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Understanding Financial Markets and Institutions: A Comprehensive Guide

This introductory chapter explores the importance of studying financial markets and institutions for prudent investment and financing. It covers the structural distinctions between primary and secondary markets, as well as money and capital markets. The chapter also delves into foreign exchange markets, derivative securities, and the regulatory landscape governing financial institutions. Readers will gain insights into how financial institutions facilitate the flow of funds, reduce transaction costs, and provide valuable services to the economy, as well as the implications of global financial market trends.

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Understanding Financial Markets and Institutions: A Comprehensive Guide

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  1. Chapter One Introduction

  2. Why study Financial Markets and Institutions? • Prudent investment and financing requires a thorough understanding of • the structure of domestic and international markets • the flow of funds through domestic and international markets • the strategies used to manage risks faced by investors and savers McGraw-Hill/Irwin

  3. Financial Markets • Financial markets are structures through which funds flow • Financial markets can be distinguished along two dimensions • primary versus secondary markets • money versus capital markets McGraw-Hill/Irwin

  4. Primary versus Secondary Markets • Primary markets • markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds) • Secondary markets • markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq) McGraw-Hill/Irwin

  5. Money versus Capital Markets • Money markets • markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills) • Capital markets • markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year McGraw-Hill/Irwin

  6. Money Market Instruments Outstanding, ($Bn) McGraw-Hill/Irwin

  7. Capital Market Instruments Outstanding, ($Bn) McGraw-Hill/Irwin

  8. Foreign Exchange (FX) Markets • FX markets • trading one currency for another (e.g., dollar for yen) • Spot FX • the immediate exchange of currencies at current exchange rates • Forward FX • the exchange of currencies in the future on a specific date and at a pre-specified exchange rate McGraw-Hill/Irwin

  9. DerivativeSecurityMarkets • Derivative security • a financial security whose payoff is linked to (i.e., “derived” from) another security or commodity • generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future McGraw-Hill/Irwin

  10. Financial Market Regulation • The Securities Act of 1933 • full and fair disclosure and securities registration • The Securities Exchange Act of 1934 • Securities and Exchange Commission (SEC) is the main regulator of securities markets McGraw-Hill/Irwin

  11. Financial Institutions (FIs) • Financial Institutions • institutions through which suppliers channel money to users of funds • Financial Institutions are distinguished by whether they accept deposits • depository versus non-depository financial institutions McGraw-Hill/Irwin

  12. Flow of Funds in a World without FIs Flow of Funds in a World without FIs Financial Claims (equity and debt instruments) Suppliers of Funds (households) Users of Funds (corporations) Cash McGraw-Hill/Irwin

  13. Flow of Funds in a World without FIs Flow of Funds in a World with FIs FIs (brokers) FIs (asset transformers) Users of Funds Suppliers of Funds Cash Cash Financial Claims (equity and debt securities) Financial Claims (deposits and insurance policies) McGraw-Hill/Irwin

  14. Depository versus Non-Depository FIs • Depository institutions • commercial banks, savings associations, savings banks, credit unions • Non-depository institutions • insurance companies, securities firms and investment banks, mutual funds, pension funds McGraw-Hill/Irwin

  15. FIs Benefit Suppliers of Funds • Reduce monitoring costs • Increase liquidity and lower price risk • Reduce transaction costs • Provide maturity intermediation • Provide denomination intermediation McGraw-Hill/Irwin

  16. FIs Benefit the Overall Economy • Conduit through which Federal Reserve conducts monetary policy • Provides efficient credit allocation • Provide for intergenerational wealth transfers • Provide payment services McGraw-Hill/Irwin

  17. Credit Foreign exchange Country or sovereign Interest rate Market Off-balance-sheet Liquidity Technology Operational Insolvency Risks Faced by Financial Institutions McGraw-Hill/Irwin

  18. Regulation of Financial Institutions • FIs are heavily regulated to protect society at large from market failures • Regulations impose a burden on FIs and recent U.S. regulatory changes have been deregulatory in nature • Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation McGraw-Hill/Irwin

  19. Globalization of Financial Markets and Institutions • The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before • Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access • International mutual funds allow diversified foreign investment with low transactions costs McGraw-Hill/Irwin

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