Made with Xodo PDF Reader and Editor

Chapter one
An Overview of the Financial System
1.1 Introduction
This unit is designed to introduce you to the basic concepts of the Financial Systems in the
economy of the globe. The coverage of this unit is the preliminary issues of the subject matter.
The unit examines the nature, role and operation of the financial system and its characteristics. It
will provide information regarding both the importance of financial institutions and the
distinctiveness of various financial transactions formulated and performed in the money and
capital markets.
The substances of the unit incorporate the origins and perspective of the financial system and the
role and functions of the financial systems in an economy. The unit is designed to introduce the
modern financial asset instruments for business students by giving an indication about the nature
& importance of financial scheme and the sources of information for financial decision making
in the economic development of the country.
1.2 Role of Financial System in the Economy
Financial system is a system that allows the transfer of money between savers and borrowers. It
comprises of a set of complex and closely interconnected financial institutions, markets,
instruments, services, practices, and transactions. The end-users of the system are people and
firms whose desire is to lend and to borrow. These firms, faced with a desire to lend or borrow or
the end-users of most financial systems have a choice between three broad approaches. Firstly,
they may decide to deal directly with one another, though this, as we shall see, it is costly, risky,
inefficient and, consequently, not very likely.
More typically they may decide to use one or more of many organized markets. In these markets,
lenders buy the liabilities issued by borrowers. If the liability is newly issued, the issuer receives
funds directly from the lender. More frequently, however, a lender will buy an existing liability
from another lender. In effect, this refinances the original loan, though the borrower is
completely unaware of this ‘secondary’ transaction. The best-known markets are the stock
exchanges in major financial center such as London, New York and Tokyo. These and other
markets are used by individuals as well as by financial and non-financial firms.
Financial system in today’s world is perhaps the most important system among all the systems as
all the economics of the world have become interlinked- it has become a very complex system.
The financial system in it, includes all whether its banks or stock market or financial institutions.
Let’s see some of the important functions which are performed by the financial system.
Liquidity Role/ Function
Financial system enhances liquidity of financial claims. To put it differently, financial system
also makes sure that one can liquidate his or her savings whenever he or she wants it and
therefore individuals can have both the things, which involve return on investments as well as
comfort that they can liquidate their investments whenever they want.
It is a means of raising funds by converting securities and other financial assets into cash
balances. The financial system provides liquidity for savers holding financial instruments but

1
 Made with Xodo PDF Reader and Editor

who are in need of money. Money can be spent as it is without the necessity of converting it into
some other form. However money generally earns the lowest rate of return of all assets traded in
the financial system, and its purchasing power is seriously eroded by inflation. That is why
savers generally minimize their holdings of money and hold bonds and other financial assets
until spend able funds really are needed.
Wealth Role/Function
It is shifting power from high earning periods to warnings periods of life. For the business and
individuals choosing to save, the financial instruments sold in the money and capital markets
provide an excellent way to store wealth (to preserve value or hold purchasing power) until funds
are needed for spending in the future periods.
While we might choose to store our wealth in things” (e.g. automobiles and clothes), such items
are subject to depreciation and often carry great risk of loss. However, bonds, stocks, deposits
and other financial instruments, do not wear out overtime, usually generate income, and
normally, their risk of loss is less as compared to many other forms of stored wealth.
Credit Role/Function
The role of credit is to provide a continuous supply of credit for the business, consumers and
governments; to support both the consumption and investment spending in the economy.
Example, Governments borrow funds to construct public facilities and to cover daily expenses
until tax revenues flow in.
Saving Role/Function
The first and foremost function which financial system perform is the channelization of the
savings of individuals and making it available for various borrowers which are the companies
that take loan in order to increase the production of goods and services, which in turn increases
the overall growth of the economy.
The system of financial markets and institutions provides a conduit for the public’s savings.
Bonds, stocks, deposits, and other financial claims sold in the money and capital markets provide
a profitable, relatively low-risk outlet for the public’s savings. When savings flow decline,
however, the growth of investment and living standards tends to elevated. The savings function
of any financial system supplies the vital raw material of funds to invest so that economic growth
and living standards can flourish.
Payments Role/ Function
The financial system ensures the efficient functioning of the payment mechanism in an economy.
All transactions between the buyers and sellers of goods and services are effected smoothly
because of financial system. In other words, it is with the help of financial system that one can
make payment whenever and wherever he or she wants with the help of checks, credit card and
debit card. It provides a mechanism for making payments to purchase goods and services; certain
financial assets, mainly checking accounts and now negotiable order of withdrawal accounts,
serve as a medium of exchange in the making of payments.

2
 Made with Xodo PDF Reader and Editor

Policy Role/Function
In recent decades, the financial market has been the principal channel through which the federal
government has carried out its policy of attempting to stabilize the economy and avoid excessive
inflation by manipulating the interest rate and the availability of credit. Government can affect
through its financial system the borrowing and spending plans of the public which in turn
influence the growth of jobs Production and the prices of goods and services.
Risk Role/Function
Financial system helps in risk transformation by diversification, as in case of mutual funds.
Financial system also provide an individual various options when it comes to protecting against
various risks like, risk arising from accidents, health related, etc… through various life insurance
options. Financial markets and the diverse financial instruments traded in those markets allow
investors with the greatest taste for risk.
The financial markets offer business, consumers and governments protection against life, health,
property and income risks. Thus, capital markets allow the risk that is inherent to all investments
to be borne by investors most willing to bear that risk. This allocation of risk also benefits the
firms that need to wise capital to finance their investments. When investors can self-select into
security types with risk-return characteristics, that best suits their preferences, each security can
be sold for the best possible price. This facilitates the process of building the economies stuck of
real assets. The financial system provides a means to protect business consumers and
Governments against risk to people property and income.

In addition to the above major roles/functions the financial system can perform different
functions as follows:
 Financial system works as an effective conduit for optimum allocation of financial
resources in an economy.
 It helps in establishing a link between the savers and the investors.
 Financial system allows ‘asset-liability transformation’. Banks create claims (liabilities)
against themselves when they accept deposits from customers but also create assets when
they provide loans to clients.
 Economic resources (i.e., funds) are transferred from one party to another through
financial system.
 Financial system helps price discovery of financial assets resulting from the interaction of
buyers and sellers. For example, the prices of securities are determined by demand and
supply forces in the capital market.
 Financial system helps reducing the cost of transactions.
1.4. Financial Assets: Role and Properties
An asset is any resource that is expected to provide future benefits, and thus possesses economic
value. Assets are divided into two categories: tangible assets with physical properties and
intangible assets. An intangible asset represents a legal claim to some future economic benefits.

3
 Made with Xodo PDF Reader and Editor

The value of an intangible asset bears no relation to the form, physical or otherwise, in which the
claims are recorded.
Financial assets, often called financial instruments, are intangible assets, which are expected to
provide future benefits in the form of a claim to future cash. Some financial instruments are
called securities and generally include stocks and bonds. They do not depreciate like physical
goods, and their physical condition or form is usually not relevant in determining their market
value. Their cost of transportation and storage is low, such that they have little or no value as a
commodity. Financial assets are fungible – they can easily be changed in form and substituted
for other assets.
Any transaction related to financial instrument includes at least two parties:
a) The party that has agreed to make future cash payments and is called the Issuer;
b) The party that owns the financial instrument, and therefore the right to receive the
payments made by the issuer, is called the Investor.
1.4.1 Characteristic of financial asset
There are peculiar characteristics that are inherent in financial assets that are normally used
partly to determine their pricing in the financial markets. These characteristics are identified and
discussed below.
1. Moneyness
The moneyness of the financial assets implies that they are easily convertible to cash within a
defined time and determinable value. The cost of transactions involved in securing funds from
them before the maturity date can be likened to agency cost besides the cost of discounting some
of them, which reduces their face value. Therefore, these financial instruments are regarded as
near money because of the ease with which they can be traded for cash. Examples are Treasury
bills, Treasury certificates, Trade bills, Commercial papers, and Certificate of Deposits, among
others.
2. Divisibility & Denomination
The financial assets are usually made out in denominations depending on the face value that the
corporate organizations and institutions that are using them to raise funds from the financial
markets. The divisibility of such near money refers to the minimum monetary value in which a
financial asset can be liquidated or exchanged for money by the holder.
Divisibility for financial assets is imperative so as to enable both suppliers and borrowers to
understand the magnitude of funds involved in each of them; the borrowers have certain amount
to source and the suppliers will like to know the amount that is required of him to part with for
the transaction. It is also necessary so that a limit cab set for the minimum amount of
subscription for each instrument and the overall amount of subscription that may accrue to a
particular investor. For instance, many bonds can denominated like N1,000 denomination while
that of certificate of deposits are denominated form N500,000.
3. Reversibility
The financial assets are highly reversible in the sense that they are like deposits in accounts of
customers with the banks. This implies that the cost of investing in the financial assets and

4
 Made with Xodo PDF Reader and Editor

getting them back into cash is negligible. Hence reversibility of financial assets is often regarded
as turnaround cost or roundtrip cost.
4. Cash Flow
This refers to the return that an investor will derive from holding a financial asset, which
invariably depends on all the cash distributions that the asset will pay holders. This is expressed
in terms of the dividend on shares or coupon yield payments that are associated with bonds.
The return on investment in a financial asset is also affected by the repayment of the principal
amount for a debt instrument and any expected price variation of the stock. In calculation of
expected returns on a financial asset, factors that should be considered include non-cash
payments in form of stock dividend yield and options to purchase additional stock or the
distribution of other securities that must be factored in the consideration. The issue of inflation
implies that there is difference between normal effective return and real effective return on
financial assets. Therefore, the net real return on financial assets is the amount of cash returns
that are accruable after adjusting the nominal returns against inflation.
5. Maturity Period
In financial parlance, the maturity period refers to the length of time within which the corporate
entity or institution that employs a financial instrument to raise funds will use the funds before its
payment back to the holders of such instrument. For instance, a bond can be held by a corporate
entity for a period of thirty (30) years while that of government can extend to a period of ninety-
nine (99) years before their repayment to the holders.
There are some financial instruments being traded in the financial markets that may not reach the
stated maturity dates before they are terminated by the corporate entities that use them to raise
funds. There are reasons that may be responsible for such situation which include the following:
Bankruptcy:- a situation in which the company is being unable to meet its external financial
obligations and therefore, declared bankrupt;
Reorganization:- a situation in which the company is restructuring its ownership structure and
operations; and
Call Provision:- the financial instrument being associated with call provision.
The case of call provision implies that the company as the debtor or user of the funds takes
responsibility of setting aside sinking funds with which to redeem the instruments eventually.
The sinking fund is normally made as one of the contractual obligations that are established in
the agreement or indenture regulating the usage of the funds from the financial instrument.
6. Convertibility
This characteristic implies that a financial asset or instrument can be converted into another class
of asset which will still be held by the corporate entity has original used to raise funds for its
operations. The conversion can take a form of bond being converted to bond, preference shares
being converted to equity shares, and a company bond being converted into equity shares of the
company.

5
 Made with Xodo PDF Reader and Editor

The opportunity for convertibility of financial instruments into another financial assets has to be
entrenched in the covenant which has been written to guide the contractual agreement on the
instrument or to regulate the behaviour of the company using the funds from the instruments.
Nevertheless, such a provision can be negotiated in the course of the usage of the funds by a
company especially when the holders discover that the company is manipulating its operational
and financial records to shortchange them.
7. Currency
Financial assets are normally denominated in currencies of the various countries around the
world. This implies financial assets of the Nigerian financial system are denominated in Naira
such as Federal Government Loan Stock, Treasury Bills, Treasury Certificate, Shares and
Corporate and State Government Bonds. Those financial assets in Japan are denominated in Yen,
those in the United States of America are in Dollars, those in United Kingdom are in Pounds
Sterling while those in China are in Yuan, etc.
8. Liquidity
You have learned from above that one of the main characteristics of financial assets is the
moneyness of such instruments which implies that they are easily convertible to cash within a
defined time and determinable value. The cost of transactions involved in securing funds from
them before the maturity date can be likened to agency cost besides the cost of discounting some
of them, which reduces their face value. Hence, these financial instruments are regarded as near
money because they are highly liquid in terms of the ease with which they can be traded for cash.
Good examples of highly liquid financial instruments include Treasury bills, Treasury
certificates, Certificate of Deposits, Bills of Exchange, and shares of blue chip companies, e.g.,
Shares of Cadbury, First Bank, Guaranty Trust Bank, etc. However, there are some financial
instruments that cannot be easily converted to cash whenever the holders need money.
9. Predictable Returns
The return on financial assets must be predictable for the purpose of their being patronized by
investors. For instance, the investors should be able to know the percentage of interest that are
attached to certain debt instruments before they will be prepared to stake their funds on them.
This is because performance of a company cannot be taken for granted due to the mere fact that
top management and the boards of directors are known to be manipulating the accounting
records of their companies these days. This is more reason why investors are always very
skeptical in patronizing financial instruments of some corporate entities due to their antecedents
in manipulating their accounting records.
However, the returns on bonds, development loan stocks, and preference shares are determinable
so that the investors are aware about the expected returns on their investment. There other
government securities such as Treasury bills and Treasury certificates which are traded in money
market that command fixed returns.
10. Tax Status of Returns
The returns on various financial assets are subject to tax status because they are taxable earnings.
The tax authorities are interested in collection of taxes on earnings from financial assets as

6
 Made with Xodo PDF Reader and Editor

securities which are regarded as incomes for investors. However, the tax status on financial
assets varies from one economy to another.

The rate of such taxes on financial assets is also subject to variation from time to time depending
on the interest of the government which must be adhered to by the tax authorities. The tax status
on financial assets also differs from one type of security to another depending on the nature of
the issuing companies or institutions such as Federal, State, or local government.
1.4.2 Role of Financial Assets
Financial assets provide the following key economic functions.
 They allow the transfer of funds from those entities, who have surplus funds to invest to
those who need funds to invest in tangible assets.
 Financial instruments act as a means of payment (like money): Employees take stock
options as payment for working.
 Financial instruments act as stores of value (like money): Financial instruments generate
increases in wealth that are larger than from holding money.
 Financial instruments can be used to transfer purchasing power into the future.
 Financial instruments allow for the transfer of risk (unlike money): Futures and insurance
contracts allows one person to transfer risk to another.
1.5. Financial markets: role, classifications and participants
In economics a market is an organizational device which brings together buyers and sellers.
Textbooks usually hurry on to point out that a market does not have to have a physical location,
though plainly it could do so. A financial market is a market in which financial assets (securities)
such as stocks and bonds can be purchased or sold. Funds are transferred in financial markets
when one party purchases financial assets previously held by another party. Financial markets
facilitate the flow of funds and thereby allow financing and investing by households, firms, and
government agencies. This chapter provides some background on financial markets and on the
financial institutions that participate in them.
Financial markets transfer funds from those who have excess funds to those who need funds.
They enable college students to obtain student loans, families to obtain mortgages, businesses to
finance their growth, and governments to finance many of their expenditures. Many households
and businesses with excess funds are willing to supply funds to financial markets because they
earn a return on their investment. If funds were not supplied, the financial markets would not be
able to transfer funds to those who need them.
Those participants who receive more money than they spend are referred to as surplus units (or
investors). They provide their net savings to the financial markets. Those participants who spend
more money than they receive are referred to as deficit units. They access funds from financial
markets so that they can spend more money than they receive. Many individuals provide funds to
financial markets in some periods and access funds in other periods.
EXAMPLE

7
 Made with Xodo PDF Reader and Editor

College students are typically deficit units, as they often borrow from financial markets to
support their education. After they obtain their degree, they earn more income than they spend
and thus become surplus units by investing their excess funds. A few years later, they may
become deficit units again by purchasing a home. At this stage, they may provide funds to and
access funds from financial markets simultaneously. That is, they may periodically deposit
savings in a financial institution while also borrowing a large amount of money from a financial
institution to buy a home.
Many deficit units such as firms and government agencies access funds from financial markets
by issuing securities, which represent a claim on the issuer.
1.5.1 Role of Financial Market
The role of financial markets in the success and strength of an economy cannot be
underestimated. Here are four important functions of financial markets:
1. Puts savings into more productive use
As mentioned in the example above, a savings account that has money in it should not just let
that money sit in the vault. Thus, financial markets like banks open it up to individuals and
companies that need a home loan, student loan, or business loan.
2. Determines the price of securities
Investors aim to make profits from their securities. However, unlike goods and services whose
price is determined by the law of supply and demand, prices of securities are determined by
financial markets.
3. Makes financial assets liquid
Buyers and sellers can decide to trade their securities anytime. They can use financial markets to
sell their securities or make investments as they desire.
4. Lowers the cost of transactions
In financial markets, various types of information regarding securities can be acquired without
the need to spend.
Other Importance of Financial Markets
There are many things that financial markets make possible, including the following:
 Financial markets provide a place where participants like investors and debtors,
regardless of their size, will receive fair and proper treatment.
 They provide individuals, companies, and government organizations with access to
capital.
 Financial markets help lower the unemployment rate because of the many job
opportunities it offers
1.5.2 Types of financial markets

1.5.3 Participants in the Financial Market

Participants in the financial markets can generally be classified as firms with excess of cash and
firms with shortage of cash. But for the purpose of simplicity let us discuss the major participants
in the financial markets:

8
 Made with Xodo PDF Reader and Editor

In the financial markets, there are more topics to consider, than it may seem at first glance when
you open a trading platform and enter your orders. Various entities in the financial market also
have completely different approaches and purposes for operating in the financial market. To
correctly understand the entire financial market, you also have to know other participants in the
global financial market.
Retail traders – These are speculators. In the financial market, retail traders operate to invest
their capital and their main goal is profit. Retail traders typically trade over the trading platform,
or through other specific platforms or technology solutions from their broker.
Retail traders in the financial market are trading via a provider, called a broker. Profitability of
traders depends on their trading strategy, money management, experiences and also how fair and
solid their broker is, and it can vary considerably from 10% to 50%. According to the statistics,
the higher the trader's capital, the higher success rate he is usually able to achieve because he is
better at managing risk.
Insurance Companies
 Issue contracts to provide a future payment if a certain event happens
 Use the fees from these contracts to invest in equities, debt and property
Finance Companies
 Involve in Short to medium term debt capital
 Get funds by issuing debentures and borrowing from the general public
 Provide short-to-medium-term funds to business, particularly leasing finance
Banks
 Are the largest providers of funds to business
 Get most of their funds from deposits
 Provide a wide range of debt securities to business

Merchant Banks
 Get funds by short-term borrowing
 Lend mainly to corporations in such things as foreign currency and commercial
bills
Companies
 Often have surplus funds from operations
 Invest funds on money market, commercial bills and sometimes buy shares in
businesses
Mutual Funds
 Get funds from the savings of people preparing for retirement.
 Invest funds on money market, commercial bills and sometimes buy shares in
businesses
Government

9
 Made with Xodo PDF Reader and Editor

 Acts for the government to ensure gaps in the supply of funds are filled
 Works through the authorized dealers
1.6. Lending and Borrowing in the Financial System
In this section, we want to discuss people’s reasons for lending and borrowing and the differing
needs of lenders and borrowers that financial intermediaries have to try to meet. In modern
economies, where savers make their surplus available to borrowers via financial intermediaries,
it is sometimes useful to refer to the savers and borrowers as ultimate lenders and ultimate
borrowers. This enables us to distinguish their behavior from that of the intermediaries
themselves who are also ‘lending’ (to ultimate borrowers) and ‘borrowing’ (from ultimate
lenders) and frequently lending and borrowing between themselves. It is ultimate lenders and
borrowers that we are concerned with here.
Ultimate lenders: Agents whose excess of income over expenditure creates a financial surplus
which they are willing to lend.
Ultimate borrowers: Agents whose excess of expenditure over income creates a financial deficit
which they wish to meet by borrowing.
I. Saving and lending
In any developed economy there will be people and organizations whose incomes are greater
than they need to finance their current consumption. The difference between current income and
consumption we call saving. The saving could be used to buy ‘real’ assets, that is to say
machinery, industrial premises and equipment, for example, in which case as well as saving they
would be investing. However, many people will be saving at a level which exceeds their
spending on physical investment. Indeed, in the personal sector there will be people who save
but undertake no physical investment at all. The difference between saving and physical
investment is their financial surplus. It is this surplus that is available for lending.
What conditions have to be met to induce those with a surplus to lend? We can say that in their
choice of asset, lenders will be seeking to minimize risk (often expressed as maximizing
liquidity) and to maximize return.
Risk might arise from someone else’s default or simply from market conditions. One situation
which both borrowers and lenders have to anticipate is the risk of needing early repayment (for
lenders) and the risk of being called to make early repayment (for borrowers). For lenders this
poses a particular form of capital risk and explains why lenders are generally prepared to trade
liquidity for return. A lender who needs to dispose of an asset unexpectedly wishes to do so
quickly, cheaply and in the knowledge that the proceeds of the sale are fairly certain. These are
the joint characteristics of liquidity. In the absence of these characteristics, a lender requiring
unexpected repayment faces capital risk since any asset – even a house – can be sold quickly if
the seller is prepared to face a sufficiently large capital loss. If we express our objective in
liquidity terms, therefore, liquidity and its component characteristics are thus one feature that
lenders will wish to maximize, ceteris paribus. Alternatively, we can express the same objective
as a minimization of risk.

10
 Made with Xodo PDF Reader and Editor

The second characteristic which lenders will look at, again with a view to maximization, is
return. The return on a financial asset may take a number of forms. It may take the form of an
interest payment at discrete intervals. This interest payment may be fixed at the outset of the
loan or it may vary, but, fixed or variable, it will be paid to the lender for so long as the loan is
outstanding. Notice, because it will be important later, that if an asset pays a fixed rate of
interest, as do government bonds, and then movements in market interest rates will make that
asset more or less attractive. If market rates rise above the level paid on a fixed-interest rate
asset, that asset will be less attractive than current alternatives and its price will fall. If market
rates fall, it will become more attractive and its price will rise.
Another form which yield may take is the dividend. Unlike a rate of interest which has to be
paid for as long as the loan is outstanding, a dividend payment normally reflects the ability of the
borrower to pay. Thus in a good year, the borrower may pay the lender a large dividend, but in a
poor year the dividend may be small or even non-existent. Entitlement to a dividend, therefore,
normally indicates that the lender is sharing in the risk of the borrower’s business.
A third source of yield, which may be less obvious than either of these, is the yield that comes
from an appreciation in the capital value of the asset. Clearly, many people hold company
shares not just for the dividends paid out annually but because they expect the value of the shares
to rise over time. Government stock which bears a fixed rate of interest also has a fixed date and
a fixed value at which it will be redeemed (repaid). If market interest rates have forced the
market value of a stock below its redemption value, buying the stock and holding it to
redemption will produce a guaranteed capital gain which can be expressed as an annual rate of
return over the rest of its life. Some assets, treasury bills for example, have no interest paid on
them but are sold ‘at a discount’ to their redemption value. In this case the yield consists entirely
of capital gain.
Thirdly, lenders will wish to minimize transaction costs. There is little point in finding a
lending opportunity which seems to offer a superior rate of return if the charges for entering into
the commitment absorb the margin over the next best rate of return. This is a problem that
confronts many small lenders in particular.
II. Borrowing
At the same time as some people have income which they do not wish to spend entirely upon
current consumption, there will be those firms, people and public authorities whose expenditure
plans exceed their income. These plans can be realized only if their owners either draw on past
savings or engage in borrowing. The plans may be to spend on ‘real’ assets. These in turn may be
of two types: ‘investment’ or ‘capital’ goods as bought by firms to assist in producing more
goods; or consumer goods, usually of the ‘durable’ kind whose initial cost is high in relation to
income but which will provide a flow of benefits over several years. In certain circumstances,
however, one can envisage people borrowing in order to acquire ‘financial’ assets.

We can simply summarize the objective of lender and borrowers as shown in the figure below:

11
Made with Xodo PDF Reader and Editor

12