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Chapter One

Chapter One. Introduction. 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

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Chapter One

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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) • Through financial institutions called investment bank • IPO: the first public issue of financial instruments by a firm McGraw-Hill/Irwin

  5. Primary versus Secondary Markets • Secondary markets • markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq) • Provide the opportunity to trade securities at their market values quickly with varying risk-return characteristics • Derivative security: a financial security whose payoffs are linked to other, previously issued securities McGraw-Hill/Irwin

  6. Primary versus Secondary Markets • Secondary markets • Derivative security: A financial security whose payoffs are linked to other, previously issued securities McGraw-Hill/Irwin

  7. 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) • Most U.S. money markets are over-the-counter (OTC) markets. • OTC: markets that don’t operate in a specific fixed location McGraw-Hill/Irwin

  8. Money versus Capital Markets • Money markets instruments • Issued by corporations & governments to obtain short-term funds • For example: T-bills, commercial paper, negotiable certificates McGraw-Hill/Irwin

  9. Money versus Capital Markets • Capital markets • markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year • With longer maturity, instruments experience wider price fluctuations in the secondary markets McGraw-Hill/Irwin

  10. Money versus Capital Markets • Capital markets instruments • For example: corporate stocks, mortgages, and bonds McGraw-Hill/Irwin

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

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

  13. Foreign Exchange (FX) Markets • FX markets • trading one currency for another (e.g., dollar for yen) • Financial managers have to understand how events and movements in financial markets in other countries affect the profitability and performance of a corporate • Foreign currency exchange rates are flexible (demand & supply ) McGraw-Hill/Irwin

  14. Foreign Exchange (FX) Markets • 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

  15. 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

  16. 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

  17. Financial Market Regulation • Securities and Exchange Commission: • Register the public securities • Monitor trading • Prevent the inside information • Full and accurate information available • Impose regulations to reduce excessive price fluctuations McGraw-Hill/Irwin

  18. 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

  19. Financial Institutions (FIs) • Direct transfer • A corporation sells its stock or debt directly to investors without going through a financial institution • Indirect transfer • A transfer of funds between suppliers and users of funds through a financial intermediary McGraw-Hill/Irwin

  20. 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

  21. 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

  22. 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

  23. FIs Benefit Suppliers of Funds • Reduce monitoring costs • Superior skills and training • Alleviates the “free-rider” problem • Delegated monitor: an economic agent appointed to act on behalf of smaller investors in collecting information and/or investing fund on their behalf McGraw-Hill/Irwin

  24. FIs Benefit Suppliers of Funds • Increase liquidity and lower price risk • Asset transformers: financial claims issued by an FI that are more attractive to investors than are the claims directly issued by corporations • FI purchase the financial claims issued by users of funds and finance these purchases by selling financial claims to investors • FI claims have liquidity attributes McGraw-Hill/Irwin

  25. FIs Benefit Suppliers of Funds • Increase liquidity and lower price risk • Diversify: the ability of an economic agent to reduce risk by holding a number of securities in a portfolio • Diversification allows an FI to predict more accurately expected return and risk on its investment portfolio > credibly promises to the suppliers to provide highly liquid claims with little price risk McGraw-Hill/Irwin

  26. FIs Benefit Suppliers of Funds • Reduce transaction costs • Economies of scale: cost of reduction in trading and other transaction services results from increased efficiency when FI perform these services • Etrade and private placement McGraw-Hill/Irwin

  27. FIs Benefit Suppliers of Funds • Provide maturity intermediation • Ability to bear the risk of mismatching the maturity of their assets and liabilities than can small savers • Provide denomination intermediation • By pooling the funds of many small savers McGraw-Hill/Irwin

  28. FIs Benefit the Overall Economy • Provides efficient credit allocation • The major source of financing for particular sector • Provide for intergenerational wealth transfers • Important to country social well-being McGraw-Hill/Irwin

  29. Risks Faced by Financial Institutions • Credit Risk • Risk that promised cash flows from loans and securities held by FIs may not be paid in full • Foreign exchange risk • Risk that exchange rate changes can affect the value of an FI’s assets and liabilities located abroad McGraw-Hill/Irwin

  30. Risks Faced by Financial Institutions • Country or sovereign risk • Repayments from foreign borrowers may be interrupted because of interference from foreign governments • Market risk • Incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other assets price McGraw-Hill/Irwin

  31. Risks Faced by Financial Institutions • Liquidity risk • Requiring an FI to liquidate assets in a very short period of time and at low price • Technology risk • Technological investment do not produce anticipated cost saving • Insolvency risk • May not have capital to offset a sudden decline in the value of its assets McGraw-Hill/Irwin

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

  33. 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

  34. 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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