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FINANCIAL MARKETS
AND INSTITUTIONS

CONTENTS
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FINANCIAL MARKETS
FINANCIAL INSTITUTIONS
FINANCIAL REGULATIONS

AN OVERVIEW OF FINANCIAL
SYSTEM
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AN OVERVIEW OF
FINANCIAL MARKETS

What is Financial Markets?

Structure of Financial markets?
Instruments traded in Financial markets?
Functions of Financial markets

What is Financial system?

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Financial system (FS) a framework for

describing set of markets, organisations,
and individuals that engage in the
transaction
of
financial
instruments
(securities),
as
well
as
regulatory
institutions.
- the basic role of FS is essentially
channelling of funds
within the different
units of the economy from
surplus
units to deficit units for productive
purposes.

What is Financial Markets?

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Financial markets perform the essential function of

channeling funds from economic players that have
saved surplus funds to those that have a shortage of
funds
At any point in time in an economy, there are individuals
or organizations with excess amounts of funds, and
others with a lack of funds they need for example to
consume or to invest.

Exchange between these two groups of agents is settled

in financial markets
The first group is commonly referred to as lenders, the
second group is commonly referred to as the borrowers of
funds.

What is Financial Markets?

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We will start our discussion on financial markets

with some basic definitions:

There exist two different forms of exchange in financial

markets. The first one is direct finance, in which lenders
and borrowers meet directly to exchange securities.
Securities are claims on the borrowers future
income or assets. Common examples are stock, bonds
or foreign exchange
The second type of financial trade occurs with the help of
financial intermediaries and is known as indirect
finance. In this scenario borrowers and lenders never
meet directly, but lenders provide funds to a financial
intermediary such as a bank and those intermediaries
independently pass these funds on to borrowers

I.2 Structure of Financial

Markets
Financial markets can be categorized as
follows:

Debt vs Equity markets

Primary vs Secondary markets
Exchange vs Over the Counter (OTC)
Money vs Capital Markets

Debt vs Equity

Financial markets are split into debt and equity markets.

Debt titles are the most commonly traded security. In these

arrangements, the issuer of the title (borrower) earns some initial
amount of money (such as the price of a bond) and the holder
(lender) subsequently receives a fixed amount of payments over
a specified period of time, known as the maturity of a debt title.

Debt titles can be issued on short term (maturity < 1 yr.), long
term (maturity >10 yrs.) and intermediate terms (1 yr. < maturity
< 10 yrs.).

The holder of a debt title does not achieve ownership of the

borrowers enterprise.

Common debt titles are bonds or mortgages.

Debt vs Equity

Equity titles are somewhat different from bonds. The most

common equity title is (common) stock.

First and foremost, an equity instruments makes its buyer

(lender) an owner of the borrowers enterprise.

Formally this entitles the holder of an equity instrument to earn

a share of the borrowers enterprises income, but only
some firms actually pay (more or less) periodic payments to
their equity holders known as dividends. Often these titles,
thus, are held primarily to be sold and resold.

Equity titles do not expire and their maturity is, thus,

infinite. Hence they are considered long term securities.
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PRIMARY MARKETS Vs SECONDERY MARKETS

Markets are divided into primary and secondary
markets

Primary markets are markets in which financial instruments

are newly issued by borrowers.

Secondary
instruments
lenders.

Secondary markets can be organized as exchanges, in which

titles are traded in a central location, such as a stock
exchange, or alternatively as over-the-counter markets in
which titles are sold in several locations.

markets are markets in which financial

already in existence are traded among

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MONEY MARKETS VS CAPITAL MARKETS

Finally, we make a distinction between money and capital
markets.

Money markets are markets in which only short term

debt titles are traded.

Capital markets are markets in which longer term debt

and equity instruments are traded.

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I.3 INSTRUMENTS TRADED

IN THE FINANCIAL MARKETS

Principal Money Market Instruments (maturity < 1 yr.)

Source: Miskin

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I.3. INSTRUMENTS TRADED

IN THE FINANCIAL MARKETS (Cont)
INSTRUMENTS TRADED IN THE CAPITAL MARKETS

Source: Miskin

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I.3 INSTRUMENTS TRADED

IN THE FINANCIAL MARKETS

Most commonly you will encounter:

Corporate stocks are privately issued equity instruments,

which have a maturity of infinity by definition and, thus, are
classified as capital market instruments

Corporate bonds are private debt instruments which have a

certain specified maturity. They tend to be long-run
instruments and are, hence, capital market instruments

The short-run equivalent to corporate bonds are

commercial papers which are issued to satisfy short-run
cash needs of private enterprises.
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I.3 INSTRUMENTS TRADED

IN THE FINANCIAL MARKETS

Most commonly you will encounter:

On the government side, the most commonly used long-run

debt instruments are Treasury Bonds or T-Bonds. Their
maturity exceeds ten years.

Short-run liquidity needs are satisfied by the issuance of

Treasury Bills or T-Bills, which are short-run debt titles with a
maturity of less than one year.

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Valuing a Bond
C1
C2
1,000 CN
PV

...
1
2
N
(1 r) (1 r)
(1 r)
Price of a bond is the sum of the discounted future cash flows.

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Valuing a Bond

What is the discount rate = market

determined, affected by perceived risk?

As discount rates the price

Inverse relationship between price and

yield

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Valuing a Bond

Clearly higher rates lead to a fall in

price

Also note: Bond price par

as bond maturity.

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Interest Rates

Sensitivity of bond prices to interest rate

changes?

Longer dated bonds - more sensitive

Lower coupon bonds - more sensitive

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What effects bond prices?

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1.
2.
3.
4.

Interest rates
Coupon and Maturity
Credit ratings, (Moodys, S&P etc.)
Economic Environment
Flight to quality?

Functions of Financial markets

Borrowing and Lending

Financial markets channel funds from households, firms,

governments and foreigners that have saved surplus
funds to those who encounter a shortage of funds (for
purposes of consumption and investment)

Price Determination

Financial markets determine the prices of financial assets.

The secondary market herein plays an important role in
determining the prices for newly issued assets
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Functions of Financial markets

Coordination and Provision of Information

The exchange of funds is characterized by a high amount of

incomplete and asymmetric information. Financial markets
collect and provide much information to facilitate this
exchange.

Risk Sharing

Trade in financial markets is partly motivated by the transfer of

risk from borrowers to lenders who use the obtained funds to
invest

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Functions of Financial markets

Liquidity

The existence of financial markets enables the owners of

assets to buy and resell these assets. Generally this leads
to an increase in the liquidity of these financial instruments

Efficiency

The facilitation of financial transactions through financial

markets lead to a decrease in informational cost and
transaction costs, which from an economic point of view
leads to an increase in efficiency.
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II.FINANCIAL INSTITUTIONS
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What are Financial Institutions?

Financial Institutions and their function
Types of Financial Institutions

II.1What are Financial

Institutions ?

Financial intermediaries are firms that collect the funds from

lenders and channel those funds to borrowers (Mishkin)
Financial intermediaries are firms whose primary business is to
provide customers with financial products and services that can
not be obtained more efficiently by transacting directly in
securities markets (Z.Bodie &Merton)

Any classification of financial institutions is ultimately somewhat

arbitrary, since financial markets are subject to high dynamics
and frequent innovation. Thus, we roughly use four categories:
Brokers
Engage in trade in securities
Dealers
(direct finance)
Investment banks

Financial intermediaries

Engage in financial asset

transformation (indirect
finance)

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II.1What are Financial Institutions?

(Cont)

Brokers are agents who match buyers with sellers for a

desired transaction.

A broker does not take position in the assets she/he trades

(i.e. does not maintain inventories of those assets)

Brokers charge commissions on buyers and/or sellers using

their services

Examples: Real estate brokers, stock brokers

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II.1What are Financial Institutions?

(Cont)

Like brokers, dealers match sellers and buyers of financial

assets.

Dealers, however, take position in their assets, their trading.

As opposed to charging commission, dealers obtain their profits from

buying assets at low prices and selling them at high prices.

A dealers profit margin, the so-called bid-ask spread is the

difference between the price at which a dealer offers to sell an asset
(the asked price) and the price at which a dealer offers to buy an
asset (the bid price)

Examples: Dealers in U.S. government bonds, Nasdaq stock dealers

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II.1What are Financial Institutions?

(Cont)

Investment Banks

Investment banks assist in the initial sale of newly issued

securities (e.g. IPOs)

Investment banks are involved in a variety of services for

their customers, such as advice, sales assistance and
underwriting of issuances

Examples: Morgan-Stanley,
Brothers ..(Before Crisis 2008)

Goldman

Sachs,

...Lehman

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II.1What are Financial Institutions?

(Cont)

Financial Intermediaries

Financial intermediaries match sellers and buyers indirectly

through the process of financial asset transformation.

As opposed to three above mentioned institutions. they buy a

specific kind of asset from borrowers usually a long term
loan contract and sell a different financial asset to savers
usually some sort of highly-liquid short-run claim.
Although securities markets receive a lot of media attention,
financial intermediaries are still the primary source of
funding for businesses.

Even in the United States and Canada, enterprises tend to

obtain funds through financial intermediaries rather than
through securities markets.

Other than historic reasons, this prevalence results from a

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variety of factors.

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II.2 Function of Financial

Intermediaries: Indirect Finance
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Lower transaction costs

Economies of scale
Liquidity services
Since transaction costs are reduced, financial intermediaries are able to provide
customers with additional liquidity services, such as checking accounts
which can be used as methods of payment or deposits which can be
liquidated any time while still bearing some interest .

Reduce Risk

Risk Sharing (Asset Transformation)

Diversification

Through the process of asset transformation not only maturities, but also the
risk of an asset can change: A financial intermediary uses funds it
acquires (e.g. through deposits) and often turns them into a more risky asset
(e.g. a larger loan). The risk then is spread out between various borrowers
and the financial intermediary itself.
The process of risk sharing is further augmented through diversification of
assets (portfolio-choice), which involves spreading out funds over a
portfolio of assets with different types of risk.

II.2 Functions of Financial

Intermediaries: Indirect Finance
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Reduce Asymmetric Information

Asymmetric Information in financial markets - one
party often does not know enough about the other
party to make accurate decisions.
Adverse Selection (before the transaction)more
likely to select risky borrower
Moral Hazard (after the transaction)less likely
borrower will repay loan
=> Financial intermediaries are important in the
production of information. They help reduce
informational asymmetries about some
unobservable quality of the borrower for example
through screening, monitoring or rating of
borrowers, Net worth and collateral.

II.2 Functions of Financial

Intermediaries: Indirect Finance

Finally, some financial intermediaries specialize on services

such as management of payments for their customers or
insurance contracts against loss of supplied funds.

Through all of these channels financial intermediaries increase

market efficiency from an economic point of view.

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II.3TYPES OF FINANCIAL
INTERMEDIARIES

There are roughly

intermediaries:

three

classes

of

financial

Depository institutions accept deposits from savers and

transform them into loans (Commercial banks, savings and
loan associations, mutual savings banks and credit unions)

Contractual savings institutions acquire funds at

periodic intervals on a contractual basis (insurance and
pension funds)

Investment intermediaries serve different forms of

finance. They include finance companies, mutual funds
and money market mutual funds.
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Commercial Bank
Savings and Loans Associations (S&L)
Depository
Institutions

Mutual Saving Banks

Credit Unions
Specialized Banks

Financial
Intermed
iaries

Contractual
savings
Institutions

Insurance Companies
Pension Funds

Finance Companies
Investment
Intermedarie
s

Mutual Funds (Investment Funds)

Money market Mutual Funds

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III. FINANCIAL REGULATION

Why regulate financial markets?
Financial

markets are among the most

regulated markets in modern economies.

The

first reason for this extensive regulation is

to increase the information available to
investors (and, thus, to protect them).

The

second reason is to ensure

soundness of the financial system.
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the

III. FINANCIAL REGULATION

1. Increasing information available to
investors

As mentioned above, asymmetric information can cause

severe problems in financial markets (Risk behavior, insider
trades,....)

Certain regulations are supposed to prohibit agents with

superior information from exploiting less informed agents.

In the U.S. the stock-market crash of 1929 led to the

establishment of the Securities and Exchange Commission
(SEC), which requires companies involved in the issuance of
securities to disclose certain information relevant to their
stockholders. The SEC further prohibits insider trades
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III. FINANCIAL REGULATION

2. Ensuring the soundness of financial
intermediaries

Even more devastating consequences from asymmetric information

manifest themselves in collapses of the entire financial system
so called financial panics.

Financial panics occur if providers of funds on a large scale

withdraw their funds in a brief period of time from the financial
system leading to a collapse of the system. These panics can produce
enormous damage to an economy.

Examples of some recent panics are the crises in the Asian Tiger
states, Argentina or Russia. The United States, while spared for most of
the second half of 20th century, has a long tradition of financial crises
throughout the 19th century up to the Great Depression.
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III. FINANCIAL REGULATION

3. Solutions for ensuring the soundness of
financial intermediaries

Restrictions on entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates
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Financial regulation
Limits to Competition

An argument of politics rather than economics is that

overly hard competition in the banking sector increases
the risk of bank failure. This belief has (especially in the
past) led to some restrictions in the commercial
banking sectors

In the U.S. private banks e.g. were prohibited to open

branches in different states

The empirical evidence for the benefits of limiting

competition is weak and from an economic point of view
it appears more as an obstacle to risk diversification
rather than a useful regulation
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Financial regulation
Restriction of interest rates

The experience of the Great Depression in the U.S. has led

to the widespread belief that interest rate competition
paid on deposits might facilitate bank failure and to
strong regulation of interest rates on bank deposits

Unlike most other developed economies, banks in the U.S.

were prohibited from paying any interest on
deposits from 1933. Under what is known as
Regulation Q, the Federal Reserve System had the power
to set the maximum interest rates payable on savings
deposits until 1986.

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