Ch01.Ppt Overview

Power Point Slides for:
Financial Institutions, Markets, &

Money, 11th Edition
Authors: Kidwell, Blackwell, Whidbee &
Sias
Prepared by:
Deniz K. Tudor, San Francisco State University
Copyright 2012 John Wiley & Sons, Inc.
CHAPTER 1
An Overview of Financial Markets and
Institutions
The Financial System

Provides for efficient flow of funds from
saving to investment by bringing savers and
borrowers together via financial markets
and financial institutions.
Exhibit 1.1 Transfer of Funds
Basic components of the financial system: Markets and institutions.
Financial markets are markets for financial

claims, also called financial instruments or
securities.
Financial institutions (also called financial
intermediaries) facilitate flows of funds from
savers to borrowers.
Economic units with financial needs: Households, Businesses,

Governments.
Households supply labor, demand products, and

save for the future.
Businesses demand labor, supply products, and
invest in productive assets.
Governments collect taxes and provide public
goods (e.g. education, defense).
Budget positions creating financial needs of economic units:

Surplus or deficit.
Surplus spending units ( SSUs) have income

for the period that exceeds spending,
resulting in savings.
Other words for SSU are saver, lender, or
investor. Most SSUs are households.
Deficit spending units (DSUs) have

spending for the period that exceeds income .
Another word for DSU is borrower. Most
DSUs are businesses or governments.
Financial claims arise as SSUs lend to DSUs.
SSUs claim against DSU is liability to

DSU and asset to SSU.
Ones liability is anothers asset: What is
payable by one is receivable by another.
Assets arising this way are financial
assets. The financial system balancestotal financial assets equal total liabilities .
Marketability: Ease with which a financial asset may be sold to

another SSU.
Ability to resell financial claims makes them

more liquid by giving SSUs choices:
Match maturity of claim to planned investment
period;
Buy claim with longer maturity, but sell at end of
period; or
Buy claim with shorter maturity, then reinvest.
Direct Financing: The simplest way for funds to flow.
DSU and SSU find each other and bargain.

SSU transfers funds directly to DSU.
DSU issues claim directly to SSU.
Preferences of both must match as to-Amount
-Maturity
-Risk
-Liquidity
10
Direct Financing: efficient for large transactions if preferences

match.
DSUs and SSUs seize the day

DSUs fund desired projects immediately.
SSUs earn timely returns on savings.
Direct markets are wholesale markets.
Transactions typically $1 million or more.
Institutional arrangements common.
11
Institutional arrangements common in direct finance.
Private placements are simplest.

Investment bankers underwrite new
issues of securities.
Brokers and dealers bring buyers and
sellers of direct claims together.
12
Private placements are simplest.
DSU sells whole security issue to one

investor or investor group.
Advantages include speed and low
transactions costs.
13
Investment bankers underwrite new issues of securities.
Buy entire issues of securities from DSUs

Find SSUs to buy securities at higher price
Profit from difference - underwriting
spread
14
Brokers and dealers

Brokers buy or sell at best possible price for
their clients.
Dealers make markets by carrying
inventories of securities.
buy at bid price; sell at ask price
Bid-ask spread is dealers gross profit
15
Problem with direct financing: DSUs and SSUs cannot always match
preferences.
Not every SSU can afford wholesale

denominations of $1 million or more.
DSUs and SSUs often prefer different terms
to maturity.
16
Indirect Financing (Financial Intermediation):
Financial intermediaries transform

claims:
raise funds by issuing claims to SSUs;
use funds to buy claims issued by DSUs.
Claims can have unmatched characteristics:
SSU has claim against intermediary;
Intermediary has claim against DSU.
17
Economics of financial intermediation
Financial intermediaries exist due to market

imperfections:
Transaction costs
Information costs
Asymmetric information problems:
Adverse selection
Moral hazard
18
Familiar forms of financial intermediation

Commercial Banking
Insurance
19
Commercial Banks
Take deposits and make loans Depositors are SSUs
Borrowers are DSUs.
20
Insurance Companies
Issue policies, collect premiums, and invest
in stocks and bonds.
Policyholders are SSUs;
Businesses or governments are DSUs.
21
Benefits of financial intermediation are a primary rationale for the

financial system.
Financial intermediaries lower the cost of financial

services as they pursue profit.
Financial intermediaries perform 5 basic services
as they transform claims.
22
Intermediaries lower the cost of financial services as they pursue

profit.
3 sources of comparative advantage:

Economies of scale
Transaction cost control
Risk management expertise
Competition pulls interest rates down

Financing less costly
Projects have higher NPVs
Investment in real assets boosts economy
23
Intermediaries perform 5 basic services as they transform

claims.
Denomination Divisibility pool savings of many

small SSUs into large investments.
Currency Transformation buy and sell financial
claims denominated in various currencies.
Maturity Flexibility Offer different ranges of
maturities to both DSUs and SSUs.
24
Intermediation Services, cont.
Credit Risk Diversification Assume credit risks

of DSUs; spread risk over many different types of
DSUs.
Liquidity Give SSUs and DSUs different choices
about when, to what extent, and for how long to
commit to financial relationships.
25
4 Major types of financial intermediaries transform claims to meet

various needs.
Deposit-type or Depository Institutions

Contractual Savings Institutions
Investment Funds
Other Institutions
26
Depository Institutions take deposits and make loans.
Commercial Banks
Thrift Institutions
Savings & Loan Associations
Savings Banks
Credit Unions
27
Commercial Banks
Largest single class of financial institution
Issue wide variety of deposit products checking, savings, time deposits
Carry widely diversified portfolios of loans,
leases, government securities
May offer trust or underwriting services
28
Thrift Institutions
Closely resemble commercial banks
Focus more on real estate loans, savings deposits,
and time deposits
29
Credit Unions: Unique Characteristics

Mutual ownership -owned by depositors
or members
Common bond - members must share
some meaningful common association
Not-for-profit and tax-exempt
Restricted mostly to small consumer loans
30
Contractual Institutions bring long-term savers and borrowers

together.
Life Insurance Companies

Casualty Insurance Companies
Pension Funds
31
Life Insurance Companies insure against lost income at death.
Policyholders pay premiums, which are

pooled and invested in stocks, bonds, and
mortgages
Investment earnings cover the costs and
reward the risks of the insurance company
Investments are liquidated to pay benefits.
32
Casualty Insurance Companies cover property against loss or

damage.
Sources and uses of funds resemble those of

life insurers, but
Casualty claims are not as predictable as
death claims; so
More assets are in short-term, easily
marketable investments
33
Pension Funds help workers plan for retirement.
Workers and/or employers make

contributions, which are pooled and
invested in stocks, bonds, and mortgages
Net of administrative costs, investment
earnings are reinvested and compounded
Retirement benefits replace paychecks (at
least partly)
34
Investment Funds help small investors share the benefits of large

investments.
Mutual Funds provide intermediated access to

various capital markets
shareholders money is pooled and invested in
stocks, bonds, or other securities according to
some objective
Money Market Mutual Funds (MMMFs) are
uninsured substitutes for deposit accounts
MMMFs buy money market instruments
wholesale, pay investors interest, and allow
limited check-writing
35
Other Financial Institutions

Finance Companies
Make loans but do not take deposits; raise
loanable funds in commercial paper market and
from shareholders
Federal Agencies
Issue agency securities backed by government
and lend at sub-market rates for favored social
purposes
36
Exhibit 1.4Major Financial Intermediaries
37
Exhibit 1.5
Major Financial Intermediaries: Sources & Uses of Funds
38
Financial Markets are classified in several ways.
Primary and Secondary

Exchange and Over-the-Counter
Public and Private
Futures and Options
Foreign Exchange
International and Domestic
Money and Capital
39
Primary and Secondary Markets
Primary markets are where financial claims are

born: DSUs receive funds, claims are first
issued.
Secondary markets are where financial claims
liveare resold and repriced.
Claims become more liquid because SSUs
can set their own holding periods.
Trading sets prices and yields of widely held
securities.
40
Exchanges and Over-the-Counter Markets

Exchanges: physical, relatively exclusive.
Physical trading floor and facilities available to
members of exchange, for securities listed on
exchange.
New York Stock Exchange
Chicago Board of Trade
OTC Markets: virtual, relatively inclusive.
Decentralized network available to any licensed
dealer willing to buy access and obey rules, for
wide range of securities.
The NASDAQ is a famous OTC market.
41
Futures Markets
Spot Markets: immediate pricing, immediate
delivery
Futures or Forward Markets: immediate pricing,
promise of future delivery
Futures contracts: standardized as to amounts, forms,
and dates; trade on organized exchanges
Forward contracts: individualized between parties
with particular needs
42
Options Markets
Rights in underlying securities or commodities
writer grants owner some exclusive right for some
certain time
Main types of options: Puts (options to sell)
Calls (options to buy)
Options on listed securities and widely held
commodities trade actively on organized
exchanges
43
Foreign Exchange Markets

Any currency is convertible to any other at some
exchange rate
Forex involves spot, future, forward, and option
markets
44
International and Domestic Markets

Help participants diversify both sources and uses
of funds
Examples of major international markets:
EurodollarsUS dollars deposited outside US
EurobondsBonds issued outside US but
denominated in US dollars
45
Money and Capital Markets

Money markets: wholesale markets for short-term
debt instruments resembling money itself
Capital markets: where capital goods are
permanently financed through long-term financial
instruments
(Capital goodsreal assets held long-term to
produce wealthland, buildings, equipment, etc.)
46
Money Markets
Help participants adjust liquidity
DSUs borrow short-term to fund current operations
SSUs lend short-term to avoid holding idle cash
Common characteristics of money market

instruments
Short maturities (usually 90 days or less)
High liquidity (active secondary markets)
Low risk (and consequently low yield)
Dealer/OTC more than organized exchange
47
Examples of Major Money Market Instruments
Treasury Bills
Negotiable Certificates of Deposit
Commercial Paper
Federal Funds (Fed Funds)
48
Exhibit 1.2Major Money Market Instruments
49
Capital Markets
Help participants build wealth

DSUs seek long-term financing for capital projects
SSUs seek highest possible return for given risk
Differences from money markets

Long maturities (5 to 30 years)
Less liquidity
(secondary markets active but more volatile)
Higher risk in most cases

(with higher potential yield)
Traded wholesale and retail on organized

exchanges and in OTC markets
50
Examples of
Major Capital Market Instruments
Common stock
Corporate bonds
Municipal bonds
Mortgages
51
Exhibit 1.3Major Capital Market Instruments
52
Risks of Financial Institutions

Credit or default risk: risk that a DSU may not
pay as agreed
Interest rate risk: fluctuations in a security's price
or reinvestment income caused by changes in
market interest rates
Liquidity risk: risk that a financial institution may
be unable to disburse required cash outflows, even
if essentially profitable
53
Risks of Financial Institutions, cont.

Foreign exchange risk: effect of exchange rate
fluctuations on profit of financial institution
Political risk: risk of government or regulatory
action harmful to interests of financial institution.
54
Regulation of the financial system
Protect consumers against industry abuses

Stabilize the financial system
Highlights of the Financial Regulatory
Reform Act of 2010
55

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Power Point Slides for:

Financial Institutions, Markets, &

Copyright 2012 John Wiley & Sons, Inc.

The Financial System

Copyright 2012 John Wiley & Sons, Inc.

Exhibit 1.1 Transfer of Funds

Copyright 2012 John Wiley & Sons, Inc.

Basic components of the financial system: Markets and institutions.

Financial markets are markets for financial

Copyright 2012 John Wiley & Sons, Inc.

Economic units with financial needs: Households, Businesses,

Households supply labor, demand products, and

Copyright 2012 John Wiley & Sons, Inc.

Budget positions creating financial needs of economic units:

Surplus spending units ( SSUs) have income

Deficit spending units (DSUs) have

Financial claims arise as SSUs lend to DSUs.

SSUs claim against DSU is liability to

Marketability: Ease with which a financial asset may be sold to

Ability to resell financial claims makes them

Copyright 2012 John Wiley & Sons, Inc.

Direct Financing: The simplest way for funds to flow.

DSU and SSU find each other and bargain.

Copyright 2012 John Wiley & Sons, Inc.

Direct Financing: efficient for large transactions if preferences

DSUs and SSUs seize the day

Copyright 2012 John Wiley & Sons, Inc.

Institutional arrangements common in direct finance.

Private placements are simplest.

Copyright 2012 John Wiley & Sons, Inc.

Private placements are simplest.

DSU sells whole security issue to one

Copyright 2012 John Wiley & Sons, Inc.

Investment bankers underwrite new issues of securities.

Buy entire issues of securities from DSUs

Copyright 2012 John Wiley & Sons, Inc.

Brokers and dealers

Copyright 2012 John Wiley & Sons, Inc.

Not every SSU can afford wholesale

Copyright 2012 John Wiley & Sons, Inc.

Indirect Financing (Financial Intermediation):

Financial intermediaries transform

Copyright 2012 John Wiley & Sons, Inc.

Economics of financial intermediation

Financial intermediaries exist due to market

Copyright 2012 John Wiley & Sons, Inc.

Familiar forms of financial intermediation

Copyright 2012 John Wiley & Sons, Inc.

Copyright 2012 John Wiley & Sons, Inc.

Copyright 2012 John Wiley & Sons, Inc.

Benefits of financial intermediation are a primary rationale for the

Financial intermediaries lower the cost of financial

Copyright 2012 John Wiley & Sons, Inc.

Intermediaries lower the cost of financial services as they pursue

3 sources of comparative advantage:

Competition pulls interest rates down

Intermediaries perform 5 basic services as they transform

Denomination Divisibility pool savings of many

Copyright 2012 John Wiley & Sons, Inc.

Intermediation Services, cont.

Credit Risk Diversification Assume credit risks

Copyright 2012 John Wiley & Sons, Inc.

4 Major types of financial intermediaries transform claims to meet

Deposit-type or Depository Institutions