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

1. 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)

2. 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 investing in 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

  1. Monitoring costs- Aggregation of funds in FIs provides greater incentive to collect a firm’s information and monitor its actions (economies of scale)
  2. Liquidity and price risk – Insurance firms etc offer liquid investments and diversify away risk for funds providers and may even guarantee a fixed return
  3. Reduced transaction costs – Similar to economies of scale in information production, FIs tremendously reduce transaction costs
  4. 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
1. 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
2. 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

  1. Bull- this is a speculator in the stock exchange who buys shares in expectations of a rise in their prices.
  2. Bear- speculator in the stock exchange who sells shares in the anticipation of a fall in their prices.
  3. 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

  1. Provides a ready market for stock, shares, bonds, debentures etc.
  2. facilitates the flow of new capital into the industry
  3. Facilitates savings (encourages savings by individuals)
  4. Protects investors by reasons of the rules of the stock exchange.
  5. Companies seeking capital are advised and guided by all stages.
  6. Shows the trend of business in the stock exchange provides an important barometer for business throughout the country.
  7. Investors are able to obtain capital from the public.
  8. It enhances the inflow of foreign capital.
  9. The title to any quoted security is transferred speedily and cheaply.
  10. 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

  1. A quoted company is able to raise finances quickly and easily.
  2. A quoted company is considered to be financially stable.
  3. A quoted company can easily obtain a loan.
  4. A quoted company can compare itself with other companies.
  5. There is prestige associated with quoted companies.
  6. Quoted companies are forced to operate within certain guidelines

Disadvantages

  1. 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.
  2. In case the company’s profits decline this will be revealed to the public and will lower the share prices of such a company.
  3. There is loss of control to incoming shareholders.
  4. It is expensive because of the fee payable to the stock market.
  5. The formalities of quotation are tedious and tiresome.
  6. Immediately after quotation the prices are likely to be low.
  7. A quoted company can easily be taken over by people buying shares in the stock exchange.

Terms Use in the Stock Exchange
1. Par value: it is the value of shares printed on the face of the share certificate.
2. Dividends: it is the profit that is distributed to the shareholders
3. 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.
4. Speculation: it is the expectation about the future changes I the share prices.
5. Blue chips- they are shares with a good dividend history e.g. shares of KPLC, Barclays bank.
6. 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.
7. Bonus issued: it is where the existing shareholder is issued with free shares out of the retained earnings.
8. 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.
9. Cum-dividends: It implies the shares that have been sold to the buyer give the buyer rights to receive dividends if they are declared.
10. 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.
11. 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.

Advantages of CDS

  1. It shortens the registration process in the stock exchange
  2. It improves the liquidity of stock exchange than increase the turnover of the equity shares in the market
  3. It lowers the clearing and settlement cost
  4. It’s faster and less risky settlement of securities which make the market more attractive to investors
  5. It will lead to an efficient and transparent securities market to adhere to international standards for the benefit of all stakeholders
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