INTRODUCTION TOINTRODUCTION TO

THE FINANCIAL SYSTEMTHE FINANCIAL SYSTEM

Financial MarketsFinancial MarketsInstrumentsInstrumentsInstitutionsInstitutions

THE PLAYERS

1) Firms: net borrowers.

2) Households: net savers.

3) Governments: either borrowers or lenders.

4) Financial intermediaries: institutions (e.g. banks) that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers.

5) Investment companies: firms that pool and manage funds of many investors. For example, they might manage several mutual funds.

6) Investment bankers: specialize in the sale of new securities to the public, typically by underwriting the issue.

FUNCTIONS OF FINANCIAL MARKETS IN THE ECONOMY

Consumption timing: Financial markets fulfill the “store of wealth” function of money but provide higher rewards to savers.Financial markets also affect the level consumption by affecting wealth (particularly in US).

Facilitating Business Investment: (thus, affect its timing)

Allocation of risk: Financial markets enable transfer of risks.

Signaling: Prices in financial markets provide signals to business decision makers (e.g. stock market acts as a leading indicator)

CLASSIFICATION OF FINANCIAL INSTRUMENTS

There are three broad types of financial assets:

•Fixed income securities: bills, notes, bonds, (treasuries)

•Common stock or equity

•Derivative instruments (forwards, futures, options, swaps, …)

And there are many hybrids (product of financial engineering):

Preferred stocks, convertible bonds, ….

CLASSIFICATION OF FINANCIAL MARKETSCLASSIFICATION OF FINANCIAL MARKETS

Money MarketMoney Market ( T < 1 year ) ( T < 1 year )Fixed income, short term, marketable, liquid, low risk debt also Fixed income, short term, marketable, liquid, low risk debt also

called cash equivalents, it is a subsector of the fixed income called cash equivalents, it is a subsector of the fixed income market.market.

Treasury billsTreasury bills Certificates of deposit (CD’s)Certificates of deposit (CD’s) Commercial PaperCommercial Paper EurodollarsEurodollars Repurchase Agreements (RPs)Repurchase Agreements (RPs) Federal FundsFederal Funds

Capital MarketCapital Market ( T > 1 year) ( T > 1 year) Bonds, NotesBonds, Notes StocksStocks

Also: Also: FX Markets, Commodity MarketsFX Markets, Commodity Markets

FINANCIAL INSTITUTIONSFINANCIAL INSTITUTIONS

Indirect FinanceIndirect Finance: :

Banks [ Banks [ Commercial Banks, Development Banks, ThriftsCommercial Banks, Development Banks, Thrifts ( (Savings & Savings &

Loan Associations, Credit Unions, Mutual Savings BanksLoan Associations, Credit Unions, Mutual Savings Banks), ), Mortgage Mortgage

Banks, Islamic BanksBanks, Islamic Banks ] ]

Finance Companies, Leasing, Factoring CompaniesFinance Companies, Leasing, Factoring Companies

Regulation: BRSA, FDIC, Central Banks, TreasuryRegulation: BRSA, FDIC, Central Banks, Treasury

Direct Finance: Direct Finance:

Brokerage houses, Investment Banks, Investment Brokerage houses, Investment Banks, Investment companies, Mutual Funds, Hedge Funds, Pension Fundscompanies, Mutual Funds, Hedge Funds, Pension Funds

Regulation: SEC, CFTC, FSARegulation: SEC, CFTC, FSA

FURTHER CLASSIFICATION OF MARKETS

Primary vs. Secondary MarketsPrimary market: refers to the initial sale (emission) of securities by governments and corporations. IPO, T-Bond auctionsA public offering involves selling securities to the general public, A private placement is a negotiated sale involving a specific buyer.

Secondary markets: those in which these securities are bought and sold (second hand). NYSE, DB, Euronext, TSE

provide means for transferring ownership.

Economic function of financing is provided by primary markets. The function of secondary markets is to help the success of primary markets by providing liquidity.

By law, public offerings of debt and equity must be registered with the Securities and Exchange Commission (SEC).

Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal, and selling costs of public offerings can be considerable.

Partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the SEC and do not require the involvement of underwriters (investment banks that specialize in selling securities to the public)

Listing: stocks which trade on an organized exchange are said to be listed on that exchange. In order to be listed, firms must meet a certain minimum criteria which is different for each exchange.

IPO’s:

An underwriter is an investment bank (or brokerage house) that acts as intermediary between a company selling securities and the investing public.

There are two basic types of underwriting:

Firm commitment underwriting: issuer sells entire issue to the underwriters who then attempt to resell it. Therefore the underwriter takes all the risk.

Best effort underwriting: the underwriter is legally bound to use "best efforts" to sell the securities, but it does not guarantee any particular amount.

Secondary offerings: Public offerings by firms that already have outstanding securities.

MARKET STRUCTURE

There are four main mechanisms to match surplus and deficit units:

1) Direct search market: buyers and sellers seek each other out directly, not organized (ex. selling a car through a newspaper)

2) Brokered markets: a broker helps buyer and seller meet (ex. the real state market where economies of scale in searches make it worthwhile for participants to pay brokers).

3) Dealer market: dealers provide liquidity by buy and sell for their own account.

4) Auction market: where all traders meet at one place and submit orders to buy or sell an asset.

Organization of MarketsOrganization of Markets

Organized exchangesOrganized exchanges: physical place, : physical place, administration (a legal entity), well-defined strict administration (a legal entity), well-defined strict rules and procedures, clearing houserules and procedures, clearing house

OTC marketOTC market: via dealers: via dealers

Third market: OTC trading outside the opening Third market: OTC trading outside the opening hours.hours.

Fourth market: block trades outside the market Fourth market: block trades outside the market mechanism in an organized exchangemechanism in an organized exchange

Trading SystemsTrading Systems

Batch ProcessingBatch Processing

* Continuous Auction* Continuous Auction

Open OutcryOpen Outcry

Specialist systemsSpecialist systems

* Computerized Trading (blind matching) * Computerized Trading (blind matching)

Costs of Trading (Transaction Costs)Costs of Trading (Transaction Costs)

CommissionCommission: fee paid to broker for making : fee paid to broker for making the transactionthe transaction

SpreadSpread: cost of trading with dealer: cost of trading with dealer BidBid: price dealer will buy from you: price dealer will buy from you AskAsk: price dealer will sell to you: price dealer will sell to you SpreadSpread: ask – bid : ask – bid

CombinationCombination: on some trades both are paid : on some trades both are paid Price impactPrice impact

Liquidity

Is the spread and easyness with which an asset can be sold and still fetch a fair price. It is a relationship between the time dimension (how long it takes to sell) and the price dimension (discount from fair market price) of an asset to be sold.

Cash and money market instruments are the most liquid assets, real estate is the least liquid.

Short saleThe sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan.Normally, an investor would first buy a stock and later sell it. With a short sale the order is reversed.

Order TypesOrder Types

Limit OrdersLimit Orders: fixed price, no guarantee to get filled: fixed price, no guarantee to get filled GTC ordersGTC orders Market OrdersMarket Orders: immediately filled, at : immediately filled, at

instantaneously available counterparty offersinstantaneously available counterparty offers Fill-or-kill ordersFill-or-kill orders Stop-loss orders:Stop-loss orders: a market order is submitted a market order is submitted

when market hits a designated price. when market hits a designated price. (Take-profit (Take-profit orders work symmetrically in a similar way.)orders work symmetrically in a similar way.)

Stop limit orders Stop limit orders

Key TrendsKey Trends

Globalization Globalization

IT TechnologyIT Technology

SecuritizationSecuritization

Financial Engineering (Financial Engineering (Repackaging Services of Repackaging Services of Financial Intermediaries: Bundling and unbundling of cash Financial Intermediaries: Bundling and unbundling of cash flows, Slicing and dicing of cash flows.flows, Slicing and dicing of cash flows.Examples: strips, CDOs, SIVs, dual purpose funds, Examples: strips, CDOs, SIVs, dual purpose funds,

principal/interest splitsprincipal/interest splits))

Preferred stock(nonvoting shares usually paying a fixed stream of dividends)

• Fixed dividends, usually cumulative• Has seniority over common stocks• Can be callable, convertible, adjustable rate- dividend tied to current interest rates

•Managed Investment Companies

Open-End Funds:

Stand ready to redeem or issue shares at their NAV (with fees).

If an investor wants to cash out they sell their shares back to the Fund at NAV.

Closed-End Funds: Do not redeem or issue shares. Investors who wish to cash out must sell their shares to other investors. Shares of closed-end funds are traded on organized exchanges and can be purchased through brokers just like common stock. Consequently, their prices differ from NAV

Key DifferencesKey DifferencesShares OutstandingShares OutstandingClosed-end: no change unless new stock is offeredClosed-end: no change unless new stock is offeredOpen-end: changes when new shares are sold or old shares are redeemedOpen-end: changes when new shares are sold or old shares are redeemedPricingPricingOpen-end: Net Asset Value (NAV)Open-end: Net Asset Value (NAV)Closed-end: can trade at any price set by the market (below or above NAV)Closed-end: can trade at any price set by the market (below or above NAV)