FUNCTIONS OF MONEY

Functions of Money:
Money is something that is accepted as a form of payment for products or services, or for the payment of obligations. It is a medium of exchange with a specific value by which the value of all other things can be measured, which greatly facilitates trade and allows modern economies to enjoy the benefits of the division of labor. Wealth is the value of assets minus liabilities; money is one of those assets.

1. Unit of Account/Measure of Value:

Everything in the economy is quoted in terms of money. In this way, money functions as a unit of account.
This means that money is being used as the common benchmark to designate the prices of goods throughout the economy.
Because money is standardized into specific values, it can be used to price goods and services, and allows the easy comparison of prices.
Prices provide information for consumers and producers who allocate economic resources to their most desirable uses.
Items in demand command a higher price, which induces sellers to provide more of those items.

2. Medium of Exchange
Money is a medium of exchange because it can be used to buy goods and services in an attempt to satisfy unlimited needs and wants. Buyers give up money and receive goods. Sellers give up goods and receive money.
With a generally accepted medium of exchange, trades are easier and more efficient.

3. Store of Value
Value is obtained from a good when it is consumed, when it is used to satisfy wants and needs.
Money is one way of postponing the satisfaction obtained from using or consuming goods until at a later time.
The problem with storing value in money is price changes.
If the price of commodities rises, then money becomes a less effective means of storing value.
Unfortunately, inflation prevents most of the money in existence today from serving as a pure store of value, because the money loses a significant portion of its purchasing power over time. However, if there were no inflation, then money would serve as a near-perfect store of value.
4.TIME VALUE OF MONEY
A dollar in hand today is worth more than a dollar to be received in the future because, if you had it now, you could invest that dollar and earn interest.
Of all the techniques used in finance, none is more important than the concept of time value of money, also called discounted cash flow (DCF) analysis.
Future value and present value techniques can be applied to a single cash flow (lump sum), ordinary annuities, annuities due, and uneven cash flow streams. 
When compounding occurs more frequently than once a year, the effective rate of interest is greater than the quoted rate.

FUNCTIONS OF FINANCIAL MARKETS

Financial market is a market for the exchange of money. It brings together two kinds of people:
People who need money:
Borrowers in the financial market can be individuals who need money for personal consumption like buying a house, car, etc., private & public companies which need funds for expansion, setting up manufacturing facilities, launching a new product, R&D, etc., governments and other local authorities like municipalities to spend on public service and infrastructure like roads, healthcare, sanitation.
People who have surplus money:
Lenders in the financial market are actually the investors who have extra funds and want to use the additional money to earn more money. Their invested money is used to finance the requirements of borrowers. In return the investors expect to earn in the form of interests, dividends, company ownership, etc.

Financial Markets Functions:
Financial markets serve five basic functions. These functions are:
1.
Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment by the lender or consumption purposes by the borrower.

2.Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial product values and the flow of funds from lenders to borrowers.
This is an important function when it comes to transparency and results in better price discovery.
3.Price Determination:
Financial markets provide the platform by which prices are set both for new issues as well as existing financial products.
This function is similar to the way price mechanisms work in other markets through demand and supply.
A higher demand for a particular financial product results in a higher price and vice versa.
4.Risk Management:
Financial markets allow a transfer of risk from one person to another.
Examples of risk sharing are present in foreign currency transactions, derivatives etc.
If an exporter is worried about the Dollar appreciating, he can lock in the exchange rate by entering into a forward contract to buy in the future at a predetermined price.

5.Liquidity:
Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.

FUNCTIONS OF MONEY

Functions of Money:
Money is something that is accepted as a form of payment for products or services, or for the payment of obligations. It is a medium of exchange with a specific value by which the value of all other things can be measured, which greatly facilitates trade and allows modern economies to enjoy the benefits of the division of labor. Wealth is the value of assets minus liabilities; money is one of those assets.

1. Unit of Account/Measure of Value:

Everything in the economy is quoted in terms of money. In this way, money functions as a unit of account.
This means that money is being used as the common benchmark to designate the prices of goods throughout the economy.
Because money is standardized into specific values, it can be used to price goods and services, and allows the easy comparison of prices.
Prices provide information for consumers and producers who allocate economic resources to their most desirable uses.
Items in demand command a higher price, which induces sellers to provide more of those items.

2. Medium of Exchange
Money is a medium of exchange because it can be used to buy goods and services in an attempt to satisfy unlimited needs and wants. Buyers give up money and receive goods. Sellers give up goods and receive money.
With a generally accepted medium of exchange, trades are easier and more efficient.

3. Store of Value
Value is obtained from a good when it is consumed, when it is used to satisfy wants and needs.
Money is one way of postponing the satisfaction obtained from using or consuming goods until at a later time.
The problem with storing value in money is price changes.
If the price of commodities rises, then money becomes a less effective means of storing value.
Unfortunately, inflation prevents most of the money in existence today from serving as a pure store of value, because the money loses a significant portion of its purchasing power over time. However, if there were no inflation, then money would serve as a near-perfect store of value.
4.TIME VALUE OF MONEY
A dollar in hand today is worth more than a dollar to be received in the future because, if you had it now, you could invest that dollar and earn interest.
Of all the techniques used in finance, none is more important than the concept of time value of money, also called discounted cash flow (DCF) analysis.
Future value and present value techniques can be applied to a single cash flow (lump sum), ordinary annuities, annuities due, and uneven cash flow streams. 
When compounding occurs more frequently than once a year, the effective rate of interest is greater than the quoted rate.

CORE PRINCIPLES OF MONEY AND BANKING

The Five Core Principles of Money and Banking
Five core principles inform our analysis of the financial system and its interaction with the real economy. These principles are based on Time, Risk, Information, Markets, and Stability:

1.Time has value:
The first principle of money and banking is that time has value. Time has a price.  Time affects the value of financial transactions. Financial instruments with long maturities attract a higher compensation as compared to those with short term maturities. A dollar today is valuable than a dollar tomorrow.

2.Risk requires compensation:
With uncertainty, comes risk and dealing with risk requires that you consider the full range of possibilities in order to eliminate some risks, reduce others, pay someone to assume particular risks, and live with what’s left. Needless to say, no one will assume your risks for free. Compensation is made in the form of payments.

3.Information is the basis for decisions:
Most people collect information before making decisions. The collection and processing of information is the foundation of the financial system. Without information or with limited information, one makes un-informed choices that could lead to negative outcomes like losses. This is crippled by transaction costs.

4.Markets determine prices and allocate resources:
Markets are the place, physical or virtual where buyers and sellers meet.
Financial markets gather information from a large number of individual participants and aggregate it into a set of prices that signals what is valuable and what is not.
Thus markets are sources of information.
By attaching prices to different stocks, they provide a basis for the allocation of capital.

5.Stability improves welfare:
Stability is a desirable quality.
Volatility creates risk, reducing volatility reduces risk.
Hence, a major goal of financial systems is to provide economic stability.
Central banks have the major role of keeping the economy stable or stabilizing it if it falters. Central banks accomplish this by effecting monetary policies, such as adjusting the cost of money

CLASSIFICATIONS OF FINANCIAL INTERMEDIARIES TYPES OF FINANCIAL INTERMEDIARIES

2.5 Financial Intermediaries: Classifcation And Relationship.

Financial intermediaries are an organization of financial institutions, individuals and groups that link lenders and borrowers in the financial market. They act as middlemen and facilitate exchange of funds for financial securities. As expressed  earlier, financial institutions  exist primarily because of the conflict between lenders’ and borrowers’ requirements in  terms of deal size,  term to maturity, quality,  price and liquidity.
 
The distinguishing characteristics between banks, finance houses, insurance companies, unit trusts or any other type of intermediary lie  in the nature of  the claims  and services offered  to lenders and in  the nature of the  claims and  services offered  to the borrowers. 

It  is logical  to divide  financial intermediaries  into two broad  categories: mainstream financial  intermediaries (MFIs)  and QFIs.
It is  then reasonable  to classify  the  MFIs into deposit  and  non-deposit  intermediaries.
While  the  former  category  is  straightforward,  the second category may be split up in various ways.
A sensible split is into three categories:

1.Contractual Intermediaries (CIs),
2.Collective  Investment schemes (also  known as “portfolio intermediaries”)  (CISs)
3.Alternative Investments (AIs).

A.Deposit Intermediaries:
Under the category deposit intermediaries a central bank and the private sector banks are always present. In many countries other deposit-taking intermediaries are established for various reasons, such as mutual banks, savings and loan intermediaries, a Post  Office Bank etc.

Central bank: As is evident, the central bank intermediates between ultimate lenders; mainly the government (in its capacity as government banker), and the household sector (in its capacity as issuer of bank notes and coins) and the banks (i.e., their reserves required to be held for solvency and monetary policy purposes).
Private sector banks: The private  sector banks  intermediate between  all the  sectors that  make up  the ultimate  lenders, and virtually all other financial  institutions (in the form of  deposits and loans), on the  one hand, and all ultimate  borrowers (in the form of  loans, instalment credit and leasing contracts, mortgage advances and the  purchase of securities) on the other hand. E.g. Barclays Bank, Equity Bank.

B. Contractual Intermediaries:
The category contractual intermediaries  (CIs) is reserved for those intermediaries that offer contractual savings (and other like)  facilities: the insurers and the pension funds.

Insurers: Insurers may be split into two groups:  short-term insurers, long-term insurers (life companies or assurors). There  are also re-insurers, but they  fall into either of these  two groups.
Short-term insurers: intermediate between the  corporate and household sectors on the liabilities side of their collective balance  sheet (this is mainly in  the form of insurance policies issued), and the corporate and government sectors on the asset side of their balance sheet. E.g. Kenindia Insurance.
Long-term insurers: have a similar intermediation function as the short-term insurers. Their liabilities are comprised of various long-term polices, which are held mainly by  the corporate and household sectors, while, on the  asset side of their  balance sheet, they hold the  securities of all sectors  with the exception of the household sector. E.g. NHIF
Re-insurers: Like short-term insurers, they are not regarded as financial intermediaries by purist economists, because  their  liabilities  are  not certain. 
They intermediate between  other insurance companies and the corporate and  government sectors (in the form  of holdings of their securities).
Pension funds: Retirement funds also known as pension and provident funds intermediate between the public in the form of so-called contractual  savings on the one hand, and  ultimate borrowers mainly in the form  of shares/equities and securities of the  corporate and government and foreign sectors held. E.g. NSSF

Collective Unit Trusts:
The category  collective investment schemes  (CISs) applies to securities  unit trusts,  property unit trusts, and exchange traded funds  (ETFs).  It will be recalled that in many countries there are two main types of CISs: Securities unit trusts SUTs, and Property unit trusts PUTs
Securities Unit Trusts: intermediate almost solely  between the household sector  on the one hand and ultimate  borrowers (the  corporate and government  sectors) and  financial intermediaries  (mainly banks) on the other. Their assets are made up of almost all the securities of the corporate and government sectors (such as shares,  bonds, treasury bills) and bank  liabilities.
Property Unit Trusts: differ from the Securities unit trusts in that they are closed funds (i.e. their investment portfolio is  fixed on property development). They intermediate mainly  between the household  sector and pension funds, on  the one  hand, and  the corporate  sector on  the  other hand  (i.e. the  borrowers of  funds for property developments).
Alternative Investments:
In many countries another category of financial intermediary has emerged over the past number of years: alternative investments comprised of  private equity funds and hedge funds.
Hedge funds:  accept funds from certain  high net worth  individuals, foreign sector investors,  and contractual intermediaries in  the shape mainly of retirement  funds. They are investors in the corporate and government sectors and have derivatives margin  balances.
Private equity funds: They are large funds and invest in private equity, i.e. non-listed companies that they often “nurse” back to health (and listed companies that they delist, restructure, and list again).

C. Quasi-Financial Intermediaries:

It will be recalled that there are a number of institutions and funds that border on being classifed as financial intermediaries.
These institutions do  not borrow and/or  lend to the same  extent as the mainstream  intermediaries, or are not ongoing lenders and borrowers,  i.e. they tend to have liability and asset  financial portfolios that tend to be static
.
Development Finance Institutions:
These generally  intermediate  between ultimate  lenders  and fnancial  institutions  on  the one  hand  and mainly domestic  ultimate borrowers on  the other. 
The domestic ultimate  borrowers are  comprised of the household  sector  (mainly housing  loans and  small business  loans to  them), the  corporate sector (Mortgage loans and shares) and the government sector  (loans to local  authorities). E.g. Development Bank of Africa
Finance companies:
Finance themselves by share  capital and loans in various forms (from banks or other companies).
Their assets are  loans in various forms to  the household and corporate sectors. E.g. Housing Finance Company
Credit union: The business of a credit union, known also as a savings and credit cooperative (SACCO) is similar to  that of a bank, but  with the diference that it  is a co-operative institution. The essence  of its business is that of buying and selling money within a group of people who work in the same place or  who are members of the same community  (i.e. have a common bond). E.g. Mwalimu Sacco, Unaitas Sacco.
Micro-lenders: lend exclusively to  the household sector. On the liability side  of their balance sheets they are funded from own capital (i.e. from the  household sector) and loans (from the household sector and from the corporate sector). E.g. Shy-locks

FUNCTIONS OF FINANCIAL INTERMEDIARIES

. Economic functions of financial intermediaries
As noted, the financial  intermediaries essentially metamorphose the unacceptable claims on  borrowers into acceptable claims on  themselves. From this a number  of benefits for the economy arise:

1..Facilitation of flow of funds:

In essence,  financial intermediaries facilitate  the flow  of funds from  surplus economic  units to deficit economic units. Without sound financial intermediaries, much of the savings of the ultimate lenders will not be available to the ultimate borrowers.

This function may also be described as a savings and wealth storage function, i.e. surplus economic units have an  outlet  for their  funds and  are  thus able  to store  (preserve)  their wealth  in low-risk  (certain non-government securities) or risk-free (government  securities) or even risky (other non-government) financial instruments.
2.
Effcient allocation of funds
Financial intermediaries have the expertise to ensure that the flow of funds is allocated in the most efficient manner.
Intermediaries, particularly the  banks, are  aware of  the existence  of asymmetric  information and its two by-products, the  problems of adverse selection and moral hazard.

Asymmetric information means that the potential borrower has more information than the bank does about his/her business.
Adverse selection means that  bad risk borrowers are more  likely to want loans than  good risk borrowers.
  Moral hazard purports that once a loan is granted the borrower may be  inclined to take risks with the money that are not disclosed to the bank  in the application.
They thus ensure that available funds are allocated to borrowers that are expected to utilise the funds prudently, which in turn leads to an increase in economic activity.

3. Assistance in price discovery

Closely allied  with efficient  allocation of funds  is price discovery. 
The financial  intermediaries are the professionals on the financial  system, and are therefore keenly involved in price discovery. They are actively involved in the pricing of financial services and securities.

The central bank plays a major role in this regard via  its monetary policy.
As this is implemented via the banking sector, this sector  also plays a major role in the discovery  of interest rates.
Certain  institutions  also play  a  major  role  in the  discovery  of  other  asset  prices.
For  example, fund managers that manage pension funds are active in  differentiating between the market price and the  fair value of  equities, and influence the  pricing of equities via  their actions of either buy or sell in  the equity market.

4.
Money creation
This function may  also be  termed the bank loan/credit  function, because  it is this  action of  banks that  creates money  in the form  of new deposits.
Not only  are existing funds allocated  efficiently, but new  loans are allocated efficiently by the banking sector.
They  have the  unique ability  to create  money provided of course that the central bank assists in the process through the supply of borrowed cash reserves to the  banks.

The banks may thus be seen as the intermediaries that ease the constraint of income on expenditure, thereby enabling the consumer to spend in anticipation of income and the entrepreneur to easily acquire physical capital. 
These activities  are crucial  in terms  of output  and employment growth.

5. Enhanced liquidity for lender
If an individual purchases the securities of  the ultimate borrower  (such as making  a loan to  a company), liquidity is zero until maturity of the loan. Intermediaries purchase less or non-marketable indirect securities, and offer liquid investments to  the ultimate lenders.

A good example  is the banking  sector that makes non-marketable  securities such as  mortgages, leases and instalment credit contracts, and finances these by offering products that are immediately “cashable” such as current accounts and savings  accounts.

6. Price risk lessened for the ultimate lender

Financial  intermediaries take on price  risk and offer products  that have little or zero price risk. An example is an insurer that has a portfolio of shares and bonds that involve substantial price  risk, but offers products that have zero  price risk, such as guaranteed annuities.

Another fine  example is banks  that have  a diverse portfolio  that includes  price-sensitive bonds, loans and share/equity investments, and offer products that  have zero price risk such  as fixed deposits to depositors.

7. Improved diversification for lender

Members of  the household sector (i.e.  ultimate lenders) usually  have a smaller  wealth size and  can therefore only  achieve limited diversification compared  to a  financial intermediary  that aggregates  small amounts  for investment in the securities of the ultimate borrowers.
Thus, an individual has limited diversification possibilities and therefore carries a higher risk level than financial intermediaries, which are able to hold a wide variety of investments.
The central doctrine of portfolio theory (and practice) is that risk is reduced as the number of securities in a portfolio is increased.

8.Economies of scale
Because of the sheer  scale of financial intermediaries compared with individual participants, a number of economies are achieved. Two main economies are realised: Transactions costs and Research costs.

Transaction Costs:
The  largest  benefit  of  financial  intermediation  is  the  reduction  in  transactions  costs.
Even more important is  payment system costs.  The banking system,  through the use  of sophisticated technology, provides an efficient  payments service
(cheque clearing,  EFTs, ATM withdrawals, etc.) that  is relatively inexpensive.
Individual participants in the financial system cannot achieve this reduction in transactions costs.
Research Costs:
Another benefit is in terms of research costs. An individual holder of a diversified portfolio of shares has the task of monitoring the performance of each company,  which involves economic  analysis, industry analysis, ratio analysis, etc.
Financial  intermediaries do have the resources to  carry out research, which essentially benefits the holders of its products. A good example  is the retirement fund.  The retirement fund  member has a “share” or “participation interest” in the  portfolio of the fund, and  the fund has the resources to research  the investments on behalf of  the many members.

9.Payments system
The financial system (speciffically the banking sector) provides the mechanism for the making of payments for anything that  is purchased (goods, services,  securities).
Certain financial assets  serve as a means of payment and purchases are settled efficiently. The financial assets that are  accepted as a means of  payment (i.e. money) are: Bank notes and coins , and Bank deposits [transferred by cheques, credit cards, debit cards, EFTs etc.].

10. Risk alleviation
Certain financial  intermediaries are in  the business of offering protection against adverse occurrences such as untimely death, health problems, damage to property and loss of income.
In addition, the financial system allows for self-insurance, i.e. the storage and building of wealth in order to protect against adverse life, property and income  occurrences.

FINANCIAL INTERMEDIARIES

Financial Intermediaries.
Financial  intermediaries evolved  over many  years  to perform  the  financial-related functions  desired by the  four sectors  of the economy:  household, corporate,  government and  foreign sectors. However, some of them have been legislated  into being, such as the central bank.

Financial Intermediation
Income does not usually match expenditure; therefore surplus and deficit economic units exist. Given their  existence, which amounts to  a supply of  and a demand  for loanable funds,  some financial conduit is necessary  if the excess funds of surplus  units are to be transferred  to deficit units. The needs of these  units may  be reconciled  either through direct  financing or  indirect financing,  i.e. through the interposition of financial intermediaries.

Direct financing
This involves the bringing together of lenders and borrowers. However, a clash of  interests  exists between borrowers and lenders, and it is therefore rare that the ultimate lenders and borrowers are able to meet in order to consummate a deal. This is so because lenders tend to require investments (instruments / securities) that differ from those that  borrowers prefer to issue, and  the differences involve characteristics  such as size, term to maturity,  quality,  liquidity, etc. Borrowers  generally require  accommodation on terms differing from those  which lenders are willing or able to grant.

Financial intermediaries
Financial intermediaries performing indirect financing, assist in resolving this conflict between lenders  and  borrowers by  creating  markets  in  two types  of  financial  instruments,  i.e.  one type  for borrowers and another for lenders. They offer claims against themselves, customised to satisfy the needs (in terms of characteristics of instruments) of the lenders, in turn acquiring claims on the borrowers. The former claims are usually referred to as indirect securities and the latter as  primary securities.

The financial intermediaries receive a fee, represented by the difference between the cost of the indirect securities they issue and the revenue  earned  from the primary  securities they purchase(interest, dividends, capital gains).  In the case  of banks this is  called the margin.