Why study Financial Markets and Institutions

1
Why study Financial Markets and Institutions?

• They are the cornerstones of the overall
  financial system in which financial managers
  operate
• Individuals use both for investing
• Corporations and governments use both for
  financing

2
Overview of Financial Markets

• Primary Markets versus Secondary Markets
• Money Markets versus Capital Markets
• Foreign Exchange Markets
• Derivatives Markets

3
Primary Markets versus Secondary Markets

• Primary Markets
• markets in which users of funds (e.g.
  corporations, 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, NASDAQ)

4
Money Markets versus Capital Markets

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

5
Foreign Exchange Markets

• FX markets deal in trading one currency for
  another (e.g. dollar for yen)
• The spot FX transaction involves the immediate
  exchange of currencies at the current exchange
  rate
• The forward FX transaction involves the
  exchange of currencies at a specified date in the
  future and at a specified exchange rate

6
Derivatives Markets

• Derivatives Financial securities whose payoffs
  are linked to other, previously issued
  securities.
• Examples of derivatives
• Forwards
• Futures
• Options
• Swaps

7
Financial Market Regulation

• In the US the primary focus of market regulation
  is full and fair disclosure of information
• Caveat Emptor!

8
Overview of Financial Institutions

• Institutions that perform the essential function
  of channeling funds from those with surplus funds
  to those with shortages of funds (e.g. banks,
  thrifts, insurance companies, securities firms
  and investment banks, finance companies, mutual
  funds, pension funds)

9
Flow of Funds in a World without FIs Direct
Transfer
Financial Claims (Equity and debt instruments)
Suppliers of Funds (Households)
Users of Funds (Corporations)
Cash
Example A firm sells shares directly to
investors without going through a financial
institution.
10
Flow of Funds in a world with FIs Indirect
transfer
FI (Brokers) FI (Asset transformers)
Users of Funds
Suppliers of Funds
Cash
Cash
Financial Claims (Equity and debt securities)
Financial Claims (Deposits and insurance policies)
11
Types of FIs

• Commercial banks
• depository institutions whose major assets are
  loans and major liabilities are deposits
• Thrifts
• depository institutions in the form of savings
  and loans, credit unions
• Insurance companies
• financial institutions that protect individuals
  and corporations from adverse events

(continued)
12

• Securities firms and investment banks
• financial institutions that underwrite securities
  and engage in securities brokerage and trading
• Finance companies
• financial institutions that make loans to
  individuals and businesses
• Mutual Funds
• financial institutions that pool financial
  resources and invest in diversified portfolios
• Pension Funds
• financial institutions that offer savings plans
  for retirement

13
Services Performed by Financial Intermediaries

• Monitoring Costs
• aggregation of funds provides greater incentive
  to collect a firms information and monitor
  actions
• Liquidity and Price Risk
• provide financial claims to savers with superior
  liquidity and lower price risk

(continued)
14

• Transaction Cost Services
• transaction costs are reduced through economies
  of scale
• Maturity Intermediation
• greater ability to bear risk of mismatching
  maturities of assets and liabilities
• Denomination Intermediation
• allow small investors to overcome constraints
  imposed to buying assets imposed by large minimum
  denomination size

15
Services Provided by FIs Benefiting the Overall
Economy

• Money Supply Transmission
• Depository institutions are the conduit through
  which monetary policy actions impact the economy
  in general
• Credit Allocation
• often viewed as the major source of financing for
  a particular sector of the economy (e.g. farming
  and real estate)

(continued)
16
Services Provided by FIs Benefiting
the Overall Economy

• Intergenerational Wealth Transfers
• life insurance companies and pension funds
  provide savers with the ability to transfer
  wealth from one generation to the next
• Payment Services
• efficiency with which depository institutions
  provide payment services directly benefits the
  economy

17
Risks Faced by Financial Institutions

• Interest Rate Risk
• Foreign Exchange Risk
• Market Risk
• Credit Risk
• Liquidity Risk
• Off-Balance-Sheet Risk
• Technology Risk
• Operational Risk
• Country or Sovereign Risk
• Insolvency Risk

18
Regulation of Financial Institutions

• Prevent the failure of large numbers of financial
  institutions due to financial panics the
  safety net
• Limit risk taking by financial institutions

19
Globalization of Financial Markets and
Institutions

• Financial Markets became more global as the value
  of stocks traded in foreign markets soared
• Foreign bond markets have served as a major
  source of international capital
• Globalization also evident in the derivative
  securities market

20
Factors Leading to Significant Growth in Foreign
Markets

• The pool of savings from foreign investors has
  increased
• International investors have turned to U.S. and
  other markets to expand their investment
  opportunities
• Information on foreign investments and markets is
  now more accessible (e.g. internet)
• Some mutual funds allow ability to invest in
  foreign securities with low transaction costs
• Deregulation has enhanced globalization of
  capital flows