Chapter One

Introduction

Copyright 2015 by McGraw-Hill Education. All rights reserve

Why Study Financial Markets

and Institutions?

Markets
Markets and
and institutions
institutions are
are primary
primary

channels
channels to
to allocate
allocate capital
capital in
in our
our society
society

Proper
Proper capital
capital allocation
allocation leads
leads to
to growth
growth in:
in:

Societal
Societal wealth
wealth

Income
Income

Economic
Economic opportunity
opportunity

1-2

Why Study Financial Markets

and Institutions?

In
In this
this text
text we
we will
will examine:
examine:

the
the structure
structure of
of domestic
domestic and
and international
international

markets
markets

the
the flow
flow of
of funds
funds through
through domestic
domestic and
and
international
international markets
markets

an
an overview
overview of
of the
the strategies
strategies used
used to
to manage
manage
risks
risks faced
faced by
by investors
investors and
and savers
savers

1-3

Financial Markets

Financial
Financial markets
markets are
are one
one type
type of
of

structure
structure through
through which
which funds
funds flow
flow

Financial
Financial markets
markets can
can be
be distinguished
distinguished
along
along two
two dimensions:
dimensions:

primary
primary versus
versus secondary
secondary markets
markets

money
money versus
versus capital
capital markets
markets

1-4

Primary versus Secondary

Markets

Primary
Primary markets
markets

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

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

Secondary
Secondary markets
markets

markets
markets where
where existing
existing financial
financial instruments
instruments are
are

traded
traded among
among investors
investors (e.g.,
(e.g., exchange
exchange traded:
traded:
NYSE
NYSE and
and over-the-counter:
over-the-counter: NASDAQ)
NASDAQ)
1-5

Primary versus Secondary

Markets

1-6

Primary versus Secondary

Markets

How
How were
were primary
primary markets
markets affected
affected by
by

the
the financial
financial crisis?
crisis?

Do
Do secondary
secondary markets
markets add
add value
value to
to

society
society or
or are
are they
they simply
simply aa legalized
legalized
form
form of
of gambling?
gambling?

How
How does
does the
the existence
existence of
of secondary
secondary markets
markets

affect
affect primary
primary markets?
markets?

1-7

Money versus Capital Markets

Money
Money markets
markets

markets
marketsthat
thattrade
tradedebt
debtsecurities
securitieswith
withmaturities
maturitiesof
ofone
one
year
yearor
orless
less(e.g.,
(e.g.,CDs
CDsand
and U.S.
U.S.Treasury
Treasurybills)
bills)

little
littleor
orno
norisk
riskof
ofcapital
capitalloss,
loss,but
butlow
lowreturn
return

Capital
Capital markets
markets

markets
marketsthat
thattrade
tradedebt
debt(bonds)
(bonds)and
andequity
equity(stock)
(stock)
instruments
instrumentswith
withmaturities
maturitiesof
ofmore
morethan
thanone
oneyear
year

substantial
substantialrisk
riskof
ofcapital
capitalloss,
loss,but
buthigher
higherpromised
promisedreturn
return
Figure 1.3

1-8

Money Market Instruments

Outstanding, ($Bn)

1-9

Capital Market Instruments

Outstanding, ($Bn)

1-10

Foreign Exchange (FX) Markets

FX
FX markets
markets

trading
tradingone
onecurrency
currencyfor
foranother
another(e.g.,
(e.g.,dollar
dollarfor
foryen)
yen)

Spot
Spot FX
FX

the
theimmediate
immediateexchange
exchangeof
ofcurrencies
currenciesat
atcurrent
current
exchange
exchangerates
rates

Forward
Forward FX
FX

the
theexchange
exchangeof
ofcurrencies
currenciesin
inthe
thefuture
futureon
onaaspecific
specificdate
date
and
andat
ataapre-specified
pre-specifiedexchange
exchangerate
rate

1-11

Derivative Security Markets

Derivative
Derivative security
security

aafinancial
financialsecurity
securitywhose
whosepayoff
payoffisislinked
linkedto
to(i.e.,
(i.e.,derived
derived
from)
from)another
anothersecurity
securityor
orcommodity,
commodity,

generally
generallyan
anagreement
agreementto
toexchange
exchangeaastandard
standardquantity
quantity
of
ofassets
assetsat
ataaset
setprice
priceon
onaaspecific
specificdate
dateininthe
thefuture,
future,

the
themain
mainpurpose
purposeof
ofthe
thederivatives
derivativesmarkets
marketsisisto
totransfer
transfer
risk
riskbetween
betweenmarket
marketparticipants.
participants.

1-12

Derivative Security Markets

Selected
Selected examples
examples of
of derivative
derivative

securities
securities

Exchange
Exchange listed
listed derivatives
derivatives

Many
Manyoptions,
options,futures
futurescontracts
contracts

Over
Over the
the counter
counter derivatives
derivatives

Forward
Forwardcontracts
contracts

Forward
Forwardrate
rateagreements
agreements

Swaps
Swaps

Securitized
Securitizedloans
loans

1-13

Derivatives and the Crisis

1.
1. Mortgage
Mortgagederivatives
derivativesallowed
allowedaalarger
largeramount
amountof
of
mortgage
mortgage credit
credit to
tobe
becreated
createdin
inthe
themid-2000s.
mid-2000s.

Growing
Growingimportance
importanceof
ofshadow
shadowbanking
bankingsystem
system
2.
2. Mortgage
Mortgagederivatives
derivativesspread
spreadthe
therisk
risk of
of mortgages
mortgagesto
toaa
broader
broader base
baseof
ofinvestors.
investors.
3.
3. Change
Changein
inbanking
bankingfrom
from originate
originateand
andhold
holdloans
loansto
to
originate
originateand
andsell
sellloans.
loans.

Decline
Declinein
inunderwriting
underwritingstandards
standards on
onloans
loans
1-14

Derivatives and the Crisis

1.
1. Subprime
Subprimemortgage
mortgagelosses
losseswere
werelarge,
large,reaching
reachingover
over
$700
$700billion.
billion.
2.
2. The
TheGreat
GreatRecession
Recessionwas
wasthe
theworst
worstsince
sincethe
theGreat
Great
Depression
Depressionof
ofthe
the1930s.
1930s.

Trillions
Trillions$$global
globalwealth
wealthlost,
lost,peak
peakto
totrough
troughstock
stockprices
prices
fell
fellover
over50%
50%ininthe
theU.S.
U.S.

Lingering
Lingeringhigh
highunemployment
unemploymentand
andbelow
belowtrend
trendgrowth
growthinin
the
theU.S.
U.S.

Sovereign
Sovereigndebt
debtlevels
levelsinindeveloped
developedeconomies
economiesreached
reached
post-war
post-warall-time
all-timehighs
highs

1-15

Financial Market Regulation

The
The Securities
Securities Act
Act of
of 1933
1933

full
full and
and fair
fair disclosure
disclosure and
and securities
securities registration
registration

The
The Securities
Securities Exchange
Exchange Act
Act of
of 1934
1934

Securities
Securities and
and Exchange
Exchange Commission
Commission (SEC)
(SEC) isis

the
the main
main regulator
regulator of
of securities
securities markets
markets

1-16

Financial Institutions (FIs)

Financial
Financial Institutions
Institutions

institutions
institutionsthrough
throughwhich
whichsuppliers
supplierschannel
channelmoney
moneyto
to

users
usersof
of funds
funds

Financial
Financial Institutions
Institutions are
are distinguished
distinguished by:
by:

whether
whetherthey
theyaccept
accept insured
insureddeposits
deposits

depository
depositoryversus
versusnon-depository
non-depository financial
financial

institutions
institutions

whether
whetherthey
theyreceive
receivecontractual
contractual payments
paymentsfrom
from
customers
customers

1-17

Percentage Shares of Assets of Financial

Institutions in the United States, 19292013

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
1-19

Suppliers of
Funds
(households)

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

Depository
Depository institutions:
institutions:

commercial
commercialbanks,
banks,savings
savingsassociations,
associations,savings
savingsbanks,
banks,
credit
creditunions
unions

Non-depository
Non-depository institutions
institutions

Contractual:
Contractual:

insurance
insurancecompanies,
companies,pension
pensionfunds,
funds,

Non-contractual:
Non-contractual:

securities
securitiesfirms
firmsand
andinvestment
investmentbanks,
banks,mutual
mutualfunds.
funds.

1-21

FIs Benefit Suppliers of Funds

Reduce
Reduce monitoring
monitoring costs
costs

Increase
Increase liquidity
liquidity and
and lower
lower price
price risk
risk

Reduce
Reduce transaction
transaction costs
costs

Provide
Provide maturity
maturity intermediation
intermediation

Provide
Provide denomination
denomination intermediation
intermediation

1-22

FIs Benefit the Overall Economy

Conduit
Conduit through
through which
which Federal
Federal Reserve
Reserve

conducts
conducts monetary
monetary policy
policy

Provides
Provides efficient
efficient credit
credit allocation
allocation

Provide
Provide for
for intergenerational
intergenerational wealth
wealth
transfers
transfers

Provide
Provide payment
payment services
services

1-23

Risks Faced by Financial

Institutions

Credit
Credit

Off-balance-sheet
Off-balance-sheet

Foreign
Foreign exchange
exchange

Liquidity
Liquidity

Country
Country or
or

Technology
Technology

sovereign
sovereign

Interest
Interest rate
rate

Market
Market

Operational
Operational

Insolvency
Insolvency

Volcker Rule: Insured

institutions may not
engage in proprietary
trading
1-24

Regulation of Financial
Institutions

FIs
FIs are
are heavily
heavily regulated
regulated to
to protect
protect society
society at
at

large
large from
from market
market failures
failures

Regulations
Regulations impose
impose aa burden
burden on
on FIs;
FIs; before
before the
the
financial
financial crisis,
crisis, U.S.
U.S. regulatory
regulatory changes
changes were
were
deregulatory
deregulatory in
in nature
nature

Regulators
Regulators attempt
attempt to
to maximize
maximize social
social welfare
welfare
while
while minimizing
minimizing the
the burden
burden imposed
imposed by
by
regulation
regulation

1-25

Regulation of Financial
Institutions

Dodd-Frank
Dodd-Frank Bill
Bill
1.1.

Promote
Promoterobust
robust supervision
supervisionof
of FIs
FIs

Financial
Financial Service
Service Oversight
Oversight Council
Council to
to identify
identify
and
andlimit
limit systemic
systemicrisk,
risk,

Broader
Broader authority
authorityfor
for Federal
Federal Reserve
Reserve (Fed)
(Fed) to
to
oversee
overseenon-bank
non-bankFIs,
FIs,

Higher
Higherequity
equitycapital
capital requirements,
requirements,

Registration
Registration of
of hedge
hedge funds
funds and
and private
privateequity
equity
funds.
funds.

1-26

Regulation of Financial
Institutions

Dodd-Frank
Dodd-Frank Bill
Bill
2.2.

Comprehensive
Comprehensive supervision
supervision of
of financial
financial markets
markets

New
New regulations
regulationsfor
forsecuritization
securitizationand
andover
over
the
thecounter
counter derivatives
derivatives

Additional
Additional oversight
oversight by
byFed
Fedof
of payment
payment
systems
systems

3.3.

Establishes
Establishesaa new
new Consumer
Consumer Financial
Financial
Protection
ProtectionAgency
Agency

1-27

Regulation of Financial
Institutions

Dodd-Frank
Dodd-Frank Bill
Bill
4.4.

New
New methods
methods to
to resolve
resolvenon-bank
non-bankfinancial
financial
crises
crises

More
Moreoversight
oversight of
of Fed
Fedbailout
bailout decisions
decisions

5.5.

Increase
Increaseinternational
international capital
capital standards
standardsand
and
increased
increased oversight
oversight of
of international
internationaloperations
operations
of
of FIs.
FIs.

1-28

Globalization of Financial Markets

and Institutions
The
Thepool
poolof
ofsavings
savingsfrom
fromforeign
foreigninvestors
investorsis
is
increasing
increasingand
andinvestors
investorslook
lookto
todiversify
diversifyglobally
globallynow
now
more
morethan
thanever
everbefore,
before,

Information
Informationon
onforeign
foreignmarkets
marketsand
andinvestments
investmentsis
is
becoming
becomingreadily
readilyaccessible
accessibleand
andderegulation
deregulationacross
across
the
theglobe
globeis
isallowing
allowingeven
evengreater
greateraccess
accessto
toforeign
foreign
markets,
markets,

International
Internationalmutual
mutualfunds
fundsallow
allow diversified
diversifiedforeign
foreign
investment
investmentwith
withlow
low transactions
transactionscosts,
costs,

Global
Globalcapital
capitalflows
flowsare
arelarger
largerthan
thanever.
ever.

1-29

Appendix: FIs and the Crisis

Timeline
Timelineof
of events
events

Home
Homeprices
pricesdecline
decline in
in late
late 2006
2006 and
and early
early2007
2007

Delinquencies
Delinquencieson
onsubprime
subprimemortgages
mortgagesincrease
increase

Huge
Hugelosses
losseson
onmortgage-backed
mortgage-backed securities
securities
(MBS)
(MBS) announced
announcedby
byinstitutions
institutions

Bear
BearStearns
Stearnsfails
failsand
andis
isbought
boughtby
byJ.P.
J.P.Morgan
Morgan

Chase
Chasefor
for$2
$2aashare
share(deal
(dealhad
hadgovernment
governmentbacking)
backing)

1-30

Appendix: FIs and the Crisis

Timeline
Timelineof
of events
events

September
September2008,
2008,the
thegovernment
governmentseizes
seizesgovernmentgovernmentsponsored
sponsored mortgage
mortgage agencies
agenciesFannie
Fannie Mae
Mae and
and
Freddie
FreddieMac
Mac

The
Thetwo
twohad
had$9
$9billion
billion in
in losses
lossesin
in the
thesecond
secondhalf
half
2007
2007

Now
Now run
runby
byFederal
Federal Housing
Housing Finance
FinanceAgency
Agency
(FHFA)
(FHFA)

September
September2008,
2008,Lehman
Lehman Brothers
Brothersfiles
filesfor
for

bankruptcy;
bankruptcy; Dow
Dow drops
drops500
500points
points
1-31

Appendix: FIs and the Crisis

Figure 1-9 The Dow Jones Industrial Average, October 2007January
2010

1-32

Appendix: FIs and the Crisis

Figure 1-10 Overnight London Interbank Offered Rate (LIBOR),
20012010

1-33

Appendix: Government Rescue

Plan
Table 1-12 Federal Government Rescue Efforts through December 2009

1-34

Appendix: Government Rescue

Plan
Table 1-12 Federal Government Rescue Efforts through December 2009

1-35

Appendix: Government Rescue

Plan
Figure 1-11 Federal Funds Rate and Discount Window RateJanuary
1971 through January 2010

1-36

Appendix: Government Rescue

Plan
Table 1-13 Major Items in the $787 Billion Stimulus Program as
Passed by the U.S. Congress, February 13, 2009

1-37