Chapter One

Introduction

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 Why study Financial Markets and
Institutions?

• They are the cornerstones of the overall

financial system in which financial
managers operate
• Individuals use both for investing
• Corporations and governments use both for
financing

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 Overview of Financial Markets

• Primary Markets versus Secondary

Markets
• Money Markets versus Capital Markets
• Foreign Exchange Markets

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 Primary Markets versus Secondary
Markets

• Primary Markets
– markets in which users of funds (e.g.
corporations, 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, NASDAQ)

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 Money Markets versus Capital Markets

• Money Markets
– markets that trade debt securities with
maturities of one year or less (e.g. CD’s, U.S.
Treasury bills)
• Capital Markets
– markets that trade debt (bonds) and equity
(stock) instruments with maturities of more
than one year

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 Money Market Instruments
Outstanding, 1990-1999 ($Bn)
1400
1200
1000
800
600
400
200
0
1990 1995 1999

Commercial paper Fed Funds and Repo

U.S. T-bills Banker's accept.

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 Capital Market Instruments
Outstanding, 1990-1999 ($Bn)
20000

15000

10000

5000

0
1990 1995 1999
Corp. stocks Res. Mortgages
Comm/farm mort. Corp. bonds
Treas. Sec. St. & Loc. Gov. bonds
U.S. gov owned agencies U.S. gov sponsored agencies
Bank and consumer loans
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 Foreign Exchange Markets

• “FX” markets deal in trading one currency for

another (e.g. dollar for yen)
• The “spot” FX transaction involves the
immediate exchange of currencies at the current
exchange rate
• The “forward” FX transaction involves the
exchange of currencies at a specified date in the
future and at a specified exchange rate
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 Overview of Financial Institutions

• Institutions that perform the essential

function of channeling funds from those
with surplus funds to those with shortages
of funds (e.g. banks, thrifts, insurance
companies, securities firms and
investment banks, finance companies,
mutual funds, pension funds)
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 Flow of Funds in a World without FIs:
Direct Transfer
Financial Claims
(Equity and debt
instruments)
Suppliers of
Users of Funds
Funds
(Corporations)
(Households)
Cash

Example: A firm sells shares directly to investors without going

through a financial institution

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 Flow of Funds in a world with FIs:
Indirect transfer

FI
Users of Funds Suppliers of Funds
(Brokers)

FI
(Asset
transformers)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and Insurance policies)

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 Types of FIs

• Commercial banks
– depository institutions whose major assets are
loans and major liabilities are deposits
• Thrifts
– depository institutions in the form of savings
and loans, credit unions
• Insurance companies
– financial institutions that protect individuals
and corporations from adverse events
(continued)
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 • Securities firms and investment banks
– financial institutions that underwrite securities
and engage in securities brokerage and trading
• Finance companies
– financial institutions that make loans to
individuals and businesses
• Mutual Funds
– financial institutions that pool financial
resources and invest in diversified portfolios
• Pension Funds
– financial institutions that offer savings plans for
retirement
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 Services Performed by Financial
Intermediaries

• Monitoring Costs
– aggregation of funds provides greater incentive
to collect a firm’s information and monitor
actions
• Liquidity and Price Risk
– provide financial claims to savers with superior
liquidity and lower price risk

(continued)
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 • Transaction Cost Services
– transaction costs are reduced through
economies of scale
• Maturity Intermediation
– greater ability to bear risk of mismatching
maturities of assets and liabilities
• Denomination Intermediation
– allow small investors to overcome constraints
imposed to buying assets imposed by large
minimum denomination size

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 Services Provided by FIs Benefiting the
Overall Economy

• Money Supply Transmission

– Depository institutions are the conduit through
which monetary policy actions impact the
economy in general
• Credit Allocation
– often viewed as the major source of financing for
a particular sector of the economy (e.g. farming
and real estate)
(continued)
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 Services Provided by FIs Benefiting
the Overall Economy

• Intergenerational Wealth Transfers

– life insurance companies and pension funds
provide savers with the ability to transfer
wealth from one generation to the next
• Payment Services
– efficiency with which depository institutions
provide payment services directly benefits the
economy

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 Risks Faced by Financial Institutions

• Interest Rate Risk

• Foreign Exchange Risk
• Market Risk
• Credit Risk
• Liquidity Risk
• Off-Balance-Sheet Risk
• Technology Risk
• Operation Risk
• Country or Sovereign Risk
• Insolvency Risk
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 Regulation of Financial Institutions

• FIs provide vital financial services to all

sectors of the economy; therefore, their
regulation is in the public interest
• In an attempt to prevent their failure and
the failure of financial markets overall

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 Globalization of Financial Markets and
Institutions

• Financial Markets became more global as the

value of stocks traded in foreign markets
soared
• Foreign bond markets have served as a major
source of international capital
• Globalization also evident in the derivative
securities market

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 Factors Leading to Significant Growth
in Foreign Markets
• The pool of savings from foreign investors has
increased
• International investors have turned to U.S. and other
markets to expand their investment opportunities
• Information on foreign investments and markets is
now more accessible (e.g. internet)
• Some mutual funds allow ability to invest in foreign
securities with low transaction costs
• Deregulation has enhanced globalization of capital
flows
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