Financial market and institutions

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Financial markets and Institutions

Required Reading: Mishkin, Chapter 1 and Chapter 2

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CONTENTS

FINANCIAL MARKETS FINANCIAL INSTITUTIONS FINANCIAL REGULATIONS

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AN OVERVIEW OF FINANCIAL SYSTEM

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I. AN OVERVIEW OF FINANCIAL MARKETS

What is Financial Markets? Structure of Financial markets? Instruments traded in Financial markets? Functions of Financial markets

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What is Financial system?Financial system (FS) – a framework for describing set of markets, organisations, and individuals that engage in the transaction of financial instruments (securities), as well as regulatory institutions.

- the basic role of FS is essentially channelling of funds within the different units of the economy – from surplus units to deficit units for productive purposes.

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1. What is Financial Markets? Financial markets perform the essential function of channeling

funds from economic players that have saved surplus funds to those that have a shortage of funds

At any point in time in an economy, there are individuals or organizations with excess amounts of funds, and others with a lack of funds they need for example to consume or to invest.

Exchange between these two groups of agents is settled in financial markets

The first group is commonly referred to as lenders, the second group is commonly referred to as the borrowers of funds.

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I.1 What is Financial Markets?

We will start our discussion on financial markets with some basic definitions: There exist two different forms of exchange in financial markets.

The first one is direct finance, in which lenders and borrowers meet directly to exchange securities.

Securities are claims on the borrower’s future income or assets. Common examples are stock, bonds or foreign exchange

The second type of financial trade occurs with the help of financial intermediaries and is known as indirect finance. In this scenario borrowers and lenders never meet directly, but lenders provide funds to a financial intermediary such as a bank and those intermediaries independently pass these funds on to borrowers

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I.2 Structure of Financial MarketsFinancial markets can be categorized as follows:

Debt vs Equity markets Primary vs Secondary markets Exchange vs Over the Counter (OTC) Money vs Capital Markets

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Debt vs Equity

Financial markets are split into debt and equity markets.

Debt titles are the most commonly traded security. In these arrangements, the issuer of the title (borrower) earns some initial amount of money (such as the price of a bond) and the holder (lender) subsequently receives a fixed amount of payments over a specified period of time, known as the maturity of a debt title.

Debt titles can be issued on short term (maturity < 1 yr.), long term (maturity >10 yrs.) and intermediate terms (1 yr. < maturity < 10 yrs.).

The holder of a debt title does not achieve ownership of the borrower’s enterprise.

Common debt titles are bonds or mortgages.

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Debt vs Equity

Equity titles are somewhat different from bonds. The most common equity title is (common) stock.

First and foremost, an equity instruments makes its buyer (lender) an owner of the borrower’s enterprise.

Formally this entitles the holder of an equity instrument to earn a share of the borrower’s enterprise’s income, but only some firms actually pay (more or less) periodic payments to their equity holders known as dividends. Often these titles, thus, are held primarily to be sold and resold.

Equity titles do not expire and their maturity is, thus, infinite. Hence they are considered long term securities.

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PRIMARY MARKETS Vs SECONDERY MARKETS

Markets are divided into primary and secondary markets

Primary markets are markets in which financial instruments are newly issued by borrowers.

Secondary markets are markets in which financial instruments already in existence are traded among lenders.

Secondary markets can be organized as exchanges, in which titles are traded in a central location, such as a stock exchange, or alternatively as over-the-counter markets in which titles are sold in several locations.

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MONEY MARKETS VS CAPITAL MARKETS

Finally, we make a distinction between money and capital markets.

Money markets are markets in which only short term debt titles are traded.

Capital markets are markets in which longer term debt and equity instruments are traded.

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I.3 INSTRUMENTS TRADED IN THE FINANCIAL MARKETS

Principal Money Market Instruments (maturity < 1 yr.)

Source: Miskin

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I.3. INSTRUMENTS TRADED IN THE FINANCIAL MARKETS (Cont)

INSTRUMENTS TRADED IN THE CAPITAL MARKETS

Source: Miskin

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Most commonly you will encounter:

Corporate stocks are privately issued equity instruments, which have a maturity of infinity by definition and, thus, are classified as capital market instruments

Corporate bonds are private debt instruments which have a certain specified maturity. They tend to be long-run instruments and are, hence, capital market instruments

The short-run equivalent to corporate bonds are commercial papers which are issued to satisfy short-run cash needs of private enterprises.

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Most commonly you will encounter:

On the government side, the most commonly used long-run debt instruments are Treasury Bonds or T-Bonds. Their maturity exceeds ten years.

Short-run liquidity needs are satisfied by the issuance of Treasury Bills or T-Bills, which are short-run debt titles with a maturity of less than one year.

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Valuing a Bond

PV C1

(1 r)1 C2

(1 r)2 ...1,000 CN

(1 r)N

Price of a bond is the sum of the discounted future cash flows.Price of a bond is the sum of the discounted future cash flows.

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Valuing a Bond

What is the discount rate = market determined, affected by perceived risk?

As discount rates ↑ the price ↓

Inverse relationship between price and yield

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Valuing a Bond Clearly higher rates lead to a fall in price

Also note: Bond price → par

as bond → maturity.

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Interest Rates Sensitivity of bond prices to interest rate changes?

Longer dated bonds - more sensitive

Lower coupon bonds - more sensitive

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What effects bond prices?1. Interest rates

2. Coupon and Maturity

3. Credit ratings, (Moodys, S&P etc.)

4. Economic Environment

Flight to quality?

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Functions of Financial markets

Borrowing and Lending

Financial markets channel funds from households, firms, governments and foreigners that have saved surplus funds to those who encounter a shortage of funds (for purposes of consumption and investment)

Price Determination

Financial markets determine the prices of financial assets. The secondary market herein plays an important role in determining the prices for newly issued assets

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Coordination and Provision of Information

The exchange of funds is characterized by a high amount of incomplete and asymmetric information. Financial markets collect and provide much information to facilitate this exchange.

Risk Sharing

Trade in financial markets is partly motivated by the transfer of risk from borrowers to lenders who use the obtained funds to invest

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Liquidity

The existence of financial markets enables the owners of assets to buy and resell these assets. Generally this leads to an increase in the liquidity of these financial instruments

Efficiency

The facilitation of financial transactions through financial markets lead to a decrease in informational cost and transaction costs, which from an economic point of view leads to an increase in efficiency.

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II.FINANCIAL INSTITUTIONS What are Financial Institutions? Financial Institutions and their function Types of Financial Institutions

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II.1What are Financial Institutions ?

Financial intermediaries are firms that collect the funds from lenders and channel those funds to borrowers (Mishkin)

Financial intermediaries are firms whose primary business is to provide customers with financial products and services that can not be obtained more efficiently by transacting directly in securities markets (Z.Bodie &Merton)

Any classification of financial institutions is ultimately somewhat arbitrary, since financial markets are subject to high dynamics and frequent innovation. Thus, we roughly use four categories:

Brokers Dealers Investment banks

Financial intermediaries

Engage in trade in securities (direct finance)

Engage in financial asset transformation (indirect finance)

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II.1What are Financial Institutions? (Cont)

Brokers are agents who match buyers with sellers for a desired transaction.

A broker does not take position in the assets she/he trades (i.e. does not maintain inventories of those assets)

Brokers charge commissions on buyers and/or sellers using their services

Examples: Real estate brokers, stock brokers

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Like brokers, dealers match sellers and buyers of financial assets.

Dealers, however, take position in their assets, their trading.

As opposed to charging commission, dealers obtain their profits from buying assets at low prices and selling them at high prices.

A dealer’s profit margin, the so-called bid-ask spread is the difference between the price at which a dealer offers to sell an asset (the asked price) and the price at which a dealer offers to buy an asset (the bid price)

Examples: Dealers in U.S. government bonds, Nasdaq stock dealers

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Investment Banks

Investment banks assist in the initial sale of newly issued securities (e.g. IPOs)

Investment banks are involved in a variety of services for their customers, such as advice, sales assistance and underwriting of issuances

Examples: Morgan-Stanley, Goldman Sachs, ...Lehman Brothers ..(Before Crisis 2008)

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Financial Intermediaries

Financial intermediaries match sellers and buyers indirectly through the process of financial asset transformation.

As opposed to three above mentioned institutions. they buy a specific kind of asset from borrowers –usually a long term loan contract – and sell a different financial asset to savers –usually some sort of highly-liquid short-run claim.

Although securities markets receive a lot of media attention, financial intermediaries are still the primary source of funding for businesses.

Even in the United States and Canada, enterprises tend to obtain funds through financial intermediaries rather than through securities markets.

Other than historic reasons, this prevalence results from a variety of factors.

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II.2 Function of Financial Intermediaries: Indirect Finance

Lower transaction costs Economies of scale Liquidity services

Since transaction costs are reduced, financial intermediaries are able to provide customers with additional liquidity services, such as checking accounts which can be used as methods of payment or deposits which can be liquidated any time while still bearing some interest.

Reduce Risk Risk Sharing (Asset Transformation) Diversification

Through the process of asset transformation not only maturities, but also the risk of an asset can change: A financial intermediary uses funds it acquires (e.g. through deposits) and often turns them into a more risky asset (e.g. a larger loan). The risk then is spread out between various borrowers and the financial intermediary itself.

The process of risk sharing is further augmented through diversification of assets (portfolio-choice), which involves spreading out funds over a portfolio of assets with different types of risk.

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II.2 Functions of Financial Intermediaries: Indirect Finance

Reduce Asymmetric Information Asymmetric Information in financial markets - one party often

does not know enough about the other party to make accurate decisions.

Adverse Selection (before the transaction)—more likely to select risky borrower

Moral Hazard (after the transaction)—less likely borrower will repay loan

=> Financial intermediaries are important in the production of information. They help reduce informational asymmetries about some unobservable quality of the borrower for example through screening, monitoring or rating of borrowers, Net worth and collateral.

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II.2 Functions of Financial Intermediaries: Indirect Finance

Finally, some financial intermediaries specialize on services such as management of payments for their customers or insurance contracts against loss of supplied funds.

Through all of these channels financial intermediaries increase market efficiency from an economic point of view.

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II.3TYPES OF FINANCIAL INTERMEDIARIES

There are roughly three classes of financial intermediaries:

Depository institutions accept deposits from savers and transform them into loans (Commercial banks, savings and loan associations, mutual savings banks and credit unions)

Contractual savings institutions acquire funds at periodic intervals on a contractual basis (insurance and pension funds)

Investment intermediaries serve different forms of finance. They include finance companies, mutual funds and money market mutual funds.

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Financial Intermed

iaries

Contractual savings

Institutions

Investment Intermedarie

s

Depository Institutions

Commercial Bank

Mutual Funds (Investment Funds)

Finance Companies

Pension Funds

Credit Unions

Insurance Companies

Savings and Loans Associations (S&L)

Mutual Saving Banks

Money market Mutual Funds

Specialized Banks

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III. FINANCIAL REGULATIONWhy regulate financial markets?

Financial markets are among the most regulated markets in modern economies.

The first reason for this extensive regulation is to increase the information available to investors (and, thus, to protect them).

The second reason is to ensure the soundness of the financial system.

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III. FINANCIAL REGULATION1. Increasing information available to investors

As mentioned above, asymmetric information can cause severe problems in financial markets (Risk behavior, insider trades,....)

Certain regulations are supposed to prohibit agents with superior information from exploiting less informed agents.

In the U.S. the stock-market crash of 1929 led to the establishment of the Securities and Exchange Commission (SEC), which requires companies involved in the issuance of securities to disclose certain information relevant to their stockholders. The SEC further prohibits insider trades

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III. FINANCIAL REGULATION2. Ensuring the soundness of financial intermediaries

Even more devastating consequences from asymmetric information manifest themselves in collapses of the entire financial system – so called financial panics.

Financial panics occur if providers of funds on a large scale withdraw their funds in a brief period of time from the financial system leading to a collapse of the system. These panics can produce enormous damage to an economy.

Examples of some recent panics are the crises in the Asian Tiger states, Argentina or Russia. The United States, while spared for most of the second half of 20th century, has a long tradition of financial crises throughout the 19th century up to the Great Depression.

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III. FINANCIAL REGULATION3. Solutions for ensuring the soundness of financial

intermediaries

Restrictions on entry Disclosure Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates

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Financial regulation Limits to Competition

An argument of politics rather than economics is that overly hard competition in the banking sector increases the risk of bank failure. This belief has (especially in the past) led to some restrictions in the commercial banking sectors

In the U.S. private banks e.g. were prohibited to open branches in different states

The empirical evidence for the benefits of limiting competition is weak and from an economic point of view it appears more as an obstacle to risk diversification rather than a useful regulation

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Financial regulationRestriction of interest rates

The experience of the Great Depression in the U.S. has led to the widespread belief that interest rate competition paid on deposits might facilitate bank failure and to strong regulation of interest rates on bank deposits

Unlike most other developed economies, banks in the U.S. were prohibited from paying any interest on deposits from 1933. Under what is known as Regulation Q, the Federal Reserve System had the power to set the maximum interest rates payable on savings deposits until 1986.

Financial market and institutions

Economy & Finance

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