Chapter 2An Overview of the Financial System

Function of Financial MarketsPerform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of fundsPromotes economic efficiency by producing an efficient allocation of capital, which increases production Directly improve the well-being of consumers by allowing them to time purchases better

Structure of Financial MarketsDebt and Equity MarketsPrimary and Secondary MarketsInvestment Banks underwrite securities in primary marketsBrokers and dealers work in secondary marketsExchanges and Over-the-Counter (OTC) MarketsMoney and Capital MarketsMoney markets deal in short-term debt instrumentsCapital markets deal in longer-term debt and equity instruments

Internationalization of Financial MarketsForeign Bondssold in a foreign country and denominated in that countrys currencyEurobondbond denominated in a currency other than that of the country in which it is soldEurocurrenciesforeign currencies deposited in banks outside the home countryEurodollarsU.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banksWorld Stock Markets

Function of Financial Intermediaries: Indirect FinanceLower transaction costsEconomies of scaleLiquidity servicesReduce RiskRisk Sharing (Asset Transformation)DiversificationAsymmetric InformationAdverse Selection (before the transaction)more likely to select risky borrowerMoral Hazard (after the transaction)less likely borrower will repay loan

Regulation of the Financial SystemTo increase the information available to investors:Reduce adverse selection and moral hazard problemsReduce insider tradingTo ensure the soundness of financial intermediaries:Restrictions on entryDisclosureRestrictions on Assets and ActivitiesDeposit InsuranceLimits on CompetitionRestrictions on Interest Rates