Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial...

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Copyright© 2006 John Wiley & Sons, Inc. 1 Power Point Slides for: Financial Institutions, Markets, and Money, 9 th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University And Lanny R. Martindale, Texas A&M University

Transcript of Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial...

Page 1: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

1

Power Point Slides for:

Financial Institutions, Markets, and Money, 9th Edition

Authors: Kidwell, Blackwell, Whidbee &

Peterson

Prepared by: Babu G. Baradwaj, Towson University And

Lanny R. Martindale, Texas A&M University

Page 2: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

CHAPTER 1

An Overview of Financial

Markets and Institutions

Page 3: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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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.

Page 4: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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Exhibit 1.1 – Transfer of Funds

Page 5: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Basic components of the financial system: Markets and institutions.

Financial markets are markets for financial

instruments, also called financial claims or

securities.

Financial institutions (also called financial

intermediaries) facilitate flows of funds from

savers to borrowers.

Page 6: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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).

Page 7: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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.

Page 8: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Financial claims arise as SSUs lend to DSUs.

SSU’s claim against DSU is liability to DSU and asset to SSU.

One’s liability is another’s 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.

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Marketability: Ease with which a financial asset may be sold to

another SSU.

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; or

Buy claim with shorter maturity, then reinvest.

Page 10: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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

-Liquidity

Page 11: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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.

Page 12: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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.

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Private placements are simplest.

DSU sells whole security issue to one

investor or investor group.

Advantages include speed and low

transactions costs.

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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”

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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 price” “Bid-ask spread” is dealer’s gross profit

Page 16: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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.

Page 17: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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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.

Page 18: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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Financial intermediaries transform claims

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Familiar forms of financial intermediation

Commercial Banking

Insurance

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Commercial Banks

Take deposits and make loans -

Depositors are SSUs

Borrowers are DSUs.

Page 21: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Insurance Companies

Issue policies, collect premiums, and invest

in stocks and bonds.

Policyholders are SSUs;

Businesses or governments are DSUs.

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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.

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Intermediaries lower the cost of financial services as they pursue

profit.

3 sources of comparative advantage:

Economies of scale Transaction cost control Risk management expertise

Competition pulls interest rates down

Financing less costly Projects have higher NPVs Investment in real assets boosts economy

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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.

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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.

Page 26: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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4 Major types of financial intermediaries transform claims to meet

various needs.

Deposit-type or “Depository” Institutions

Contractual Savings Institutions

Investment Funds

“Other” Institutions

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Depository Institutions take deposits and make loans.

Commercial Banks

Thrift Institutions Savings & Loan Associations Savings Banks

Credit Unions

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Commercial Banks

Largest 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

Page 29: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Thrift Institutions

Closely resemble commercial banks

Focus more on real estate loans, savings deposits,

and time deposits

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Credit Unions: Unique Characteristics

Mutual 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

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Contractual Institutions bring long-term savers and borrowers

together.

Life Insurance Companies

Casualty Insurance Companies

Pension Funds

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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.

Page 33: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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

Page 34: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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)

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Investment Funds help small investors share the benefits of large

investments.

Mutual Funds provide intermediated access to various capital markets

shareholders’ 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-writing

Page 36: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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“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

Page 37: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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Page 38: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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Page 39: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Financial Markets are classified in several ways.

Primary and Secondary

Organized and Over-the-Counter

Spot and Futures

Options

Foreign Exchange

International and Domestic

Money and Capital

Page 40: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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 repriced

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

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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.

Page 42: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Spot and Futures Markets

Spot Markets: immediate payment for immediate delivery

Futures or Forward Markets: immediate payment for 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

Page 43: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Option Markets

Rights in underlying securities or commodities—writer 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 exchanges

Page 44: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Foreign Exchange Markets

Any currency is convertible to any other at some

exchange rate

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

markets

Page 45: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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

Page 46: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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.)

Page 47: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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Money Markets

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

SSUs 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 exchange

Page 48: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Examples of Major Money Market Instruments

Treasury Bills

Negotiable Certificates of Deposit

Commercial Paper

Federal Funds (“Fed Funds”)

Page 49: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Page 50: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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Money Market Balance Sheet Position of Major Participants

COMMERCIAL

BANKS

FEDERALRESERVE

SYSTEMTREASURY

DEPARTMENT

INVESTMENTBANKS,DEALERS,

AND BROKERS CORPORATIONS

INSTRUMENT A L A L A L A L A L

Treasury bills • • • • •

Agency securities • • • •

Negotiable CDs • • •

Commercial paper • • • •

Banker’s acceptances • • • • •

Federal Funds • •

Repurchase agreements • • • • • •

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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

Page 52: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Examples of

Major Capital Market Instruments

Common stock

Corporate bonds

Municipal bonds

Mortgages

Page 53: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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Page 54: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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Efficiency in financial markets

Allocational Efficiency: highest/best use of funds

DSUs 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 information

Informationally efficient markets reprice quickly on new information;

informationally inefficient markets offer opportunities to buy “underpriced” assets or sell “overpriced” assets

Operational Efficiency: transactions costs minimized

Page 55: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

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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

Page 56: Financial Institutions, Markets, and Money, 9 th Edition · Basic components of the financial system: Markets and institutions. Financial markets are markets for financial instruments,

Copyright© 2006 John Wiley & Sons, Inc.

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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.