Corporate finance chapter 02 the financial system
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Chapter 2: The Financial
System
Objective
1
Understanding the workings of
the financial system
Determining rates
of return
Chapter 2 Contents
• 1 What is a Financial
System
• 7 Financial Intermediaries
• 2 The Flow of Funds
• 8 Financial Infrastructure
and Regulation
• 3 The Functional
Perspective
• 9 Governmental & QuasiGovernmental Organizations
• 4 Financial Innovation & the
“Invisible Hand”
• 5 Financial Markets
• 6 Financial Market Rates
2
The Flow of Funds Diagram
Markets
Surplus Units
Deficit Units
Intermediaries
3
Fund Flows via Market
Markets
Surplus Units
Deficit Units
Intermediaries
4
Fund Flows via Intermediary
Markets
Surplus Units
Deficit Units
Intermediaries
5
Fund Flows via Intermediary
and Market
Markets
Surplus Units
Deficit Units
Intermediaries
6
Funds Flow via Markets and
Intermediaries
Markets
Surplus Units
Deficit Units
Intermediaries
7
Funds Flow: Disintermediation
Markets
Surplus Units
Deficit Units
Intermediaries
8
Funds Flow: Secured Credit
Markets
Poor Credit Risk
Surplus Units
Deficit Units
Intermediaries
9
Six Key Financial Functions:
– Transferring Resources Across Time & Space
– Managing Risk
– Clearing and Settling Payments
– Pooling Resources and Subdividing Shares
– Providing Information
– Dealing with Incentive Problems
10
Exchange Rate Example
Time
Japan
15000 ¥
U.K.
•150 ¥/£
3% ¥/¥ (direct)
1.73% ¥/£/£/¥
15260 ¥
15450 ¥
£100
9%£/£
140 ¥/£
11
£109
Exchange Rate Example
Time
Japan
15000 ¥
U.K.
150 ¥/£
3% ¥/¥ (direct)
8.27% ¥/£/£/¥
16241 ¥
15450 ¥
£100
9%£/£
149 ¥/£
12
£109
Exchange Rate Example
Time
Japan
15000 ¥
(borrowed)
U.K.
150 ¥/£
3% ¥/¥ (direct)
3% ¥/£/£/¥
15450 ¥
15450 ¥
Repaid
£100
Invested
9%£/£
Forward ¥/£
13
£109
Matures
US Treasury Yiled Curve, Jan 97
7.50
Annualized Yield (%)
7.00
6.50
6.00
5.50
5.00
4.50
0
5
10
15
20
Years to Maturity
14
25
30
Yield Comparisons
April '95
1 - 10 Years
10 ++ Years
US
Corporate
Corporate
Treasury
High Quality Med Quality
6.92%
7.57%
7.86%
7.65%
8.15%
8.55%
15
Computation of Return
( EndPrice − StartPrice) + CashDividend
Return =
StartPrice
($105 − $100) + $5
Return =
= 0.10 = 10%
$100
16
Security Returns
60.00
40.00
% Return
20.00
0.00
1925
1930
1935
1940
1945
1950
1955
1960
1965
1970
-20.00
-40.00
Bills
Bonds
Stocks
Inflation
-60.00
Year
17
1975
1980
1985
1990
1995
Consolidated Indicies
1000.0000
Index (Log Scale)
Bills_Index
Bonds_Index
Stocks_Index
Inflation_Index
100.0000
10.0000
1.0000
1925
1930
1935
1940
1945
1950
1955
1960
Year
1965 181970
1975
1980
1985
1990
1995
Frequency of Returns
70
60
Freq_Bills
Freq_Bonds
Freq_Stock
Freq_Inflation
Probability
50
40
30
20
10
0
-50
-40
-30
-20
-10
0
Percent
10
20
19
30
40
50
Nominal to Real
(1 + NominalRate) = (1 + RealRate) * (1 + InflationRate)
⇒
NominalRate − InflationRate
RealRate =
1 + InflationRate
20
