Chapter One

Introduction

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Why study Financial Markets

and Institutions?
l

Markets and institutions are primary

channels to allocate capital in our society
l

Proper capital allocation leads to growth in:

l Societal Wealth
l Income
l Economic opportunity

1-2

Why study Financial Markets

and Institutions?
l

In this text we will examine:

l

the structure of domestic and international

markets
the flow of funds through domestic and
international markets
an overview of the strategies used to manage
risks faced by investors and savers

1-3

Financial Markets
Financial markets are one type of
structure through which funds flow
l Financial markets can be distinguished
along two dimensions:
l

l
l

primary versus secondary markets

money versus capital markets

1-4

Primary versus Secondary

Markets
l

Primary markets
l

markets in which users of funds (e.g.,

corporations and governments) raise funds by
issuing financial instruments (e.g., stocks and
bonds)

Secondary markets
l

markets where financial instruments are traded

among investors (e.g., NYSE and Nasdaq)

1-5

Primary versus Secondary

Markets

1-6

Primary versus Secondary

Markets
l

Do secondary markets add value to

society or are they simply a legalized
form of gambling?
l

How does the existence of secondary markets

affect primary markets?

1-7

Money versus Capital Markets

l

Money markets
l

markets that trade debt securities with maturities of one

year or less (e.g., CDs and U.S. Treasury bills)
little or no risk of capital loss, but low return

Capital markets
l

markets that trade debt (bonds) and equity (stock)

instruments with maturities of more than one year
substantial risk of capital loss, but higher promised return

1-8

Money Market Instruments

Outstanding, ($Bn)

1-9

Capital Market Instruments

Outstanding, ($Bn)

1-10

Foreign Exchange (FX) Markets

l

FX markets
l

Spot FX
l

trading one currency for another (e.g., dollar for yen)

the immediate exchange of currencies at current exchange
rates

Forward FX
l

the exchange of currencies in the future on a specific date

and at a pre-specified exchange rate

1-11

Derivative Security Markets

l

Derivative security
l

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,
the main purpose of the derivatives markets is to transfer
risk between market participants.

1-12

Derivative Security Markets

l

Selected examples of derivative

securities
l

Exchange listed derivatives

l

Many options, futures contracts

Over the counter derivatives

l
l
l
l

Forward contracts
Forward rate agreements
Swaps
Securitized loans

1-13

Derivatives and the Crisis

1.

Mortgage derivatives allowed a larger amount of mortgage

credit to be created in the mid-2000s.

2.

Mortgage derivatives spread the risk of mortgages to a

broader base of investors.

3.

Change in banking from originate and hold loans to

originate and sell loans.
l

Decline in underwriting standards on loans

1-14

Derivatives and the Crisis

1.

2.

Subprime mortgage losses have been quite large,

reaching over $700 billion.
The Great Recession was the worst since the Great
Depression of the 1930s.
l
Trillions $ global wealth lost, peak to trough stock prices
fell over 50% in the U.S.
l
Lingering high unemployment in the U.S.
l
Sovereign debt levels in developed economies at alltime highs

1-15

Financial Market Regulation

l

The Securities Act of 1933

l

full and fair disclosure and securities registration

The Securities Exchange Act of 1934

l

Securities and Exchange Commission (SEC) is

the main regulator of securities markets

1-16

Financial Institutions (FIs)

l

Financial Institutions
l

institutions through which suppliers channel money to

users of funds

Financial Institutions are distinguished by:

l

whether they accept insured deposits,

l depository versus non-depository financial institutions
whether they receive contractual payments from
customers.

1-17

Asset Size and Number of Selected

U.S. Financial Institutions 2010

INSTITUTION

TOTAL ASSETS
(BILL $)

NUMBER OF
FEDERALLY INSURED
INSTITUTIONS

Commercial Banks

$12,130

6,622

Savings Associations

$ 1,253

1,138

Credit Unions

7,554

Insurance Companies

$ 6,459

Private Pension Funds

$ 5,661

Finance Companies

$ 1,613

Mutual Funds

$ 7,376

Money Market Mutual Funds

$ 2,746

885

Data from September 2010, data sources include Federal Reserve Board, Flow of Funds Accounts, Levels Tables,
FDIC Stats at a Glance and the NCUA website. The mutual funds category excludes money market funds.

1-18

Non-Intermediated (Direct)
Flows of Funds
Flow of Funds in a World without FIs
Direct Financing

Financial Claims
(equity and debt
instruments)
Users of Funds
(corporations)

Cash

Suppliers of
Funds
(households)

1-19

Intermediated Flows of Funds

Flow of Funds in a World with FIs
Users of Funds

Cash

Intermediated Financing
FIs
Suppliers of Funds
(brokers)

FIs
(asset
transformers)

Financial Claims
(equity and debt securities)

Cash

Financial Claims
(deposits and insurance policies)

1-20

Depository versus Non-Depository FIs

l

Depository institutions:
l

commercial banks, savings associations, savings banks,

credit unions

Non-depository institutions
l

Contractual:
l insurance companies, pension funds,
Non-contractual:
l securities firms and investment banks, mutual funds.

1-21

FIs Benefit Suppliers of Funds

Reduce monitoring costs
l Increase liquidity and lower price risk
l Reduce transaction costs
l Provide maturity intermediation
l Provide denomination intermediation
l

1-22

FIs Benefit the Overall Economy

Conduit through which Federal Reserve
conducts monetary policy
l Provides efficient credit allocation
l Provide for intergenerational wealth
transfers
l Provide payment services
l

1-23

Risks Faced by Financial

Institutions
Credit
l Foreign exchange
l Country or
sovereign
l Interest rate
l Market
l

Off-balance-sheet
l Liquidity
l Technology
l Operational
l Insolvency
l

1-24

Regulation of Financial
Institutions
l

FIs are heavily regulated to protect society at

large from market failures
Regulations impose a burden on FIs and before
the financial crisis, recent U.S. regulatory
changes were deregulatory in nature
Regulators attempt to maximize social welfare
while minimizing the burden imposed by
regulation

1-25

Regulation of Financial
Institutions
l

New Dodd-Frank Bill

1.

Promote robust supervision of FIs

l Financial Service Oversight Council to identify and
limit systemic risk,
l Broader authority for Federal Reserve (Fed) to
oversee non-bank FIs,
l Higher equity capital requirements,
l Registration of hedge funds and private equity funds.

1-26

Regulation of Financial
Institutions
1.

New Dodd-Frank Bill

1.

Comprehensive supervision of financial markets

New regulations for securitization and over the
counter derivatives
Additional oversight by Fed of payment systems

2.

Establishes a new Consumer Financial Protection

Agency

1-27

Regulation of Financial
Institutions
l

New Dodd-Frank Bill

1.

New methods to resolve non-bank financial crises

More oversight of Fed bailout decisions

2.

Increase international capital standards and

increased oversight of international operations of
FIs.

1-28

Globalization of Financial Markets

and Institutions
l

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,
Global capital flows are larger than ever.

1-29

Appendix: FIs and the Crisis

Timeline of events
l Home prices decline in late 2006 and early
2007
l
l

Delinquencies on subprime mortgages increase

Huge losses on mortgage-backed securities
(MBS) announced by institutions

Bear Stearns fails and is bought out by J.P.

Morgan Chase for $2 a share (deal had
government backing).
1-30

Appendix: FIs and the Crisis

Timeline of events
l September 2008, the government seizes governmentsponsored mortgage agencies Fannie Mae and Freddie
Mac
l
l

The two had $9 billion in losses in the second half 2007

Now run by Federal Housing Finance Agency (FHFA)

September 2008, Lehman Brothers files for

bankruptcy; Dow drops 500 points

1-31

Appendix: FIs and the Crisis

1-32

Appendix: FIs and the Crisis

1-33

Appendix: Government Rescue Plan

1-34

Appendix: Government Rescue

Plan

1-35

Appendix: Government Rescue Plan

1-36

Appendix: Government Rescue

Plan

1-37