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©2009, The McGraw-Hill Companies, All Rights Reserved
Chapter OneIntroduction
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Why study Financial Markets and Institutions?
• Prudent investment and financing requires a thorough understanding of– the structure of domestic and international
markets– the flow of funds through domestic and
international markets– the strategies used to manage risks faced by
investors and savers
• Prudent investment and financing requires a thorough understanding of– the structure of domestic and international
markets– the flow of funds through domestic and
international markets– the strategies used to manage risks faced by
investors and savers
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Financial Markets
• Financial markets are structures through which funds flow
• Financial markets can be distinguished along two dimensions– primary versus secondary markets– money versus capital markets
• Financial markets are structures through which funds flow
• Financial markets can be distinguished along two dimensions– primary versus secondary markets– money versus capital markets
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Primary versus Secondary Markets
• Primary markets– markets in which users of funds (e.g.,
corporations and 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 and Nasdaq)
• Primary markets– markets in which users of funds (e.g.,
corporations and 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 and Nasdaq)
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Money versus Capital Markets
• Money markets– markets that trade debt securities with
maturities of one year or less (e.g., CDs and U.S. Treasury bills)
• Capital markets– markets that trade debt (bonds) and equity
(stock) instruments with maturities of more than one year
• Money markets– markets that trade debt securities with
maturities of one year or less (e.g., CDs and 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, ($Bn)
0
500
1000
1500
2000
2500
3000
1990q4 2000q4 2007q1
Fed funds and repos Commercial paper Negotiable CDs
U.S. Treasury bills Banker's accept.
0
500
1000
1500
2000
2500
3000
1990q4 2000q4 2007q1
Fed funds and repos Commercial paper Negotiable CDs
U.S. Treasury bills Banker's accept.
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Capital Market Instruments Outstanding, ($Bn)
0
5000
10000
15000
20000
25000
1990q4 2000q4 2007q1
Corporate stocks Mortgages Corporate bonds
U.S. gov't agencies Treasury securities State & local gov't bonds
Bank and consumer loans
0
5000
10000
15000
20000
25000
1990q4 2000q4 2007q1
Corporate stocks Mortgages Corporate bonds
U.S. gov't agencies Treasury securities State & local gov't bonds
Bank and consumer loans
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Foreign Exchange (FX) Markets
• FX markets– trading one currency for another (e.g., dollar for yen)
• Spot FX– the immediate exchange of currencies at current
exchange rates
• Forward FX– the exchange of currencies in the future on a specific
date and at a pre-specified exchange rate
• FX markets– trading one currency for another (e.g., dollar for yen)
• Spot FX– the immediate exchange of currencies at current
exchange rates
• Forward FX– the exchange of currencies in the future on a specific
date and at a pre-specified exchange rate
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Derivative Security Markets
• Derivative security– a financial security whose payoff is linked to
(i.e., “derived” from) another security or commodity
– generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future
• Derivative security– a financial security whose payoff is linked to
(i.e., “derived” from) another security or commodity
– generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future
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Financial Market Regulation
• The Securities Act of 1933– full and fair disclosure and securities
registration
• The Securities Exchange Act of 1934– Securities and Exchange Commission (SEC) is
the main regulator of securities markets
• The Securities Act of 1933– full and fair disclosure and securities
registration
• The Securities Exchange Act of 1934– Securities and Exchange Commission (SEC) is
the main regulator of securities markets
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Financial Institutions (FIs)
• Financial Institutions– institutions through which suppliers channel
money to users of funds
• Financial Institutions are distinguished by whether they accept deposits– depository versus non-depository financial
institutions
• Financial Institutions– institutions through which suppliers channel
money to users of funds
• Financial Institutions are distinguished by whether they accept deposits– depository versus non-depository financial
institutions
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Users of Funds(corporations)
Suppliers of Funds
(households)
Financial Claims(equity and debt
instruments)
Cash
Flow of Funds in a World without FIsFlow of Funds in a World without FIs
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Users of FundsFIs
(brokers)
FIs(asset
transformers)
Suppliers of Funds
Financial Claims(equity and debt securities)
Financial Claims(deposits and insurance policies)
Cash Cash
Flow of Funds in a World without FIsFlow of Funds in a World with FIs
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Depository versus Non-Depository FIs
• Depository institutions– commercial banks, savings associations,
savings banks, credit unions
• Non-depository institutions– insurance companies, securities firms and
investment banks, mutual funds, pension funds
• Depository institutions– commercial banks, savings associations,
savings banks, credit unions
• Non-depository institutions– insurance companies, securities firms and
investment banks, mutual funds, pension funds
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FIs Benefit Suppliers of Funds
• Reduce monitoring costs
• Increase liquidity and lower price risk
• Reduce transaction costs
• Provide maturity intermediation
• Provide denomination intermediation
• Reduce monitoring costs
• Increase liquidity and lower price risk
• Reduce transaction costs
• Provide maturity intermediation
• Provide denomination intermediation
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FIs Benefit the Overall Economy
• Conduit through which Federal Reserve conducts monetary policy
• Provides efficient credit allocation
• Provide for intergenerational wealth transfers
• Provide payment services
• Conduit through which Federal Reserve conducts monetary policy
• Provides efficient credit allocation
• Provide for intergenerational wealth transfers
• Provide payment services
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Risks Faced by Financial Institutions
• Credit
• Foreign exchange
• Country or sovereign
• Interest rate
• Market
• Credit
• Foreign exchange
• Country or sovereign
• Interest rate
• Market
• Off-balance-sheet
• Liquidity
• Technology
• Operational
• Insolvency
• Off-balance-sheet
• Liquidity
• Technology
• Operational
• Insolvency
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Regulation of Financial Institutions
• FIs are heavily regulated to protect society at large from market failures
• Regulations impose a burden on FIs and recent U.S. regulatory changes have been deregulatory in nature
• Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation
• FIs are heavily regulated to protect society at large from market failures
• Regulations impose a burden on FIs and recent U.S. regulatory changes have been deregulatory in nature
• Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation
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Globalization of Financial Markets and Institutions
• The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before
• Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access
• International mutual funds allow diversified foreign investment with low transactions costs
• The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before
• Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access
• International mutual funds allow diversified foreign investment with low transactions costs