Finance and Financial Markets

Third Edition

by Keith Pilbeam

Chapter 2 - Financial Intermediation and Financial Markets

Find an overview and useful learning resources below to accompany Finance and Financial Markets chapter two.

Chapter Introduction

Financial intermediation is the process of transferring sums of money from economic agents with surplus funds to economic agents that would like to utilize those funds. The key to understanding the process and the range of financial instruments available lies in recognizing that economic agents are a heterogeneous bunch having very different financial positions, investment, business and financial needs. For this reason, there are a wide range of financial intermediaries and financial instruments servicing these needs.

In this chapter we look at the various types of economic agents, making a crucial distinction between surplus and deficit agents. Money is transferred from one economic agent to another by a financial intermediary by means of the issuance of a financial security. The financial security is an asset for one party and a liability for the other party. As we shall see, financial intermediaries play a very important economic role in facilitating the transfer of funds between deficit and surplus economic agents, in large part because they are able to reconcile the often-conflicting needs of the two types of agent.

The chapter then proceeds to look at financial markets, where the financial securities are bought and sold, as well as the different types of players that operate in these markets. We look at various classifications that have been applied to financial markets, making the important distinction between primary and secondary markets. We then also look at the various players in financial markets that ultimately determine the prices of financial securities, that is, the hedgers, speculators and arbitrageurs.

Learning Objectives

In this chapter you will learn about:

  • What is meant by financial intermediation
  • Type I, II, III and IV financial liabilities
  • Risk and maturity transformation
  • The economic roles played by financial institutions
  • The difference between primary and secondary markets
  • Hedgers, speculators and arbitrageurs

Further Reading

Buckle, M. and Thompson, J. (2004) The UK Financial System: Theory and Practice, 3rd edn, Manchester University Press.

Falaschetti, D. and Orlando, M. (2008) Money, Intermediation and Governance. Edward Elgar.

Mayer, C. and Vives, X. (1995) Capital Markets and Financial Intermediation, Cambridge University Press.

Mikdashi, Z. (2001) Financial Intermediation in the Twenty-first Century, Palgrave Macmillan.

Spajic, L.D. (2002) Financial Intermediation in Europe, Kluwer Academic Press.

Thakor, A. and Boot, A. (eds) (2008) Handbook of Financial Intermediation and Banking, Elsevier.

Revision Questions

  1. Briefly describe the key functions of a financial system with regard to surplus and deficit agents.
  2. Briefly describe five types of product innovation that can occur in financial markets.
  3. Which is the riskier claim, equity or debt issued by a company? What are the implications for the required rate of return on the two types of claim?
  4. Explain the difference between Type I, Type II, Type III and Type IV liabilities.
  5. Explain the difference between maturity transformation and risk transformation.
  6. What is meant by the term ‘liquidity’ when applied to financial markets? How might it be measured?

Multiple Choice Questions

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