Thursday, June 14, 2007

Financial Literacy Series: Financial System

I have been busy working on the financial literacy programme for me and you. If you have come here without looking at this backgrounder post, It will be my request that you take a look at the introduction post too.
Before we discuss in detail the various instruments available in the financial market and their role and significance in personal financial planning, it would be helpful to have a brief overview of the financial system in India.
The Financial System Consists of
o Financial Market Segments,
o Players in the Financial Markets
o Financial Instruments

The financial system basically facilitates transfer of funds from the cash surplus economic units to those who need it, and does it in the most efficient manner.

There are three major types of economic units.
a. Households where personal finance is involved.
b. Business entities which resort to Financial management and we can refer it as business finance
c. Government where we come across fiscal and monetary policies.

Usually, the business entities and governments are fund deficit units and require funds to finance their capital and operational expenditure. The householders as a group are net savers and channelise their savings to the other units through the mechanism of the financial markets.

So you and me are surplus economic inits and the government and business use our money and make us look like beggars!!

This fund transfer from the surplus units to deficit units may be done in one of the two ways – directly or through financial intermediaries such as banks or insurance companies.

In case of direct transfer, the deficit units sell financial claims on themselves, which are purchased by the surplus units. An example is the debentures issued by a company. These debentures are sold at a price. These represent financial claims on the issuing company in the form of a promise to pay periodic interest and principal repayment. This method is more cost efficient as no intermediary costs are involved here.

However, deficit and surplus units may not be in a position to access each other directly. E.g. the households are interested in a wide array of assets, and evaluate investment vehicles based on their return, risk characteristics as well as tax treatment.

The corporate houses want to get the best possible price and keep the cost of funds as low as possible. Financial intermediaries (FI) such as banks and insurance companies help bring these two together. They pool funds from the investors, invest money on a large scale.
They are able to diversify their asset base that is rather difficult for individual investors. These intermediaries also gain expertise in the course of their business that enables them to give a better deal to the investors. , FI are able to reap the benefits of Economies of Scale, Lower Transaction Costs, and Reduction in Information Costs due to their intimate knowledge of finance.
The Government simply passes taxation legislation (bullies us) and gets load of money from us to fill its coffer and serve the social needs!

Financial markets can be over the counter (OTC) or organized. In case of an OTC market, the buyer and seller directly meet each other, may negotiate the price and strike the deal.
In case of organized markets (say securities exchanges or Stock markets), buyers and sellers give their price quotes and the exchange facilitates matching of buy and sell orders based on compatibility of price quotes. In fact, the same instrument may be traded either way. For example, if an investor buys units of a mutual fund directly from the fund, it is OTC. However, units of certain mutual funds are also listed and traded on the securities exchange.
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