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Chapter One

Introduction

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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
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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

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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)
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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
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Money Market Instruments Outstanding, ($Bn)


3000 2500 2000 1500 1000 500 0 1990q4 Fed funds and repos U.S. Treasury bills
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2000q4 Commercial paper Banker's accept.


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2007q1 Negotiable CDs

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Capital Market Instruments Outstanding, ($Bn)


25000 20000 15000 10000 5000 0 1990q4
Corporate stocks U.S. gov't agencies Bank and consumer loans
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2000q4
Mortgages Treasury securities

2007q1
Corporate bonds State & local gov't bonds

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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

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Derivative Security Markets


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

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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

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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

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Flow of Funds in a World without FIs


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

Suppliers of Funds (households)

Cash

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Flow Flow ofof Funds Funds inin aa World World without with FIs FIs

Users of Funds

FIs (brokers)

Suppliers of Funds

Cash

Financial Claims (equity and debt securities)

FIs (asset transformers)

Cash

Financial Claims (deposits and insurance policies)

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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

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FIs Benefit Suppliers of Funds


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

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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

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Risks Faced by Financial Institutions


Credit Foreign exchange Country or sovereign Interest rate Market Off-balance-sheet Liquidity Technology Operational Insolvency

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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

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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

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