1

Role of Financial Markets and Institutions

Chapter Objectives
Describe

the types of financial markets

Describe

the role of financial institutions with financial markets

Identify

the types of financial institutions that facilitate transactions

Overview of Financial Markets

Financial Market: a market in which financial assets (securities) such as stocks and bonds can be purchased or sold

Financial markets provide for financial intermediation--financial savings (Surplus Units) to investment (Deficit Units) Financial markets provide payments system Financial markets provide means to manage risk

Overview of Financial Markets

Financial Market:

You act as a Surplus Unit as you put money in your checking/savings account, buy stocks, bonds and shares in Mutual funds and/or have part of your pay put into a retirement account. You act as a Deficit Unit as you buy with your credit card, borrow to buy a house or car and take out Student loans to go to school.

Overview of Financial Markets

Financial Markets

Financial markets provide payments system that you use every day to buy gas with your credit card, a check or even cash. Financial markets is a system allows a company, a school, a city, a county and a state to issue stocks and bonds to get the funds needed for their future. Financial markets allows you and I a way to get money to pay for a house or a car.

Overview of Financial Markets

Financial Market

Financial markets provide the means to manage risk by allowing one to fixed the rate of interest on their home loan for up to thirty years. Financial markets provide the means to manage risk for individuals and other investors to reduce their risk through the derivative market. Financial markets provide the means to manage risk by providing a safe haven for our funds, banks, savings and loans and credit unions.

Overview of Financial Markets

Broad Classifications of Financial Markets

Primary versus Secondary Markets Money versus Capital Markets Organized versus Over-the-Counter Markets

Primary Vs. Secondary Markets

PRIMARY
New

SECONDARY
Trading

Issue of Securities of Funds for Financial Claim for Borrower; an IOU for Lender

Previously Issued Securities New Funds for Issuer Liquidity

Exchange

No

Funds

Provides

for Seller

Money vs. Capital Markets

Money Short-Term, < 1 Year High Quality Issuers Debt Only Primary Market Focus Liquidity Market-Low Returns

Capital Long-Term, >1Yr Range of Issuer Quality Debt and Equity Secondary Market Focus Financing Investment--Higher Returns

Organized vs. Over-the-Counter Markets

Organized Visible Marketplace

Members

OTC Wired Network of Dealers

No

Trade Listed Central, Physical Location Securities Traded off the Exchanges

Securities

New

York Stock Exchange

All

Securities Traded in Financial Markets

Money Market Securities

Debt securities Only

Debt and equity securities

Capital market securities

Derivative Securities
Financial contracts whose value is derived from the values of underlying assets Used for hedging (risk reduction) and speculation (risk seeking)

Debt vs. Equity Securities

Debt Securities:
Contractual obligations (IOU) of Debtor (borrower) to Creditor (lender)
Investor

receives interest Capital gain/loss when sold Maturity date

Debt vs. Equity Securities

Equity Securities:
Claim with ownership rights and responsibilities
Investor

receives dividends if declared Capital gain/loss when sold No maturity dateneed market to sell

Valuation of Securities

Value a function of:

Future cash flows When cash flows are received Risk of cash flows

Present value of cash flows discounted at the market required rate of return Value determined by market demand/supply Value changes with new information

Investor Assessment of New Information

Economic Conditions

Industry Conditions

Impact of Future Cash Flows

Evaluation of Security Pricing

Investor Decision to Trade

Firm Specific Information

Exhibit 1.3

Financial Market Efficiency

Security

prices reflect available information

New

information is quickly included in security prices

balance liquidity, risk, and return needs

Investors

Financial Market Regulation

Why Government Regulation?
To

Promote Efficiency

High

level of competition Efficient payments mechanism Low cost risk management contracts

Financial Market Regulation Why Government Regulation?

To

Maintain Financial Market Stability

Prevent

market crashes Circuit breakers Federal Reserve discount window Prevent Inflation--Monetary policy Prevent Excessive Risk Taking by Financial Institutions

Financial Market Regulation

Why Government Regulation?
To

Provide Consumer Protection

Provide

adequate disclosure Set rules for business conduct

To

Pursue Social Policies

Transfer

income and wealth Allocate saving to socially desirable areas

Housing Student

loans

Financial Market Globalization

Increased

international funds flow

Increased

disclosure of information Reduced transaction costs Reduced foreign regulation on capital flows Increased privatization
Results: Increased financial integration--capital flows to highest expected risk-adjusted return

Role of Financial Institutions in Financial Markets

Information processing Serve special needs of lenders (liabilities) and borrowers (assets)

By denomination and term By risk and return

Lower transaction cost Serve to resolve problems of market imperfection

Role of Financial Institutions in Financial Markets

Types of Depository Financial Institutions
Commercial Banks $5 Trillion Total Assets

Savings Institutions $1.3 Trillion Total Assets

Credit Unions $.5 Trillion Total Assets

Types of Nondepository Financial Institutions

Insurance

companies Mutual funds Pension funds Securities companies Finance companies Security pools

Role of Nondepository Financial Institutions

Focused on capital market Longer-term, higher risk intermediation Less focus on liquidity Less regulation Greater focus on equity investments

Trends in Financial Institutions

Rapid growth of mutual funds and pension funds Increased consolidation of financial institutions via mergers Increased competition between financial institutions Growth of financial conglomerates

Global Expansion by Financial Institutions

International expansion International mergers Impact of the single European currency Emerging markets