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CHAPTER 1:

INTRODUCTION TO
FINANCIAL MARKETS
AND INSTITUTIONS

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INTRODUCTION
 General concept of financial markets and
institutions
 The role and importance of financial
markets and institutions
 Financial markets and institutions in
Malaysia

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Learning objectives
 Students will be able to:
◦ Explain the definition and the importance of
financial markets and institutions
◦ Identify the financial landscape in Malaysia
◦ Discuss the role and evolution of financial
system in Malaysia

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Glossary
 Assets: anything owned by a person or business that has a
market value
 Liabilities: a legally enforceable claim on the assets of a
business or individual
 Financial instruments/ financial securities/ financial assets: claims
that those who lend their savings have on the borrowers
who use those funds for investments: ie. bond., stocks, etc
 Debt: refers to something owned by one party (borrower) to
a second party (lender); a contractual claim, usually paying
dollar amounts (interest); repayment= principal + interest
 Shareholder’s equity: the portion of the balance sheet that
represents the capital received from investors in exchange of
stocks + retained earnings; income = a residual claim on
earnings after creditors are satisfied (dividend)

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 Liquidity: the ease with which an asset can be sold or
redeemed for a known amount of cash at shirt notice
and at low risk of loss of nominal value
 Consumption: the real amount of spending by
households on good and services.
 Production: process of combining various inputs to
produce output, services and goods which have value
and contributes to the utility of individuals
 Wealth: an individual’s total resources
 Financial intermediation: indirect finance through the
services of a financial institutions (middleman) that
channels funds from savers to those who ultimately
make capital investments.
 Maturity : the time until final principal and interest
payments are due to the holders of a financial
instruments.
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Financial system
=
 Financial markets (ie: equity market, bond
market, derivatives market, money market,
foreign exchange market etc.)
+
 Financial institutions (ie: banking institutions
[commercial banks, Islamic banks,
investment banks]; non-bank financial
intermediaries [NBFIs] etc.)
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Why study Financial Markets & Institutions?

 To examine how financial markets and


institutions work in the financial system.
 The working of FMI would affect everyday
daily life, behavior of customers, businesses
activities & profits, production of goods &
services and economic well-being
 To study the unique role of each FMI in the
financial system and their contributions in
the economy.

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Financial markets
 Definitions:
◦ A financial market is a market in which
financial assets (securities) such as stocks and
bonds can be purchased or sold.
◦ Financial market – markets in which funds are
transferred from people who have an excess
of available funds (surplus units) to people
who have a shortage of funds (deficit units)
◦ A market for the exchange of capital and
credit.

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Financial markets

 In finance, financial markets facilitate (role):


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)
– and are used to match those who want capital to
those who have it.

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Financial Markets

 Financial markets are structures through


which funds flow
 Financial markets can be distinguished
along two dimensions
◦ primary versus secondary markets
◦ money versus capital markets

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Primary versus Secondary Markets

 Primary markets
◦ markets in which users of funds (e.g.,
corporations and governments) raise funds by
issuing NEW financial instruments (e.g., stocks
and bonds)
 Secondary markets
markets where EXISTING financial
instruments are traded among investors (e.g.,
NYSE, Nasdaq & Bursa Malaysia)

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PRIMARY MARKETS VS SECONDARY MARKETS

PRIMARY MARKETS SECONDARY


MARKETS
- facilitate the issuance of - facilitate the issuance of
new securities existing securities
-participants: issuers & -participants: trading among
investors investors
-provide funds to the -funds flows among
issuers investors
- Low liquidity -high liquidity
-example: IPO,s SEOs -subsequent trading of
financial securities.
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Money versus Capital Markets

 Money markets
◦ markets that trade debt securities with
maturities of one year or less (e.g., Certificate
of Deposits and Treasury bills)
 Capital markets
◦ markets that trade debt (bonds) and equity
(stock) instruments with maturities of more
than one year

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Securities Traded in Financial Markets

1. Money Market Securities:


a. Treasury bills
b. Banker’s acceptance
c. Negotiable certificate of deposits (NCDs)
2. Capital Market Securities
a. Bonds
b. Mortgages and mortgage-backed securities
c. Stocks
3. Derivative Securities.
a. Speculation using an underlying asset
b. Risk management and hedging

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The importance of financial market

 Financial markets are crucial to promoting


greater economic efficiency by channeling
funds from people who do not have a
productive use for them to those who do
 Well functioning financial markets are a
key factor in producing high economic
growth, and poorly performing financial
markets is one of the reasons why a
country remaining poor

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Function of Financial Markets

1. Surplus units: participants who receive more money


than they spend such as investors-MORE MONEY

2. Deficit units: participants who spend more money


than they receive, such as borrowers-LESS MONEY

3. Securities: claims on issuers


a. Debt securities
b. Equity securities

4. Function: To link the surplus units and deficit units


through the issuance of securities.

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Financial Institutions (FIs)

 Financial Institutions
◦ institutions through which suppliers channel
money to users of funds
◦ Assisting in financial transactions
 Financial Institutions are
distinguished by whether they
accept deposits
◦ depository versus non-depository financial
institutions

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Depository versus Non-Depository FIs

 Depository institutions
◦ commercial banks, savings associations, savings
banks, credit unions
◦ They are legally allowed to accept deposits from
customers
◦ Importance role in economy: transform deposits
into loans
 Non-depository institutions
◦ insurance companies, securities firms and
investment banks, mutual funds, pension funds
◦ They are legally not allowed to accept deposits
from customers

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The role of financial institutions
 Who make financial markets work:
-They are the players in the financial markets
-They facilitate activities in the financial markets
 Improve the market efficiency of the economy:
market efficiency is when the security prices fully
reflect all available information
 When market is inefficient, investors can use
available information ignored by the market to
earn abnormally high returns on their
investments.

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Flow of Funds in a World without FIs
(direct financing)

Financial Claims
(equity and debt
instruments)

Suppliers of Funds
Users of Funds (households)
(corporations)

Cash

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Flow of Funds in a World with FIs
Indirect financing

FIs
Users of Funds Suppliers of Funds
(brokers)

FIs
(asset
transformers)

Financial Claims Financial Claims


(equity and debt securities) (deposits and insurance policies)

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ASYMMETRIC INFORMATION AND FINANCIAL
INTERMEDIATION

 Asymmetric information: information possessed by


one party to a financial transaction but not by the
other party or one party has more material
knowledge that other party; which leads to 2
main problems:

(1) Adverse selection: possibility of selecting of wrong


or high risk borrowers : before the transaction

(2) Moral hazard: the possibility that a borrower


may engage in more risky behavior after a loan
has been made: after the transaction
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 How FIs reduce asymmetric information?

(1) Information gathering/sharing: pay slip,


collateral, payment history
(2) Credit assessment
(3) CTOS/CRIS-BNM
(4) Credit monitoring
(5) Updated, sophisticated and timeliness
system for information gathering,
assessing and distributing

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Comparison of Roles Among Financial Institutions

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Summary of Institutional Sources and Uses of Funds

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FIs Benefit Suppliers of Funds
 Reduce monitoring costs: FIs undertake
the monitoring role
 Increase liquidity: help the issuers and
investors in the transaction, thus, the
process of buying and selling would
become more easy.
 Reduce transaction costs: economies of
scale: reduction in average cost per
unit as the level of output increases.
 Provide maturity intermediation
 Provide denomination intermediation
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