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Chapter One

Introduction

Copyright © 2015 by McGraw-Hill Education. All rights reserve

Why Study Financial Markets
and Institutions?

Markets
Markets and
and institutions
institutions are
are primary
primary

channels
channels to
to allocate
allocate capital
capital in
in our
our society
society

 Proper
Proper capital
capital allocation
allocation leads
leads to
to growth
growth in:
in:

Societal
Societal wealth
wealth

Income
Income

Economic
Economic opportunity
opportunity

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Why Study Financial Markets
and Institutions?

In
In this
this text
text we
we will
will examine:
examine:

 the
the structure
structure of
of domestic
domestic and
and international
international

markets
markets

 the
the flow
flow of
of funds
funds through
through domestic
domestic and
and
international
international markets
markets

 an
an overview
overview of
of 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 one one type type of of structure structure through through which which funds funds flow flow  Financial Financial markets markets can can be be distinguished distinguished along along two two dimensions: dimensions:   primary primary versus versus secondary secondary markets markets   money money versus versus capital capital markets markets 1-4 .

..g..g. (e. corporations corporations and and governments) governments) raise raise funds funds by by issuing issuing financial financial instruments instruments (e. stocks stocks and and bonds) bonds)  Secondary Secondary markets markets   markets markets where where existing existing financial financial instruments instruments are are traded traded among among investors investors (e..g. (e. (e.g..Primary versus Secondary Markets  Primary Primary markets markets   markets markets in in which which users users of of funds funds (e.g. exchange exchange traded: traded: NYSE NYSE and and over-the-counter: over-the-counter: NASDAQ) NASDAQ) 1-5 ..g.

Primary versus Secondary Markets 1-6 .

Primary versus Secondary Markets  How How were were primary primary markets markets affected affected by by the the financial financial crisis? crisis?  Do Do secondary secondary markets markets add add value value to to society society or or are are they they simply simply aa legalized legalized form form of of gambling? gambling?   How How does does the the existence existence of of secondary secondary markets markets affect affect primary primary markets? markets? 1-7 .

U.S.g.. loss..Treasury Treasurybills) bills)   little littleor orno norisk riskof ofcapital capitalloss.g.3   1-8 . loss.but butlow lowreturn return     Capital Capital markets markets markets marketsthat thattrade tradedebt debt(bonds) (bonds)and andequity equity(stock) (stock) instruments instrumentswith withmaturities maturitiesof ofmore morethan thanone oneyear year   substantial substantialrisk riskof ofcapital capitalloss.S. (e.but buthigher higherpromised promisedreturn return Figure 1.Money versus Capital Markets   Money Money markets markets markets marketsthat thattrade tradedebt debtsecurities securitieswith withmaturities maturitiesof ofone one year yearor orless less(e.CDs CDsand and U.

Money Market Instruments Outstanding. ($Bn) 1-9 .

($Bn) 1-10 .Capital Market Instruments Outstanding.

dollar dollarfor foryen) yen)   Spot Spot FX FX   the theimmediate immediateexchange exchangeof ofcurrencies currenciesat atcurrent current exchange exchangerates rates   Forward Forward FX FX   the theexchange exchangeof ofcurrencies currenciesin inthe thefuture futureon onaaspecific specificdate date and andat ataapre-specified pre-specifiedexchange exchangerate rate 1-11 . (e.Foreign Exchange (FX) Markets   FX FX markets markets   trading tradingone onecurrency currencyfor foranother another(e.g..g..

  generally generallyan anagreement agreementto toexchange exchangeaastandard standardquantity quantity of ofassets assetsat ataaset setprice priceon onaaspecific specificdate dateininthe thefuture.e.e.   the themain mainpurpose purposeof ofthe thederivatives derivativesmarkets marketsisisto totransfer transfer risk riskbetween betweenmarket marketparticipants. (i.. participants. commodity.Derivative Security Markets  Derivative Derivative security security aafinancial financialsecurity securitywhose whosepayoff payoffisislinked linkedto to(i.“derived” “derived” from) from)another anothersecurity securityor orcommodity..   1-12 . future.

futures futurescontracts contracts   Over Over the the counter counter derivatives derivatives   Forward Forwardcontracts contracts   Forward Forwardrate rateagreements agreements   Swaps Swaps   Securitized Securitizedloans loans 1-13 . options.Derivative Security Markets  Selected Selected examples examples of of derivative derivative securities securities   Exchange Exchange listed listed derivatives derivatives   Many Manyoptions.

3. Change Changein inbanking bankingfrom from ‘originate ‘originateand andhold’ hold’loans loansto to ‘originate ‘originateand andsell’ sell’loans. investors.Derivatives and the Crisis 1. Mortgage Mortgagederivatives derivativesspread spreadthe therisk risk of of mortgages mortgagesto toaa broader broader base baseof ofinvestors.   Decline Declinein inunderwriting underwritingstandards standards on onloans loans 1-14 . mid-2000s. 3. 2. Mortgage Mortgagederivatives derivativesallowed allowedaalarger largeramount amountof of mortgage mortgage credit credit to tobe becreated createdin inthe themid-2000s. 1.   Growing Growingimportance importanceof of‘shadow ‘shadowbanking bankingsystem’ system’ 2. loans.

1930s. The The“Great “GreatRecession” Recession”was wasthe theworst worstsince sincethe the“Great “Great Depression” Depression”of ofthe the1930s.peak peakto totrough troughstock stockprices prices fell fellover over50% 50%ininthe theU. Subprime Subprimemortgage mortgagelosses losseswere werelarge.S.reaching reachingover over $700 $700billion. lost. large.S.Derivatives and the Crisis 1. 2. U.S.   Trillions Trillions$$global globalwealth wealthlost.S. billion. U.   Lingering Lingeringhigh highunemployment unemploymentand andbelow belowtrend trendgrowth growthinin the theU.   Sovereign Sovereigndebt debtlevels levelsinindeveloped developedeconomies economiesreached reached post-war post-warall-time all-timehighs highs 1-15 . 2. 1.

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 1-16 .

Financial Institutions (FIs)   Financial Financial Institutions Institutions   institutions institutionsthrough throughwhich whichsuppliers supplierschannel channelmoney moneyto to users usersof of funds funds   Financial Financial Institutions Institutions are are distinguished distinguished by: by:   whether whetherthey theyaccept accept insured insureddeposits deposits  depository depositoryversus versusnon-depository non-depository financial financial institutions institutions   whether whetherthey theyreceive receivecontractual contractual payments paymentsfrom from customers customers 1-17 .

Percentage Shares of Assets of Financial Institutions in the United States. 1929–2013 1-18 .

Non-Intermediated (Direct) Flows of Funds Flow of Funds in a World without FIs Direct Financing Financial Claims (equity and debt instruments) Users of Funds (corporations) Cash 1-19 Suppliers of Funds (households) .

Intermediated Flows of Funds Flow of Funds in a World with FIs Users of Funds Cash Intermediated Financing FIs Suppliers of Funds (brokers) FIs (asset transformers) Financial Claims (equity and debt securities) Cash Financial Claims (deposits and insurance policies) 1-20 .

companies. credit creditunions unions   Non-depository Non-depository institutions institutions Contractual: Contractual:   insurance insurancecompanies. banks. funds.mutual mutualfunds.   Non-contractual: Non-contractual:   securities securitiesfirms firmsand andinvestment investmentbanks. banks.Depository versus Non-Depository FIs   Depository Depository institutions: institutions:   commercial commercialbanks.savings savingsbanks.pension pensionfunds. associations. funds. banks.   1-21 .savings savingsassociations.

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 1-22 .

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 1-23 .

Risks Faced by Financial Institutions  Credit Credit  Off-balance-sheet Off-balance-sheet  Foreign Foreign exchange exchange  Liquidity Liquidity  Country Country or or  Technology Technology sovereign sovereign  Interest Interest rate rate  Market Market  Operational Operational  Insolvency Insolvency Volcker Rule: Insured institutions may not engage in proprietary trading 1-24 .

FIs. crisis.S.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. regulatory regulatory changes changes were were deregulatory deregulatory in in nature nature   Regulators Regulators attempt attempt to to maximize maximize social social welfare welfare while while minimizing minimizing the the burden burden imposed imposed by by regulation regulation 1-25 . U.S. U. before before the the financial financial crisis.

  Broader Broader authority authorityfor for Federal Federal Reserve Reserve (Fed) (Fed) to to oversee overseenon-bank non-bankFIs. FIs. requirements.   Higher Higherequity equitycapital capital requirements. funds.   Registration Registration of of hedge hedge funds funds and and private privateequity equity funds. risk.Regulation of Financial Institutions   Dodd-Frank Dodd-Frank Bill Bill 1. 1-26 .1. Promote Promoterobust robust supervision supervisionof of FIs FIs   Financial Financial Service Service Oversight Oversight Council Council to to identify identify and andlimit limit systemic systemicrisk.

Comprehensive Comprehensive supervision supervision of of financial financial markets markets   New New regulations regulationsfor forsecuritization securitizationand andover over the thecounter counter derivatives derivatives   Additional Additional oversight oversight by byFed Fedof of payment payment systems systems 3. Establishes Establishesaa new new Consumer Consumer Financial Financial Protection ProtectionAgency Agency 1-27 .3.Regulation of Financial Institutions   Dodd-Frank Dodd-Frank Bill Bill 2.2.

Regulation of Financial Institutions   Dodd-Frank Dodd-Frank Bill Bill 4. 1-28 . FIs.4. New New methods methods to to resolve resolvenon-bank non-bankfinancial financial crises crises   More Moreoversight oversight of of Fed Fedbailout bailout decisions decisions 5.5. Increase Increaseinternational international capital capital standards standardsand and increased increased oversight oversight of of international internationaloperations operations of of FIs.

  1-29 .   Information Informationon onforeign foreignmarkets marketsand andinvestments investmentsis is becoming becomingreadily readilyaccessible accessibleand andderegulation deregulationacross across the theglobe globeis isallowing allowingeven evengreater greateraccess accessto toforeign foreign markets. ever. before.   International Internationalmutual mutualfunds fundsallow allow diversified diversifiedforeign foreign investment investmentwith withlow low transactions transactionscosts. costs. markets.Globalization of Financial Markets and Institutions The Thepool poolof ofsavings savingsfrom fromforeign foreigninvestors investorsis is increasing increasingand andinvestors investorslook lookto todiversify diversifyglobally globallynow now more morethan thanever everbefore.   Global Globalcapital capitalflows flowsare arelarger largerthan thanever.

J.Appendix: FIs and the Crisis Timeline Timelineof of events events   Home Homeprices pricesdecline decline in in late late 2006 2006 and and early early2007 2007   Delinquencies Delinquencieson onsubprime subprimemortgages mortgagesincrease increase   Huge Hugelosses losseson onmortgage-backed mortgage-backed securities securities (MBS) (MBS) announced announcedby byinstitutions institutions  Bear BearStearns Stearnsfails failsand andis isbought boughtby byJ.Morgan Morgan Chase Chasefor for$2 $2aashare share(deal (dealhad hadgovernment governmentbacking) backing) 1-30 .P.P.

Lehman Lehman Brothers Brothersfiles filesfor for bankruptcy. 2008. Dow Dow drops drops500 500points points 1-31 . bankruptcy.the thegovernment governmentseizes seizesgovernmentgovernmentsponsored sponsored mortgage mortgage agencies agenciesFannie Fannie Mae Mae and and Freddie FreddieMac Mac   The Thetwo twohad had$9 $9billion billion in in losses lossesin in the thesecond secondhalf half 2007 2007   Now Now run runby byFederal Federal Housing Housing Finance FinanceAgency Agency (FHFA) (FHFA)  September September2008.Appendix: FIs and the Crisis Timeline Timelineof of events events  September September2008. 2008.

October 2007–January 2010 1-32 .Appendix: FIs and the Crisis Figure 1-9 The Dow Jones Industrial Average.

Appendix: FIs and the Crisis Figure 1-10 Overnight London Interbank Offered Rate (LIBOR). 2001–2010 1-33 .

Appendix: Government Rescue Plan Table 1-12 Federal Government Rescue Efforts through December 2009 1-34 .

Appendix: Government Rescue Plan Table 1-12 Federal Government Rescue Efforts through December 2009 1-35 .

Appendix: Government Rescue Plan Figure 1-11 Federal Funds Rate and Discount Window Rate—January 1971 through January 2010 1-36 .

S.Appendix: Government Rescue Plan Table 1-13 Major Items in the $787 Billion Stimulus Program as Passed by the U. February 13. Congress. 2009 1-37 .