Chapter One

Introduction

©2009, The McGraw-Hill Companies, All Rights Reserved

 Why study Financial Markets
and Institutions?
•• Prudent
Prudent investment
investment and
and financing
financing
requires
requires aa thorough
thorough understanding
understanding of
of
–– the
the structure
structure of
of domestic
domestic and
and international
international
markets
markets
–– the
the flow
flowofof funds
funds through
through domestic
domestic andand
international
international markets
markets
–– the
the strategies
strategies used
used to
to manage
manage risks
risks faced
faced by
by
investors
investors and
and savers
savers

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 Financial Markets

•• Financial
Financial markets
markets are
are structures
structures
through
through which
which funds
funds flow
flow
•• Financial
Financial markets
markets can
can bebe distinguished
distinguished
along
along two
two dimensions
dimensions
–– primary
primary versus
versus secondary
secondary markets
markets
–– money
money versus
versus capital
capital markets
markets

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 Primary versus Secondary Markets

•• Primary
Primary markets
markets
–– markets
markets inin which
which users
users of
of funds
funds (e.g.,
(e.g.,
corporations
corporations and
and governments)
governments) raise
raise funds
funds by
by
issuing
issuing financial
financial instruments
instruments (e.g.,
(e.g., stocks
stocks and
and
bonds)
bonds)
•• Secondary
Secondary markets
markets
–– markets
markets where
where financial
financial instruments
instruments are
are traded
traded
among
among investors
investors (e.g.,
(e.g., NYSE
NYSE and
and Nasdaq)
Nasdaq)

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 Money versus Capital Markets

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

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 Money Market Instruments
Outstanding, ($Bn)
3000
3000
2500
2500
2000
2000
1500
1500
1000
1000
500
500
00
1990q4
1990q4 2000q4
2000q4 2007q1
2007q1
Fed
Fedfunds
fundsand
andrepos
repos Commercial
Commercialpaper
paper Negotiable
NegotiableCDs
CDs
U.S.
U.S.Treasury
Treasurybills
bills Banker's
Banker'saccept.
accept.
McGraw-Hill/Irwin 1-6 ©2009, The McGraw-Hill Companies, All Rights Reserved
 Capital Market Instruments
Outstanding, ($Bn)
25000
25000
20000
20000
15000
15000
10000
10000
5000
5000
00
1990q4
1990q4 2000q4
2000q4 2007q1
2007q1
Corporate
Corporatestocks
stocks Mortgages
Mortgages Corporate
Corporatebonds
bonds
U.S.
U.S.gov't
gov'tagencies
agencies Treasury
Treasurysecurities
securities State
State&
&local
localgov't
gov'tbonds
bonds
Bank
Bankand
andconsumer
consumerloans
loans

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 Foreign Exchange (FX) Markets

•• FX
FX markets
markets
–– trading
tradingone
onecurrency
currencyfor
foranother
another(e.g.,
(e.g.,dollar
dollarfor
foryen)
yen)
•• Spot
Spot FX
FX
–– the
theimmediate
immediateexchange
exchangeof
ofcurrencies
currenciesatatcurrent
current
exchange
exchangerates
rates
•• Forward
Forward FX
FX
–– the
theexchange
exchangeof ofcurrencies
currenciesin
inthe
thefuture
futureon
onaaspecific
specific
date
dateand
andatataapre-specified
pre-specifiedexchange
exchangerate
rate

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 Derivative Security Markets

•• Derivative
Derivative security
security
–– aa financial
financial security
security whose
whose payoff
payoff isis linked
linked to
to
(i.e.,
(i.e., “derived”
“derived” from)
from) another
another security
security or or
commodity
commodity
–– generally
generally an an agreement
agreement to to exchange
exchange aa standard
standard
quantity
quantity of of assets
assets at
at aa set
set price
price on
on aa specific
specific
date
date inin the
the future
future

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 Financial Market Regulation

•• The
The Securities
Securities Act
Act of
of 1933
1933
–– full
full and
and fair
fair disclosure
disclosure and
and securities
securities
registration
registration
•• The
The Securities
Securities Exchange
Exchange Act
Act of
of 1934
1934
–– Securities
Securities and
and Exchange
Exchange Commission
Commission (SEC)
(SEC) isis
the
the main
main regulator
regulator of
of securities
securities markets
markets

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 Financial Institutions (FIs)

•• Financial
Financial Institutions
Institutions
–– institutions
institutions through
through which
which suppliers
suppliers channel
channel
money
money to to users
users of
of funds
funds
•• Financial
Financial Institutions
Institutions are
are distinguished
distinguished
by
by whether
whether they
they accept
accept deposits
deposits
–– depository
depository versus
versus non-depository
non-depository financial
financial
institutions
institutions

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 Flow of Funds in a World without FIs

Financial Claims
(equity and debt
instruments)
Users of Funds Suppliers of
(corporations) Funds
(households)
Cash

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 Flow
FlowofofFunds
Fundsinina aWorld
Worldwithout
with FIs
FIs

FIs
Users of Funds Suppliers of Funds
(brokers)

Cash FIs
(asset Cash
transformers)
Financial Claims Financial Claims
(equity and debt securities) (deposits and insurance policies)

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 Depository versus Non-Depository FIs

•• Depository
Depository institutions
institutions
–– commercial
commercial banks,
banks, savings
savings associations,
associations,
savings
savings banks,
banks, credit
credit unions
unions
•• Non-depository
Non-depository institutions
institutions
–– insurance
insurance companies,
companies, securities
securities firms
firms and
and
investment
investment banks,
banks, mutual
mutual funds,
funds, pension
pension funds
funds

McGraw-Hill/Irwin 1-14 ©2009, The McGraw-Hill Companies, All Rights Reserved

 FIs Benefit Suppliers of Funds

•• Reduce
Reduce monitoring
monitoring costs
costs
•• Increase
Increase liquidity
liquidity and
and lower
lower price
price risk
risk
•• Reduce
Reduce transaction
transaction costs
costs
•• Provide
Provide maturity
maturity intermediation
intermediation
•• Provide
Provide denomination
denomination intermediation
intermediation

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 FIs Benefit the Overall Economy

•• Conduit
Conduit through
through which
which Federal
Federal Reserve
Reserve
conducts
conducts monetary
monetary policy
policy
•• Provides
Provides efficient
efficient credit
credit allocation
allocation
•• Provide
Provide for
for intergenerational
intergenerational wealth
wealth
transfers
transfers
•• Provide
Provide payment
payment services
services

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 Risks Faced by Financial Institutions

•• Credit
Credit •• Off-balance-sheet
Off-balance-sheet
•• Foreign
Foreign exchange
exchange •• Liquidity
Liquidity
•• Country
Country oror •• Technology
Technology
sovereign
sovereign •• Operational
Operational
•• Interest
Interest rate
rate •• Insolvency
Insolvency
•• Market
Market

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 Regulation of Financial Institutions

•• FIs
FIs are
are heavily
heavily regulated
regulated to
to protect
protect society
society at
at
large
large from
from market
market failures
failures
•• Regulations
Regulations impose
impose aa burden
burden on
on FIs
FIs and
and recent
recent
U.S.
U.S. regulatory
regulatory changes
changes have
have been
been
deregulatory
deregulatory inin nature
nature
•• Regulators
Regulators attempt
attempt toto maximize
maximize social
social welfare
welfare
while
while minimizing
minimizing the
the burden
burden imposed
imposed byby
regulation
regulation

McGraw-Hill/Irwin 1-18 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Globalization of Financial Markets and
Institutions
•• The
Thepool
poolof
ofsavings
savingsfrom
fromforeign
foreigninvestors
investorsisis
increasing
increasingandandinvestors
investorslook
looktotodiversify
diversifyglobally
globally
now
nowmore
morethan
thanever
everbefore
before
•• Information
Informationon onforeign
foreignmarkets
marketsandandinvestments
investmentsisis
becoming
becomingreadily
readilyaccessible
accessibleand
andderegulation
deregulationacross
across
the
theglobe
globeisisallowing
allowingeven
evengreater
greateraccess
access
•• International
Internationalmutual
mutualfunds
fundsallow
allowdiversified
diversifiedforeign
foreign
investment
investmentwithwithlow
lowtransactions
transactionscosts
costs

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