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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

• 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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Historical Drivers of Change in Financial Markets

• Financial institutions (FI’s) were approaching a full cycle

– Banks were originally “full service”

• Performed all financial services

– 1930’s collapse led to separation of some of these services

– 70’s & 80’s new services come into being

• e.g. brokerage funds, mutual funds

– We were coming into an era where one FI offered all services again

• Citigroup for example

• This trend may be interrupted by the scandals of 2002

• Innovation is also driving change in the industry

• Asset securitization

• Derivative securities

• Internationalization of financial services

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Current Drivers of Change in Financial Markets

• Technological innovation is currently a major driver of change in the industry

• Asset securitization• The growth of derivative securities• Globalization of financial services

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Globalization of Financial Markets and Institutions

• Financial Markets have become 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 is also evident in the derivative securities market

• Financial Markets have become 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 is also evident in the derivative securities market

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Financial Markets

• Financial Markets defined

– Structures or arenas through which funds flow

• Financial Markets are comprised of two sectors - Primary & Secondary

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Primary Markets

• Primary Markets

– Borrowers or users of funds (corps) raise funds through issuance of financial instruments

– Suppliers of funds exchange cash for financial instruments issued in the primary market

– Generally, primary market transactions are facilitated by FI’s called investment banks

– Morgan Stanley, Lehman Bros, CSFB, Merrill, Goldman, etc.

– Security issuer can minimize risk by engaging in “Firm commitment underwriting”

• Investment bank buys entire issue, assuming the risk of not selling it all

• Issuer gets a guaranteed cashflow

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Primary Markets continued

• Primary Markets continued– Primary Market securities include:

• Equity offerings (stocks)– Initial public offerings (IPO’s)– Additional equity offerings (aka secondary offerings)

• Debt offerings (bonds)

– Primary Market transactions are often collaborative• Syndicates (groups of investment banks) underwrite the issuance

– Spreads risk– Enhances distribution

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Secondary Markets

• Secondary markets defined

– A market that trades securities after they are issued.

• Original security issuers are not involved in secondary market transactions

– Transactions involve buyers, sellers and brokers

• Secondary markets have two primary components

– Equity markets (stocks)

– Fixed income markets (bonds)

• Benefits of secondary markets

– For investors (suppliers of funds)

• Liquidity - able to turn the asset into cash relatively easily

• Diversification - mitigate risk by purchasing securities from many issuers

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Secondary Markets continued

• Benefits of secondary markets– For original issuers (users of funds)

• How their securities are currently trading will tell them much about:– How well they are using the funds raised from previous issues– How successful they would be in issuing instruments now– What it would cost them to issue securities now

• Example - Fixed Income - Household Finance– Context for spread volatility

• Slow economy hurting profitability• Recently fined $484 million for “predatory lending practices”• Speculation about “aggressive accounting” practices

– November 2002 announcement of a merge with HSBC

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Household Financial Example

February 2007 Treasury currently 2.68%

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Money Markets vs. Capital Markets

• Both (primary &secondary) markets are segmented according to maturity:– Money Markets

• Maturities one year or less• Fixed Income (debt) only

– Capital Markets• Maturities greater than one year• Fixed Income & Equity (Debt & Stocks)

– Some of the largest sectors of the Capital Markets» Stocks» Mortage-backed securities» Corporate and Agency Debt issuance

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Money Market Instruments Outstanding, 1990-2004 ($Bn)

0

500

1000

1500

2000

1990 2000 2004

Commercial paper Fed Funds and Repo U.S. T-bills

Negotiable CDs Banker's accept.

0

500

1000

1500

2000

1990 2000 2004

Commercial paper Fed Funds and Repo U.S. T-bills

Negotiable CDs Banker's accept.

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Capital Market Instruments Outstanding, 1990-2004 ($Bn)

0

5000

10000

15000

20000

1990 2000 2004

Corporate stocks Mortgages Corporate bonds

Treasury Securities State & Local Govt. bonds U.S. Govt agencies

Bank and consumer loans

0

5000

10000

15000

20000

1990 2000 2004

Corporate stocks Mortgages Corporate bonds

Treasury Securities State & Local Govt. bonds U.S. Govt agencies

Bank and consumer loans

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Exchange based and OTC markets

• Exchange based market

– A market located in a particular location

• Orders must arrive at that location to be executed

• Equity markets have historically been exchange based, Nasdaq is changing this characteristic

• Examples

– New York Stock Exchange

– Chicago Mercantile Exchange

– Chicago Board of Trade

• Over the counter market (OTC)

– Markets that have no particular location, transactions occur through a network of brokers/buyers/sellers linked by telephones and computer networks

• Fixed income markets are over the counter markets

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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

• “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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Derivative Security Markets

• The markets in which derivative securities trade.

• Derivative Security– An agreement between two parties to exchange

a standard quantity of an asset at a predetermined price on a specified date in the future.

• The markets in which derivative securities trade.

• Derivative Security– An agreement between two parties to exchange

a standard quantity of an asset at a predetermined price on a specified date in the future.

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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)

• 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

Users of Funds(Corporations)

Suppliers of Funds

(Households)

Financial Claims(Equity and debt

instruments)

Cash

Example: A firm sells shares directly to investors without going through a financial institution.

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Flow of Funds in a world with FIs: Indirect transfer

Users of FundsFI

(Brokers)

FI(Asset

transformers)

Suppliers of Funds

Financial Claims(Equity and debt securities)

Financial Claims(Deposits and insurance policies)

Cash Cash

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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

• 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

• 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

• Liquidity and Price Risk

• Transaction Cost Services

• Maturity Intermediation

• Denomination Intermediation

• Monitoring Costs

• Liquidity and Price Risk

• Transaction Cost Services

• Maturity Intermediation

• Denomination Intermediation

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Services Provided by FIs Benefiting the Overall Economy

• Money Supply Transmission

• Credit Allocation

• Intergenerational Wealth Transfers

• Payment Services

• Money Supply Transmission

• Credit Allocation

• Intergenerational Wealth Transfers

• Payment Services

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Risks Faced by Financial Institutions

• Interest Rate Risk• Foreign Exchange Risk• Market Risk• Credit Risk• Liquidity Risk• Technology Risk• Operational Risk• Country or Sovereign Risk• Insolvency Risk

• Interest Rate Risk• Foreign Exchange Risk• Market Risk• Credit Risk• Liquidity Risk• Technology Risk• Operational 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

• 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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Securities and Exchange Commission (SEC)

• Primary regulatory agency– Firms planning new security issuance must comply

with disclosure criteria imposed by the SEC– The SEC is concerned with ensuring that all

investors are given accurate and timely information on which to make investment decisions

– The SEC is not concerned with helping investors avoid bad investment decisions

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Financial Market Regulation

• SEC also interested in “damping” large price fluctuations in securities markets - examples include:

– “Circuit breakers”

• Cessation of trading when prices fluctuate in excess of % thresholds

– “Curbs”

• When prices fluctuate in excess of % thresholds trading is delayed until a counter-trend trade is executed

• Private placements do not fall under SEC oversight

– Private placements defined

• Securities not available to the public that are sold to a few large, sophisticated investors