Chapter 2: Overview of the Financial System
The financial system plays a crucial role in channeling funds from those who have excess
savings (lender-savers) to those who need funds for productive use (borrower-spenders). This
improves economic efficiency and supports economic growth.
1. Functions of Financial Markets
Financial markets exist to facilitate the transfer of funds between different economic participants.
They help in:
Efficient capital allocation: Ensuring money is invested in profitable opportunities.
Improving consumer welfare: Allowing people to save and invest their money.
2. How Funds Are Transferred
There are two main ways money moves in financial markets:
1. Direct finance – Borrowers get funds directly from lenders by issuing securities (stocks
or bonds).
2. Indirect finance – Financial intermediaries like banks collect money from savers and
lend it to borrowers.
3. Types of Financial Markets
Financial markets can be categorized based on the type of security and its function:
Debt markets: Where bonds (loans) are issued. They can be:
o Money market (short-term, less than 1 year).
o Capital market (long-term, more than 1 year).
Equity markets: Where stocks (ownership shares) are traded.
Primary market: Where new securities are issued.
Secondary market: Where existing securities are bought and sold (e.g., stock exchanges
like NYSE).
4. Financial Intermediaries & Their Importance
Financial intermediaries, such as banks, investment funds, and insurance companies, help:
Reduce transaction costs: They make it easier for people to invest.
Manage risk: They spread risk across many investors.
Solve information problems: They analyze borrowers to reduce fraud and defaults.
5. Government Regulation of Financial Markets
Governments regulate financial markets to:
Ensure fairness and transparency.
Protect investors from fraud.
Prevent financial crises by monitoring banks and financial institutions.
Chapter 3: Interest Rates and Their Role in Valuation
Interest rates affect borrowing, lending, investment, and financial asset valuation. They
determine how much it costs to borrow and how much investors earn from lending.
1. Definition of Interest Rates
Interest rates represent:
The cost of borrowing money.
The return on investment for lenders.
A key measure is Yield to Maturity (YTM), which calculates the true return of a loan or bond.
2. Present Value (PV) and Interest Rates
The concept of Present Value (PV) states that money today is worth more than money in the
future because of investment opportunities.
Formula:
PV=FV(1+i)nPV=(1+i)nFV
Where:
PV = present value
FV = future value
i = interest rate
n = number of years
3. Types of Credit Instruments
There are four main types of loans, each with different repayment structures:
1. Simple Loan – Borrower repays the principal + interest in one lump sum.
2. Fixed Payment Loan – Borrower makes regular payments (e.g., mortgages).
3. Coupon Bond – Pays interest periodically, then repays the principal (e.g., government
bonds).
4. Discount Bond – Sold at a discount and repaid in full later (e.g., Treasury bills).
4. Real vs. Nominal Interest Rates
Nominal interest rate = stated rate (does not account for inflation).
Real interest rate = adjusted for inflation (Real rate = Nominal rate - Inflation).
Example:
If the nominal rate is 10% and inflation is 3%, the real rate is 7%.
If inflation is higher than the nominal rate, the real rate can be negative.
5. How Interest Rates Affect Bond Prices
When interest rates increase, bond prices decrease.
When interest rates decrease, bond prices increase.
This is because investors want higher returns when rates rise, lowering existing bond prices.
Chapter 6: Are Financial Markets Efficient?
This chapter discusses the Efficient Market Hypothesis (EMH), which suggests that stock
prices reflect all available information, making it difficult to "beat the market."
1. What is the Efficient Market Hypothesis (EMH)?
The EMH states that financial markets incorporate all available information into stock
prices. This means:
Stocks always trade at their fair value.
It is impossible to consistently earn above-average returns unless you have inside
information.
2. Evidence Supporting Market Efficiency
Investment analysts rarely outperform the market in the long run.
Stock prices adjust quickly to new public information.
Technical analysis does not work well (past price trends do not predict future prices).
The random walk theory suggests that stock price movements are unpredictable.
3. Evidence Against Market Efficiency (Market Anomalies)
Some patterns suggest that markets are not always efficient:
Small-firm effect: Small companies tend to earn higher returns than expected.
January effect: Stocks often rise in January due to investor behavior.
Market overreaction: Stock prices sometimes drop too much after bad news, then
slowly recover.
Excessive volatility: Prices fluctuate more than fundamental values suggest.
Mean reversion: Stocks that perform poorly tend to improve over time.
4. Behavioral Finance & Market Bubbles
Behavioral finance explains how investor emotions and psychology affect markets:
Overconfidence: Investors often believe they are better at predicting the market than
they actually are.
Herd behavior: People tend to follow the crowd, which can create stock
market bubbles and crashes.
Loss aversion: Investors fear losses more than they seek gains, affecting decision-
making.
5. What Does This Mean for Investors?
Don't trust "hot tips" – If markets are efficient, prices already reflect this information.
Invest for the long term – A buy-and-hold strategy is often better than trying to time
the market.
Use index funds – Since professional investors rarely beat the market, low-cost index
funds are a smart option.
