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b. Secondary Markets –markets (e.g. NYSE, NASDAQ) that trade financial instruments once they are
issued. Offers quick trade at market values thereby giving buyers and sellers liquidity(ability to turn an
asset into cash quickly) with the existence of centralized markets that allow trade at low transaction
costs. Gives issuers price information to evaluate usage of previously issued shares and predict
performance of any subsequent issue.
i. Secondary markets exist for:
1. Stocks and bonds
2. Mortgages and other assets
3. Foreign Exchange
4. Futures and Options(e.g.,Derivative Securities)
ii. Examples of secondary market transactions:
1. IBM sells $5 million of GM preferred stock out of its marketable securities portfolio
2. The Magellan Fund buys $100 million of previously issued IBM bonds
3. Prudential Insurance Co. sells $10 million of GM common stock
b. Capital Markets – are markets that trade equity (stocks) and debt (bonds) instruments with maturities
of more than one year.
i. Corporations and Governments – major supplier of capital market securities
ii. Households – major supplier of funds for capital market securities
iii. Examples of capital market instruments:
1. Corporate stocks or equities
2. Residential mortgages
3. Commercial and Farm mortgages
4. Securitized mortgages (are those mortgages that FIs have packaged together and sold
as bonds backed by mortgage cash flows such as interest and principal repayments)
5. Corporate bonds
6. Treasury Bonds - are government securities which mature beyond one year. At present
there are five maturities of bonds (1) 2- year (2) 5 – year (3) 7 – year 4) 10 – year and (5)
20-year. These are sold at its face value on origination. The yield is represented by the
coupons, expressed as a percentage of the face value on per annum basis, payable semi-
annually.
7. Treasury notes
8. State and Local Government Bonds
9. Bank and Consumer Loans
c. What determines the price of financial instruments?The price of any financial instrument is the present
value of future cash flows discounted at an appropriate rate. The longer the maturity of an instrument
the greater the time period of discounting. A small change in interest rates causes a large change in
present value of distant cash flows.
d. Which are riskier, capital market instruments or money market instruments? The prices of long-term
capital market instruments are more sensitive to changes in interest rates. In addition, distant cash
flows for stocks are not known with certainty. Changing economic prospects can cause very large
changes in current stock values. Money market instruments have predictable cash flows and mature in
one year or less, so they are much less risky.
e. How does the location of the money market differ from that of the capital market?
i. The capital markets are more likely to be characterized by actual physical locations such as the
New York Stock Exchange or the American Stock Exchange. Money market transactions are
more likely to occur via telephone, wire transfers, and computer trading.
Financial Claims
(Equity and debt instruments)
Cash
i. High Cost of Direct Transfer – If there were no FIs then the users of funds, such as corporations
in the economy, would have to approach the savers of funds, such as households, directly in
order to fund their investment projects and fill their borrowing needs. This would be extremely
costly because of the up-front information costs faced by potential lenders. These include costs
associated with identifying potential borrowers, pooling small savings into loans of sufficient size
to finance corporate activities, and assessing risk and investment opportunities. Moreover,
lenders would have to monitor the activities of borrowers over each loan's life span, which is
compounded by the free rider problem. The net result is an imperfect allocation of resources in
an economy.
ii. Low levels of fund flows in a world limited to Direct Transfers. There are at least two reasons
for this:
1. Once they have lent money in exchange for financial claims, suppliers of funds need to
monitor or check the use of their funds. They must be sure that the user of funds
neither absconds with nor wastes the funds on projects that have low or negative
returns, since this would lower the chances of being repaid and/or earning a positive
income on their investment (such as dividends or interest). Such monitoring actions are
often extremely costly for any given fund supplier because they require considerable
time, expense, and effort to collect this information relative to the size of the average
fund supplier’s investment.
2. The relatively long term nature of some financial claims (e.g., mortgages, corporate
stock, and bonds) creates a second disincentive for suppliers of funds to hold the direct
financial claims issued by users of funds. Specifically, given the choice between holding
cash and long term securities, fund suppliers may well choose to hold cash for liquidity
reasons, especially if they plan to use savings to finance consumption expenditures in
the near future and financial markets are not very deep in terms of active buyers and
sellers.
a. Price Risk – The risk that an asset’s sale price will be lower than its purchase
price
b. Indirect Transfer – a transfer of funds between suppliers and users of funds through a financial
intermediary
FI
Users of (Brokers) Suppliers of
Funds Funds
Cash FI Cash
(Asset
transforme
rs)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and insurance
policies)
VII. Financial Institutions (FIs) – institutions that perform the essential function of channeling funds from those
with surplus funds to those with shortages of funds
a. Types of Financial Institutions
i. Commercial banks – depository institutions whose major assets are loans and major liabilities
are deposits. Commercial banks’ loans are broader in range, including consumer,
commercial,and real estate loans, than other depository institutions. Commercial banks’
liabilities, include more non-deposit sources of funds, such as subordinate notes and
debentures, than other depository institutions.
ii. Thrifts - depository institutions in the form of savings and loans, savings banks, and credit
unions. Thrifts generally perform services similar to commercial banks, but they tend
toconcentrate their loans in one segment, such as real estate loans or consumer loans.
iii. Insurance companies - financial institutions that protect individuals and corporations
(policyholders) from adverse events. Life insurance companies provide protection in the event
of untimely death, illness, and retirement. Property casualty insurance protects against personal
injury and liability due to accidents, theft, fire, etc.
iv. Securities firms and investment banks - financial institutions that underwrite securities and
engage in related activities such as securities brokerage, securities trading, and making a market
in which securities can trade.
v. Finance companies - financial intermediaries that make loans to both individual and businesses.
Unlike depository institutions, finance companies do not accept deposits but instead rely on
short- and long-term debt for funding.
vi. Mutual funds - financial institutions that pool financial resources of individuals and companies
and invest those resources in diversified portfolios of asset.
vii. Pension funds - financial institutions that offer savings plans through which fund participants
accumulated savings during their working years before withdrawing them during
theirretirement years. Funds originally invested in and accumulated in a pension fund are
exempt from current taxation.
2. Liquidity and Price Risk – FIs provide financial claims to household savers with superior
liquidity attributes and with lower price risk thru:
a. Asset Transformation – The process of turning risky assets into safer assets for
investors by creating and selling assets with risk characteristics that people are
comfortable with and then using the funds acquired by selling these assets to
purchase other assets that may have far more risk.
i. Example: FIs act as Asset Transformers (financial claims issued by an FI
that are more attractive to investors than are the claims directly issued
by corporations) by purchasing the financial claims issued by users of
funds – primary securities such as mortgages, bonds, and stocks – and
finance these purchases by selling financial claims to household
investors and other fund suppliers in the form of deposits, insurance
policies, or other secondary securities
AC 509 Notes on Introduction 2017 – JMD (4)
b. Diversification – the ability of an economic agent to reduce risk by holding a
number of securities in a portfolio. (E.g., As the number of securities in an FI’s
asset portfolio increases, portfolio risk falls, albeit at a diminishing rate)A
mutual fund invested in a diverse group of stocks and fixed income securities
will best provide diversification for an investor.
4. Maturity Intermediation – FIs can better bear the risk of mismatching the maturities of
their assets and liabilities
a. If net borrowers and net lenders have different optimal time horizons, FIs can
service both sectors by matching their asset and liability maturities. That is, the
FI can offer the relatively short-term liabilities desired by households (say, in the
form of bank deposits) and also satisfy the demand for long-term loans (say, in
the form of home mortgages). By investing in a portfolio of long-and short-term
assets and liabilities, the FI can both reduce risk exposure through
diversification and manage risk exposure by centralizing its hedging activities.
2. Credit Allocation–FIs are often viewed as the major, and sometimes only, source of
financing for a particular sector of the economy.
a. Major Sectors Deserving Credit Allocation:
i. Farming
ii. Residential real estate.
4. Payment Services – The efficiency with which depository institutions provide payment
services directly benefits the economy. Example of payment services:
a. Check clearing
b. Wire transfer services (e.g., Fedwire and CHIPS – Clearing House Interbank
Payments System)
e. Advantages of raising funds via a financial intermediary (FI) rather than by selling securities to the public
i. Speed: funds can normally be raised more quickly through FIs.
ii. Registration process/cost: The registration process can be quite costly and time consuming in
terms of person hours, audit fees and fees to investment bankers. Raising funds via a FI can be
less expensive, particularly for smaller capital needs or when funds are needed for only a short
time period. (Maturities of 270 days or less do not require registration, nor do private
placements).
iii. Nonstandard terms can be negotiated with FIs but are difficult to sell to the public. E.G. if a
borrower can only begin paying interest after 2 years, they would have a difficult time selling
bonds to the public.
iv. There is a greater ability to renegotiate terms if necessary. Terms of public issue generally
cannot be changed outside of court.
v. Less information made public.
f. Major disadvantage of putting your money in an intermediary: Forego potentially higher returns if you
do not purchase the more risky direct claims.
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