CHAPTER 1
An overview of Financial
Markets and Institutions
Provides for efficient flow of funds
from saving to investment by
bringing savers and borrowers
together via financial markets and
financial institutions.
The Financial System
Financial system consists of financial markets
and financial institutions.
In Financial markets people buy and sell
financial instruments such as stocks, bonds,
and futures contracts
Financial institutions are firms such as
commercial banks, credit unions, insurance
companies, pension funds, mutual funds and
finance companies that provide financial
services to consumers, businesses and
government units.
FEATURES OF FINANCIAL
SYSTEM
If the financial system is competitive, the rate of interest on CDs
will be high or near the market rate. In case of borrowings, the
borrowers can borrow at a near or lowest possible interest rate
in the market.
High competition among banks in a market will drive CD rates up
and loan rates down
Banks and depository institutions like Insurance companies
gather money from consumers in small amounts and then make
loans in large amounts
One of the important function of the financial system is to
allocate money to the most productive investments (high risk
projects) in the economy
Banks in general are profit making organisations. They earn their
profits from the difference between lending and borrowing rates
BUDGET POSITION
An economic unit can have one of the three
budget positions
1. A Balanced budget: Income = expenditure
2. A Surplus budget : Income
expenditure.
These economic units have money to lend
and are called Surplus Spending Units (SSU)
3. A Deficit budget : Expenditure
Income.
These economic units need to borrow
money and are called Deficit Spending Units
(DSU)
FINANCIAL CLAIMS
Claim against someone elses money at
a future date.
Other names for financial claims :
securities or financial instruments
Financial claims are liabilities for
borrowers (DSU) whereas assets for
lenders (SSUs)
Transfer of Funds
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.
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).
Fund flow through the
financial system
[Link] financing
[Link] financing
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
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
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.
Private placements are simplest.
DSU sells whole security issue to
one investor or investor group.
Advantages include speed and
low transactions costs.
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
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 dealers gross
profit
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.
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.
Benefits of financial intermediation
1. lower the cost of financial services
2. Three sources of comparative advantage
Economies of scale
Transaction cost control
Risk management expertise
3. Competition pulls interest rates down
Financing less costly
Projects have higher NPVs
Investment in real assets boosts economy
4. perform 5 basic services as they transform claims
5 basic services
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.
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.
4 Major types of financial
intermediaries transform claims to
meet various needs.
Deposit-type or Depository Institutions
[Link] Banks
[Link] Institutions
Savings & Loan Associations
Savings Banks
[Link] Unions
Contractual Savings Institutions
[Link] Insurance Companies
[Link] Insurance Companies
[Link] Funds
Investment Funds
[Link] Funds
[Link] Market Mutual Funds
Other Institutions
[Link] Companies
[Link] Agencies
Deposit-type or Depository Institutions
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
Thrift Institutions
Closely resemble commercial banks
Focus more on real estate loans, savings
deposits, and time deposits
Deposit-type or Depository
Institutions (Contd..)
Credit Unions
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
Contractual Savings Institutions
Life Insurance: 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
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
Contractual Savings
Institutions
Pension Funds
Pension funds obtain their funds from
employer and employee
contributions during the employees
working years and provide monthly
payments upon retirement.
Investment funds
Mutual funds: sell equity shares to
investors and use these funds to
purchase stocks or bonds
Money market mutual funds: a
mutual fund that invests in money
market securities (short term
securities) with low default risk
Other Institutions
Finance companies : make loans to
consumers and small businesses but
do not take deposits. They obtain funds
by selling commercial paper , equity
capital and long term debt obligations
Federal Agencies
Issue agency securities backed by
government and lend at sub-market
rates for favored social purposes
Financial Markets
Financial Markets are classified in
several ways.
Primary and Secondary
Organized and Over-the-Counter
Public and Private
Futures and Options
Foreign Exchange
International and Domestic
Money and Capital
Primary market: Financial claims are
sold by DSUs in primary market
Secondary market: are where financial
claims liveare resold and repriced
Organized market : a physical
meeting place and communication
facilities for members to conduct their
business Eg. New York Stock Exchange
Over the counter market : securities
not listed on an exchange are bought
and sold here
Public market : organized financial markets were
securities registered with the Securities and
Exchange Commission (SEC) are bought and sold
Private markets : involves direct transactions
between two parties.
Futures and Options markets (derivative
securities) : Future contracts are contracts for
delivery of assets in the future. Options contracts
call for one party (the option writer) to perform a
specific act if called on to do so by the option buyer
or owner.
Option contracts and future contracts can be used to
hedge risk
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 longterm financial instruments
(Capital goodsreal assets held long-term to
produce wealthland, buildings, equipment,
etc.)
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
Examples of Major Money Market
Instruments
Treasury Bills
Negotiable Certificates of Deposit
Commercial Paper
Federal Funds (Fed Funds)
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
Examples of
Major Capital Market Instruments
Common stock
Corporate bonds
Municipal bonds
Mortgages
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
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.
