Financial Institution and Market

Wollega university College of business and economics Chapter one The Financial systems in perspective Introduction .
In this chapter we are concerned with the relationship between the financial system and what is sometimes called the real economy. The real economy consists of firms, households and other agencies engaged in the production of goods and services which can either be consumed now or put to use with a view to producing more in future. This chapter explains how financial markets function and surveys different types of financial instruments and institutions involved in those markets. It also discusses the roles of financial intermediaries and the implications of automated financial trading for both domestic and world financial markets. Financial markets and institutions are part of the financial system and therefore, we need to understand the nature of financial system. In this section of the course therefore we start by introducing to the components, function and the role of the financial system in the economy. Chapter objectives : After completing this lecture, you should be able to: Define a financial system and identify its components Outline the functions of the financial system and its components Critically examine the role of the financial system in the economy. Definition Financial system is a system that aims at establishing and providing a regular, smooth, effective and efficient linkage between depositors and investors. Or Financial system is a set of complex and closely connected instructions, agents, practices, markets, transactions, claims and liabilities relating to financial aspects of an economy. Features of Financial System Financial system provides an ideal linkage between depositors and investors. It encourages savings and investment.
A lecture note on Financial Institution and Market for ppt : Compiled by Bizuneh Z.
Page 1
Financial system facilitates expansion of financial markets over space and time. Financial system promotes efficient allocation of financial resources for socially desirable and economically productive purposes.
Financial system influences both the quality and the pace of economic
development.
Financial system is concerned with the process, service, institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments. The financial systems or the financial sector(financial infrastructure) of any country consists of : a) Specialized and non-specialized institutions. b) Organized and unrecognized financial markets, and c) Financial instruments and services which facilitates the transfer of funds. NB: Procedures and practices adopted in the markets, and financial interrelationship are also part of the system. The word system, in the term financial system implies a set of closely connected or intermixed institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial systems is concerned about money, credit,, and finance- the terms intimately related yet somewhat different from each other. Money refers to the current medium of exchange or means of payment. Credit or loan is a sum of money to be returned normally with interest: it refers to a debt of economic unit. Finance is monetary resources comprising debt and ownership funds of the state, company, or person. Below figure 1.1 presents a typical structure of financial system in any country: Financial system
Financial Institutions
Financial Markets
Financial Instruments
Financial Services
1.1 Financial Market
Page 2
Financial market: is a mechanism that allows people to easily buy and sell (trade) financial securities ( such as stocks and bonds), commodities ( metal or agricultural goods), and other tangible items of value at low transaction costs and at prices that reflect the efficient market hypothesis. Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. Whereas the loans and investments of institutions are made without the direct knowledge of the suppliers of funds (savers), suppliers in the financial markets know where their funds are being lent or invested. They are important means of channeling funds from those who have excess funds (savers, lenders) to those who have a shortage (investors, borrowers). Functions of financial markets 1. Transfer of resources: Financial markets facilitate the transfer of real economic resources from lenders to ultimate borrowers. 2. Enhancing income: financial markets allow lenders earn interest /dividend on their surplus investible funds, thus contributing to the enhancement of the individual & the national income. 3. Productive usage: Financial markets allow for the productive use of the funds borrowed, thus enhancing the income & the gross national production. 4. Capital formations: financial markets provide a channel through which new savings flow to aid capital formation of a country. 5. Price determination: financial markets allow for the determination of the price of the traded financial asset through the interaction of buyers & sellers, i.e., through demand & supply. 6. Sale mechanism: financial markets provide a mechanism for selling of a financial asset by an investor so as to offer the benefits of marketability & liquidity of such assets. 7. Information: the activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market, so as to reduce the cost of transaction of financial assets. To sum up, financial markets facilitates: The raising of capital (in the capital market) International trade (in the currency market) The transfer of risk ( in the derivative market), They facilitate buying and selling of financial claims, assets, services, and securities. In financial markets funds or savings are transferred from surplus units to deficit units. and are used to match those who want capital to those who have it. Participants of financial market
A lecture note on Financial Institution and Market for ppt : Compiled by Bizuneh Z. Page 3
Participants of financial market can be grouped in to two: Lenders ( surplus unit ) ; that include individuals and corporations with capital in excess of their current requirement. Borrowers ( deficient agents); includes individuals, companies, central or local government, municipalities public corporations or institutions with different investment opportunities ( expansion, replacement, additions or making new investment), but lack adequate internal capital to finance their investment.
Lenders (surplus unit) Individual lenders: A person lends money when he/she puts money in a saving account at a bank; contributes in a pension plan; pays premiums to an insurance company; invest in a government bonds; or invest in a company shares. Companies lenders: have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term market called money market. Borrowers ( deficient unit) Individual borrowers: borrow money via bankers loans for short term needs or longer term mortgage to help finance a house purchases. Government borrowers: borrow to make their deficit and to on behalf of nationalized industries, local authorities, municipalities and other public sectors. Municipalities and local authorities: may borrow in their own name as well as receiving fund from national governments. Public corporations : these may include governmental owned service providers with customer charging basis: such as, public enterprise , utility companies ---etc.
Thus, without financial markets, borrowers (deficient unit) have difficulty findings lenders (surplus unit) themselves. A financial market may or may not have a particular physical existence.
Classification/ Types of Financial Market Different financial markets serve different types of customers or different parts of the economic sector . Financial markets also vary depending on the maturity of the securities being traded and the types of assets used to back the securities. Financial markets can be classified based on
different ways. For these reasons it is often useful to classify markets along the following dimensions: Following are some classification of financial markets: 1. Classifications by types of financial claim A. Equity (stock) market : deals with variable income securities B. Bond (debt) market: deals with fixed income securities 2. Classifications by maturity date (period) A. Money market; which provides short term debt financing and investment. B. Capital market: the market for debt and equity instruments with a maturity of more than one year. 3. Classification by time of delivery A. Spot market: ( market for immediate delivery) B. Future/forward market: ( a market after certain time in the future) 4. Classifications by origin A. Primary market: markets dealing with financial assets that are issued for first time (deals with newly issued securities). B. Secondary market: markets deals with previously issued financial instruments. 5. Classification by organizational structure: A. Auction market: market on the floor of stock exchange B. Over-the counter (OTC) market : market by interconnected computers. That is, it does not denote a particular place where dealers assemble and transact securities .
6. Other classifications: A. Commodity market: which facilitates the trading of commodities ( agricultural and industrial products; such as precious metals) a B. Foreign exchange market: which facilitate the trading of foreign currency. C. Derivatives market: which provides instruments or the management of financial market. Primary Vs Secondary market 1. Primary Market Primary market is a market in which newly-issued securities are sold to initial buyers by the corporation or government borrowing the funds. Securities available for the first time are offered through the primary market. That is, in the primary market, companies interact with investors directly while in the secondary market investors interact with themselves.
Page 5
The securities offered may be a new type for the issuer or additional amounts of a security used frequently in the past. The company receives the money and issues new security certificates to the investors. The traditional middleman in the primary market is called an investment banker. Investment banking firms play an important role in many primary market transactions by underwriting securities: they guarantee a price for a corporations securities and then sell those securities to the public.
That is, it buys the new issue form the issuer at an agreed upon price and hopes to resell it to the investing public at a higher price. Usually, a group of investment bankers joins to underwrite a security offering and form what is called an underwriting syndicate. Companies raise new capital in the primary market through: a) Public issues ( initial public offering) or IPO b) Right issue c) Private placement
In public issue/ offering: The will be established companies sell directly securities to the general public. To all individuals and institutions.
new
In right issue: Offering of securities may be made only to the existing shareholders. Thus, when securities are offered only to the companys existing shareholders, it is called right issue.
Private placement: Instead of public issue of securities, a company may offer securities privately only to a few selected investors. This is referred to as private placement. The investment bankers may act as a finder, that is, he locates the institutional buyer for a fee.
2. Secondary Market The secondary market is also known as, the aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds options, are bought and sold (traded). Secondary market is a market where already issued or existing or outstanding financial assets are traded among investors In the secondary market the issuer of the asset does not receive funds from the buyer unlike primary market.
Page 6
Rather, the existing issue changes hands and funds flow from the buyer of the asset to the seller in secondary market.
Function of secondary Market In short it has the following are economic functions of secondary market both for the issuer and investors : Benefits to the issuers Provides regular information about the value of the security. For example, higher value of shares indicates- higher goodwill (public image) from the investors point of view, good management of funds raised from earlier primary markets by the firm. Help determining fair prices based on demand and supply forces and all available information. Benefits to investors ( buyers) or security holders. Secondary market offer them high liquidity for their assets as well as information about their assets fair market values. They can sell their shares at readily available market. Provide easy marketability and liquidity for investors It helps investors feel confidence that they can shift from one financial asset to another. Thus, by keeping the cost of both searching & transaction costs low, secondary market encourages investors to purchases financial assets. Money and Capital Markets Another way of distinguishing between financial markets is on the basis of the maturity of the securities traded in each market. The money market is a financial market in which only shortterm debt instruments (maturity of less than one year) are traded; the capital market is the market in which long-term debt (maturity of one year or greater) and equity Instruments are traded. Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid.
Money Market A lecture note on Financial Institution and Market for ppt : Compiled by Bizuneh Z. Page 7
The money market is where short-term obligations such as treasury bills ( TB), commercial paper, bankers acceptanceetc are bought and sold.
Participants borrow and lend for short periods of time, typically up to one year. Money market is the term designed to include the financial institutions which handle the purchase, sale & transfers of short term credit instruments.
It includes the entire machinery for the channelizing of short term funds.
Characteristics of money market The general characteristics of a money market are given below: 1. Short term funds are borrowed & lent 2. No fixed place for conduct of operations, the transaction being conducted even over the prone & therefore there is an essential need for the presence of well developed communications system. 3. Dealings may be conducted with or with out the help of brokers. 4. Funds are traded for a maximum period of one year. Money market instruments A. Commercial paper market Commercial paper is a debt instrument that are issued by well known, high creditworthy corporations for raising short term financial resources from money market.
Characteristics of CP They are unsecured debts of corporate. They are issued in the form of promissory notes. They are redeemable at par to the holder at maturity, i.e., they are issued at discount to face value. They are issued by top rated corporate (credit worthy companies) . The marketability of the CPs is influenced by the rates prevailing in the call money market & the foreign exchange market, i.e., attractive rates in call money market affects the demand of CPs. B. Certificate of Deposits (CD) market
Page 8
Certificate of deposit is a financial document showing that a person or organization has a specified sum on deposit at a bank, usually for a specific period, at special interest rate.
Is a time deposit with bank.
Features of CD Negotiable instrument: CDs are negotiable time deposit certificate issued by commercial banks /financial institution at discount. Maturity: They have a specified maturity date. The maturity period of CDs ranges from 15 days to one year. C. Treasury bill markets TB is a financial document /promissory note issued by the government under discount for a fixed period, not exceeding one year. or It is a short term obligation issued by the government sold at a discount from its face value & redeemed of its face value upon maturity.
Features of TB 1. Issuer: it is issued by the government for raisings short term funds for bridging temporary gaps between revenue and expenditure. 2. Liquidity: it enjoys high degree of liquidity Monetary Mgt: TBs serve as an important tool of monetary management used by the central bank of the country to influence liquidity in to the economy. D. Repurchase Agreement (Repo or RP) RP is an agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price and on a specific date in the future. Individuals or firms with temporary idle or excess capital buy short term securities. ( eg. T-bills ) from their banks in order to earn small return until the money is needed . the bank then agrees to repurchase the T- bills in the future at a higher price.
Debt and Equity Markets
One way of classifying financial markets is based on the type of claim associated with the fund
transferred through the transaction in that market. Accordingly, if the transaction represents a mere borrowing and does not give ownership title to the buyer of the security the market is termed as debt market. A firm may for example raise fund by issuing a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The buyer of the debt instrument will then will get his money with some return. In cases of loss or bankruptcy, he will have first claim over the assets of the firm. I.e, if the firm that issues the instrument went bankrupt and could not pay its debt, the holder of the instrument has the right to enforce the firm to liquidate its assets and get his money. On the other hand, the holder of the instrument will not have ownership title over the firm and hence his return will not depend on the profitability of the firm. But, if the transaction gives ownership title to the buyer of the instrument, the market is termed as equity market. In this case, the buyer of the financial asset will be one of the owners of the firm and unlike in the case of debt market he will not expect a predetermined return. He will rather expect to get a series returns in terms of dividend and capital gain. Thus, unlike the buyer of a debt instrument, his return will depend on the profitability of the firm and in case of bankruptcy he will have a residual claim like the other owners of the firm. Spot and Future (option) markets: Financial markets can also be classified based on the timing of the contract and the transaction. Spot markets are markets where the transaction is made at the time of lag-on the spot. For example, if we consider a spot foreign exchange market, the exchange will be made at the time of agreement except for some short time lag in delivery like hours or few days. While future markets are markets where the transaction is made in a future time specified in the contract. They are markets where future contracts are traded. Future contracts are contracts which are agreements to deliver items on a specified future date at a price specified today but not paid until delivery. To use the same example of a foreign exchange market, a buyer and a seller may agree today to transact a foreign currency after some time say three months at rate they fix now. Future markets are important to avoid risk arising from fluctuations in the spot market. Open outcry and over-the- counter (OTC ) Market. The other classifications of financial market can be made on the basis of trading locations.
Accordingly, the following are the two major classifications. Open outcry market: some transactions are carried out on a trading floor, by a method known as open outcry. This type of auction is used in stock exchange and commodity exchanges where traders may enter verbal bids and offers simultaneously. Over the Counter (OTC) : The other types of stock exchange is a virtual kind, composed of a network of computers where traders are made electronically via traders.
Foreign Exchange Market (FOREX) Market Different countries have different currencies and the settlement of all business transactions with in a country is done in the local currency. The foreign exchange market provides a forum where the currency of one country is traded for the currency of another country. Example, suppose an Ethiopian importer import goods from the USA and has to make payments in US Dollars. To do so, an Ethiopian importer has to purchase US Dollars in the foreign exchange market and pay to US firm. Therefore, the foreign exchange market is a market where foreign currencies are bought and sold. Since foreign exchange market deals with a large volume of funds as well as a large number of currencies (belonging to various countries), it is not only world wide market but also the worlds largest financial market.
Major Participants in foreign exchange market The participants in the foreign exchange market are: 1. Individuals 2. firms 3. banks 4. governments 5. occasionally international agencies Individuals: are normally the tourists who exchange the currencies, as also migrants sending a part of their income to their family members living in their home countries.
Page 11
The firms: are generally the importers and exporters. An exporter prefers to get the payment in its own currencies or in a strong convertible currency. Importers need foreign exchange for making payments for their import.
Banks: When firms and individual approaches the local branch of a bank, the local branch in turn approaches the foreign exchange department in its head office. Government: Though it is a fact that commercial banks dominate, the government or monetary authorities too participate in the foreign exchange market but to help stabilize the value of domestic currencies.
International agencies: They buy and sell foreign currencies in the foreign exchange market, but that is not a routine affairs.
1.2 Financial Institutions

Direct funds transfers are more common among individuals and small businesses, and in economies where financial markets and institutions are less developed. While businesses in more developed economies do occasionally rely on direct transfers, they generally find it more efficient to enlist the services of one or more financial institutions when it comes time to raise capital. Financial institutions are business organizations that provides savings and financing opportunities. Financial institutions are business organizations that act as mobilizes and depositories of savings and as purveyors of credit or finance. They also provides various financial services to the community. They differ from non-financial ( industrial and commercial) business organizations in respect of their wares, I,e., while the former deals in financial assets such as deposits,. Loans securities and so on, the latter deal in real assets such as machinery, equipment, real estate and so on. The activities of different financial institutions may be either specialized or they may overlap; quite often they overlap. Yet, we need to classify the financial institutions and this is done on such basis as their primary activity or degree of their specializations with relations to savers or borrowers with whom they customarily deal or the manner of their creations. In other word, the functional, geographical, sectoral scope of activity or the type of ownership are some of the criteria large number and variety of financial institutions which exist in the economy. However, it should be kept in mind that such classifications is likely to be imperfect and tentative.
Classification of financial institutions.
Financial intermediaries serve to reduce problems associated with asymmetric information in financial transactions. Asymmetric information can lead to potential problems stemming from adverse selection and moral hazard. Financial intermediaries may also allow savers to benefit from economies of scale as a result of lower average costs of fund management.
Page 12
Thus, financial institutions act as a channel through which scattered savings are collected and then invested in business firms. These institutions may broadly be divided in to there categories, namely ,depository institutions, contractual savings institutions, and investment intermediaries.
Depository institutions
Depository institutions are financial intermediaries that accept deposits from individuals and institutions and make loans. These intuitions include commercial banks, savings and loan associations, microfinance institutions and credit unions. They are unique from the other intermediaries in that they are directly engaged in accepting deposit and channeling it to others.
Contractual Savings Institutions /non-bank thrift institutions /

Contractual Savings Institutions are financial intermediaries that acquire funds at periodic intervals on a contractual basis. This group of financial intermediaries includes different insurance companies and pension funds. Their main purpose is giving different services (insurance and pension services). But, they are also important financial intermediaries because they raise huge fund which they channel to investors in different ways.
Investment Intermediaries
This group of financial intermediaries includes investment banks, security brokers and mutual funds which are involved in the purchase and sale of different securities such as bonds and stocks. One of their functions is to help firms issue and sell securities. They advise investors about their portfolio choice and pricing of different securities. They also serve as security traders by arranging traders among borrowers and lenders. Besides, they acquire funds by issuing and selling different securities and use the funds so raised to purchase diversified portfolio of securities. The other classification of financial institutions can be made as formal financial institutions, semi-formal financial institutions and informal financial institutions. Formal financial institutions are those that are subject not only to general laws and regulations, but also to specific regulations and supervisions. Their operations where under a direct supervision of central bank. Includes Development banks ( both private and public) Commercial banks ( both public and private)
Page 13
Saving banks Non- bank financial intermediaries ( insurance companies, investment companies ..etc)
Semi formal institutions are those that are formal in the sense of being registered entities subject to all relevant laws, including the commercial laws, but informal insofar as they are, with few exceptions, not under the bank regulations and supervisions. Includes: Credit unions Multipurpose cooperatives Self help associations ( such as Ikub Idir)
For example semi-formal financial institutions are: Free to set their own interest rate Free from minimum capital requirement , unlike banks. Their operations are not subject to direct supervision of national (central ) bank. Informal Financial providers ( generally not referred to as institutions) are those to which neither special bank law, nor general commercial law applies, and whose operations are also so informal that disputes arising from contract with them often cannot be settled by recourse to the legal system. Informal providers consists of : Individual money lenders Traders, land lords, Families, friends----etc. Role of financial institutions The most important role of financial institutions is to assist in the transfer of funds from surplus agents to deficit agents to deficit agents. In assisting this process a financial intermediary undertakes several economic functions. The provision of a payment mechanism Maturity transformations Risk transformations Liquidity provision Reduction of transactions, information and search costs. I. Provision of payment mechanism
Page 14
Financial intermediaries, especially commercial banks, facilitate the payments of funds by non cash measures such as; cheques, credit cards, electronic transfer, letter of creditetc. An effective payment system is essential to the health of a modern economy among domestic agents and between domestic and foreign agents. II. Maturity transformation role.
Surplus agents typically wish to have their surplus funds redeemable at short notice, and deficit agents ( investors) wish to borrow funds over long term horizon. Thus, financial intermediaries, such as a commercial banks, accepts investors fund on a short term basis and channel these funds to long-term borrowers. The process of converting short term liabilities (deposits) into long-term assets (loan) is known as maturity transformations.
III.
Risk diversification role
Surplus agents needs complete protection for their capital. On the other hand , borrowers needs capital to finance in risky investment projects. Thus the demand of these two agents contradict each other. If a surplus agent lends directly to a deficit agent, this would leave them heavily exposed to the risk of default by the deficit agent. Financial intermediaries can play an important part in transforming the low risk requirement of savers into meeting the risk- finance requirement of firms. Thus, a financial intermediaries that receives funds from many surplus agents can pool these funds lend to a large number of deficit agents. (diversification) . Financial intermediaries mitigate several types of risk. First, bank take deposits from many people and make thousands of loans with these deposits. Thus, each depositor faces only a small amount of the risk associated with loans that would go default. No one depositor losses all there assets when a bank loan goes unpaid. Banks also provide a low-cost way for depositors to diversify their investments. Mutual fund companies off small investors a way to purchase a diversified portfolio of several different stocks. IV. Liquidity role
Liquidity refers to the ease with which an asset can be converted into cash. Surplus agents would not be willing to hold the financial assets (bonds or shares) unless they have the ability
to sell them at short notice at fair market place. Thus, deposit taking institutions are therefore able to ensure liquidity provision without maintaining large balances in relation to total deposits. V. Reduction of contracting, search and information costs role
The cost of acquiring and processing the information about the borrower ( known as information processing costs) must be considered when you lend money. The cost of loan contracts are referred to as contracting cost. In addition cost of contracting, the ability, and cost of enforcing the terms of loan agreements should also be considered by lenders. Most surplus agents lack the time, skill and resources to find and analysis prospective deficit agents and draw up and enforce the necessary legal contracts. Financial institutions such as banks, provides cost effective intermediations; financial intermediations benefits from considerable economies o scale, because they are looking for many prospective investment opportunities, they can devote resources to recruiting and training high quality staff to assist in the process of finding suitable deficit agents. They draw up more standardized contract or they can recruit legal counsel as part of professional staff to write contract involving more complex transactions. The two potential credit cost necessarily incurred by the lenders (surplus agent) and which is eliminated by financial intermediations is cost of analyzing credit worthiness of borrowers and cost of developing contract ( stationary, witness perdiumetc)
1.3 Financial Instruments

Financial security or financial assets is simply a legal claim to a future cash flows. Or
Financial Assets: Are assets that are dealt in a financial market, that include deposits and loans, corporate stocks and bonds, government bonds, and other instruments or
Financial instruments are documents that have a monetary value or evidence a legal enforceable (binding) agreement between two or more parties regarding a right to payment of money. Financial instruments are often called financial securities, financial assets, or financial claims.
Financial instruments are promissory notes that represent the transfer of fund from one party to another. They are also termed as financial assets or securities. They are traded in financial markets. When a firm wants to raise a fund it may issue a financial instrument and sell. The buyer will pay money to the seller of the financial instrument and will in turn get the instrument with a promise that he will get him money back with some positive return. Financial instruments are Written legal obligation of a transfer of something of value from one party to another party at some future time under certain conditions. Let's break this definition down into four parts: 1. Legal Obligation: Financial Instruments are backed by government rules and regulations. If you violate the agreement set forth in an instrument, you are subject to legal penalties. 2. Transfer something of value from one party to another: Typically a financial instrument will dictate the payments of money from one person/ firm to the other. 3. At some future date: So instruments will have a time dimension tied to them. My student loans require a monthly payment for the next years. The instrument will be specific on when money changes hands. 4. Under specific conditions: Some instruments will have rules on when money is to be transferred. The simplest example is that of insurance. The insurance company will pay a claim only under certain conditions. Broadly speaking, There are two general distinct types of financial instruments- debt claim and equity claims. With a debt claim the holder ( investor) has a predetermined cash claims via a rate of interest charged are often be fixed. On the contrary, with equity claim the holder (investor) are entitled an ownership right of the future earning and also entitled a variable cash payment in the form of dividends , such as common stock. Many financial instruments are a mixture of debt and equity such as preference share. Some financial instruments are discussed below: Treasury Bills: are shot term debt instruments issued by governments to finance budget deficits. They pay a predetermined amount at maturity and have not interest payment, but they effectively pay interest by initially selling at a discount, that is, at a price lower than the set amount at the maturity. Stocks: are equity claims on the net income and assets of a corporation. They are issued by corporate firms to raise fund. The buyers of stock become owners of the company. Typically there are two class of stock; common stock and preferred stock.
a. Common Stock: It entitles the investor to receive dividends distributed by a company. Investors have a claim to a pro rata share of the net assets value of a company in case of liquidation. Common stock can also be known as residual claim. i.e., it obligates the issuer of the financial assets to pay the holder an amount based on earnings, if any, after holder of debt instruments have been paid. Pros and cons of Common Shares Equity capital is the most important long term source of financing. It offers the following advantage. 1. Permanent Capital: Since ordinary shares are not redeemable, the company has no liability for cash out flow associated with its redemption. 2. Borrowing base: Lenders generally lend in proportion to the company's equity capital. By issuing ordinary shares, the company increases its financial capabilities because it can borrow additional funds. Thus, the amount of equity capital increases the borrowing limit of a company. 3. Dividend Payment Discretion: A company is not legally obliged to pay dividend. In times of financial difficulties, it can reduce or suspend payment of dividend. Thus, it can avoid cash outflow associated with ordinary share.
Common stock has the following limitation: 1. Cost: Equity capitals have a higher cost at least for two reasons; a. Dividends are not tax deductible as an interest payment. b. Flotation costs on ordinary shares are higher than those on debt. 2. Risk: Equity shares are riskier from investors' point of view as there is uncertainty regarding dividend and capital gains. Therefore, the equity holders require a relatively higher rate of return. 3. Earnings dilution: The issue of new ordinary shares dilute the existing shareholders' earning per share if the profit is not increase in equal proportion with the increase in number of ordinary shares.
Page 18
4. Ownership dilution: The issuance of new ordinary shares may dilute the ownership and control of the existing shareholders. That means the issuance of ordinary shares can change the ownership.
B. Preference Shares A preference share is often considered to be a hybrid security since it has many features of both ordinary shares and debentures. It is similar with ordinary share in: 1. The non- payment of dividend does not force the company to insolvency. 2. Dividends are not deductible for tax purpose. 3. In some cases, it has no fixed maturity date. It is similar with debenture (bond) in: 1. Dividend rate is fixed. 2. Preference shareholders have claims on income and assets prior to ordinary shareholders. 3. They do not share in the residual earnings. 4. They do not have voting rights. Features of preference share: 1. Claims on income and assets: Preference shares are a senior security as compared to ordinary shares. It has prior claim on the company's income in the event of distribution dividend and prior claim on assets in case of liquidation. 2. Fixed dividend: The amount of preference dividend is fixed. That is, it will be equal to the dividend rate multiplied by the par value. 3. Cumulative dividend: Preference shares are requiring that all past unpaid preference dividend be paid before any ordinary dividends are paid. This feature is a protective device for preference shareholders. Pros and cons of Preference shares Preference shares have been providing the following advantages: 1. Risk less leverage advantage: Preference share provides financial leverage advantages since preference dividend is a fixed obligation. This advantage occurs without a series risk of default. The non-payment of preference dividend does not force the company into insolvency.
2. Dividend postponability: Since preference shares can postpone payment of dividend, it provides some financial flexibility to the company. 3. Fixed dividend: The preference dividend payments are restricted to the stated amount. Shareholders do not participate in excess profit as do the ordinary shareholders. 4. Limited voting rights: Preference shareholders do not have voting rights except in case of dividend arrears exist.
Preference shares have the following limitations: 1. Commitment to pay dividend: Preference dividend can not be omitted, they have to be paid because of their cumulative nature. 2. Non-deductibility of dividend: Preference dividend is not tax deductible. Thus, it is costlier than debenture. Mortgages: are loans to households or firms to purchase housing, land or other fixed assets where the asset itself serves as collateral for the loans. Bonds: are instruments that represent loan and may be issued by firms or governments. They pay interest unlike treasury bills. Bank Loans: These are loans to consumers and businesses made by banks. In the case of consumers they are given for the purchase of consumer durables like house. Certificates of Deposit: Are certificates or books issued by banks certifying that the holder has deposited some money in the bank. Saving deposits are good examples. Cheques: Are papers issued by banks and given to depository who have checking accounts at the banks. They allow the holder to make transactions by writing them. 1.4 Financial Services Financial services comprise of various functions and services that are provided by financial institutions in a financial system. Eg. Leasing, factoring, underwriting, depository, housing finance etc. Financial service can be defined as the product and service offered by institutions like banks of various kinds for the facilitations of various financial transactions and other related activities in the world of finance like loans, insurance, credit cards, investment opportunities, and money
Page 20
management ( saving) as well as providing information on the stock market and other issues like market trends. The following are some of financial services ; Banking and other financial services ( excluding insurance) I. II. Acceptance of deposit and other payable funds from the public; Lending of all types, including consumers credit, mortgage credit, factoring and financing of commercial transactions. III. IV. Financial leasing All payment and money transmissions services, including credit card, travelers cheques and bankers draft. V. Trading from own account or for accounts of customers, whether on exchange, in an over-the-counter market or otherwise, the following. A. Money market instrument ( including cheques, bills, certificates of deposit). B. Foreign exchange C. Transferable securities D. Other negotiable instruments and financial assets. Insurance and insurance -related services VI. Direct insurance ( including co- insurance) A. Life, and B. Non-life VII. VIII. IX. Reinsurance and retrocession; Insurance intermediation, such as brokerage and agency. Service auxiliary to insurance, such as consultancy, actuarial, risk assessment and claim settlement services.
Page 21

Financial Institution and Market

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Institution and Market

Uploaded by

Copyright:

Available Formats

Wollega university College of business and economics Chapter one The Financial systems in perspective Introduction .

1.1 Financial Market

Is a time deposit with bank.

Debt and Equity Markets

1.2 Financial Institutions

Contractual Savings Institutions /non-bank thrift institutions /

Risk diversification role

1.3 Financial Instruments

You might also like