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CH1

Role of Financial Markets and Institutions

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How much do you know about financial
markets?

 1) By definition, the money market involves the buying and

selling of

 A) stocks and bonds.

 B) short-term funds.

 C) funds that mature in more than one year.

 D) flows of funds.
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How much do you know about financial
markets?

 2) Long-term debt instruments used by both government and

business are known as

 A) stocks.

 B) bills.

 C) bonds.

 D) equities.
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How much do you know about financial
markets?

 3) Government usually

 A) is a net supplier of funds.

 B) is a net demander of funds.

 C) borrows funds directly from financial institutions.

 D) maintains permanent deposits with financial institutions.

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How much do you know about financial
markets?

 4) Firms that require funds from external sources can obtain

them in one of the following ways EXCEPT

 A) financial institution.

 B) financial markets.

 C) government.

 D) private placement.
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How much do you know about financial
markets?

 5) The nonexclusive sale of either bonds or stocks to the

general public is called

 A) private placement.

 B) public offering.

 C) organized selling.

 D) none of the above.

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How much do you know about
financial markets?
 A primary market is a financial market in which pre-owned
securities are traded. (TRUE OR FALSE)

 5) Capital markets are for investors who want a safe

temporary place to deposit funds where they can earn
interest and for borrowers who have a short term need for
funds. (TRUE OR FALSE)

 Money markets involve the trading of securities with

maturities of one year or less while capital market involve the
buying and selling of securities with maturities of more than
one year. (TRUE OR FALSE)
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Chapter Objectives

 Describe the types of financial markets

 Describe the role of financial institutions with financial

markets

 Identify the types of financial institutions that facilitate

transactions
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Overview of Financial Markets

 Financial
markets provide for financial
intermediation--financial savings (Surplus Units) to
investment (Deficit Units)
 Financial markets provide payments system
 Financial markets provide means to manage risk
 Toposition risk and return for financial
tools(the nature of financial market)
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Overview of Financial Markets

 Broad Classifications of Financial Markets

Money versus Capital Markets

Primary versus Secondary Markets

 Organized versus Over-the-Counter Markets

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Primary vs. Secondary Markets
 SECONDARY
 PRIMARY
 New Issue of  Trading Previously Issued
Securities(ipo) Securities

 No New Funds for Issuer

 Exchange of Funds for
Financial Claim
 Provides Liquidity for
 Funds for Borrower; an Seller
IOU for Lender
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Money vs. Capital Markets
 Money  Capital
 Short-Term, < 1 Year  Long-Term, >1Yr
 High Quality Issuers  Range of Issuer Quality
 Debt Only  Debt and Equity
 Primary Market Focus  Secondary Market Focus
 Liquidity Market--Low  Financing Investment--
Returns Higher Returns
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Organized vs. Over-the-Counter
Markets
 Organized  OTC
 Visible Marketplace  Wired Network of
 Members Trade Dealers
 Securities Listed  No Central, Physical

 New York Stock

Location
Exchange  All Securities Traded
off the Exchanges
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Securities Traded in Financial Markets
 Money Market Securities
 Debt securities Only: treasury bills and commercial papers.

 Capital market securities

 Debt and equity securities: bonds, stocks and mortgages.

 Derivative Securities
 Financial contracts whose value is derived from the values of
underlying assets
 Used for hedging (risk reduction) and speculation (risk
seeking)
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Debt vs. Equity Securities

Debt Securities: Contractual obligations (IOU) of Debtor (borrower) to

Creditor (lender)
Investor receives interest
Capital gain/loss when sold
Maturity date
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Debt vs. Equity Securities

Equity Securities: Claim with ownership

rights and responsibilities
 Investor receives dividends if declared
 Capital gain/loss when sold
 No maturity date—need market to sell
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Valuation of Securities

 Value a function of:

 Future cash flows
 When cash flows are received
 Risk of cash flows

 Present value of cash flows discounted at the market required

rate of return

 Value determined by market demand/supply

 Value changes with new information

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Financial Market Efficiency

 Security prices reflect available information

 New information is quickly included in security prices

 Uncertainity about value of Google when it first issued stock on
Aug 18, 2004.

 Investors balance liquidity, risk, and return needs

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Financial Market Regulation

Why Government Regulation?

 To Promote Efficiency

 High level of competition

 All investors have equal access to disclosures.

 Independent and proper auditing.

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Financial Market Regulation

Why Government Regulation?

 To Maintain Financial Market Stability

 Prevent market crashes
 Circuit breakers
 Federal Reserve discount window

 Prevent Inflation--Monetary policy

 Prevent Excessive Risk Taking by Financial Institutions

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Financial Market Regulation

Why Government Regulation?

 To Provide Consumer Protection
 Provide adequate disclosure
 Set rules for business conduct
 To Pursue Social Policies
 Transfer income and wealth
 Allocate saving to socially desirable areas
 Housing
 Student loans
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Financial Market Globalization

 Increased international funds flow

 Increased disclosure of information
 Reduced transaction costs
 Reduced foreign regulation on capital flows
 Increased privatization

Results: Increased financial integration--capital flows to highest

expected risk-adjusted return
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Role of Financial Institutions in
Financial Markets

 Information processing

 Serve special needs of lenders (liabilities) and borrowers

(assets)
 By denomination and term
 By risk and return

 Lower transaction cost

 Serve to resolve problems of market imperfection

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Role of Financial Institutions in
Financial Markets
Types of Depository Financial Institutions

Savings Credit Unions

Institutions $.5 Trillion
Commercial $1.3 Trillion Total Assets
Banks Total Assets
$5 Trillion
Total Assets
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Types of Non-depository Financial
Institutions

 Insurance companies

 Mutual funds

 Pension funds

 Securities companies

 Finance companies
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Role of Non-depository Financial
Institutions

 Focused on capital market

 Longer-term, higher risk intermediation

 Less focus on liquidity

 Less regulation

 Greater focus on equity investments

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Trends in Financial Institutions

 Rapid growth of mutual funds and pension funds

 Increased consolidation of financial institutions via mergers

 Increased competition between financial Institutions

 Growth of financial conglomerates

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Global Expansion by Financial
Institutions
 International expansion

 International mergers

 Impact of the single European currency

 Emerging markets