©2009, The McGraw-Hill Companies, All Rights Reserved 2.WEEK INTRODUCTION TO FINANCIAL MARKETS,...

©2009, The McGraw-Hill Companies, All Rights Reserved

2.WEEK

INTRODUCTION TO FINANCIAL MARKETS, INSTITUTIONS AND

INSTRUMENTS

2


Why study Financial Markets and Institutions?

Prudent investment and financing requires a full 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 full 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 SYSTEM

Financial markets Financial institutions & İndividuals Financial assets (instruments, securities) Rules and regulations

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Financial Markets

Financial markets are structures through which funds flow.

Financial markets consist of

- fund suppliers or lenders

- fund demanders or borrowers

- financials instruments (fin assets, securities)

- financial institutions (intermediaries)

Financial markets are structures through which funds flow.

Financial markets consist of

- fund suppliers or lenders

- fund demanders or borrowers

- financials instruments (fin assets, securities)

- financial institutions (intermediaries)

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Types of Financial Markets

Money market Foreign exchange market Stock market Bonds and bills market Derivatives market Gold market

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Types of Fınancıal Markets cont.

Financial markets can be distinguished along three dimensions primary versus secondary markets money versus capital markets organized versus over the counter

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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Organized versus Over the Counter (OTC) Markets

Organized markets- Have a central physical

location- Commission- Registration is required- Controlling system: Formal- Customers’ orders provide

liquidity- Listing

Organized markets- Have a central physical

location- Commission- Registration is required- Controlling system: Formal- Customers’ orders provide

liquidity- Listing

OTC markets- No physical location- No commission- No need for registration- Any controlling system:

Informal- Dealers- No listing (except

NASDAQ)

OTC markets- No physical location- No commission- No need for registration- Any controlling system:

Informal- Dealers- No listing (except

NASDAQ)

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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 between two parties to exchange a standard quantity of assets at a predetermined 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 between two parties to exchange a standard quantity of assets at a predetermined price on a specific date in the future

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The Role (Economic Functions)of Financial Markets

1. They provide a mechanism for determinig the price of financial assets: Price discovery process, Efficiency of Financial Markets.

2. They make assets more liquid.

3. They reduce cost of exchanging assets: Search costs, Information costs.

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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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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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Users of Funds(corporations)

Suppliers of Funds

(households)

Financial Claims(equity and debt

instruments)

Cash

Flow of Funds in a World without FIs: Direct Transfer

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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 with FIs

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Services that are provided by FIs

1. Transform fin. assets acquired into assets that are more attractive to the public. (Fin. Intermediaries)

2. Exchange fin. Assets on the behalf of others (Brokers)3. Exchange fin. Assets for their own. (Dealers)4. Assists in the creation of fin. assets for their customers and

then sell these fin. assets to others.(underwriting)5. Provide inv. advices6. Provide portfolio management

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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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Financial Assets

An asset is any possession that has value in exchange.

Tangible-intangible assets Financial assets= Financial

Instruments=Securities are intangible assets. Issuer: The entitiy that agrees to make future

cash payments. Investor: The owner of the financial asset.

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Examples of Fin. Assets

The bond issed by the Turkish governmnet The bond issued by Koç Holding An automibile loan. A home mortgage. Common Stock issued by a company.

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Debt vs Equity Claims

Debt Claims (Debt Instruments)= Fixed Income securities= Bonds

Equity Claims (Residual claims)=Common Stock

There are also preferred stock, convertible bonds.

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The Role of Financial Assets

Fin Assets has two economic functions;

1. Transfering of funds who have surplus of funds to those who need funds to invest in tangible assets.

2. Transferring funds in such a way that redistributes the unavoidable risk associated with the CF generated by the tangible assets among those seeking and those providing the funds.

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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

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Globalization of Financial Markets and Institutions cont.

Foreign Markets: Foreigners can issue securities in other country markets, subject to national regulations. For example, Japanese firms can issue dollar-dominated securities in the United States but they must follow U.S. regulations, which apply to nationals and foreigners alike.

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Globalization of Financial Markets and Institutions cont.

International (Off shore or Euro) Market: Securities are issued outside the jurisdiction of any

country. The motivation for foreign and Eurodollar is that

many underdeveloped nations simply do not have a sizable capital market to meet their funds needs. Also Eurodollar loans are often less expensive since institutions holding such funds are not hampered by regulations.

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Financial Innovation

Categorizations of Financial Innovation;- Market-broadening Instruments- Risk management instruments,- Arbitraging instruments

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Motivation for Financial Innovation

1. Increased volatility of interest rates, inflation, equity prices, exchange rates.

2. Advances in computer&telecomminication technologies.

3. Greater sophistication and educational training among professional market participants.

4. Financial intermediary competition.5. Incentives to get around existing regulation and tax

laws.6. Changing global patterns of financial wealth

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Asset Securitization

It involves tha collection or pooling of loans and sale of securities backed by those loans.

©2009, The McGraw-Hill Companies, All Rights Reserved 2.WEEK INTRODUCTION TO FINANCIAL MARKETS,...

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