Chapter Two

THE ROLE OF
FINANCIAL MARKETS

Mohammed Sohail Mustafa

Chapter Outline
2

An Overview of Financial System.

The Financial Market.
The Financial Institutions.
The Financial Instruments.
The Real VS The Nominal Interest Rates.

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An Overview of Financial System

3

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What is Financial System

4

According to Franklin Allen and Douglas Gale in Comparing

Financial Systems:
Financial systems are crucial to the allocation of resources
in a modern economy. They channel household savings to
the corporate sector and allocate investment funds among
firms; they allow intertemporal smoothing of consumption
by households and expenditures by firms; and they enable
households and firms to share risks. These functions are
common to the financial systems of most developed
economies. Yet the form of these
financial systems varies
widely.
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Financial System of Bangladesh

5

The Formal Sector includes all regulated institutions like Banks, NonBank Financial Institutions (FIs), Insurance Companies, Capital
Market Intermediaries like Brokerage Houses, Merchant Banks etc.;
Micro Finance Institutions (MFIs).
2. The Semi Formal Sector includes those institutions which are
regulated otherwise but do not fall under the jurisdiction of Central
Bank, Insurance Authority, Securities and Exchange Commission or
any other enacted financial regulator. This sector is mainly
represented by Specialized Financial Institutions like House Building
Finance Corporation (HBFC), Palli Karma Sahayak Foundation
(PKSF), Samabay Bank, Grameen Bank etc., Non Governmental
Organizations (NGOs and discrete government programs.
3. The Informal Sector includes private intermediaries which are
completely unregulated.
1.

Mohammed Sohail Mustafa

The Financial Market

7

A financial market is a market in which people and entities can

trade financial securities, commodities, and other fungible

items of value at low transaction costs and at prices that reflect
supply and demand. Securities include stocks and bonds, and
commodities include precious metals or agricultural goods. In
finance, financial markets facilitate:

The raising of capital (in the capital markets)

The transfer of risk (in the derivatives markets)
Price discovery
Global transactions with integration of financial markets
The transfer of liquidity (in the money markets)
International trade (in the currency markets)

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The Financial Market

8

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Role of Financial Market

9

Saving mobilization
Investment
National Growth
Entrepreneurship growth
Industrial development

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Who are the Major Players in Financial

Markets?
10

Dealers.
Brokers.
Investment Banks.
Financial Intermediaries.

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What Types of Financial Market Structures

Exist?
11

Auction Markets conducted through brokers;

Over-the-counter (OTC) markets conducted through dealers;
Organized Exchanges, such as the New York Stock Exchange,

which combine auction and OTC market features. Specifically,

organized exchanges permit buyers and sellers to trade with each
other in a centralized location, like an auction. However, securities
are traded on the floor of the exchange with the help of specialist
traders who combine broker and dealer functions. The specialists
broker trades but also stand ready to buy and sell stocks from
personal inventories if buy and sell orders do not match up.
Intermediation financial markets conducted through financial
intermediaries;

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The Structure of Financial Market

12

Primary market
Secondary market
Money market
Capital market
Debt market
Euro Bond market.
Equity markets
Financial service market
Depository markets
Non-Depository market
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Asymmetric Information in Financial

Markets
13

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.
Two types of problems usually arise:
Adverse

selection.
Moral hazard.

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The Financial Institutions

14

In financial economics, a financial institution is an institution that provides

financial services for its clients or members. Probably the most important
financial service provided by financial institutions is acting as financial
intermediaries. Most financial institutions are regulated by the government.
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The Financial Institutionscontd.

15

Broadly speaking, there are three major types of

financial institutions:

Depositary Institutions : Deposit-taking institutions that

accept and manage deposits and make loans, including banks,
building societies, credit unions, trust companies, and
mortgage loan companies
Contractual Institutions : Insurance companies and pension
funds; and
Investment Institutes: [Investment Banks - Underwriting
underwriters], [Security Firms -Broker].

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The Financial Instruments

16

A financial instrument is the written legal obligation of one

party to transfer something of value usually money to

another party at some future date, under certain
conditions, such as stocks, loans, or insurance. According
to IAS 32 and 39, it is defined as 'any contract that gives
rise to a financial asset of one entity and a financial liability
or equity instrument of another entity'. Characteristics of
Financial Instruments
Standardization
Communicate Information

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Instrument Type

Asset
Class
Securities

Debt (Long Term>

Bonds
1 Year)
Debt (Short
Term < 1 Year)
Equity
Foreign
Exchange

Other
cash

Loans

Exchangetraded
derivatives
Bond Futures
Options on Bond
Futures

OTC derivatives
Interest Rate Swaps.
Interest Rate Caps & Floors.
Interest Rate Options.
Exotic Instruments.

T-Bills.
Commercial
Paper,

Deposit.
CD.

Short-term
interest rate
futures.

Forward rate agreement.

Stock.

N/A

Stock Options.
Equity Futures.

Stock Options.
Exotic Instruments.

N/A

Spot
Foreign
Exchange.

Currency Futures.

Foreign exchange
options.
Outright forwards.
Foreign exchange swaps.
Currency swaps..

Measuring Financial Instrument's Gain or

Loss
18

Categories
Instrumen
t Type

Measureme
nt

Gains and losses

Net income when asset is

derecognized or impaired
(foreign
exchange
and
impairment recognized in net
income immediately)

Assets

Loans and
receivables

Amortized
costs

Assets

Available for
sale financial
assets

Other comprehensive income

Deposit accou
(impairment recognized in
nt
net income immediately)
- Fair value

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Value of Financial Instruments

19

Size the promised payment. (Face Value)

When the payment will be received. (Maturity)
The likelihood the payment will be made (risk).
The conditions under which the payment will be

made. (Prerogatives)

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The Real VS Nominal Interest Rates

20

The "Real Interest Rate" is the rate of interest an investor

expects to receive after allowing for inflation. It can be described

more formally by the Fisher equation, which states that the real
interest rate is approximately the nominal interest rate minus
the inflation rate.
In finance and economics, Nominal Interest Rate or nominal
rate of interest refers to two distinct things: the rate of interest
before adjustment for inflation (in contrast with the real interest
rate); or, for interest rates "as stated" without adjustment for the
full effect of compounding (also referred to as the nominal
annual rate). An interest rate is called nominal if the frequency
of compounding (e.g. a month) is not identical to the basic time
unit (normally a year).
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Fisher Equation
21

The relation between real and nominal interest rates and the expected
inflation rate is given by the Fisher equation:

Where
i= nominal interest rate;
r= real interest rate;
E(I)= expected inflation rate.

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Self-Test Questions
22

What is Financial System? Briefly explain the financial system of

Bangladesh.
2.
What are the roles & functions of Financial Market in an economy?
3.
Who are the major players in financial markets?
4.
What types of financial market structure exist?
5.
What are the uses of asymmetric information in financial market?
6.
What roles financial institutions play in facilitating the flow of funds
in the entire economy?
7.
What are the characteristics of Financial Instruments?
8.
What are the factors to be considered in valuing a financial
instrument?
9.
Briefly explain the different types of financial instruments.
10. Differentiate between Real rate of interest & Nominal rate of
interest.
1.

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