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
Shareholders 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 earnings4
 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 individuals 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

=
Financialmarkets (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. 7
 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
Financial markets
markets are
are structures
structures
through
through which
which funds
funds flow
flow
Financial
Financial markets
markets can
can be
be
distinguished
distinguished along
along two
two
dimensions
dimensions
primary
primary versus
versus secondary
secondary markets
markets
money
money versus
versus capital
capital markets
markets

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Primary versus Secondary Markets

Primary
Primary markets
markets
markets
markets inin which
which users
users of
of funds
funds
(e.g.,
(e.g., corporations
corporations andand governments)
governments)
raise
raise funds
funds by
by issuing
issuing NEW
NEW financial
financial
instruments
instruments (e.g.,
(e.g., stocks
stocks and
and bonds)
bonds)
Secondary
Secondary markets
markets
markets
markets where
where EXISTING
EXISTING financial
financial
instruments
instruments are
are traded
traded among
among
investors
investors (e.g.,
(e.g., NYSE,
NYSE, Nasdaq
Nasdaq &&
Bursa
Bursa Malaysia)
Malaysia)
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 PRIMARY MARKETS VS SECONDARY MARKETS

PRIMARY MARKETS SECONDARY

MARKETS
- facilitate the issuance - facilitate the issuance
of new securities of existing securities
-participants: issuers & -participants: trading
investors among 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
Money markets
markets
markets
markets that
that trade
trade debt
debt securities
securities
with
with maturities
maturities ofof one
one year
year or
or less
less
(e.g.,
(e.g., Certificate
Certificate of
of Deposits
Deposits and
and
Treasury
Treasury bills)
bills)
Capital
Capital markets
markets
markets
markets that
that trade
trade debt
debt (bonds)
(bonds) and
and
equity
equity (stock)
(stock) instruments
instruments with
with
maturities
maturities of
of more
more than
than one
one year
year

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 Securities Traded in Financial Markets

1. Money Market Securities:

a. Treasury bills
b. Bankers 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 15
 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
Financial Institutions
Institutions
institutions
institutions through
through which
which suppliers
suppliers
channel
channel money
money to to users
users ofof funds
funds
Assisting
Assisting in
in financial
financial transactions
transactions
Financial
Financial Institutions
Institutions are
are
distinguished
distinguished by
by whether
whether
they
they accept
accept deposits
deposits
depository
depository versus
versus non-depository
non-depository
financial
financial institutions
institutions

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Depository versus Non-Depository FIs

Depository
Depository institutions
institutions
commercial
commercial banks,
banks, savings
savings associations,
associations,
savings
savings banks,
banks, credit
credit unions
unions
They
They are
are legally
legally allowed
allowed toto accept
accept deposits
deposits
from
from customers
customers
Importance
Importance role role inin economy:
economy: transform
transform
deposits
deposits into
into loans
loans
Non-depository
Non-depository institutions
institutions
insurance
insurance companies,
companies, securities
securities firms
firms and
and
investment
investment banks,
banks, mutual
mutual funds,
funds, pension
pension funds
funds
They
They are
are legally
legally not
not allowed
allowed to
to accept
accept deposits
deposits
from
from customers
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
Suppliers of
Users of instruments) Funds
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

Reduce monitoring
monitoring costs:
costs: FIs
FIs
undertake
undertake the the monitoring
monitoring role
role
Increase

Increase liquidity:
liquidity: help
help the
the issuers
issuers and
and
investors
investors in in the
the transaction,
transaction, thus,
thus, the
the
process
process of of buying
buying andand selling
selling would
would
become
become more
more easy.
easy.
Reduce

Reduce transaction
transaction costs:
costs: economies
economies
of
of scale:
scale: reduction
reduction in in average
average cost
cost per
per
unit
unit as
as the
the level
level of
of output
output increases.
increases.
Provide
Provide maturity
maturity intermediation
intermediation
Provide
Provide denomination
denomination intermediation
intermediation

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