The current account balance reflects the sum of the trade account (or trade balance), services
account and transfers of a country’s balance of payments
...

The services account reflects the difference between imports and exports of services such as
shipping, travel and tourism, financial services including insurance, banking and brokerage
...


Interpretation: The current account balance reflects international payments that must be
matched by capital flows or changes in official reserves
...
A current account deficit has to be financed by inward capital flows (i
...
,
foreign investment or loans) and/or the depletion of official reserves
...

However a deficit may also imply that a country has strong growth potential that is leading
to higher imports (especially in technology and capital goods) and that other countries are
willing to fund that growth either in the form of investments or loans
...
g
...

Likely impact on:
Share prices: share prices may fall if an increasing current account deficit suggests that
domestic firms are not globally competitive
...
e
...
On the other hand a worsening trade balance may also
indicate high economic growth that is leading to higher imports
...


The foreign exchange market

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The foreign exchange market is the financial market where currencies are bought and sold
...

The exchange rate is the price of one currency in terms of another currency
...
g
...


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In indirect terms it is the price of the domestic currency in terms of the foreign currency e
...
,
if one Kenya Shilling is equal to $0
...
014
...

Characteristics
Most currency exchanges are made via bank deposits
...

The foreign exchange market is highly integrated globally and operates 24 hours a day –
when one major market is closed another is open so trading can take place 24 hours a day
moving from one centre to another
...

Most foreign exchange transactions take place in US dollars – the primary vehicle currency
...

Most foreign exchange transactions take place in US dollars – the primary vehicle currency
...

(i) The spot rate
 The spot rate is quoted for ‘immediate’ (in practice, two working days) delivery
...
The bid rate is the rate at which one currency can be purchased
in exchange for another while the offer rate is the rate at which one currency can be sold in
exchange for another
...
The bid rate is the rate the bank is willing to pay to buy dollars (and
sell the non-dollar currency) and the offer rate is the rate at which the bank will offer to sell
dollars (and buy the non-dollar currency)
...


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(ii)The forward rate
Foreign exchange can be bought and sold not only on a spot basis, but also on a forward
basis for delivery on a specified future date
...
Forward transactions are known as forward
exchange contracts or forward contracts
...
The
difference between the forward rate and the spot rate reflects the interest rate differential
between the two currencies
...

Swaps
A swap transaction involves the simultaneous exchange of two currencies on a specific date
at a rate agreed at the time of the contract and a reverse exchange of the same two currencies
at a date further in the future at a rate agreed at the time of the contract
...
A put option gives the buyer of the
option the right to sell a certain amount of currency at a specified exchange rate on or before
a designated date
...

The interbank market is more accurately an inter-dealer market as investment banks and
other financial institutions have become direct competitors of the commercial banks as
dealers in the foreign exchange markets
...

Firms and corporations



Firms and corporations buy and sell foreign exchange because they are in the process of
buying or selling an asset, product or service
...


 Central banks


Central banks sometimes intervene in the foreign exchange market to increase or decrease
the supply of their currency or to purposely affect the exchange rate
...


The money market
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The market defined
The money market is defined as that part of the financial market that deals in instruments
with maturities ranging from one day to one year – the most common maturity being 3
months
...

The market has no specific location - it is centered in the large financial centre's of the world
– with most transactions being made by telephone or electronically
...
The primary
market is the market for the issue of new money market instruments
...

Central banks are key participants in the money market
...
Central banks control the supply of reserves available to
banks primarily through repurchase agreements or the outright purchase and sale of money
market instruments such as treasury bills
...

Maturity
Typically 90 days but could range from 30 to 270 days
...

Issuers
Banks

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Investors
Wide range of institutions: banks, private and public corporations, money funds, hedge
funds, mutual funds pension funds, insurance companies, and individuals
...

Maturity
From a few days up to one year
Quality
Obligation of the issuer
Issuers
Corporations

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Investors
Banks, pension funds, insurance companies, and individuals
Advantages - issuers

•
•
•

Cheaper form of funding than bank overdrafts
Maturity can be tailored to meet funding requirements and/or to tap investor demand
Able to diversify sources of funds
Advantages - investors

•
•

Wide range of maturities enable investors to find an instrument that suits their requirements
Usually repaid within one year i
...
, investors are only exposed to short-term credit risk
Disadvantages - issuers

•
•

If paper is not underwritten, issuer may not be able to place all the paper with investors and
raise the funds required
...

Maturity
From less than one year to up to five years
Quality
Obligation of the issuing bank
Issuers
Banks



Investors
Wide range of institutions: banks, private and public corporations, pension funds, insurance
companies, money funds, hedge funds, mutual funds pension funds, and individuals



Advantages - issuers
Because instruments are negotiable, banks can usually take deposits more cheaply than on
the inter-bank market



Disadvantages - investors
Large denominations are unattractive to small investors

Instruments – Treasury bills
 Definition
 A short-term debt obligation of the government payable on a certain future date
...


Advantages - issuers
 Main vehicle for central bank accommodation policy


Advantages - investors
Usually qualify as liquid assets for banks and may be held by insurers and pension funds to
satisfy their relevant investment requirements



Disadvantages - investors
Large denominations are unattractive to small investors

Instruments – Repurchase agreements
 Repurchase agreements (repos) are agreements under which funds are borrowed through the
sale of short-term securities such as treasury bills and the simultaneous agreement to
repurchase the same or similar securities after a specific time at a specified price
...
Large companies use repos to borrow short-term funds
...

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Other Market terminologies
Physical Vs
...
With advances in ICT, financial
instruments are traded over the counter (OTC) using a system of computer screens and
telephones
...
Capital Markets: markets can also be classified according to the maturity of the
securities traded in them
...


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Continuous Vs
...
However,
some markets are trade at specific times during opening hours
...
There has to be sufficient time
between calls to allow offers to buy and sell securities to accumulate and so make trading
worthwhile
...
Flow Markets: Once a security has been issued, it exists in the market place until
it matures and is redeemed
...
Clearly, it is impossible for everyone to sell their holdings of a
particular security
...

Primary Vs
...
The secondary market is the market in which existing
securities (second hand bonds and shares) are subsequently traded
...
e
...


The bond and long-term debt market

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The market defined
Capital markets are markets in which institutions, corporations, companies and governments
raise long-term funds to finance capital investments and expansion projects
...

Characteristics
Bonds and long-term debt instruments are traded on organized exchanges or over-thecounter
...
The primary
market is where new bond and long-term debt instruments issues are sold
...


Instruments

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Bonds
Definition: A fixed-interest-bearing security sold by the issuer promising to pay the holder
the nominal (face or par) value of the security plus interest (called coupons) at future dates
(usually every six months
...
When
issued by lower-ranking public bodies such as municipalities or public enterprises they are
called semi-gilt stock
...

Marketability: Certain issues have an active secondary market
Quality: Government bonds are essentially risk-free within a country as they constitute
evidence of debt of the government (country risk will apply)
...
The quality of corporate bonds depends on the issuer
...

Investors: Banks, insurance companies, hedge, mutual and pension funds, trust companies

Advantages – issuers
 Certain interest cost over the life of the bond

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Disadvantages – issuers
 If market rates fall after the bonds have been issued, the issuer can be locked into paying
interest rates above market rates

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Advantages – investors
High quality paper
Liquid secondary market
The price of a fixed-rate security moves in an inverse relationship to a movement in interest
rates
...
This gives investors an opportunity for capital gains
...
The debenture contract consists of the debenture itself and the indenture
or trust deed
...
The trust deed is a supplementary contract between the issuer and the trustees
(representatives of the debenture-holders) setting out the rights of individual debenture
holders
...

Maturity: May range from in excess of 5 years up to 30 years
...
This assists in planning and
budgeting for capital projects
...
For example a redeemable feature is
advantageous to the issuer as when interest rates fall, the issuer can redeem the outstanding
debenture and re-issue a new debenture at the lower interest rate
...
For example, restrictive covenants
may restrain the freedom of the management of the company in their operatio







Advantages – investors
Depends on the terms and conditions of the debentures
...

Disadvantages- investors
Depends on the terms and conditions of the debentures
...

Maturity: May range from three years up to 30 years
Marketability: Certain issues have an active secondary mark
Quality: Obligation of the issuer
Market Participants:
Issuers: The government, public corporations, local authorities and corporations
...

Advantages – issuers
If short-term rates decrease after the floating-rate note is issued, the issuer may fund at a rate
lower than that of a comparable fixed-rate loan
Disadvantages – issuers
If interest rates rise after the floating rate note is issued, greater costs may be incurred than if
a comparable fixed-rate bond had been issued
Advantages – investors
Coupons are adjusted to reflect general movements in interest rates which gives investors
protection against significant capital losses in periods of interest rate uncertainty
The returns on floating rate notes are usually linked to short-term interest rates, which can
be attractive when short-term rates are at historically high level
Disadvantages – investors
Less opportunity for capital gains than with fixed-rate investments
...




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