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Introduction to Financial Markets and Institutions

Overview of Financial System


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Financial system has five components:


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Money as a medium of exchange and store of wealth Financial instruments to transfer resources and risk Financial markets allow trading in financial instruments Financial institutions provide services, including access to financial markets Central banks monitor and stabilise the economy

Financial Instruments
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Financial instrument
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Is the legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions, e.g. stocks, loans, insurance

Uses of financial instruments include:


Act as a means of payment u Store of value u Allow for the trading of risk
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Characteristics of Financial Instruments


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Standardization financial instruments are homogenous Information summarise essential information about issuer. Resolve problem of information asymmetry Examples of financial instruments:
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Financial instruments used as store of value include: bank loans, bonds, mortgages, stocks Financial instruments used to transfer risk include: insurance contracts, futures contracts, options, swaps

Overview of Financial Markets


Financial Market: a market in which financial assets (securities) such as stocks and bonds can be purchased or sold
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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 Financial markets pool and communicate information about the issuers of financial instrument, summarising in the form of price

Function of Financial Markets


1. Allows transfers of funds from
person or business without investment opportunities to one who has them 2. Improves economic efficiency

Overview of Financial Markets


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Broad Classifications of Financial Markets

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

Money vs. Capital Markets


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

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

Primary vs. Secondary Markets


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PRIMARY
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SECONDARY
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New Issue of Securities Exchange of Funds for Financial Claim Funds for Borrower; an IOU for Lender

Trading Previously Issued Securities No New Funds for Issuer

Provides Liquidity for Seller

Organized vs. Over-the-Counter Markets


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Organized
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OTC
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Visible Marketplace
Members Trade

Wired Network of Dealers


No Central, Physical Location All Securities Traded off the Exchanges

Securities Listed
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GSE, NYSE

Securities Traded in Financial Markets


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Money Market Securities


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Debt securities Only

Capital market securities


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Debt and equity securities

Derivative Securities
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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 u Capital gain/loss when sold u Maturity date
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Debt vs. Equity Securities


Equity Securities: Claim with ownership rights and responsibilities
Investor receives dividends if declared u Capital gain/loss when sold u No maturity dateneed market to sell
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Valuation of Securities
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Value a function of:


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

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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

Financial Market Efficiency


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Security prices reflect available information


New information is quickly included in security prices Investors balance liquidity, risk, and return needs

The Role of Govt. in Financial Markets


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Government acts as financial intermediary through its:


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Direct lending provide credit on more favourable terms Guarantees guarantee the payment of principal and interest in whole or in part, in the event that the borrower defaults Sponsored enterprises govt. may sometimes provide capital for the formation of these firms

Financial Market Regulation


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To Maintain Financial Market Stability


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Prevent market crashes using Central


Banks discount window

Prevent Inflation--Monetary policy u Prevent Excessive Risk Taking by Financial Institutions

Financial Market Regulation


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To Promote Efficiency
High level of competition u Efficient payments mechanism u Low cost risk management contracts
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To Provide Consumer Protection


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Provide adequate disclosure Set rules for business conduct

Financial Market Regulation


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To Pursue Social Policies


Transfer income and wealth u Allocate saving to socially desirable areas
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To restrict Foreign Activities in Domestic market

To Control Level of Economic Activity

Forms of Regulation
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Disclosure Regulation Financial Activity Regulation Regulation of Financial Institutions Regulation of Foreign Participants Banking and Monetary Regulation

Financial Market Globalization


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Increased international funds flow


Increased disclosure of information l Reduced transaction costs l Reduced foreign regulation on capital flows l Increased privatization Results: Increased financial integration-capital flows to highest expected riskadjusted return
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Financial Institutions
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Financial institutions are firms that provide access to the financial markets, both to savers who wish to purchase financial instruments directly and to borrowers who want to issue them. Sit between savers and borrowers financial intermediaries e.g. banks, insurance companies, securities firms, pension funds etc.

Services of Financial Institutions


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Transforming financial assets Exchanging financial assets on behalf of customers Exchanging financial assets for own account Assisting in the creation of financial assets Providing investment advice Managing portfolios

Role of Financial Institutions in Financial Markets


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Information processing Serve special needs of lenders (liabilities) and borrowers (assets)
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By denomination and term By risk and return

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Lower transaction cost Serve to resolve problems of market imperfection

Types of Depository Financial Institutions


Types of Depository Financial Institutions
Savings Institutions Credit Unions

Commercial Banks

Types of Nondepository Financial Institutions


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Insurance companies Mutual funds Pension funds Securities companies Finance companies Security pools

Role of Nondepository Financial Institutions


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

Trends in Financial Institutions


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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


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

Hard Pegs: Currency Boards and Dollarization


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Dollarization
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One country formally adopts the currency of another country for use in all its financial transactions, completely eliminating its own monetary policy. Need not be based on the dollar. Monaco adopted the French franc in 1865 and uses the euro today. Ecuador, El Salvador. Panama has been dollarized since 1904.

Hard Pegs: Currency Boards and Dollarization


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Benefits of dollarization include:


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With no exchange, there is no risk of an exchange rate crises. Integration into the world markets increasing trade and investment By rejecting the possibility of inflationary finance, a country can reduce the risk premium it must pay on loans and generally strengthen its financial institutions. The benefits of dollarization is balanced against the loss of revenue that comes from issuing currency
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what is called seignorage.

Dollarization is not the same as monetary union.

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