An overview of the Financial

System

 Suppose you want to start a business to

develop iPhone App, but you have no start up
funds.
 At the same time, Makena has money to invest
for retirement.
 If the two of you could get together, perhaps
both of your needs can be met. But how does
that happen?

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 Chapter Preview

 Suppose you want to start a business to

develop iPhone App, but you have no start up
funds.
 At the same time, Pasha Sb. has money to
invest for retirement.
 If the two of you could get together, perhaps
both of your needs can be met. But how does
that happen?

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 Chapter Preview

We study the effects of financial markets and institutions

on the economy, and look at their general structure and
operations.
Topics include:
─ Function and Structure of Financial Markets
─ Internationalization of Financial Markets
─ Types and Functions of Financial Intermediaries
─ Regulation of the Financial System

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 Function of Financial Markets

 Channels funds from person or business

without investment opportunities (i.e.,
“Lender-Savers”) to one who has them
(i.e., “Borrower-Spenders”)
 Improves economic efficiency

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 Financial Markets Funds Transferees

Lender-Savers Borrower-Spenders
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners

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 Segments of Financial Markets

1. Direct Finance
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are
claims on the borrower’s future income or assets
2. Indirect Finance
• Borrowers borrow indirectly from lenders via
financial intermediaries (established to source
both loanable funds and loan opportunities) by
issuing financial instruments which are claims on
the borrower’s future income or assets

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Function of Financial Markets

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 Importance of Financial Markets

 This is important. For example, if you save

$1,000, but there are no financial markets,
then you can earn no return on this—might as
well put the money under your mattress.
 However, if a carpenter could use that money
to buy a new saw (increasing her productivity),
then she’d be willing to pay you some interest
for the use of the funds.

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 Importance of Financial Markets

 Financial markets are critical for producing an

efficient allocation of capital, allowing funds to
move from people who lack productive
investment opportunities to people who have
them.
 Financial markets also improve the well-being
of consumers, allowing them to time their
purchases better.

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 Structure of Financial Markets

1. Debt Markets
─ Short-Term (maturity < 1 year)
─ Long-Term (maturity > 10 year)
─ Intermediate term (maturity in-between)
─ Represented $52.4 trillion at the end of 2009.
2. Equity Markets
─ Pay dividends, in theory forever
─ Represents an ownership claim in the firm
─ Total value of all U.S. equity was $20.5 trillion at
the end of 2009.

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 Structure of Financial Markets

1. Primary Market
─ New security issues sold to initial buyers
─ Who does the issuer sell to in the Primary
Market?

2. Secondary Market
─ Securities previously issued are bought
and sold
─ Examples include the KSE
─ Who trades?

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How Firms Issue Securities Continued

 Investment Banking
 Shelf Registration
 Private Placements
 Initial Public Offerings (IPOs)
 Investment Banking

 Underwritten: firm commitment on proceeds

to the issuing firm
 Red herring
 Prospectus
 Relationship Among a Firm Issuing
Securities, the Underwriters and the Public
 Shelf Registrations

 SEC Rule 415

 Introduced in 1982
 Ready to be issued – on the shelf
 Private Placements
 Sale to a limited number of sophisticated
investors not requiring the protection of
registration
 Allowed under Rule 144A
 Dominated by institutions
 Very active market for debt securities
 Not active for stock offerings
 Why Secondary Financial
Markets Are Important
 Provides liquidity to investors who
acquire securities in the primary market
 Results in lower required returns than if
issuers had to compensate for lower
liquidity
 Helps determine market pricing for new
issues

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 Initial Public Offerings

 Process
 Road shows
 Bookbuilding
 Underpricing
 Post sale returns
 Cost to the issuing firm
 Types of Orders

 Market—executed immediately
 Bid Price
 Ask Price
 Price-contingent
 Investors specify prices
 Stop orders
 Trading Costs

 Commission: fee paid to broker for making

the transaction
 Spread: cost of trading with dealer
 Bid: price dealer will buy from you
 Ask: price dealer will sell to you
 Spread: ask - bid
 Combination: on some trades both are paid
Figure 3.5 Price-Contingent Orders
 Major Types of Orders
 Market orders
 Buy or sell at the best current price
 Provides immediate liquidity

 Limit orders
 Order specifies the buy or sell price
 Time specifications for order may vary
 Instantaneous - “fill or kill”, part of a day, a
full day, several days, a week, a month, or
good until canceled (GTC)

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 Stock Margin Trading
 Margin is currently 50%; you can borrow up to
50% of the stock value
 Set by the Fed
 Maintenance margin: minimum amount equity
in trading can be before additional funds must
be put into the account
 Margin call: notification from broker that you
must put up additional funds
 Margin Transactions
 On any type order, instead of paying 100% cash,
borrow a portion of the transaction, using the stock as
collateral
 Interest rate on margin credit may be below prime
rate
 Regulations limit proportion borrowed
 Margin requirements are from 50% up

 Changes in price affect investor’s equity

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 Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price increases to $60, position
 Value is $12,000
 Less - $5,000 borrowed
 Leaves $7,000 equity for a
 $7,000/$12,000 = 58% equity position

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 Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price decreases to $40, position
 Value is $8,000
 Less - $5,000 borrowed
 Leaves $3,000 equity for a
 $3,000/$8,000 = 37.5% equity position

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 Margin Transactions
 Initial margin requirement at least 50%. Set
up by the Fed.
 Maintenance margin
 Requirement proportion of equity to stock
 Protects broker if stock price declines
 Minimum requirement is 25%
 Margin call on undermargined account to meet
margin requirement
 If margin call not met, stock will be sold to pay
off the loan

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Margin Trading - Initial Conditions
Example 3.1
X Corp $100
60% Initial Margin
40% Maintenance Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000
Margin Trading - Maintenance Margin
Example 3.1

Stock price falls to $70 per share

New Position
Stock $7,000 Borrowed $4,000
Equity $3,000
Margin% = $3,000/$7,000 = 43%
Margin Trading - Margin Call Example
3.2

How far can the stock price fall before a

margin call?

(100P - $4,000)* / 100P = 40%

P = $66.66
* 100P - Amt Borrowed = Equity
 Short Sales
 Purpose: to profit from a decline in the price of a
stock or security
 Mechanics
 Borrow stock through a dealer
 Sell it and deposit proceeds and margin in an
account
 Closing out the position: buy the stock and return
to the party from which is was borrowed
 Can only be made on an uptick trade
 Must pay any dividends to lender
 Margin requirements apply
Short Sale – Initial Conditions Example
3.3
Dot Bomb 1,000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Sale Proceeds $100,000
Margin & Equity 50,000
Stock Owed 100,000
Short Sale - Maintenance Margin
Stock Price Rises to $110

Sale Proceeds $100,000

Initial Margin 50,000
Stock Owed 110,000
Net Equity 40,000
Margin % (40,000/110,000) 36%
 Short Sale - Margin Call

How much can the stock price rise before a

margin call?

($150,000* - 1000P) / (1000P) = 30%

P = $115.38

* Initial margin plus sale proceeds

 Structure of Financial Markets
We can further classify secondary markets as
follows:
1. Exchanges
─ Trades conducted in central locations (e.g., New
York Stock Exchange, CBT)
2. Over-the-Counter Market
─ Dealers at different locations buy and sell
─ This market has been created to provide an
automated platform through KATD enabling he
investors to trade securities in lots which are less
than the normal trading units (lots) of the securities
approved for Ready Market. The minimum volume of
a buy/sell order may be one share.
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 Circuit Breaker
A circuit breaker refers to a measure used by stock
exchanges to avert panic selling or over-exuberant
buying. After he stock’s price has risen or fallen by a
certain percentage, the exchange might activate
restrictions or trading halts.
The KSE management has imposed a circuit breaker of
7.5% or Rs. 1.50/- whichever is higher for the purpose of
upward price fluctuations in the stock price from the
closing price of the previous day and a circuit breaker of
5% or Re. 1.00/-, whichever is higher in case of
downward fluctuation in the stock price from the closing
price of the previous day.

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 Classifications of
Financial Markets

We can also further classify markets by the

maturity of the securities:
1. Money Market: Short-Term
(maturity <= 1 year)
2. Capital Market: Long-Term
(maturity > 1 year) plus equities

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 Internationalization of
Financial Markets
The internationalization of markets is an important trend. The
U.S. no longer dominates the world stage.
 International Bond Market & Eurobonds
─ Foreign bonds
• Denominated in a foreign currency
• Targeted at a foreign market
• For example, if the German automaker Porsche sells a bond in the United
States denominated in U.S. dollars, it is classified as a foreign bond.
─ Eurobonds
• Denominated in one currency, but sold in a different market
• now larger than U.S. corporate bond market)
• Over 80% of new bonds are Eurobonds.
• for example, a bond denominated in U.S. dollars sold in London
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 Internationalization of
Financial Markets

 Eurocurrency Market
─ Foreign currency deposited outside of home country
─ Eurodollars are U.S. dollars deposited, say, London.
─ Gives U.S. borrows an alternative source for dollars.
 World Stock Markets
─ U.S. stock markets are no longer always the largest—
at one point, Japan’s was larger

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 Global perspective Relative
Decline of U.S. Capital Markets

 The U.S. has lost its dominance in many

industries: auto and consumer
electronics to name a few.
 A similar trend appears at work for U.S.
financial markets, as London and Hong
Kong compete. Indeed, many U.S. firms
use these markets over the U.S.

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 Global perspective Relative
Decline of U.S. Capital Markets

Why?
1. New technology in foreign exchanges
2. 9-11 made U.S. regulations tighter
3. Greater risk of lawsuit in the U.S.
4. Sarbanes-Oxley has increased the cost
of being a U.S.-listed public company
 Homework 2:
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 Function of Financial
Intermediaries: Indirect Finance

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 Function of Financial
Intermediaries: Indirect Finance

Instead of savers lending/investing directly

with borrowers, a financial intermediary
(such as a bank) plays as the middleman:
 the intermediary obtains funds from
savers
 the intermediary then makes
loans/investments with borrowers

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 Function of Financial
Intermediaries: Indirect Finance

 This process, called financial

intermediation, is actually the primary
means of moving funds from lenders to
borrowers.
 More important source of finance than
securities markets (such as stocks)
 Needed because of transactions costs,
risk sharing, and asymmetric information

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 Function of Financial
Intermediaries: Indirect Finance
 Transactions Costs
1. Financial intermediaries make profits by
reducing transactions costs
2. Reduce transactions costs by developing
expertise and taking advantage of economies of
scale
3. liquidity services (extra services)

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 Function of Financial
Intermediaries: Indirect Finance

 A financial intermediary’s low transaction costs

mean that it can provide its customers with
liquidity services
1. Banks provide depositors with checking accounts
that enable them to pay their bills easily
2. Depositors can earn interest on checking and
savings accounts and yet still convert them into
goods and services whenever necessary

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 Function of Financial
Intermediaries: Indirect Finance

 FI’s low transaction costs allow them to reduce

the exposure of investors to risk, through a
process known as risk sharing
─ FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk from
another party
─ This process is referred to as asset transformation,
because in a sense risky assets are turned into safer
assets for investors

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 Function of Financial
Intermediaries: Indirect Finance

 Financial intermediaries also help by

providing the means for individuals and
businesses to diversify their asset
holdings.
 Low transaction costs allow them to buy
a range of assets, pool them, and then
sell rights to the diversified pool to
individuals.
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 Asymmetric Information:
Quiz

 Define Asymmetric Information. List and

explain the two major types of
Asymmetric Information that affect
financial markets.

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 Function of Financial
Intermediaries: Indirect Finance

 Another reason FIs exist is to reduce the

impact of asymmetric information.
 One party lacks crucial information
about another party, impacting decision-
making.
 We usually discuss this problem along
two fronts: adverse selection and moral
hazard.
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 Function of Financial
Intermediaries: Indirect Finance

 Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce
adverse outcome are ones most likely to
seek a loan
3. Similar problems occur with insurance
where unhealthy people want their known
medical problems covered
4. Good Aunt Vs. Bad Aunt
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 Asymmetric Information:
Adverse Selection and Moral Hazard

 Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to
engage in undesirable (immoral) activities
making it more likely that won’t pay loan back
3. Again, with insurance, people may engage in
risky activities only after being insured
4. Another view is a conflict of interest

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 Asymmetric Information:
Adverse Selection and Moral Hazard
 Financial intermediaries reduce adverse
selection and moral hazard problems,
enabling them to make profits. How they do
this is the covered in many of the chapters
to come.
 Because of their expertise in screening and
monitoring, they minimize their losses,
earning a higher return on lending and
paying higher yields to savers.
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 Types of Financial
Intermediaries

accept deposits from

individuals and institutions
and make loans-thrifts

Acquire funds at periodic

intervals on a contractual
basis

Acquire funds by selling

shares to many individuals
and use the proceeds to
purchase diversified
portfolios of stocks and
bonds 2-56
Types of Financial
Intermediaries

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 Regulation of
Financial Markets
 Main Reasons for Regulation
1. Increase Information to Investors
• Decreases adverse selection and moral hazard problems
• SEC forces corporations to disclose information
2. Ensuring the Soundness of Financial Intermediaries
• Prevents financial panics
• Chartering, reporting requirements, restrictions on assets and
activities, deposit insurance, and anti-competitive measures
3. Improving Monetary Control
• Reserve requirements
• Deposit insurance to prevent bank panics

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 Regulation Reason:
Increase Investor Information

 Asymmetric information in financial markets means that

investors may be subject to adverse selection and moral
hazard problems that may hinder the efficient operation
of financial markets and may also keep investors away
from financial markets
 The Securities and Exchange Commission (SEC)
requires corporations issuing securities to disclose
certain information about their sales, assets, and
earnings to the public and restricts trading by the largest
stockholders (known as insiders) in the corporation
SEC home page http://www.sec.gov

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 Regulation Reason:
Increase Investor Information

 Such government regulation can reduce adverse

selection and moral hazard problems in financial
markets and increase their efficiency by increasing the
amount of information available to investors. Indeed,
the SEC has been particularly active recently in
pursuing illegal insider trading.

SEC home page http://www.sec.gov

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 Regulation Reason: Ensure Soundness
of Financial Intermediaries

 Asymmetric information makes it difficult to evaluate

whether the financial intermediaries are sound or not.
 Can result in panics, bank runs, and failure of
intermediaries.

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 Regulation Reason: Ensure Soundness

of Financial Intermediaries (cont.)

 To protect the public and the economy from financial

panics, the government has implemented six types of
regulations:
─ Restrictions on Entry
─ Disclosure
─ Restrictions on Assets and Activities
─ Deposit Insurance
─ Limits on Competition
─ Restrictions on Interest Rates

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 Regulation:
Restriction on Entry

 Restrictions on Entry
─ Regulators have created very tight regulations as
to who is allowed to set up a financial intermediary
─ Individuals or groups that want to establish a
financial intermediary, such as a bank or an
insurance company, must obtain a charter from the
state or the federal government
─ Only if they are upstanding citizens with
impeccable credentials and a large amount of initial
funds will they be given a charter.

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 Regulation: Disclosure

 Disclosure Requirements
 There are stringent reporting requirements for
financial intermediaries
─ Their bookkeeping must follow certain strict
principles,
─ Their books are subject to periodic inspection,
─ They must make certain information available to
the public.

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 Regulation: Restriction on
Assets and Activities

 Restrictions on the activities and assets of

intermediaries helps to ensure depositors that their
funds are safe and that the bank or other financial
intermediary will be able to meet its obligations.
─ Intermediary are restricted from certain risky
activities
─ And from holding certain risky assets, or at least
from holding a greater quantity of these risky
assets than is prudent

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 Regulation: Deposit Insurance

 The government can insure people depositors

to a financial intermediary from any financial
loss if the financial intermediary should fail
 The Federal Deposit Insurance Corporation
(FDIC) insures each depositor at a commercial
bank or mutual savings bank up to a loss of
$250,000 per account.

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 Regulation:
Limits on Competition

 Although the evidence that unbridled competition

among financial intermediaries promotes failures that
will harm the public is extremely weak, it has not
stopped the state and federal governments from
imposing many restrictive regulations
 In the past, banks were not allowed to open up
branches in other states, and in some states banks
were restricted from opening
additional locations

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 Regulation: Restrictions
on Interest Rates

 Competition has also been inhibited by regulations that

impose restrictions on interest rates that can be paid
on deposits
 These regulations were instituted because of the
widespread belief that unrestricted interest-rate
competition helped encourage bank failures during the
Great Depression
 Later evidence does not seem to support this view, and
restrictions on interest rates have
been abolished

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 Regulation Reason:
Improve Monetary Control

 Because banks play a very important role in

determining the supply of money (which in turn affects
many aspects of the economy), much regulation of
these financial intermediaries is intended to improve
control over the money supply
 One such regulation is reserve requirements, which
make it obligatory for all depository institutions to keep
a certain fraction of their deposits in accounts with the
Federal Reserve System (the Fed), the central bank in
the United States
 Reserve requirements help the Fed exercise more
precise control over the money supply

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 Financial Regulation Abroad

 Those countries with similar economic systems

also implement financial regulation consistent
with the U.S. model: Japan, Canada, and
Western Europe
─ Financial reporting for corporations is required
─ Financial intermediaries are heavily regulated
 However, U.S. banks are more regulated along
dimensions of branching and services than
their foreign counterparts.

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 Chapter Summary (cont.)

 Internationalization of Financial Markets: We

briefly examined how debt and equity markets
have expanded in the international setting.
 Function of Financial Intermediaries: We
examined the roles of intermediaries in
reducing transaction costs, sharing risk, and
reducing information problems.

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