Chapter One

Introduction to Financial
Markets and Institution

©2009, The McGraw-Hill Companies, All Rights Reserved

 Why study Financial Markets
and Institutions?

•• sensible
sensible investment
investment and
and financing
financing
requires
requires aa thorough
thorough understanding
understanding of
of
–– the
thestructure
structureof
ofdomestic
domesticand
andinternational
international
markets
markets
–– the
theflow
flowof
offunds
fundsthrough
throughdomestic
domesticand
and
international
internationalmarkets
markets
–– the
thestrategies
strategiesused
usedto
tomanage
managerisks
risksfaced
facedby
by
investors
investors

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 Financial Markets

•• Financial
Financial markets
markets are
are structures
structures 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
primaryversus
versussecondary
secondarymarkets
markets
–– money
moneyversus
versuscapital
capitalmarkets
markets

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©2009, The McGraw-Hill Companies, All Rights Reserved
 Primary versus Secondary Markets

•• Primary
Primary markets
markets
–– markets
marketsin inwhich
whichusers
usersof
offunds
funds(e.g.,
(e.g.,
corporations
corporationsand
andgovernments)
governments)raise
raisefunds
fundsby
by
issuing
issuingfinancial
financialinstruments
instruments(e.g.,
(e.g.,stocks
stocksand
and
bonds)
bonds)
•• Secondary
Secondary markets
markets
–– markets
marketswhere
wherefinancial
financialinstruments
instrumentsare
are
traded
tradedamong
amonginvestors
investors(e.g.,
(e.g.,NYSE
NYSEand
and
Nasdaq)
Nasdaq)

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 Money versus Capital Markets

•• Money
Money markets
markets
–– markets
marketsthat
thattrade
tradedebt
debtsecurities
securitieswith
with
maturities
maturitiesof
ofone
oneyear
yearor
orless
less(e.g.,
(e.g.,CDs
CDsand
and
U.S.
U.S.Treasury
Treasurybills)
bills)
•• Capital
Capital markets
markets
–– markets
marketsthat
thattrade
tradedebt
debt(bonds)
(bonds)and
andequity
equity
(stock)
(stock)instruments
instrumentswith
withmaturities
maturitiesof
ofmore
more
than
thanone
oneyear
year

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 Foreign Exchange (FX) Markets

FX
FX markets
markets
–– trading
tradingone
onecurrency
currencyfor
foranother
another(e.g.,
(e.g.,dollar
dollarfor
foryen)
yen)
•• Spot
SpotFX
FX
–– the
theimmediate
immediateexchange
exchangeof
ofcurrencies
currenciesat
atcurrent
current
exchange
exchangerates
rates
•• Forward
ForwardFX
FX
–– the
theexchange
exchangeofofcurrencies
currenciesin
inthe
thefuture
futureon
onaaspecific
specific
date
dateand
andat
ataapre-specified
pre-specifiedexchange
exchangerate
rate

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 Derivative Security Markets

•• Derivative
Derivative security
security
–– aafinancial
financialsecurity
securitywhose
whosepayoff
payoffisislinked
linkedtoto
(i.e.,
(i.e.,“derived”
“derived”from)
from)another
anothersecurity
securityor or
commodity
commodity
–– generally
generallyan anagreement
agreementto toexchange
exchangeaa
standard
standardquantity
quantityofofassets
assetsat
ataaset
setprice
priceononaa
specific
specificdate
datein
inthe
thefuture
future

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 Financial Market Regulation

•• The
The Securities
Securities Act
Act of
of 1933
1933
–– full
fulland
andfair
fairdisclosure
disclosureand
andsecurities
securities
registration
registration
•• The
The Securities
Securities Exchange
Exchange Act
Act of
of 1934
1934
–– Securities
Securitiesand
andExchange
ExchangeCommission
Commission(SEC)
(SEC)isis
the
themain
mainregulator
regulatorof
ofsecurities
securitiesmarkets
markets

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 Financial Institutions (FIs)

•• Financial
Financial Institutions
Institutions
–– institutions
institutionsthrough
throughwhich
whichsuppliers
supplierschannel
channel
money
moneyto tousers
usersof
offunds
funds
•• Financial
Financial Institutions
Institutions are
are distinguished
distinguished by
by
whether
whether they
they accept
accept deposits
deposits
–– depository
depositoryversus
versusnon-depository
non-depositoryfinancial
financial
institutions
institutions

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 Depository versus Non-Depository FIs

•• Depository
Depository institutions
institutions
–– commercial
commercialbanks,
banks,savings
savingsassociations,
associations,
savings
savingsbanks,
banks,credit
creditunions
unions
•• Non-depository
Non-depository institutions
institutions
–– insurance
insurancecompanies,
companies,securities
securitiesfirms
firmsand
and
investment
investmentbanks,
banks,mutual
mutualfunds,
funds,pension
pension
funds
funds

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 Flow of Funds in a World without FIs
Flow of Funds in a World without FIs

Users of Funds Suppliers of

(corporations) Funds
(households)
Cash

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 Flow of Funds in a World with FIs
Flow of Funds in a World without FIs

FIs
Users of Funds Suppliers of Funds
(brokers)

Cash FIs
(asset Cash
transformers)

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 Risks Faced by Financial Institutions

•• Credit
Credit •• Off-balance-sheet
Off-balance-sheet
•• Foreign
Foreign exchange
exchange •• Liquidity
Liquidity
•• Country
Country oror •• Technology
Technology
sovereign
sovereign •• Operational
Operational
•• Interest
Interest rate
rate •• Insolvency
Insolvency
•• Market
Market

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 Regulation of Financial Institutions

•• FIs
FIsare
areheavily
heavilyregulated
regulatedtotoprotect
protectsociety
societyat
at
large
largefrom
frommarket
marketfailures
failures
•• Regulations
Regulationsimpose
imposeaaburden
burdenon
onFis
Fis
•• Regulators
Regulatorsattempt
attemptto tomaximize
maximizesocial
socialwelfare
welfare

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