PowerPoint Slides for:

Financial Markets and Institutions 6th Edition

By Jeff Madura Prepared by David R. Durst The University of Akron

CHAPTER

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

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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
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Overview of Financial Markets

Broad Classifications of Financial Markets

Money versus Capital Markets Primary versus Secondary Markets

Organized versus Over-the-Counter Markets

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Primary vs. Secondary Markets

PRIMARY

SECONDARY

New Issue of Securities

Trading Previously Issued Securities

Exchange of Funds for Financial Claim

No New Funds for Issuer

Funds for Borrower; an IOU for Lender

Provides Liquidity for Seller

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Money vs. Capital Markets

Money

Capital

Short-Term, < 1 Year High Quality Issuers Debt Only

Long-Term, >1Yr Range of Issuer Quality Debt and Equity

Primary Market Focus

Liquidity Market--Low Returns

Secondary Market Focus

Financing Investment-Higher Returns
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Organized vs. Over-the-Counter Markets

Organized

OTC

Visible Marketplace Members Trade

Wired Network of Dealers No Central, Physical Location All Securities Traded off the Exchanges
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Securities Listed
New York Stock Exchange

Securities Traded in Financial Markets

Money Market Securities

Debt securities Only

Capital market securities

Debt and equity securities

Derivative Securities

Financial contracts whose value is derived from the values of underlying assets Used for hedging (risk reduction) and speculation (risk seeking)
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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

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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

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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

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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
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Financial Market Efficiency

Security prices reflect available information New information is quickly included in security prices Investors balance liquidity, risk, and return needs
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Financial Market Regulation

Why Government Regulation?

To Promote Efficiency
High

level of competition payments mechanism

Efficient

Low

cost risk management contracts

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Financial Market Regulation

Why Government Regulation?

To Maintain Financial Market Stability

Prevent

market crashes

Circuit breakers Federal Reserve discount window

Prevent Prevent

Inflation--Monetary policy Excessive Risk Taking by Financial Institutions

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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

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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

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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

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Role of Financial Institutions in Financial Markets

Types of Depository Financial Institutions
Savings Institutions $1.3 Trillion Total Assets Credit Unions $.5 Trillion Total Assets

Commercial Banks $5 Trillion Total Assets

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Types of Nondepository Financial Institutions

Insurance companies Mutual funds Pension funds Securities companies Finance companies Security pools

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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

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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

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Global Expansion by Financial Institutions

International expansion International mergers Impact of the single European currency Emerging markets

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