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Chapter 2 An Overview of the Financial System

Function of Financial Markets

Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities. (I.E. You borrow $2500 from a friend; A corporation issues stock shares or other securities in fin. mkt AND people buy them)

With direct finance funds are channeled through the financial market from the SAVER directly to the SPENDER.

Function of Financial Markets

Well-functioning financial markets promotes economic efficiency by producing an efficient allocation of capital, which increases production Improve eco. welfare and the well-being of consumers by allowing them to time purchases better A breakdown of financial markets can result in political instability.

The principal lender-savers are HOUSEHOLDS Securities are ASSETS for the person who buys them, but are LIABILITIES for the individual or firm that issues them.

Flows of Funds Through the Financial System

Structure of Financial Markets

Debt and Equity Markets Debt instruments (maturity) and Equities (dividends) Primary and Secondary Markets Investment Banks underwrite securities in primary markets, it guarantees a price for a corporation s securities; An investment bank
purchases securities from a corporation at a predetermined price and then resells them in the market.

and then sells them to the public. Brokers and dealers work in secondary markets. BROKERS matching buyers with sellers of securities.

An important function of secondary markets is to make it easier to sell financial instruments to raise funds. Secondary markets make financial instruments more LIQUID The higher a security s price in the secondary market the MORE funds a firm can raise by selling securities in the PRIMARY market. When secondary market buyers and sellers of securities meet in one central location to conduct trades the market is called a(n) EXCHANGE Forty or so dealers establish a market in U.S. GOVERNMENT BOND by standing ready to buy and sell them.

intermediate-term DEBT - A sixty-month car loan. Long-term debt has a maturity that is 10 YEARS OR LONGER Equity holders are a corporation's residual claimants SHAREHOLDERS benefit directly from any increase in the corporation's profitability Many common stocks are traded over-thecounter, although the largest corporations usually have their shares traded at organized stock exchanges such as the New York Stock Exchange.

Which of the following statements about the characteristics of debt and equity is false? A) They can both be long-term financial instruments. B) They can both be short-term financial instruments. C) They both involve a claim on the issuer s income. D) They both enable a corporation to raise funds.

Structure of Financial Markets

Exchanges and Over-the-Counter (OTC) Markets
Exchanges: NYSE, Chicago Board of Trade OTC Markets: Foreign exchange, Federal funds.

Money markets deal in short-term debt instrument (I.E. U.S. Treasury bills) Capital markets deal in longer-term (>1YR) debt and equity instruments. (I.E. U.S. Treasury BOND; Government agency securities.)

Prices of money market instruments undergo the least price fluctuations because of the short terms to maturity for the securities. U.S. Treasury bills pay no interest but are sold at a DISCOUNT. That is, you will pay a lower purchase price than the amount you receive at maturity. negotiable certificate of deposit - A SHORT TERM debt instrument sold by a bank to its depositors that pays annual interest of a given amount and at maturity pays back the original purchase price is called Which of the following instruments is not traded in a money market? a) Residential mortgages.

commercial paper - a short-term debt instrument issued by well-known corporations is called Repurchase agreements are short-term loans in which Treasury bills serve as collateral. Federal funds - loans made by banks to each other. LIBOR RATE - The British Banker s Association average of interbank rates for dollar deposits in the London market

Internationalization of Financial Market

Foreign Bonds: sold in a foreign country and denominated in that countrys currency
Example: German sells bonds in US, in USD.

Eurobond: bond denominated in a currency other than that of the country in which it is sold
Example: Japan sells bonds in US, in Yen.

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

World Stock Markets

Help finance federal government also

Eurodollar - U.S. dollar deposits in foreign banks outside the U.S. or in foreign branches of U.S. banks Equity of U.S. companies can be purchased by U.S. citizens and foreign citizens. One reason for the extraordinary growth of foreign financial markets is increases in the pool of savings in foreign countries.

Function of Fin. Intermediaries: Indirect Finance (i.e. bank deposit; buy share in mutual fund)
TOOLS that Lower transaction costs (time and money spent in carrying out financial transactions). Economies of scale (spread the cost of writing a standardized contract over many borrowers.) Liquidity services (make it easier for customers to conduct transactions.) Reduce the exposure of investors to risk Risk Sharing (Asset Transformation/the conversion of risky assets into safer assets; financial intermediaries create and sell low-risk assets and use the proceeds to purchase riskier assets) Diversification

Risk sharing is profitable for financial institutions due to A) low transactions costs.

Deal with asymmetric information (Typically, borrowers have superior information relative to lenders about the potential returns and risks associated with an investment project or the difference in information) problems (before the transaction) Adverse Selection: try to avoid selecting the risky borrower. the lenders relative lack of information about the borrowers potential returns and risks of his investment activities. (after the transaction) Moral Hazard: ensure borrower will not engage in activities that will prevent him/her to repay the loan. Sign a contract with restrictive covenants.

Function of Financial Intermediaries: Indirect Finance

Financial intermediaries allow small savers and borrowers to benefit from the existence of financial markets.

In the United States, loans from FINANCIAL INTERMEDIARIES are far MORE important for corporate finance than are securities markets. Studies of the major developed countries show that when businesses go looking for funds to finance their activities they usually obtain these funds from FINANCIAL INTERMEDIARIES The countries that have made the least use of securities markets are JAPAN & GERMANY. Although the dominance of FINANCIAL INTERMEDIARIES over SECURITIES MARKETS is clear in all countries, the relative importance of bond versus stock markets differs widely.

Primary Assets and Liabilities of Financial Intermediaries

DEPOSITORY INSTITUION - Financial institutions that accept deposits and make loans; i.e. life insurance company; credit union; mutual savings bank; mutual fund; savings and loan association; commercial bank; its primary liabilities is DEPOSITS; its primary assets is CONSUMER LOAN Thrift institutions - savings and loan associations, mutual savings banks, and credit unions.

Contractual savings - institutions are financial intermediaries that acquire funds at periodic intervals on a contractual basis. (i.e. life insurance company, Pension funds, State and local government retirement funds) Primary assets of a pension fund are CORPORATE BOND AND STOCK Investment intermediaries i.e. Mutual funds (acquire funds by selling shares to many individuals and using the proceeds to purchase diversified portfolios of stocks and bonds), finance company (lends funds to consumers) Its primary asset is consumer and business loans.

Money market mutual fund shares function like checking accounts that pay interest and able to write checks against shareholdings. Its primary asset is money market instruments

Regulation of the Financial System

To increase the information available to investors:
Reduce adverse selection and moral hazard problems Reduce insider trading (SEC).

Regulation of the Financial System

To ensure the soundness of financial intermediaries:
Restrictions on entry (chartering process). Disclosure of information. Restrictions on Assets and Activities (control holding of risky assets). Deposit Insurance (avoid bank runs). Limits on Competition (mostly in the past):
Branching Restrictions on Interest Rates

A goal of the Securities and Exchange Commission is to reduce problems arising from asymmetric information Government regulations to reduce the possibility of financial panic include all of the following except A) transactions costs. <- ANS B) restrictions on assets and activities. C) disclosure. D) deposit insurance.

Which of the following do not provide charters? A) The Office of the Comptroller of the Currency B) The Federal Reserve System C) The National Credit Union Administration D) State banking and insurance commissions A restriction on bank activities that was repealed in 1999 was separation of commercial banking from the securities industries. In order to reduce risk and increase the safety of financial institutions, commercial banks and other depository institutions are prohibited from owning common stock.

Savings and loan associations are regulated by the Office of Thrift Supervision. The regulatory agency that sets reserve requirements for all banks is the Federal Reserve System. Asymmetric information is a universal problem. This would suggest that financial regulations in industrialized nations are similar.