Study On Finance Intermediation And Intermediaries Finance Essay - Free Essay Example

A major part of any financial institutions activity was to make loans to ultimate borrowers out of funds which were made available to them from the ultimate lenders. In fact this is what financial intermediation means ,the process of indirect finance using financial intermediaries. In other words, intermediaries create assets for lenders and liabilities for borrowers which are more attractive to each than would be the case if the parties had to deal with each other directly. Such institutions with an intermediation role are banks, investment companies, credit unions and insurance companies. By collecting surplus funds from lenders (also called savers) and allocate them to those with a deficit of funds (borrowers), financial intermediaries increase the efficiency of the economy by promoting a better allocation of resources. Another role of financial intermediaries is to bridge the gap between borrowers and lenders and reconcile their often incompatible needs and obje ctives by performing a transformation function: Financial intermediaries collect small-size deposits made by savers and repackage them into larger size loans. They perform this size-transformation function by exploiting economies of scale because they have access to a larger number of depositors than any other individual borrower does. Financial intermediaries are said to be borrowing short and lending long which means that they transform short-term funds into loans which are made available to borrowers for longer terms. In this maturity transformation process they are said to be mismatching their assets and liabilities. Financial intermediaries are able to minimise the risk of borrowers that are not being able to repay the amount of money they owe to the savers by diversifying their investments, pooling risks, screening and monitoring borrowers and holding capital and reserves as a buffer for unexpected losses. This function is known as risk transformation. Another cruc ial function is to transform primary securities into secondary securities that are more attractive to lenders. In this way, secondary securities will be less risky and more liquid than primary securities because banks benefit from economies of scale. This allows them to offer lower loan rates relative to direct financing. Arguably, savers and borrowers do not need financial intermediaries; borrowers can obtain funds directly from the lenders through direct finance in financial markets. However, there are two types of barriers that can be identified in direct finance: it is more difficult and expensive to match the needs of borrowers and lenders and, in most of the cases, these needs are incompatible Financial Markets Direct financing Savers/ Depositors Borrowers Indirect financing Financial Intermediaries The benefits of indirect financing through financial intermediaries can be summarised as followed: 1. Through indirect finance it is generall y achieved greater liquidity and there is a greater likelihood that loans will be available when required. 2. Financial intermediaries are able to reduce risk through a number of devices. Firstly, they can be confident that while some depositors will withdraw their deposits, others will be making new ones. This is known as The law of large numbers and it is one of the benefits of the financial intermediaries. Secondly, not all assets behave in the same way at the same time, therefore, holding enough different assets (there is less than perfect correlation between movements in asset returns) . 3. Financial intermediaries reduce the transaction costs because of their ability to pool funds and trade in large blocks of securities where the dealing commission is very small in proportion to the value. Also, financial intermediaries recruit high quality staff to perform the process of finding suitable deficit agents. b) To begin with, an asset is broadly defined as any posse ssion that has value in an exchange. Assets can be classified into two main categories: real assets and financial assets. Real assets are goods that provide a flow or services over a period of time(examples are buildings, machinery, land). In contrast to real assets are financial assets, such as stocks, bonds or bank deposits. They are classified as intangible assets because they do not contribute directly to the production process; they are claims to the income generated by real assets. For financial assets the typical future benefit is a claim to future cash. Their performance depends on the performance of the underlying real assets. While real assets contribute to the net income in an economy, the role of financial assets is to allocate income or wealth among various investors. Financial assets can be classified into three broad types of securities: equity, debt or derivative securities. When an investor buys ownership shares(equity) in a company he actually invests money in it. The firm uses the money so raised to buy real assets which will in turn generate income which will be distributed to the owner of the shares in the form of dividends, proportional to the investment. Debt securities, on the other hand, promise the investor a fixed stream of income regardless of the financial condition of the issuer. Finally, derivative securities, such as options and futures contracts, derive their value from the prices of other assets(bonds or stocks). They are very useful to businesses because they are among the cheapest and most readily available means at companies disposal to buffer themselves against shocks in currency values, commodity prices and interest rates . c) The three concepts that will be approached in this section- risk, return and diversification- are closely linked. They represent the key issues of an investor when choosing how to allocate his surplus funds, or in other words what assets to hold. The answer will be that he will choos e the assets that give him the rate of return required, given the risk that they involve. Assuming that investors are risk averse income maximisers they will look for assets that involve minimum risk for a given level of return. A key measure of success is the rate of return on an asset, or to put in another way, the rate at which an investors funds have grown over a given period of time. The total holding period return(HPR) of a share of stocks will consist of any income(dividend) that the asset earns plus any capital gain(or loss). The reward from an investment is its expected return(also known as mean value) which is actually the average HPR an investor would earn if repeating its investment in the asset. Any investment involves some degree of uncertainty about future holding period returns and this is where risk derives from. Some of the sources of risk come from macroeconomic fluctuations, changing fortunes of various industries, asset-specific unexpected development. Risk can be defined as the probability that the actual return on an asset may differ from the expected return. By looking at this definition it is only reasonable to suggest that risk can be measured by examining the degree of variation in the return over a period of time. Therefore, it is sensible to say that an asset with a wide dispersion of actual returns around the mean is riskier than one which returns have been tightly clustered around the mean. In technical terms, the asset with a lower variance is less risky than the one with a high variance. However, some investors are willing to invest their money in risky assets if there is a high reward that will compensate for the risk involved. This reward is called the risk premium and it is the difference between the expected HPR on the stock and the risk- free rate(for example the rate of Treasury bills). On the other hand, there are some investors who are risk averse and they are less willing to hold a risky asset. It is ob vious to say that people are risk averse if the risk premium on an asset is zero. Risk averse investors require a higher risk premium in order to invest their funds in the risky assets; the risk premium will be greater the greater their risk aversion. One way of reducing the degree of risk to which investors are exposed is diversification, one of the many benefits offered by intermediaries. Diversification implies that as more securities are added to the portofolio, so the portofolios variance diminishes. However, there is no way to avoid all risk even if a large number of risky securities are bought. This is because ultimately all securities are affected by common macroeconomic factors. The risk that remains even after diversification is the market risk, while the one that can be eliminated by diversification is the firm-specific risk. A risk averse investor will do everything possible to diversify away the firm-specific risk since the market-risk will always remain. Moreover , diversification is of no benefit when the correlation coefficient is +1(there is a positive linear association between stocks). As a result, provided that the returns on assets are less than perfectly correlated, the more diversified is a portofolio the lower will be the risk associated with a given return.