Financial Institutions and Markets

Objectives:
-          Understand Role of Financial Institutions in Finance
-          Differentiate function of Financial Markets and Financial Institutions
-          Describe differences of Money Markets and Capital Markets
-          Explain how markets and institutions enhance allocation of capital.
-          Discuss the importance of market efficiency.

Financial Institutions

Firms that require funds from external sources can obtain them in three ways:

1.       through a financial institution

2.       through financial markets

3.       through private placements

FINANCIAL INSTITUTIONS:

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

Major Financial Institutions:

·       Commercial banks – institutions that provide savers with a secure place to invest their funds and that
offers loans to individual and business borrowers.

·       Investment banks – Institutions that assist companies in raising capital, advise firms on major
transactions such as mergers or financial restructuring, and engage in trading and market making
activities.

The Capital Allocation Process

•       In a well-functioning economy, capital flows efficiently from those who supply capital to those who
demand it.

•       Suppliers of capital:  individuals and institutions with “excess funds.”  These groups are saving
money and looking for a rate of return on their investment.

•       Demanders or users of capital:  individuals and institutions who need to raise funds to finance their
investment opportunities.  These groups are willing to pay a rate of return on the capital they borrow.
As a key participant in financial transactions, individuals are net suppliers of funds because they save
more money than they borrow.
Types of Financial Institutions

1.       Investment Banks – an organization that underwrites and distributes new investment securities and
helps businesses obtain financing.

2.       Commercial Banks – traditional department store of finance, serving a variety of savers and
borrowers.

3.       Financial Service Corporation – a firm that offers a wide range of financial services including
investment, banking, brokerage operations, insurance, and commercial banking.

4.       Credit Unions or Cooperative Associations – members are supposed to have a common bond such
as being employees of the same firm.  Members ‘savings are loaned only to other members, generally for
auto [purchases, home improvement loans, and home mortgages.

5.       Pension Funds – retirement funds funded by corporations or government agencies for their workers
and administered primarily by the trust departments of commercial banks or by life insurance companies.
Pension funds invest primarily in bonds, stocks, mortgages, and real estate.
6.       Life Insurance Companies – take savings in the form of annual premiums; invest these funds in
stocks, bonds, real estate, and mortgages; and make payments to the beneficiaries of the insured parties. 

7.       Mutual Funds – corporations that accept money from savers and then sue these funds to buy stocks,
long-term bonds, or short -term debt instruments issued by business or governments nits.  These
organizations pool funds and thus reduce risks by diversification.

8.       Exchange Traded Funds (ETFs) – Similar to regular mutual funds and are often operated by mutual
fund companies.

9.       Hedge Funds – Unregulated yet similar to mutual funds.

10.   Private Equity Companies – Similar to mutual funds and hedge funds; but rather than purchasing
some of the stock of a firm, primate equity players buy and then manage entire firms.

A credit union is a type of financial cooperative that provides traditional banking services. Ranging in
size from small, volunteer-only operations to large entities with thousands of participants spanning the
country, credit unions can be formed by large corporations, organizations, and other entities for their
employees and members.
Types of Financial Markets:

1.       Physical Asset Markets versus Financial Asset Markets

2.       Spot Markets versus Futures Markets

3.       Money Markets versus Capital Markets.

4.       Primary Market versus Secondary Markets

5.       Private Markets versus Public Markets

Capital Market:

 The capital market is a market that enables suppliers and demanders of long-term funds to make
transactions.

The key capital market securities are bonds (long-term debt) and both common and preferred stock
(equity, or ownership).

–       Bonds are long-term debt instruments used by businesses and government to raise large sums of
money, generally from a diverse group of lenders.

–       Common stock are units of ownership interest or equity in a corporation.

–       Preferred stock is a special form of ownership that has features of both a bond and common stock.
Money Market:

The money market is created by a financial relationship between suppliers and demanders of short-term
funds.

 Most money market transactions are made in marketable securities which are short-term debt
instruments, such as:

•       U.S. Treasury bills issues by the federal government

•       commercial paper issued by businesses

•       negotiable certificates of deposit issued by financial institutions

 Investors generally consider marketable securities to be among the least risky investments available.
STOCK MARKET

 Basic Types of Stock Trading Market:

1.       Physical Location Exchanges – formal organizations having tangible physical locations that
conduct auction markets in designated “listed” securities.

2.       Over-the-Counter Markets – a large collection of brokers and dealers connected electronically by

telephones and computers, that provide for trading in unlisted securities.

Financial Markets

Financial markets are forums in which suppliers of funds and demanders of funds can transact business
directly.

•       Transactions in short term marketable securities take place in the money market while transactions
in long-term securities take place in the capital market.

•       A private placement involves the sale of a new security directly to an investor or group of

investors.

•       Most firms, however, raise money through a public offering of securities, which is the sale of either
bonds or stocks to the general public.

 
The Flow of Funds