THE FINANCIAL SYSTEM IN PERSPECTIVE NOTES
3.0 Introduction
Saunders and Cornett (2001) define financial markets as structures
through which funds flow. This definition off course encompasses both
financial institutions (FIs) and capital markets as structures through
which funds flow. Financial markets can be distinguished along two major
dimensions
- Primary markets Vs Secondary markets
primary markets
This are markets in which users (firms) rise funds through new issues of
financial instruments such as stocks and bonds Most such issues are
arranged through investment banks-who serve as intermediaries between
funds suppliers and users. Such intermediation is usually in the form of
underwriting – (guaranteeing the issuing firm of a fixed price by buying
the whole or part of the lot and selling it to investors at a higher
price) Primary markets financial instruments include equity issues by
firms to be traded by the public for the first time (IPOs or initial
public offers).
Secondary markets
Once financial instruments such as stocks are issued in the primary
markets they are often traded in the secondary market. New investors buy
from original investors. Examples include NYSE, AMEX, NASDAQ EASDAQ,
LSE, NSE, JSE etc Buyers of secondary market securities are economic
agents (consumers, businesses & governments) with excess funds and
sellers are economic agents with need for funds. Exchange of funds
between the sellers and buyers is usually through a securities broker
who acts as an intermediary. In this case the original issuer of the
security is not involved In addition to stocks, secondary markets also
offer bonds, mortgage backed securities, foreign exchange futures and
options (derivatives) etc .Secondary markets offer investors liquidity
and diversification benefits to investors and also lower transaction
costs Though security issuers are not involved directly in the transfer
of funds in the secondary market they obtain information on the current
market value of their instrument, this information allows issuers to
evaluate how well they are using funds generated from the issue and
provides information on how well subsequent offerings might fare in
terms of raising additional money (and at what cost)
- Money markets Vs Capital markets
- Money markets
They trade in debt securities with maturities of one year or less.
The short term nature of this nutriments means that fluctuations is
their prices in the secondary market is quite minimal They are
usually traded is over the counter (OTC) – this markets have no
specific location, rather transactions occur via phone lines, wire
transfers and computer trading. FIs & depository institutions e.g.
commercial banks are required by central banks to maintain cash
reserves as such excess is traded in these markets Money market
instruments examples – commercial paper, Treasury bills, Negotiable
certificates of deposits etc - Capital markets
They trade in equity (stocks) and debt (bond) instruments with
maturities in excess of one year. Given their longer maturities,
these instruments experience wide price fluctuations in the
secondary market than do money market instruments. Examples of
capital market instruments are corporate stocks, residential
mortgages, commercial mortgages, corporate bonds; federal and local
government bonds bank and consumer loans etc.
3.1 Characteristics/ Features of Financial Assets
- Moneyness
Money is used as a medium of exchange or for settlement of
transactions. Assets that can be transformed into money at little
cost delay or risk (e.g. time and savings deposits and government
securities) are referred to as near money. This property is the
moneyness of the asset. It is a desirable property for investors. - Divisibility and Denomination
This refers the minimum size in which a financial asset can be
liquidated and exchanged for money. The smaller the size the more
the financial asset is divisible. A deposit may be divisible to the
last cent, but other financial assets have varying degrees of
divisibility depending on their denominations (the dollar/ birr
value that the assets will pay at maturity). In the US bonds come in
$1000 denominations while commercial paper comes in $25000
denominations. Divisibility is desirable for investors but not
borrowers. - Reversibility
This refers to the cost of investingin a financial asset then getting out of it into cash again. It is commonly referred to as the turnaround cost or round-trip cost. This cost comes in the form of commissions for market makers, bid-ask spread and the time and cost of delivery of the asset if any. The bid-ask spread is mainly determined by the thickness or thinness (frequency of the transactions) of the market. A low turn around cost is clearly desirable property of a financial asset. - Cash flow
The return on an investment depends upon the cash distributions
(e.g. dividends and expected selling price on shares; and the
principle and coupons on bonds) that the asset will pay. Non cash
payments (e.g. bonus shares and options) and inflation are also
accounted for. When inflation is factored in, we have the real rate
of return; otherwise we have the nominal rate of return if the
effect of inflation is unaccounted for. - Term to maturity
This is the length of the period until the date at which the asset
is scheduled to make it final payment or the owner is entitled to
demand liquidation. Assets in which the creditor can demand payment
at any time are called demand instruments, while those with no
maturity e.g. the British Consul are called perpetual instruments.
Financial assets may have various provisions that may either extend
or shorten their maturity - Convertibility
This is the ability if the financial asset to convert into other
assets (either in the same or different classes) a bond may be
converted into another bond, a corporate convertible bond into
equity shares or preferred stock into common stock. The timing,
costs and conditions for conversion are usually spelt out in the
legal descriptions of the convertible instrument at the time it is
issued - Currency
Due to globalization and increasing integration of global financial
system, and in the light of the freely floating and often volatile
exchange rates among major currencies, the currency in which the
financial asset will make cash flows is very important for
investors. Most assets are dominated one currency, the $, € or ¥ and
investors must chose the assets with the currency feature in mind.
Some issuers in an attempt to reduce the currency risk are issuing
dual-currency instruments, which pay the interest and the principal
in different currencies. The $ and the ¥ are the usually paired
currencies in this cases. - Liquidity
If the market for a financial asset is extremely thin and one must
search for one in a very few suitable buyers, then the asset is said
to be illiquid. Less suitable buyers including speculators and
market makers may be easily located but will have to be enticed to
invest in an illiquid asset by an appropriate discount in the price.
For many financial assets liquidity is determined by the contractual
arrangements. This depends not only on the type of financial asset
at also on the quantity involved. Large quantities usually have
liquidity problems. - Return predictability
Assuming that investors are risk averse, the riskiness of an asset
can be equated with the uncertainty or unpredictability of its
return. Return predictability is a basic feature of financial
assets, in that it is a major determinant of their value. The value
of a financial asset depends on the future cash flow and on the
discount rate used to discount these cash flows. The cash flow may
be contractual be the discount rate is a function of factor such as
prevailing interest rates which are hard to predict as time
increases. Another factor that makes returns unpredictable to
predict is inflation. - Complexity
Some financial assets are complex in the sense that they are a
combination of two or more simpler assets. To find the true value of
such assets one must break them down into their component parts and
price them separately and the sum of those prices becomes the value
of the complex asset. An example is a callable bond (the issuer is
entitled to repay the bond prior the maturity date), the true value
of such a bond is therefore the price of a similar non callable
bond, less the issuers right to retire the bond early. The extent of
complexity is large; many callable bonds are also convertible. - Tax status
Government regulations about taxing income from ownership or sale of
financial assets vary widely. Tax rates also differ from year to
year from country to country and from one asset to another depending
on the issuer, length of time the asset is held nature of ownership
etc. The tax status of a financial status affects its value. Clearly
an investor will require a higher return for a taxable financial
asset of the same risk class as that of a non taxable financial asset.
3.2 Role of the Financial System in the Economy
A financial system is composed of financial institutions and financial
markets. When you talk of the financial systems role in an economy you
are indirectly addressing the role that financial institutions and
financial markets play in an economy
- Transmission of monetary policy
Because deposits are a significant component of the money supply,
which in turn impacts on the rate of inflation, depository
institutions particularly commercial banks play a key role in the
transmission of monetary policy from the central bank. This may be
through variation of the reserve ratio (in order to increase or
lower money supply) - Credit Allocation
A financial system offers the economy with a unique service as a
major conduit of credit to sectors of the economy that need special
financing such as farming and real estate (Residential
specifically). Authorities in such cases may require that a
significant portion of FIs assets be in the areas identified. - Time intermediation intergenerational wealth transfer
Most countries offer relief and subsidies to encourage investments
by savers in life insurance and pension funds to enable the older
generation to transfer wealth to the younger one. - Payment services
Depository institutions and thrifts are special in that the
efficiency in which they provide payment services directly benefits
the economy. Any breakdown in the payment systems (check clearing of
wire transfers) would result in harmful effects to the economy.
Other services to users and suppliers of funds
- Monitoring costs- Aggregation of funds in FIs provides greater
incentive to collect a firm’s information and monitor its actions
(economies of scale) - Liquidity and price risk – Insurance firms etc offer liquid
investments and diversify away risk for funds providers and may even
guarantee a fixed return - Reduced transaction costs – Similar to economies of scale in
information production, FIs tremendously reduce transaction costs - Maturity intermediation – By maturity matching FI can offer new
products such as mortgages, similarly FIs can better bear the risk
of mismatching the maturities of assets and liabilities
Denomination Intermediation – FIs offer small investors a chance to
overcome constraints of buying assets imposed by a minimum denomination size
3.3 Definition of a stock market
It is a market where securities are bought and sold. Securities refer to
shares, debentures, treasury bonds, treasury bills etc. Stock refers to
capital detained by a company through the issue of shares.
Bonds are debt instruments used to borrow money from the public.
Members of the stock exchange
- Stock jobbers
These are members who buy and sell securities in their own names. They
sell securities at a profit called a ‘turn’ They buy shares in wholesale
and hold them for speculative purposes - Stock brokers
These are middle men between the investing public and the stock
exchange. They are agents who earn a commission from the buyers and
sellers. Members of the stock exchange must pass through them for
technical advice
Similarities between Jobbers and Brokers
They both operate in the stock market
Both don’t hold shares for investment purposes
Activities of both are regulated by the rules of stock market.
Types of jobbers
- Bull- this is a speculator in the stock exchange who buys shares in
expectations of a rise in their prices. - Bear- speculator in the stock exchange who sells shares in the
anticipation of a fall in their prices. - Stag- a speculator in the stock market who purchases large block of
new issues of shares in anticipation in the rise of market price.
They buy their shares directly from the companies selling them.
Functions of Stock Exchange
- Provides a ready market for stock, shares, bonds, debentures
- facilitates the flow of new capital into the industry
- Facilitates savings (encourages savings by individuals)
- Protects investors by reasons of the rules of the stock exchange.
- Companies seeking capital are advised and guided by all stages.
- Shows the trend of business in the stock exchange provides an
important barometer for business throughout the country. - Investors are able to obtain capital from the public.
- It enhances the inflow of foreign capital.
- The title to any quoted security is transferred speedily and cheaply.
- Disciplines the company’s management by ensuring that the companies
fulfill certain requirements and follow certain rule before
securities are listed in the stock exchange.
Quotations in the Stock Exchange
Quotation is consent by the stock exchange for companies’ securities to
be dealt with in the stock market i.e. to be bought and sold in the
stock market.
Requirements of quotation
- A company must be a public limited company
- It must be registered with the registrar of companies and must
submit a certification of registration. - The company must provide details of the current directors, company
lawyes, company secretary, company auditors, financial year end and
subsidiaries (branches) of the company. - Such a company must inform the stock exchange the current
distribution of the shares. - Such a company must be willing to offer the public a minimum number
of shares. - Such a company must pay a clearing fee.
- Such a company must issue a prospectus to the stock exchange.
- Such a company must issue a statement of dividends and bonds issued
in the previous 5 years.
Advantages of Quotations
- A quoted company is able to raise finances quickly and easily.
- A quoted company is considered to be financially stable.
- A quoted company can easily obtain a loan.
- A quoted company can compare itself with other companies.
- There is prestige associated with quoted companies.
- Quoted companies are forced to operate within certain guidelines
Disadvantages
- Loss of secrecy- means the company losses its secrecy through the
publication of the company’s
shares. The secrecy is also lost by inspection of the books of
accounts by the shareholders or by the public. - In case the company’s profits decline this will be revealed to the
public and will lower the share prices of such a company. - There is loss of control to incoming shareholders.
- It is expensive because of the fee payable to the stock market.
- The formalities of quotation are tedious and tiresome.
- Immediately after quotation the prices are likely to be low.
- A quoted company can easily be taken over by people buying shares in
the stock exchange.
Terms Use in the Stock Exchange
- Par value: it is the value of shares printed on the face of the share
certificate. - Dividends: it is the profit that is distributed to the shareholders
- Market value: it is the price that is quoted at the stock exchange
i.e. the price at which the company’s shares are traded at the stock
exchange. - Speculation: it is the expectation about the future changes I the
share prices. - Blue chips- they are shares with a good dividend history e.g. shares
of KPLC, Barclays bank. - Rights issued- it is an opportunity given to an existing shareholder
to purchase additional shares from the company usually at a lower price
before they are issued to members of the public. - Bonus issued: it is where the existing shareholder is issued with
free shares out of the retained earnings. - Ex-dividends: It is where the person buying shares doesn’t receive
the right to buy additional shares from the company at a lower price if
such an opportunity is made available. - Cum-dividends: It implies the shares that have been sold to the buyer
give the buyer rights to receive dividends if they are declared. - Ex-rights: Means the person buying shares doesn’t receive the right
to buy additional shares from the company at a lower price if such an
opportunity is made available. - Cum-rights: Situation where the person buying shares receives
3.4 The Central Depository System
The Central Depository & Settlement Corporation Limited (CDSC) is a
limited liability Company approved by the Capital Markets Authority
under Section 5 of the Central Depositories
Act, 2000 to establish and operate a central depository system and
provides central clearing, settlement and depository services for
securities initially in Kenya in respect to securities listed on the
Nairobi Stock
exchange. The central depository system provides a centralized system for the transfer and registration of securities in electronic format without the necessity of physical certificates
The Central Depository & Settlement Corporation Limited (CDSC) was
incorporated on 23rd March 1999 under the Companies Act, 2000. It
commenced its operations as a central depository on 10th November 2004.
