Understanding Financial

Markets and Institutions

Saunders, Chapter 1
Mishkin, Chapter 8
Cecchetti, Chapter 6,8,11

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 Content

1. Financial Markets

2. Roles of Financial Markets

3. Structure of Financial Markets

4. Derivatives Markets

5. Internationalization of Financial Markets

6. Financial Institutions

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 Learning Outcomes

• Differentiate between primary and secondary

markets
• Differentiate between money and capital
markets
• Understand the concept of foreign exchange
markets
• Understand the concept of derivative security
markets
• Distinguish between the different types of
financial institutions
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 Financial Markets

• Financial markets are markets in which funds

are moved from people who have an excess
of available funds (and lack of investment
opportunities) to people who have investment
opportunities (and lack of funds).
• Financial markets are structures through
which funds flow

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 Structure of Financial
Markets

Financial markets can be distinguished

along three major dimensions:

1. Debt and Equity Markets

2. Primary versus secondary markets

3. Money versus capital markets

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 Debt and Equity Markets

• A bond (a debt instrument) is a contractual agreement by the

borrower to pay the holder of the instrument fixed dollar amounts
at regular intervals (interest and principal payments) until a
specified date (the maturity date), when a final payment is made.
➢ short-term (maturity < a year) ; Long-term (ten years or longer);
Intermediate-term
• Equities are claims to share in the net income (income after
expenses and taxes) and the assets of a business. Equity often
make periodic payments (dividends) to their holders and are
considered long-term securities because they have no maturity
date.
➢Residual claimant

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 Primary vs. Secondary
Markets

• Primary markets are financial

markets in which new issues of
a security are sold to initial
buyers by the corporation or
government agency borrowing
the funds.
• Secondary markets are
markets in which existing
securities are traded among
investors
→ Role of secondary market

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 Stock Exchanges vs. OTC markets

• Exchanges are markets where buyers and sellers of

securities (or their agents or brokers) meet in one
central location to conduct trades

• Over-the-counter (OTC) markets are markets, in which

dealers at different locations who have an inventory of
securities stand ready to buy and sell securities “over
the counter” to anyone who comes to them and is
willing to accept their prices

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 Money vs. Capital Markets

• Money markets are markets for short-term, highly

liquid debt securities.
• Most U.S. money markets are over-the-counter (OTC)
markets
• Capital markets are markets for intermediate- and
long-term debt and corporate stocks.
• Wider price fluctuations than money market
instruments

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 The Money Markets

• The securities in the money market are short term with high
liquidity; therefore, they are close to being “money”.
➢ Money market securities are usually sold in large
denominations ($1,000,000 or more)
➢They have low default risk.
➢They mature in one year or less from their
issue date, although most mature in less
than 120 days

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 The Money
Market Instrument

• In 2019, federal funds and

repurchase agreements,
followed by Treasury bills,
negotiable CDs, and
commercial paper, had the
largest amounts
outstanding.

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 Money Market and Secondary Market

• Once issued, money market instruments trade in active

secondary markets.
• The secondary markets for money market instruments are
extremely important, as they serve to reallocate the
(relatively) fixed amounts of liquid funds available in the
market at any time.

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 Why do we need money markets?

• Investors in Money Market: Provides a

place for warehousing surplus funds for
short periods of time.

• Lenders from money market provide

low-cost source of temporary funds.

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Various U.S. Money Market
Security Rates

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Comparing Some Money Market Securities

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 CAPITAL MARKETS

•Capital market instruments

are debt and equity
instruments with maturities of
greater than one year.

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CAPITAL MARKET INSTRUMENTS

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 Foreign Exchange Markets

• Foreign exchange risk is the sensitivity of the value of cash

flows on foreign investments to changes in the foreign
currency’s price in terms of dollars
• U.S. dollars received on a foreign investment depends on
the exchange rate between the U.S. dollar and the foreign
currency when the nondollar cash flow is converted into
U.S. dollars

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 Derivative Security Markets

• A derivative security is a financial security (e.g.,

future, option, swap, or mortgage-backed security)
whose payoff is linked to another, previously issued
security, such as a security traded in capital or
foreign exchange markets
• Derivatives are traded in derivative security markets
• Generally involves agreement between two parties to
exchange a standard quantity of an asset or cash flow
at a predetermined price and at a specified future date
• Derivative markets are the newest of financial security
markets and are also potentially the riskiest security
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 Derivative Security Markets
(Continued)
• Derivative activity:
• Tremendous growth between 1992-2013
• Large drop from 2013 to 2019, due largely to the 2014
implementation of the Volcker Rule

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 Financial Market Rates

• Interest Rates
- An interest rate is a promised rate of return, and
there are as many different interest rates as there are
distinct kinds of borrowing and lending

Rates of return of risky assets

• Many assets do not carry a promised rate of return
Let us consider how to measure the rate of return on
such risky assets
Financial assets normally generate two types of return
for investor: periodic income (dividends or interest
payments) and price change (capital gain/loss)
A holding period return is the return earned from
holding an asset for a single specified period of time.

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 Financial Market Rates

Rates of return of risky assets

• Many assets do not carry a promised rate of return
Let us consider how to measure the rate of return on
such risky assets
Financial assets normally generate two types of return
for investor: periodic income (dividends or interest
payments) and price change (capital gain/loss)
A holding period return is the return earned from
holding an asset for a single specified period of time.

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 Internationalization of Financial Markets

• Foreign Bonds: sold in a foreign country and

denominated in that country’s currency
• Eurobond: bond denominated in a currency
other than that of the country in which it is sold
• Eurocurrencies: foreign currencies deposited
in banks outside the home country
▫ Eurodollars: U.S. dollars deposited in foreign
banks
outside the U.S. or in foreign branches of U.S.
banks

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 Characteristics of a Well-Run Financial Market

• These markets must be designed to keep transaction costs

low.
• The information the market pools and communicates must
be both accurate and widely available.
• Investors need protection.

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Summary

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Financial Institutions

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 Overview of Financial
Institutions (FIs)

• Financial institutions perform the essential

function of channeling funds from those with
surplus funds to those with shortages of funds
• In a world without FIs, the level of funds flowing
between suppliers and users would likely be
quite low due to the following reasons:
• Monitoring costs
• Liquidity costs
• Price risk

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Education.
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Types of Financial Institutions

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Education.
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The Structure of the Financial Industry

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 Depository institutions

•Depository institutions take deposits and

make loans
•Depository institutions include
commercial banks and thrifts.
•Thrifts include savings and loan
associations, savings banks, and credit
unions.

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 Commercial banks

Commercial banks are the largest type of

depository institution
A commercial bank is a financial
institution that is owned by shareholders,
and engages in accepting deposits and
lending for a profit.
A bank may be owned by a bank holding
company (BHC), which is a company
that owns one or more banks.

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 Nondepository Financial Institutions
Contractual Savings Institutions
Insurance Companies

Contractual savings institutions, such as

insurance companies and pension funds,
are financial intermediaries that acquire funds
at periodic intervals on a contractual basis.

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 Insurance Companies

•Insurance companies provides various forms

of insurance and investment services to
individuals and charge a fee, called a
premium, for this service
•In general, the insurance provides a payment
to the insured (or a named beneficiary) under
conditions specified by the insurance policy
contract.

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 Insurance Companies

Insurance companies offer two types of insurance:

▫ Life insurance.
▫ Property and casualty insurance.
While a single company may provide both kinds of
insurance, the two businesses operate very differently.

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 Insurance Companies

• Life insurance comes in two basic forms.

➢Term life insurance provides a payment to the
policy holder’s beneficiaries in the event of the
insured’s death at any time during the policy’s term.
◦Generally renewable every year as long as
the policyholder is less than 65 years old.
➢Whole life insurance is a combination of term life
insurance and a savings account.
◦The policyholder pays a fixed premium over
his/her lifetime in return for a fixed benefit
when the policyholder dies

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 Insurance Companies

•Car insurance is an example of property and casualty

insurance.
▫ It is a combination of
➢Property insurance on the car itself, and
➢Casualty insurance on the driver, who is protected against liability
for harm or injury to other people or their property.
•Holders of property and casualty insurance pay premiums in
exchange for protection during the term of the policy.

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 Insurance Companies
Balance Sheet
On the balance sheets of insurance companies,
these promises to policyholders show up as
liabilities.
On the asset side, insurance companies hold a
combination of stocks and bonds.
Property and casualty companies profit from the
fees they charge for administering the policies they
write.
Because assets are essentially reserves against
sudden claims, they have to be liquid.
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 Life insurance vs Proverty and casualty insurers

◦Life insurance companies hold assets of longer

maturity than property and casualty insurers.
▫ Because more life insurance payments will be made
well into the future, this better matches the maturity of
the companies’ assets and liabilities.
▫ As a result, life insurance companies hold mostly
bonds.

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 Insurance Companies

• Adverse selection and moral hazard create significant

problems in the insurance market.
• A person with terminal cancer has an incentive to buy life
insurance for the largest amount possible - that’s adverse
selection.
• Without fire insurance, people would have more fire
extinguishers in their houses - that’s moral hazard.

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 Insurance companies

Insurance companies work hard to reduce both

adverse selection
and moral hazard.
▫ A person wanting life insurance needs a
physical exam.
▫ People who want auto insurance must
provide their driving records.
▫ Policies also include restrictive covenants
that require the insured to engage or not to
engage in certain activities.

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 Insurance companies

Insurance companies might also require

deductibles.
▫ These require the insured to pay the initial
cost of repairing accidental damage, up to
some maximum amount.
Or they may require coinsurance.
▫ This is where the insurance company shoulders
a percentage of the claim, usually 80 or 90
percent and the insured assumes the rest.

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 Pension fund

•A pension fund offers people the ability to

make premium payments today in exchange
for promised payments under certain future
circumstances.
▫ They provide an easy way to make sure that a
worker saves and has sufficient resources in old
age.
▫ They help savers to diversify their risk.
•By pooling the savings of many small
investors, pension funds spread the risk.

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 Pension Funds
• People can use a variety of methods to save for
retirement, including employer sponsored plans and
individual savings plans.

• Many employer-sponsored plans require a person work for a

certain number of years before qualifying for benefits, a
processcalled vesting.

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 Finance Companies

•Finance companies are in the lending business.

•They raise funds directly in the financial markets by
issuing commercial paper and securities and then use
them to make loans to individuals and corporations.
•They borrow in large amounts but often lend in small
amounts—a process quite different from that of banking
institutions, which collect deposits in small amounts and
then often make large loans

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 Finance Companies

Finance companies are particularly good at:

▫ Screening potential borrowers’ creditworthiness,
▫ Monitoring their performance during the term of
the loan, and
▫ Seizing collateral in the event of a default.

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 Finance Companies

Most finance companies specialize in one of three

loan types:
▫ Consumer loans,
▫ Business loans, and
▫ What are called sales loans.
▫ Some also provide commercial and home
mortgages.

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 Finance Companies

•Consumer finance firms provide small

installment loans to individual consumers.
•Business finance companies provide loans
to businesses.
▫ Business finance companies also provide
both inventory loans and accounts receivable
loans.
•Sales finance companies specialize in larger
loans for major purchases, such as automobiles.

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 Securities Firms
Brokerage Firms,
Mutual Funds,
Investment Banks

◦The primary services of brokerage firms are:

▫ Accounting (to keep track of customers’
investment balances),
▫ Custody services (to make sure valuable
records such as stock certificates are safe),
and
▫ Access to secondary markets (in which
customers can buy and sell financial
instruments).
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 Brokerage Firms,

Brokers also provide loans to customers who wish to

purchase stock on margin.

▫ They provide liquidity, both by offering check-writing

privileges with their investment accounts and by allowing

investors to sell assets quickly.

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 Mutual Funds

•These financial intermediaries acquire funds by

selling shares to many individuals and use the
proceeds to purchase diversified portfolios of
stocks and bonds.
•Mutual funds allow shareholders to pool their
resources so that they can take advantage of lower
transaction costs when buying large blocks of
stocks or bonds.

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 Mutual Funds

Provide an important service for individuals

who wish to invest funds and diversify
•Offer liquidity if they are willing to
repurchase an investor’s shares upon
request.
•Offer various different services, such as
transfers between funds and check-writing
privileges.

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 Mutual Funds

Open-end funds:
•Are open to investment from investors at any time
•Allow investors to purchase or redeem shares at any
time
• the number of fund shares is not fixed.
•All new investments into the fund are purchased at the
•The total number of shares in the fund increases if
more investments than withdrawals are made during
the day, and vice versa.

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 Mutual Funds

Closed-end funds:
•do not issue additional shares or redeem shares.
•the number of fund shares is fixed at the number sold at
issuance (i.e., at the time of the initial public offering).
•investors who want to sell their shares or investors who
want to buy shares must do so in the secondary market
where the shares are traded (either on an exchange or
in the over-the-counter market).

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 Mutual Funds
Money market mutual funds:
▫ Are portfolios of money market
instruments constructed and managed by
investment companies
▫ Allow investors to participate for as little as
$1,000
▫ Usually allow check-writing privileges
•Other funds include venture capital funds,
real estate investment trust…

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 Investment Banks

As with commercial banks, investment banks are highly

leveraged entities that play important roles in both the
primary and secondary markets.
Investment banking activities include:
➢Raising funds through public offerings and private
placement of securities.
➢Trading of securities.
➢Mergers, acquisitions, and financial restructuring
advising.
➢Merchant banking.
➢Securities finance and prime brokerage services.

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