An Overview of Financial Markets and Institutions

CHAPTER 1

Basic components of the financial system: Markets and institutions.

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Financial markets are markets for financial instruments e.g. stocks, bonds etc, also called financial claims or securities.

Financial institutions (also called financial intermediaries) facilitate the flow of funds from savers to borrowers. e.g. banks, finance companies etc.

All Economic units can be classified in to :

Households supply labor, demand products, and save for the future.

Businesses demand labor, supply products, and invest in productive assets.

Governments collect taxes and provide “public goods” (e.g. education, defense).

Budget positions creating financial needs of economic units: Surplus or deficit.

Surplus spending units ( SSUs) have income for the period that exceeds spending, resulting in savings.

Other words for “SSU” are saver, lender, or investor. Most SSUs are households.

Deficit spending units (DSUs) have spending for the period that exceeds income.

Another word for “DSU” is “borrower”. Most DSUs are businesses or governments.

Financial claims arise as SSUs lend to DSUs.

Funds can be transferred from SSU to DSU by issuing financial claims.

Financial claim is a liability to DSU and an asset to SSU.

One’s liability is another’s asset: What is payable by one is receivable by another.

Assets arising this way are called “financial assets.”

The financial system “balances”-total financial assets equal total liabilities.

• SSU can hold the financial claim until maturity or sold to someone else. The ease with which a financial asset may be sold to another SSU, is its marketability.

• Ability to resell financial claims makes them

more liquid by giving SSUs choices:Match maturity of claim to planned investment

period;Buy claim with longer maturity, but sell at end

of period; orBuy claim with shorter maturity, then reinvest.

Marketability

Exhibit 1.1 – Transfer of Funds

Direct Financing: The simplest way forfunds to flow.

DSU and SSU find each other and bargain

SSU transfers funds directly to DSUDSU issues claim directly to SSUPreferences of both must match as to-

-Amount-Maturity-Risk-Liquidity

Direct Financing: efficient for large transactions if preferences match.

DSUs and SSUs “seize the day”—DSUs fund desired projects

immediately.SSUs earn timely returns on savings.

Direct markets are “wholesale” markets.Transactions typically $1 million or

more.Institutional arrangements common.

Institutional arrangements common in direct finance.

Investment bankers : firms that help companies sell new debt or equity.

Brokers and dealers: bring buyers and sellers of direct claims together.

Investment bankers “underwrite” new issues of securities.

Buy entire issues of securities from DSUs

Find SSUs to buy securities at higher price

Profit from difference - “underwriting spread ”

Brokers and dealers

Brokers: matchmakers who bring buyers and sellers together and get commissions.

Dealers: market makers who carry inventory of securities from which they buy and sell. Dealers can also work as matchmakers. buy at “bid price;” sell at “ask price” “Bid-ask spread ” is the dealer’s

profit.

Problem with direct financing: DSUs and SSUs cannot always match preferences.

Not every SSU can afford “wholesale” denominations of $1 million or more.

DSUs and SSUs often prefer different terms to maturity.

Indirect Financing “Financial Intermediation” Financial intermediaries purchase direct

claims with one set of characteristics from DSU and transform them to indirect claims with different set of characteristics which they sell to SSU. This transformation process is called financial intermediation.

Disintermediation is the reverse process (SSUs take their money from financial institutions and invest in direct claims).

Financial intermediaries transform claims

Benefits of financial intermediation are a primary rationale

for the financial system.

Financial intermediaries lower the cost of financial services as they pursue profit.

Financial intermediaries perform 5 basic services as they transform claims.

Intermediaries lower the cost of financial services as they pursue profit.

3 sources of comparative advantage: Economies of scale due to their

specialization. Low transaction costs. More effective way of obtaining and dealing

with information.

Competition pulls interest rates down Financing less costly. Projects have higher NPVs. Investment in real assets boosts economy.

Intermediaries perform 5 basic services as they transform claims.

Denomination Divisibility – pool savings of many small SSUs into large investments.

Currency Transformation – buy and sell financial claims denominated in various currencies.

Maturity Flexibility – Offer different

ranges of maturities to both DSUs and SSUs.

Intermediation Services, cont.

Credit Risk Diversification: spread risk over many different types of DSUs (don’t put your eggs into one basket).

Liquidity: Give SSUs and DSUs different choices about when, to what extent, and for how long to commit to financial relationships.

4 Major types of financial intermediaries transform claims to meet various needs.

Deposit-type or “Depository” InstitutionsContractual Savings InstitutionsInvestment Funds“Other” Institutions

Depository Institutions take deposits and make loans.

Commercial BanksThrift Institutions

Savings & Loan Associations Savings Banks

Credit Unions

Commercial Banks

Largest single class of financial institutions.

Issue wide variety of deposit products - checking, savings, time deposits.

Carry widely diversified portfolios of loans, leases, government securities.

May offer trust or underwriting services.

Thrift InstitutionsClosely similar to commercial banks.Focus more on real estate loans, savings

deposits, and time deposits. Major provider of mortgage loans.

Credit Unions: Unique Characteristics

Mutual ownership -“owned” by depositors or “members”.

“Common bond” - members must share some meaningful common association(e.g. employees in the same firm).

Not-for-profit and tax – exempt.

Restricted mostly to small consumer loans.

Contractual Institutions bring long-term savers and borrowers together.

• Obtain funds under long-term contractual arrangements and invest in capital markets.

• Relatively steady inflow of funds so usually no liquidity problems.

Life Insurance Companies Casualty Insurance Companies Pension Funds

Life Insurance Companies insure against lost income at death.

Policyholders pay premiums, which are pooled and invested in stocks, bonds, and mortgages

Investment earnings cover the costs and reward the risks of the insurance company

Investments are liquidated to pay benefits.

Casualty Insurance Companies cover property against loss or damage.

Covers property against loss or damage.Casualty claims are not as predictable

as death claims, so: - More assets are in short-term, easily

marketable investments. To offset low return they invest in equity

securities and municipal bonds to reduce taxes.

Pension Funds help workers plan for retirement.

Workers and/or employers make contributions, which are pooled and invested in stocks, bonds, and mortgages

Outflows are predictable so Pension funds are able to invest in higher yielding long term securities.

Investment Funds help small investors share the benefits of large investments.

Mutual Funds provide intermediated access to various capital marketsshareholders’ money is pooled and invested

in stocks, bonds, or other securities according to some objective

investment risk is reduced due to diversification, economies of scale and professionalism.

Money Market Mutual Funds (“MMMFs”) are uninsured substitutes for deposit accounts MMMFs buy money market instruments

wholesale, pay investors interest, and allow limited check-writing

“Other” Financial Institutions

Finance Companies—Make loans but do not take deposits; raise loanable funds in commercial paper market and from shareholders.

Federal Agencies—• Issue “agency securities” backed by

government and lend at sub-market rates for favored social purposes.

• Support agriculture and housing.

Financial Markets are classified in several ways.

Primary and SecondaryOrganized and Over-the-CounterSpot and FuturesOptionsForeign ExchangeInternational and DomesticMoney and Capital

Primary and Secondary Markets

Primary markets are where financial claims are “born”: DSUs receive funds, claims are first issued.

Secondary markets are where financial claims “live”—are resold and re-priced.

Main benefit is providing liquidity. Trading sets prices and yields of

widely held securities

Organized and Over-the-Counter Markets

Organized Exchanges: physical, relatively exclusive. Physical trading floor and facilities available

to members of exchange, for securities listed on exchange.

New York Stock Exchange Chicago Board of Trade (futures)

OTC Markets: virtual, relatively inclusive.Decentralized network available to any

licensed dealer willing to buy access and obey rules, for wide range of securities.

The NASDAQ is a famous OTC market.

Spot and Futures Markets

Spot Markets: immediate pricing, immediate delivery

Futures or Forward Markets: immediate pricing, promise of future delivery

“Futures” contracts: standardized as to amounts, forms, and dates; trade on organized exchanges

“Forward” contracts: individualized between parties with particular needs

Option MarketsRights in underlying securities or

commodities—writer grants owner some exclusive right for some certain time but not an obligation

Main types of options: Puts (options to sell)

Calls (options to buy)

Options on listed securities and widely held commodities trade actively on organized exchanges

Foreign Exchange Markets

Any currency is convertible to any other at some exchange rate

“Forex” involves spot, future, forward, and option markets

International and Domestic Markets

Help participants diversify both sources and uses of funds

Examples of major international markets:

Eurodollars—US dollars deposited outside U.S.

Eurobonds—bonds issued outside US but denominated in $US

Money and Capital Markets

Money markets: wholesale markets for short-term debt instruments resembling money itself.

Capital markets: where “capital goods” are permanently financed through long-term financial instruments (“Capital goods”—real assets held long-term to

produce wealth—land, buildings, equipment, etc.)

Money Markets

Help participants adjust liquidity—DSUs borrow short-term to fund current

operationsSSUs lend short-term to avoid holding idle cash

conductsCommon characteristics of money market

instruments— Short maturities (usually 90 days or less) High liquidity (active secondary markets) Low risk (and consequently low yield) Dealer/OTC more than organized

exchange

Examples of Major Money Market Instruments

Treasury Bills: direct obligation from the government, no default risk and maturity from 3 months to 1 year.

Negotiable Certificates of Deposit: large denomination and can be sold in secondary markets.

Commercial Paper: unsecured promissory note of large business.

Federal Funds (“Fed Funds”): where banks make short term unsecured loans to each other and the fed funds rate is the interbank lending rate.

Capital Markets

Help participants build wealth DSUs seek long-term financing for capital projects SSUs seek highest possible return for given risk

Differences from money markets— Long maturities (5 to 30 years) Less liquidity

(secondary markets active but more volatile) Higher risk in most cases

(with higher potential yield) Traded “wholesale” and “retail” on organized

exchanges and in OTC markets

Examples of Major Capital Market Instruments

Common stock.Corporate bonds: issued by large

corporations, and bondholders receive fixed return.

Municipal bonds: issued by state and local governments, coupon income is exempt from taxes.

Mortgages: secured by real estate and have limited secondary market.

Efficiency in financial markets

Allocational Efficiency: highest/best use of fundsDSUs try to fund projects with best cost/benefit

ratios SSUs try to invest for best possible return for

given maturity and risk

Informational Efficiency: prices reflect relevant informationInformationally efficient markets re-price quickly

on new information; Informationally inefficient markets offer

opportunities to buy “underpriced” assets or sell “overpriced” assets

Operational Efficiency: transactions costs minimized

Risks of Financial Institutions

Credit or default risk: risk that a DSU may not pay as agreed.

Interest rate risk: fluctuations in a security's price or reinvestment income caused by changes in market interest rates

Liquidity risk: risk that a financial institution may be unable to disburse required cash outflows, even if essentially profitable

Risks of Financial Institutions, cont.

Foreign exchange risk: effect of exchange rate fluctuations on profit of financial institution

Political risk: risk of government or regulatory action harmful to interests of financial institution.