Ch01.Ppt Overview

Power Point Slides for: Financial Institutions, Markets, & Money, 11th EditionAuthors: Kidwell, Blackwell, Whidbee & Sias

Prepared by: Deniz K. Tudor, San Francisco State UniversityCopyright 2012 John Wiley & Sons, Inc.

Copyright 2012 John Wiley & Sons, Inc.

CHAPTER 1An Overview of Financial Markets and Institutions



The Financial System

Provides for efficient flow of funds from saving to investment by bringing savers and borrowers together via financial markets and financial institutions.

Copyright 2012 John Wiley & Sons, Inc. *


Basic components of the financial system: Markets and institutions.

Financial markets are markets for financial claims, also called financial instruments or securities.

Financial institutions (also called financial intermediaries) facilitate flows of funds from savers to borrowers.Copyright 2012 John Wiley & Sons, Inc. *


Economic units with financial needs: Households, Businesses, Governments.

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).Copyright 2012 John Wiley & Sons, Inc. *


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. Copyright 2012 John Wiley & Sons, Inc. *


Financial claims arise as SSUs lend to DSUs.

SSUs claim against DSU is liability to DSU and asset to SSU.

Ones liability is anothers asset: What is payable by one is receivable by another.

Assets arising this way are financial assets. The financial system balances-total financial assets equal total liabilities.Copyright 2012 John Wiley & Sons, Inc. *


Marketability: Ease with which a financial asset may be sold to another SSU.Ability to resell financial claims makes themmore 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.Copyright 2012 John Wiley & Sons, Inc. *


Direct Financing: The simplest way for funds to flow.

DSU and SSU find each other and bargain.SSU transfers funds directly to DSU.DSU issues claim directly to SSU.Preferences of both must match as to--Amount-Maturity-Risk-LiquidityCopyright 2012 John Wiley & Sons, Inc. *


Direct Financing: efficient for large transactions if preferences match.

DSUs and SSUs seize the dayDSUs fund desired projects immediately.SSUs earn timely returns on savings.

Direct markets are wholesale markets.Transactions typically $1 million or more.Institutional arrangements common.Copyright 2012 John Wiley & Sons, Inc. *


Institutional arrangements common in direct finance.

Private placements are simplest.Investment bankers underwrite new issues of securities. Brokers and dealers bring buyers and sellers of direct claims together.Copyright 2012 John Wiley & Sons, Inc. *


Private placements are simplest.

DSU sells whole security issue to one investor or investor group.

Advantages include speed and low transactions costs.



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 spreadCopyright 2012 John Wiley & Sons, Inc. *


Brokers and dealers

Brokers buy or sell at best possible price for their clients.Dealers make markets by carrying inventories of securities.

buy at bid price; sell at ask priceBid-ask spread is dealers gross 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 transform claims:raise funds by issuing claims to SSUs;use funds to buy claims issued by DSUs.

Claims can have unmatched characteristics:SSU has claim against intermediary;Intermediary has claim against DSU.



Economics of financial intermediationFinancial intermediaries exist due to market imperfections: Transaction costsInformation costs

Asymmetric information problems: Adverse selectionMoral hazard



Familiar forms of financial intermediation

Commercial Banking

InsuranceCopyright 2012 John Wiley & Sons, Inc. *


Commercial Banks

Take deposits and make loans -Depositors are SSUsBorrowers are DSUs. Copyright 2012 John Wiley & Sons, Inc. *


Insurance Companies

Issue policies, collect premiums, and invest in stocks and bonds.

Policyholders are SSUs; Businesses or governments are DSUs.Copyright 2012 John Wiley & Sons, Inc. *


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 scaleTransaction cost controlRisk management expertise

Competition pulls interest rates down

Financing less costlyProjects have higher NPVsInvestment in real assets boosts economyCopyright 2012 John Wiley & Sons, Inc. *


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.Copyright 2012 John Wiley & Sons, Inc. *


Intermediation Services, cont.Credit Risk Diversification Assume credit risks of DSUs; spread risk over many different types of DSUs.

Liquidity Give SSUs and DSUs different choices about when, to what extent, and for how long to commit to financial relationships.Copyright 2012 John Wiley & Sons, Inc. *


4 Major types of financial intermediaries transform claims to meet various needs. Deposit-type or Depository InstitutionsContractual Savings InstitutionsInvestment FundsOther Institutions



Commercial BanksLargest single class of financial institution

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 Copyright 2012 John Wiley & Sons, Inc. *


Thrift Institutions

Closely resemble commercial banks

Focus more on real estate loans, savings deposits, and time deposits Copyright 2012 John Wiley & Sons, Inc. *


Credit Unions: Unique CharacteristicsMutual ownership -owned by depositors or members

Common bond - members must share some meaningful common association

Not-for-profit and tax-exempt

Restricted mostly to small consumer loans Copyright 2012 John Wiley & Sons, Inc. *


Contractual Institutions bring long-term savers and borrowers together.

Life Insurance Companies

Casualty Insurance Companies

Pension FundsCopyright 2012 John Wiley & Sons, Inc. *


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.Copyright 2012 John Wiley & Sons, Inc. *


Casualty Insurance Companies cover property against loss or damage.

Sources and uses of funds resemble those of life insurers, but

Casualty claims are not as predictable as death claims; so

More assets are in short-term, easily marketable investments Copyright 2012 John Wiley & Sons, Inc. *


Pension Funds help workers plan for retirement.

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

Net of administrative costs, investment earnings are reinvested and compounded

Retirement benefits replace paychecks (at least partly)Copyright 2012 John Wiley & Sons, Inc. *


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

Money Market Mutual Funds (MMMFs) are uninsured substitutes for deposit accounts MMMFs buy money market instruments wholesale, pay investors interest, and allow limited check-writingCopyright 2012 John Wiley & Sons, Inc. *


Other Financial InstitutionsFinance CompaniesMake loans but do not take deposits; raise loanable funds in commercial paper market and from shareholders

Federal AgenciesIssue agency securities backed by government and lend at sub-market rates for favored social purposes



Exhibit 1.5Major Financial Intermediaries: Sources & Uses of Funds



Financial Markets are classified in several ways.Primary and SecondaryExchange and Over-the-CounterPublic and Private Futures and OptionsForeign ExchangeInternational and DomesticMoney and CapitalCopyright 2012 John Wiley & Sons, Inc. *


Primary and Secondary MarketsPrimary markets are where financial claims are born: DSUs receive funds, claims are first issued.

Secondary markets are where financial claims liveare resold and repriced.

Claims become more liquid because SSUs can set their own holding periods.Trading sets prices and yields of widely held securities.



Exchanges and Over-the-Counter MarketsExchanges: 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 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.Copyright 2012 John Wiley & Sons, Inc. *


Futures MarketsSpot 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 needsCopyright 2012 John Wiley & Sons, Inc. *


Options MarketsRights in underlying securities or commoditieswriter grants owner some exclusive right for some certain time

Main types of options: Puts (options to sell) Calls (options to buy)

Options on listed securities and widely held commodities trade actively on organized exchangesCopyright 2012 John Wiley & Sons, Inc. *


Foreign Exchange MarketsAny currency is convertible to any other at some exchange rate

Forex involves spot, future, forward, and option markets Copyright 2012 John Wiley & Sons, Inc. *


International and Domestic MarketsHelp participants diversify both sources and uses of funds

Examples of major international markets:EurodollarsUS dollars deposited outside USEurobondsBonds issued outside US but denominated in US dollars Copyright 2012 John Wiley & Sons, Inc. *


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 goodsreal assets held long-term to produce wealthland, buildings, equipment, etc.) Copyright 2012 John Wiley & Sons, Inc. *


Money MarketsHelp participants adjust liquidityDSUs borrow short-term to fund current operationsSSUs lend short-term to avoid holding idle cash

Common 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 exchangeCopyright 2012 John Wiley & Sons, Inc. *


Exhibit 1.2Major Money Market Instruments



Capital MarketsHelp 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 marketsCopyright 2012 John Wiley & Sons, Inc. *


Examples ofMajor Capital Market Instruments

Common stockCorporate bondsMunicipal bondsMortgages Copyright 2012 John Wiley & Sons, Inc. *


Risks of Financial InstitutionsCredit 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 profitableCopyright 2012 John Wiley & Sons, Inc. *


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.Copyright 2012 John Wiley & Sons, Inc. *


Regulation of the financial system

Protect consumers against industry abuses

Stabilize the financial system

Highlights of the Financial Regulatory Reform Act of 2010Copyright 2012 John Wiley & Sons, Inc. *


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