1
Role of Financial Markets and Institutions
Chapter Objectives
Describe
the types of financial markets
Describe
the role of financial institutions with financial markets
Identify
the types of financial institutions that facilitate transactions
Overview of Financial Markets
Financial Market: a market in which financial assets (securities) such as stocks and bonds can be purchased or sold
Financial markets provide for financial intermediation--financial savings (Surplus Units) to investment (Deficit Units) Financial markets provide payments system Financial markets provide means to manage risk
Overview of Financial Markets
Financial Market:
You act as a Surplus Unit as you put money in your checking/savings account, buy stocks, bonds and shares in Mutual funds and/or have part of your pay put into a retirement account. You act as a Deficit Unit as you buy with your credit card, borrow to buy a house or car and take out Student loans to go to school.
Overview of Financial Markets
Financial Markets
Financial markets provide payments system that you use every day to buy gas with your credit card, a check or even cash. Financial markets is a system allows a company, a school, a city, a county and a state to issue stocks and bonds to get the funds needed for their future. Financial markets allows you and I a way to get money to pay for a house or a car.
Overview of Financial Markets
Financial Market
Financial markets provide the means to manage risk by allowing one to fixed the rate of interest on their home loan for up to thirty years. Financial markets provide the means to manage risk for individuals and other investors to reduce their risk through the derivative market. Financial markets provide the means to manage risk by providing a safe haven for our funds, banks, savings and loans and credit unions.
Overview of Financial Markets
Broad Classifications of Financial Markets
Primary versus Secondary Markets Money versus Capital Markets Organized versus Over-the-Counter Markets
Primary Vs. Secondary Markets
PRIMARY
New
SECONDARY
Trading
Issue of Securities of Funds for Financial Claim for Borrower; an IOU for Lender
Previously Issued Securities New Funds for Issuer Liquidity
Exchange
No
Funds
Provides
for Seller
Money vs. Capital Markets
Money Short-Term, < 1 Year High Quality Issuers Debt Only Primary Market Focus Liquidity Market-Low Returns
Capital Long-Term, >1Yr Range of Issuer Quality Debt and Equity Secondary Market Focus Financing Investment--Higher Returns
Organized vs. Over-the-Counter Markets
Organized Visible Marketplace
Members
OTC Wired Network of Dealers
No
Trade Listed Central, Physical Location Securities Traded off the Exchanges
Securities
New
York Stock Exchange
All
Securities Traded in Financial Markets
Money Market Securities
Debt securities Only
Debt and equity securities
Capital market securities
Derivative Securities
Financial contracts whose value is derived from the values of underlying assets Used for hedging (risk reduction) and speculation (risk seeking)
Debt vs. Equity Securities
Debt Securities:
Contractual obligations (IOU) of Debtor (borrower) to Creditor (lender)
Investor
receives interest Capital gain/loss when sold Maturity date
Debt vs. Equity Securities
Equity Securities:
Claim with ownership rights and responsibilities
Investor
receives dividends if declared Capital gain/loss when sold No maturity dateneed market to sell
Valuation of Securities
Value a function of:
Future cash flows When cash flows are received Risk of cash flows
Present value of cash flows discounted at the market required rate of return Value determined by market demand/supply Value changes with new information
Investor Assessment of New Information
Economic Conditions
Industry Conditions
Impact of Future Cash Flows
Evaluation of Security Pricing
Investor Decision to Trade
Firm Specific Information
Exhibit 1.3
Financial Market Efficiency
Security
prices reflect available information
New
information is quickly included in security prices
balance liquidity, risk, and return needs
Investors
Financial Market Regulation
Why Government Regulation?
To
Promote Efficiency
High
level of competition Efficient payments mechanism Low cost risk management contracts
Financial Market Regulation Why Government Regulation?
To
Maintain Financial Market Stability
Prevent
market crashes Circuit breakers Federal Reserve discount window Prevent Inflation--Monetary policy Prevent Excessive Risk Taking by Financial Institutions
Financial Market Regulation
Why Government Regulation?
To
Provide Consumer Protection
Provide
adequate disclosure Set rules for business conduct
To
Pursue Social Policies
Transfer
income and wealth Allocate saving to socially desirable areas
Housing Student
loans
Financial Market Globalization
Increased
international funds flow
Increased
disclosure of information Reduced transaction costs Reduced foreign regulation on capital flows Increased privatization
Results: Increased financial integration--capital flows to highest expected risk-adjusted return
Role of Financial Institutions in Financial Markets
Information processing Serve special needs of lenders (liabilities) and borrowers (assets)
By denomination and term By risk and return
Lower transaction cost Serve to resolve problems of market imperfection
Role of Financial Institutions in Financial Markets
Types of Depository Financial Institutions
Commercial Banks $5 Trillion Total Assets
Savings Institutions $1.3 Trillion Total Assets
Credit Unions $.5 Trillion Total Assets
Types of Nondepository Financial Institutions
Insurance
companies Mutual funds Pension funds Securities companies Finance companies Security pools
Role of Nondepository Financial Institutions
Focused on capital market Longer-term, higher risk intermediation Less focus on liquidity Less regulation Greater focus on equity investments
Trends in Financial Institutions
Rapid growth of mutual funds and pension funds Increased consolidation of financial institutions via mergers Increased competition between financial institutions Growth of financial conglomerates
Global Expansion by Financial Institutions
International expansion International mergers Impact of the single European currency Emerging markets
