OVERVIEW OF FINANCIAL MARKET & INSTITUTIONS

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

What is Financial System?

A financial system' is a system that allows the exchange of funds between lenders, investors, and
borrowers. Financial systems operate at national and global level

Where to exchange of funds between lenders, investors and borrowers?

Private Placements - the sale of a new security directly to an investor or group of investors.

Financial Institutions – intermediaries that channel the savings of individuals, businesses, and
governments into loans or investments.

Financial Markets – organized forums in which the suppliers and users of various types of funds
can make transactions

Note:
▪ Due to the increased need for security for the performance of obligations arising from
these transactions and due to the growing size of the financial system, the transfers of
funds from one party to another are made through Financial Instruments.

What is Financial Institutions(FIs)?

An 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

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

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.
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

Regulation of Financial Institutions

FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in
the public interest

In an attempt to prevent their failure and the failure of financial markets overall

Importance of the banking industry

▪ Provision of Credit and Liquidity – Banks provide credit facilities to borrowers which
allow them to address their liquidity concerns.

▪ Risk Management Services – Banks provide advisory service on asset-liability

management and can also provide recommendations regarding the appropriate financing
schemes for a company’s funding requirement.

▪ Money Remittance – Banks can act as conduits or intermediaries for money remittances.

▪ Economic Development

▪ Channel for Saving and Investment

▪ Promotion of Entrepreneurship

What is a Financial Instruments?

Is a real or a virtual document representing a legal agreement involving some sort-of monetary
value These can be debt securities like corporate bonds or equity like shares of stock.

When a financial instrument is issued, it gives rise to a financial asset on one hand and a
financial liability or equity instrument on the other.

A Financial Asset is any asset that is:

• Cash
• An equity instrument of another entity
• A contractual right to receive cash or another financial asset from another entity.
• A contractual right to exchange instruments with another entity under conditions that are
potentially favorable. (IAS 32.11)
Examples: Notes Receivable, Loans Receivable, Investment in Stocks, Investment in Bonds
A Financial Liability is any liability that is a contractual obligation:
• To deliver cash or other financial instrument to another entity.
• To exchange financial instruments with another entity under conditions that are potentially
unfavorable. (IAS 32)
Examples: Notes Payable, Loans Payable, Bonds Payable

Role of Financial Assets

Transfer funds from surplus units to deficit units.

Transfer funds so as to redistribute unavoidable risk associated with cash flows generated from
both tangible and intangible assets.

Characteristics or Properties of Financial Assets

Moneyness - the moneyness of the financial assets implies that they are easily convertible to
cash within a defined time and determinable value;

Divisibility and Denomination - Divisibility relates to the minimum size at which a financial
asset can be liquidated and exchanged for money.

Reversibility - Refers to the cost of investing in a financial asset and then getting out of it and
back into cash again

Reversibility is also referred to round-trip cost

Deposit at a bank is highly reversible because usually the investor incurs no charge for adding to
or withdrawing from it.

Term to Maturity or Maturity Period - Is the length of the interval until the date when the
instrument is scheduled to make its final payment, or the owner is entitled to demand liquidation

There are reasons that maybe responsible for not able to reach the maturity dates as follows:

Bankruptcy – a situation in which the company is being unable to meet its external
financial obligations

Reorganization- a situation in which a company is restructuring its ownership structure and

operations

Call Provision – the financial instruments being associated with call provision

Liquidity - Is where a financial assets can be easily converted to cash whenever the holder needs
money while illiquid financial assets are those that cannot be easily converted to cash.

Good examples of highly liquid financial instruments include:

▪ Treasury bills, Treasury Certificates, Certificate of Deposits, Bills of Exchange, and

shares of blue chip companies

Examples of Illiquid financial instruments include:

▪ A stock of a small corporation or the bond issued by a small school district. For which the
market is extremely thin, and one must search out the few suitable buyers

▪ Private Pension may be regarded as totally illiquid , because they can be cashed only at
retirement
Convertibility - This characteristics implies that a financial asset or instrument can be converted
into another class of asset which will still be held by the corporate entity has original used to
raise funds for its operations.

The conversion can take a form of bond being converted to another bond, preference share being
converted to equity shares, and a company bond being converted into equity shares of the
company.

Currency - Financial assets are normally denominated in currencies of the various countries
around the world. Some issuers, responding to investors’ wishes to reduce foreign exchange risk,
have issued dual-currency securities

Cash Flow & Return Predictability - The return that a investor will realize by holding a
financial asset depends on the cash flow expected to be received, which include dividend
payment on stock and interest payments on debt instruments, as well as repayment of principal
for a debt instrument and the expected sales price of a stock. Therefore, the predictability of the
expected return depends on the predictability of the cash flow.

Complexity - Some financial assets are complex in the sense that they combine two or more
simpler assets.

Most complex financial assets involve a choice or option granted to the issuer or investor to do
something to alter the cash flow.

Tax Status - An important feature of any financial asset is its tax status. Governmental codes for
taxing the income from the ownership or sale of financial assets vary widely if not wildly. Tax
rates differ from year to year, country to country, and even among municipal units within a
country.

What is Financial Markets?

A Financial Market is a market in which financial instruments ( financial assets or securities) can
be purchased or sold.

Financial markets facilitate transfers of funds from person or business without investment
opportunities (i.e., “Lender-Savers”, or “Surplus Unit”) to those who have investment
opportunities (i.e., “Borrower-Spenders”, or “Deficit Unit

Role of Financial Markets

• Determine price or required rate of return of asset.

• Provide liquidity.

• Reduce transactions costs, which consists of search costs and information costs.

Financial Market Participants

• Households

• Business units

• Federal, state, and local governments

• Government agencies

• Supranational

• Regulators
Classification of Financial Markets

• Money market vs. capital market

• Primary vs. secondary market

• Debt vs. equity markets

Financial markets can be distinguished by the maturity structure and trading structure of
its securities

• The flow of short-term funds is facilitated by money markets

• The flow of long-term funds is facilitated by capital markets

MARKET PLACE (Organized Securities Exchanges, OTC Market)

Organized Securities Exchanges

• The New York Stock Exchange (NYSE)

– Largest stock exchange—over 3,025 companies
– Accounts for 90% of stocks traded on exchanges
– Specialists make transactions in key stocks
– Strictest listing policies
• The American Exchange (AMEX)
– Second largest stock exchange—about 800 companies and 4% of stocks traded on
exchanges
– Major market for Exchange Traded Funds
– Typically smaller and younger companies who cannot meet stricter listing
requirements for NYSE

• Regional Stock Exchanges

– Typically lists between 100–500 companies
– Most listed stocks also listed on NYSE or AMEX
– Best-known: Chicago, Pacific, Philadelphia, Boston,
and Cincinnati
• Options Exchanges
– Allows trading of options
– Best-known: Chicago Board Options Exchange (CBOE)
• Futures Exchanges
– Allows trading of financial futures (discussed in Chapter 15)
- Best-known: Chicago Board of Trade (CBT)

Over-the-Counter (OTC) Market

• Nasdaq
– Electronic network that connects OTC dealers with buyers and sellers
– About 7,000 stocks trade on the Nasdaq
– Both IPOs and secondary distributions are sold on OTC
• Bid Price: the highest price offered by market maker to purchase a given security
• Ask Price: the lowest price at which a market maker is willing to sell a given security

NASDAQ is an acronym for the National Association of Securities Dealers Automated

Quotations. It was founded in 1971 by the National Association of Securities Dealers (NASD),
which divested itself of Nasdaq in a series of sales in 2000 and 2001.
Regulation of Securities Markets

Securities Act of 1933 - Required full disclosure of information by companies

Securities Act of 1934 - Established SEC as government regulatory body

Maloney Act of 1938 - Allowed self-regulation of securities industry through trade associations
such as the National Association of Securities Dealers (NASD)

Investment Company Act of 1940 - Created & regulated mutual funds

Investment Advisors Act of 1940 - Required investment advisers to make full disclosure about
their backgrounds and their investments, as well as register with the SEC

Securities Acts Amendments of 1975 - Abolished fixed-commissions and established an

electronic communications network to make stock pricing more competitive

Insider Trading and Fraud Act of 1988 - Prohibited insider trading on nonpublic information

Sarbanes-Oxley Act of 2002 - Tightened accounting and audit guidelines to reduce corporate
fraud