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Chapter One

Chapter One. Introduction. Why study Financial Markets and Institutions?. Prudent investment and financing requires a thorough understanding of the structure of domestic and international markets the flow of funds through domestic and international markets

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Chapter One

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  1. Chapter One Introduction

  2. Why study Financial Markets and Institutions? • Prudent investment and financing requires a thorough understanding of • the structure of domestic and international markets • the flow of funds through domestic and international markets • the strategies used to manage risks faced by investors and savers McGraw-Hill/Irwin

  3. Financial Markets • Financial markets are structures through which funds flow • Financial markets can be distinguished along two dimensions • primary versus secondary markets • money versus capital markets McGraw-Hill/Irwin

  4. Primary versus Secondary Markets • Primary markets • markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds) • Secondary markets • markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq) McGraw-Hill/Irwin

  5. Money versus Capital Markets • Money markets • markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills) • Capital markets • markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year McGraw-Hill/Irwin

  6. Money Market Instruments Outstanding, ($Bn) McGraw-Hill/Irwin

  7. Capital Market Instruments Outstanding, ($Bn) McGraw-Hill/Irwin

  8. Foreign Exchange (FX) Markets • FX markets • trading one currency for another (e.g., dollar for yen) • Spot FX • the immediate exchange of currencies at current exchange rates • Forward FX • the exchange of currencies in the future on a specific date and at a pre-specified exchange rate McGraw-Hill/Irwin

  9. DerivativeSecurityMarkets • Derivative security • a financial security whose payoff is linked to (i.e., “derived” from) another security or commodity • generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future McGraw-Hill/Irwin

  10. Financial Market Regulation • The Securities Act of 1933 • full and fair disclosure and securities registration • The Securities Exchange Act of 1934 • Securities and Exchange Commission (SEC) is the main regulator of securities markets McGraw-Hill/Irwin

  11. Financial Institutions (FIs) • Financial Institutions • institutions through which suppliers channel money to users of funds • Financial Institutions are distinguished by whether they accept deposits • depository versus non-depository financial institutions McGraw-Hill/Irwin

  12. Flow of Funds in a World without FIs Flow of Funds in a World without FIs Financial Claims (equity and debt instruments) Suppliers of Funds (households) Users of Funds (corporations) Cash McGraw-Hill/Irwin

  13. Flow of Funds in a World without FIs Flow of Funds in a World with FIs FIs (brokers) FIs (asset transformers) Users of Funds Suppliers of Funds Cash Cash Financial Claims (equity and debt securities) Financial Claims (deposits and insurance policies) McGraw-Hill/Irwin

  14. Depository versus Non-Depository FIs • Depository institutions • commercial banks, savings associations, savings banks, credit unions • Non-depository institutions • insurance companies, securities firms and investment banks, mutual funds, pension funds McGraw-Hill/Irwin

  15. FIs Benefit Suppliers of Funds • Reduce monitoring costs • Increase liquidity and lower price risk • Reduce transaction costs • Provide maturity intermediation • Provide denomination intermediation McGraw-Hill/Irwin

  16. FIs Benefit the Overall Economy • Conduit through which Federal Reserve conducts monetary policy • Provides efficient credit allocation • Provide for intergenerational wealth transfers • Provide payment services McGraw-Hill/Irwin

  17. Credit Foreign exchange Country or sovereign Interest rate Market Off-balance-sheet Liquidity Technology Operational Insolvency Risks Faced by Financial Institutions McGraw-Hill/Irwin

  18. Regulation of Financial Institutions • FIs are heavily regulated to protect society at large from market failures • Regulations impose a burden on FIs and recent U.S. regulatory changes have been deregulatory in nature • Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation McGraw-Hill/Irwin

  19. Globalization of Financial Markets and Institutions • The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before • Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access • International mutual funds allow diversified foreign investment with low transactions costs McGraw-Hill/Irwin

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