Chapter One

The Role of the Financial System in the Economy

Financial System

The financial system is complex, comprising many different types of

private sector financial institutions, including banks, insurance
companies, mutual funds, finance companies, and investment banks, all
of which are heavily regulated by the government. If an individual wanted
to make a loan to IBM or General Motors, for example, he or she would
not go directly to the president of the company and offer a loan. Instead,
he or she would lend to such companies indirectly through financial
intermediaries, institutions that borrow funds from people who have
saved and in turn make loans to others.

Financial systems, i.e. financial intermediaries and financial markets,

are important for economic growth. They can lead to a more efficient
allocation of resources because they
1) reduce the costs of moving funds between borrowers and lenders,
and
2) help overcome information asymmetry between borrowers and
lenders.

If they do not function well the economy can not operate efficiently and
economic growth will be negatively affected. Information asymmetry
arises because borrowers generally know more about their investment
projects than lenders. Imperfect information can lead to a lack of market
coordination.

Functions of Financial Systems in the Economy

The financial system consists of financial markets and institutions. A

financial institution is an institution whose primary source of profits is
through financial asset transactions.
Financial institutions, as part of the financial system, facilitate the flow
of funds from savers to borrowers in the most efficient manner. They are
institutions such as banks that collect the savings of individuals and
corporations and funnel them to firms that use the money to finance
their investments in plant, equipment, research and development, and so
forth. They perform two main types of financial service that reduce the
costs of moving funds between borrowers and lenders, leading to a more
efficient allocation of resources and faster economic growth. These are
the provision of liquidity and the transformation of the risk
characteristics of assets.

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 a. Provision of liquidity
The link between liquidity and economic performance arises because
many high return investment projects require long-term commitments of
capital, but risk adverse lenders (savers) are generally unwilling to
delegate control over their savings to borrowers (investors) for long
periods. Financial systems mobilize savings by agglomerating and
pooling funds from disparate sources and creating small denomination
instruments. These instruments provide opportunities for individuals to
hold diversified portfolios. Without pooling individuals and households
would have to buy and sell entire firms.
Financial markets can also transform illiquid assets (long-term capital
investments in illiquid production processes) into liquid liabilities
(financial instrument). With liquid financial markets savers/lenders can
hold assets like equity or bonds, which can be quickly and easily
converted into purchasing power, if they need to access their savings.
For lenders, the services performed by financial markets and
intermediaries are substitutable around the desired risk, return and
liquidity provided by particular investments. Financial intermediaries
and markets make longer-term investments more attractive and facilitate
investment in higher return, longer gestation investment and
technologies. They provide different forms of finance to borrowers.
Financial markets provide arms length debt or equity finance (to those
firms able to access markets), often at a lower cost than finance from
financial intermediaries.
b. Transformation of the risk characteristics of assets
The second main service financial intermediaries and markets provide is
the transformation of the risk characteristics of assets. Financial systems
perform this function in at least two ways. First, they can enhance risk
diversification and second, they resolve an information asymmetry
problem that may otherwise prevent the exchange of goods and services,
in this case the provision of capital.
Financial systems facilitate risk-sharing by reducing information and
transactions costs. If there are costs associated with the channeling of
funds between borrowers and lenders, financial systems can reduce the
costs of holding a diversified portfolio of assets. Intermediaries perform
this role by taking advantage of economies of scale, markets do so by
facilitating the broad offer and trade of assets comprising investors’
portfolios.
Financial systems can reduce information and transaction costs that
arise from an information asymmetry between borrowers and lenders. In
credit markets an information asymmetry arises because borrowers
generally know more about their investment projects than lenders. A
borrower may have an entrepreneurial “gut feeling” that can not be

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communicated to lenders, or more simply, may have information about a
looming financial risk to their firm that they may not wish to share with
past or potential lenders.
The link between financial systems and economic growth
There are two main channels through which financial systems can have
an effect on economic growth:
1. Capital accumulation (both physical and human) and
2. Technological innovation.
Capital accumulation

Financial systems affect capital accumulation in three ways. First,

financial systems lower the cost of channeling funds between borrowers
and lenders, by reducing information and transaction costs. A decline in
the cost of accessing finance frees up resources for other uses, including
consumption, investment and capital accumulation.

Second, they can alter individuals’ and households’ saving decisions by

making long term investments more attractive. If financial intermediaries
and markets are unable to convince savers of the soundness of the
investment projects that they are planning for funding, savers may
choose to consume rather than save or place their savings in other, less
productive forms.

Third, financial intermediation affects capital accumulation by

reallocating funds to their most productive uses, which raises the rate of
return to saving. However, the effects of a change in the rate of return on
saving are ambiguous. This is because higher rates of return increase the
cost of consumption today or the cost of not saving, leading to more
saving.
Technological innovation

Financial systems may affect technological innovation by allowing

diversification. Financial systems allow savers to obtain their desired
level of exposure to high risk/reward firms, potentially increasing the
level of finance directed at such activities. Financial intermediaries are
well suited to provide external finance to new firms that require staged
finance because they can credibly commit to additional funding based on
key benchmarks. Specialized intermediaries can improve the willingness
of savers to provide finance to firms with innovative or novel business
plans through monitoring and oversight activities.

Financial markets are effective at financing industries where relatively

little information or few data are available or where a diversity of opinion
is persistent. This is because markets allow investors with similar views
to form coalitions to finance a particular investment project. New

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investment financed by financial intermediaries or markets is a channel
for the diffusion of new technologies and productivity gains.

Types of Financial Markets

• Capital Market: is an arena in which firms and other institutions that require funds
to finance their long term operations come together with individuals and institutions that
have money to invest. Capital Market makes long term debt financing and
capital possible. It consists of primary market and secondary market.
In primary market newly issued bonds and stocks are exchanged and in
secondary market buying and selling of already existing bonds and
stocks take place. So, the Capital Market can be divided into Bond
Market and Stock Market. Bond market provides financing by bond
issuance and bond trading. Stock market provides financing by shares
or stock issuance and by share trading. As a whole, Capital Market
facilitates rising of capital.

• Money Market: Money Market facilitates short term debt financing and
capital.

• Derivatives Market: Derivatives Market provides instruments which

help in controlling financial risk.

• Foreign Exchange Market: Foreign Exchange Market facilitates the

foreign exchange trading.

• Insurance Market: Insurance Market helps in relocation of various

risks.

• Commodity Market: Commodity Market organizes trading of

commodities

Purpose of Financial Markets

Financial Market is the place where financial securities like stocks and
bonds and commodities like valuable metals are exchanged at efficient
market prices. Here, by efficient market prices we mean the unbiased
price that reflects belief at collective speculation of all investors about the
future prospect. The trading of stocks and bonds in the Financial Market
can take place directly between buyers and sellers or by the medium of
Stock Exchange. Financial Markets can be domestic or international.

In other words a financial market is a market in which financial assets

are traded. In addition to enabling exchange of previously issued
financial assets, financial markets facilitate borrowing and lending by
facilitating the sale of newly issued financial assets.

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Asymmetric Information in Financial Markets

Asymmetric information in a market for goods, services, or assets refers to

differences ("asymmetries") between the information available to buyers
and the information available to sellers. For example, in markets for
financial assets, asymmetric information may arise between lenders
(buyers of financial assets) and borrowers (sellers of financial assets).

Problems arising in markets due to asymmetric information are typically

divided into two basic types: "adverse selection;" and "moral hazard."
This section explains these two types of problems, using financial
markets for concrete illustration.

1. Adverse Selection

Adverse selection is a problem that arises for a buyer of goods, services,

or assets when the buyer has difficulty assessing the quality of these
items in advance of purchase.

Consequently, adverse selection is a problem that arises because of

different ("asymmetric") information between a buyer and a seller before
any purchase agreement takes place.

An Illustration of Adverse Selection in Loan Markets:

In the context of a loan market, an adverse selection problem arises if the

contractual terms that a lender sets in advance in an attempt to protect
himself against the consequences of inadvertently lending to high risk
borrowers have the perverse effect of encouraging high risk borrowers to
self-select into the lender's loan applicant pool while at the same time
encouraging low risk borrowers to self-select out of this pool. In this
case, the lender's pool of loan applicants is adversely affected in the
sense that the average quality of borrowers in the pool decreases.

2. Moral Hazard

Moral hazard is said to exist in a market if, after the signing of a

purchase agreement between the buyer and seller of a good, service, or
asset:

 the seller changes his or her behavior in such a way that the
probabilities (risk calculations) used by the buyer to determine the
terms of the purchase agreement are no longer accurate;
 the buyer is only imperfectly able to monitor (observe) this change
in the seller's behavior.

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For example, a moral hazard problem arises if, after a lender purchases a
loan contract from a borrower, the borrower increases the risks originally
associated with the loan contract by investing his borrowed funds in
more risky projects than he originally reported to the lender.

Functions of Financial Markets

Financial markets serve six basic functions. These functions are briefly
listed below:

 Borrowing and Lending: Financial markets permit the transfer of

funds (purchasing power) from one agent to another for either
investment or consumption purposes.
 Price Determination: Financial markets provide vehicles by which
prices are set both for newly issued financial assets and for the
existing stock of financial assets.
 Information Aggregation and Coordination: Financial markets act as
collectors and aggregators of information about financial asset
values and the flow of funds from lenders to borrowers.
 Risk Sharing: Financial markets allow a transfer of risk from those
who undertake investments to those who provide funds for those
investments.
 Liquidity: Financial markets provide the holders of financial assets
with a chance to resell or liquidate these assets.
 Efficiency: Financial markets reduce transaction costs and
information costs.

In attempting to characterize the way financial markets operate, one

must consider both the various types of financial institutions that
participate in such markets and the various ways in which these
markets are structured.

Who are the Major Players in Financial Markets?

By definition, financial institutions are institutions that participate in

financial markets, i.e., in the creation and/or exchange of financial
assets. At present in the United States, financial institutions can be
roughly classified into the following four categories: "brokers;" "dealers;"
"investment bankers;" and "financial intermediaries."

Brokers:

A broker is a commissioned agent of a buyer (or seller) who facilitates

trade by locating a seller (or buyer) to complete the desired transaction. A
broker does not take a position in the assets he or she trades -- that is,
the broker does not maintain inventories in these assets. The profits of

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brokers are determined by the commissions they charge to the users of
their services (the buyers, the sellers, or both). Examples of brokers
include real estate brokers and stock brokers.

Dealers:

Like brokers, dealers facilitate trade by matching buyers with sellers of

assets; they do not engage in asset transformation. Unlike brokers,
however, a dealer can and does "take positions" (i.e., maintain
inventories) in the assets he or she trades that permit the dealer to sell
out of inventory rather than always having to locate sellers to match
every offer to buy. Also, unlike brokers, dealers do not receive sales
commissions. Rather, dealers make profits by buying assets at relatively
low prices and reselling them at relatively high prices (buy low - sell
high). The price at which a dealer offers to sell an asset (the "asked
price") minus the price at which a dealer offers to buy an asset (the "bid
price") is called the bid-ask spread and represents the dealer's profit
margin on the asset exchange. Real-world examples of dealers include
car dealers.

Investment Banks:

An investment bank assists in the initial sale of newly issued securities

(i.e., in IPOs = Initial Public Offerings) by engaging in a number of
different activities:

 Advice: Advising corporations on whether they should issue bonds

or stock, and, for bond issues, on the particular types of payment
schedules these securities should offer;
 Underwriting: Guaranteeing corporations a price on the securities
they offer, either individually or by having several different
investment banks form a syndicate to underwrite the issue jointly;
 Sales Assistance: Assisting in the sale of these securities to the
public.

Some of the best-known U.S. investment banking firms are Morgan

Stanley, Merrill Lynch, Salomon Brothers, First Boston Corporation, and
Goldman Sachs.

Financial Intermediaries:

Unlike brokers, dealers, and investment banks, financial intermediaries

are financial institutions that engage in financial asset transformation.
That is, financial intermediaries purchase one kind of financial asset
from borrowers -- generally some kind of long-term loan contract whose
terms are adapted to the specific circumstances of the borrower (e.g., a

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mortgage) -- and sell a different kind of financial asset to savers,
generally some kind of relatively liquid claim against the financial
intermediary (e.g., a deposit account). In addition, unlike brokers and
dealers, financial intermediaries typically hold financial assets as part of
an investment portfolio rather than as an inventory for resale. In addition
to making profits on their investment portfolios, financial intermediaries
make profits by charging relatively high interest rates to borrowers and
paying relatively low interest rates to savers.

Types of financial intermediaries include: Depository Institutions

(commercial banks, savings and loan associations, mutual savings
banks, credit unions); Contractual Savings Institutions (life insurance
companies, fire and casualty insurance companies, pension funds,
government retirement funds); and Investment Intermediaries (finance
companies, stock and bond mutual funds, money market mutual funds).

Important Caution: These four types of financial institutions are

simplified idealized classifications, and many actual financial institutions
in the fast-changing financial landscape today engage in activities that
overlap two or more of these classifications, or even to some extent fall
outside these classifications. Some might simultaneously acts as a
broker, a dealer (taking positions in certain stocks and bonds it sells), a
financial intermediary (e.g., through its provision of mutual funds), and
an investment banker.

MARKET EFFICIENCY - DEFINITION AND TESTS

What is an efficient market?

Definition of market efficiency linked up with assumptions about what

information is available to investors and reflected in the price.

 Efficient market is one where the market price is an unbiased

estimate of the true value of the investment.
 A market is efficient if scarce resources are allocated to their most
productive uses
 In efficient market buyers who are willing to pay highest price for
each resource must receive the resource they require.
 It is a market where the prices of financial instruments traded
there fully reflects all the latest information available.

Implicit in this derivation are several key concepts -

(a) Market efficiency does not require that the market price be equal to true
value at every point in time. All it requires is that errors in the market

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price be unbiased, i.e., that prices can be greater than or less than true
value, as long as these deviations are random.

(b) The fact that the deviations from true value are random implies, in a
rough sense, that there is an equal chance that stocks are under or over
valued at any point in time, and that these deviations are uncorrelated
with any observable variable.

(c) If the deviations of market price from true value are random, it follows
that no group of investors should be able to consistently find under or over
valued stocks using any investment strategy.

Efficient markets is a “market in which prices ‘fully reflect ’ available

information.” In other words, financial market prices are quite close to
their fundamental values and hence do not offer investors high expected
returns without exposing them to high risks. In a price efficient market,
prices reflect the aggregate information collected by all market
participants.

Forms of Efficient Market

There are three different forms of pricing efficiency:

(1) Weak form,
(2) Semi strong form, and
(3) Strong form
The distinctions among these forms rest in the presence of relevant
information that is believed to be taken into consideration in the pricing
of security at all times.

Weak form efficiency means that the price of the security reflects the past
price and trading history of the security. The current price reflects the
information contained in all past prices.
Semi strong-form efficiency means that the current price of the security
fully reflects not only in past prices but also all public information
(including financial statements and news reports)

Strong-form efficiency exists in a market where the price of a security

reflects all information, public as well as private, whether it is publicly
available or known only to insiders such as the firm ’s managers or
directors.

Implications of market efficiency

An immediate and direct implication of an efficient market is that no

group of investors should be able to consistently beat the market using a
common investment strategy.

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An efficient market would also carry very negative implications for many
investment strategies and actions that are taken for granted -

(a) In an efficient market, equity research and valuation would be a

costly task that provided no benefits. The odds of finding an undervalued
stock should be random (50/50). At best, the benefits from information
collection and equity research would cover the costs of doing the
research.

(b) In an efficient market, a strategy of randomly diversifying across

stocks or indexing to the market, carrying little or no information cost
and minimal execution costs, would be superior to any other strategy
that created larger information and execution costs. There would be no
value added by portfolio managers and investment strategists.

(c) In an efficient market, a strategy of minimizing trading, i.e., creating a

portfolio and not trading unless cash was needed would be superior to a
strategy that required frequent trading.

Necessary conditions for market efficiency

Markets do not become efficient automatically. It is the actions of

investors, sensing bargains and putting into effect schemes to beat the
market, that make markets efficient.

The necessary conditions for a market inefficiency to be eliminated are as

follows -

(1) The market inefficiency should provide the basis for a scheme to beat
the market and earn excess returns. For this to hold true -

(a) The asset (or assets) which is/are the source of the inefficiency has
to be traded.

(b) The transactions costs of executing the plan have to be smaller

than the expected profits from the plan.

(2) There should be profit maximizing investors who

(a) Recognize the 'potential for excess return'

(b) Can replicate to beat the market system that earns the excess
return

(c) Have the resources to trade on the stock until the inefficiency
disappears

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