Why is the health of the economy closely tied to the functioning of financial markets? Define the financial system and provide brief explanations of its various components.

Answer:

Financial markets refer to trading platforms where individuals exchange various financial securities, commodities, and other fungible items of value. These items are traded at low transaction costs and at prices that reflect supply and demand. Examples of securities include stocks and bonds, while commodities may include agricultural products or precious metals.

Effective financial markets are vital to the overall health of an economy. Ineffective markets for credit and capital can lead to limitations on borrowing and investment, which can have a negative impact on the entire macro-economy.

Financial crises arise when the value of financial assets or institutions drops rapidly. During such crises, there may be a panic or a "run on the banks," where investors sell off assets or withdraw money from savings accounts, fearing that the value of those assets may further decline if they remain with a financial institution.

Debt Markets and Interest Rates

Debt markets refer to a market for buying and selling debt securities like bonds, which promise to make periodic payments for a specified duration of time. These markets are essential to economic activity as they allow governments and corporations to borrow money to finance their operations. Moreover, debt markets, also known as bond markets, play a crucial role in determining interest rates. Interest rate is the amount charged by a lender to a borrower for borrowing funds or the cost paid for renting funds expressed as a percentage of the borrowed amount. The economy has several interest rates like mortgage interest rates, car loan rates, and various types of bond interest rates.


ü Mortgage markets:

The mortgage market deals with providing long-term loans to individuals for purchasing properties. After a loan is issued, it can be traded on the secondary mortgage market, much like stocks on a stock exchange. This allows the original lenders, such as banks and building societies, to recover lost liquidity. The new owner of the mortgage debt assumes the right to receive the mortgage repayments.



ü Managing Risk in Financial Institutions


In the past few years, the economic landscape has become more perilous. Interest rates have experienced drastic fluctuations, stock markets have crashed domestically and internationally, speculative crises have transpired in the foreign exchange markets, and the number of financial institution failures has risen to unprecedented levels since the Great Depression. To prevent extreme swings in profitability and the potential for failure caused by these conditions, financial institutions must focus on how to handle the heightened level of risk.







ü Financial system:


The processes and procedures used by an organization’s management to exercise financial control and accountability. These measures include recording, verification, and timely reporting of transactions that affect revenues, expenditures, assets, and liabilities.


Basic components of financial system:


The financial system is a complex network of institutions, markets, and intermediaries that facilitate the flow of funds between savers and borrowers. The five basic components of a financial system are:

1. Financial Institutions: These are entities that offer financial services to the public, such as banks, credit unions, insurance companies, and pension funds. They provide savings and investment vehicles, payment and settlement services, and credit facilities.
2. Financial Markets: These are forums where buyers and sellers come together to exchange financial assets, such as stocks, bonds, and currencies. The markets include primary and secondary markets for debt and equity instruments, foreign exchange markets, commodity markets, and derivative markets.
3. Financial Instruments: These are the assets that are traded in the financial markets, such as stocks, bonds, derivatives, and currencies. They represent claims to future cash flows or ownership of assets and are designed to meet various investment objectives and risk profiles.
4. Payment and Settlement Systems: These are the mechanisms that facilitate the transfer of funds and securities between financial institutions and their clients. They include wire transfer systems, check clearing systems, electronic payment systems, and securities settlement systems.
5. Regulatory Framework: These are the rules and regulations that govern the behavior of financial institutions and participants in the financial system. They are designed to ensure the safety and soundness of the system, protect consumers and investors, and maintain market integrity. Regulatory bodies may include central banks, securities regulators, banking regulators, and insurance regulators.