Chapter One

Introduction

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Why study Financial Markets and Institutions?

They are the cornerstones of the overall financial system in which financial managers operate Individuals use both for investing Corporations and governments use both for financing

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Overview of Financial Markets

Primary Markets versus Secondary Markets Money Markets versus Capital Markets Foreign Exchange Markets

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Primary Markets versus Secondary Markets

Primary Markets
markets in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments (e.g. stocks and bonds)

Secondary Markets
markets where financial instruments are traded among investors (e.g. NYSE, NASDAQ)
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Money Markets versus Capital Markets

Money Markets
markets that trade debt securities with maturities of one year or less (e.g. CDs, U.S. Treasury bills)

Capital Markets
markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year
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Money Market Instruments Outstanding, 1990-1999 ($Bn)

1400 1200 1000 800 600 400 200 0 1990 Commercial paper U.S. T-bills
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1995

1999 Fed Funds and Repo Banker's accept.

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Capital Market Instruments Outstanding, 1990-1999 ($Bn)

20000 15000 10000 5000 0 1990
Corp. stocks Comm/farm mort. Treas. Sec. U.S. gov owned agencies Bank and consumer loans
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1995

1999
Res. Mortgages Corp. bonds St. & Loc. Gov. bonds U.S. gov sponsored agencies

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Foreign Exchange Markets

FX markets deal in trading one currency for another (e.g. dollar for yen) The spot FX transaction involves the immediate exchange of currencies at the current exchange rate The forward FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate
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Overview of Financial Institutions Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds (e.g. banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, pension funds)
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Flow of Funds in a World without FIs: Direct Transfer

Financial Claims (Equity and debt instruments) Users of Funds (Corporations) Cash Example: A firm sells shares directly to investors without going through a financial institution Suppliers of Funds (Households)

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Flow of Funds in a world with FIs: Indirect transfer

Users of Funds FI (Brokers) Suppliers of Funds

Financial Claims (Equity and debt securities)

FI (Asset transformers)

Financial Claims (Deposits and Insurance policies)

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Types of FIs
Commercial banks depository institutions whose major assets are loans and major liabilities are deposits Thrifts depository institutions in the form of savings and loans, credit unions Insurance companies financial institutions that protect individuals and corporations from adverse events
(continued)
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 Securities firms and investment banks financial institutions that underwrite securities and engage in securities brokerage and trading Finance companies financial institutions that make loans to individuals and businesses Mutual Funds financial institutions that pool financial resources and invest in diversified portfolios Pension Funds financial institutions that offer savings plans for retirement
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Services Performed by Financial Intermediaries

Monitoring Costs
aggregation of funds provides greater incentive to collect a firms information and monitor actions

Liquidity and Price Risk

provide financial claims to savers with superior liquidity and lower price risk
(continued)
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 Transaction Cost Services

transaction costs are reduced through economies of scale

Maturity Intermediation
greater ability to bear risk of mismatching maturities of assets and liabilities

Denomination Intermediation
allow small investors to overcome constraints imposed to buying assets imposed by large minimum denomination size

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Services Provided by FIs Benefiting the Overall Economy

Money Supply Transmission
Depository institutions are the conduit through which monetary policy actions impact the economy in general

Credit Allocation
often viewed as the major source of financing for a particular sector of the economy (e.g. farming and real estate)
(continued)
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Services Provided by FIs Benefiting the Overall Economy

Intergenerational Wealth Transfers
life insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the next

Payment Services
efficiency with which depository institutions provide payment services directly benefits the economy
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Risks Faced by Financial Institutions

Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Off-Balance-Sheet Risk Technology Risk Operation Risk Country or Sovereign Risk Insolvency Risk

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Regulation of Financial Institutions FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interest In an attempt to prevent their failure and the failure of financial markets overall

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Globalization of Financial Markets and Institutions

Financial Markets became more global as the value of stocks traded in foreign markets soared Foreign bond markets have served as a major source of international capital Globalization also evident in the derivative securities market
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Factors Leading to Significant Growth in Foreign Markets

The pool of savings from foreign investors has increased International investors have turned to U.S. and other markets to expand their investment opportunities Information on foreign investments and markets is now more accessible (e.g. internet) Some mutual funds allow ability to invest in foreign securities with low transaction costs Deregulation has enhanced globalization of capital flows
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