CHAPTER ONE

INTRODUCTION
FIN 331
Financial Markets & Institutions
W.P. Carey School of Business
Arizona State University
Art Budolfson, CEBS, CFA

Regulation in the United

States
Implemented in reaction
to crisis:
Crash of 1929.
Great Depression of the
1930s.

Now implementing in
reaction to the Great
Recession.
Regulators include the
SEC, the CFTC, the U.S.
Treasury, the Federal
Reserve and many
others.

Sampling of Regulators

Shift underway
Impact of 2008
Financial crisis, aka
The Great Recession
Global trend toward reregulation of the
financial services
industry.
Shift in attitudes of
investors and
homebuyers,
particularly young
investors and young
homebuyers.

Regulatory response included:

Dodd-Frank financial reform (2010)

Rulemaking mandated by the law, touching virtually every
area of finance, is still ongoing.
A study concluded regulators missed their deadline on
78% of over 400 rules and regulations required under the
law.
SEC implementation only 50% complete as of five year
anniversary according to one SEC commissioner.
Significant impact on business practices of commercial
banks, investment banks and other financial institutions
awaiting rules.

Basel III global regulatory standard (2010)

International agreement demanding higher standards for
bank capital, stress testing and liquidity.
Phased in through 2018.

Regulatory response failed to include:

Comprehensive
reform of the
mortgage
banking and
mortgage backed
securities
industry.

Young people have found it:

More difficult to buy a
home.
More difficult to obtain a
credit card.
More difficult to establish
and maintain a good credit
score.
After suffering losses in
newly purchased homes
and stock portfolios, many
young people have more
conservative attitudes
toward investment risk
than those over age 65!

Financial professionals have experienced:

Delays waiting for new regulatory rules.

Conflicting regulatory signals:
Make more loans.
Improve capital base.

Ongoing criminal and civil actions against

them.
Renewed interest from consumers in
investment products with guarantees or
downside risk protection.
Political pressure/hostility regarding executive
compensation and risk taking.

Was 2008 really that bad?

Historically bad for stocks:

Nearly a decade of economic

progress destroyed:

How is the economic doing now?

Stock market?
Housing prices?
GDP growth?
Employment?
Consumer spending?
Wages?

Role of regulatory uncertainty?

Other more broad issues?

Impact on FIN 331

What type of financial landscape will
you be working in?
Significant rulemaking from laws already
passed complete or near completion,
but...
Impact of upcoming Congressional and
Presidential elections on future
regulations.

Course Current Event component

will help.

Financial market definition

A market (place) in which financial
assets (securities) such as stocks and
bonds can be purchased or sold. Funds
are transferred in financial markets
when one party purchases financial
assets previously held by another
party.
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Role of financial markets

Financial markets transfer funds from those who
have excess funds to those who need funds.
Surplus units: participants who receive more
money than they spend, such as investors.
Deficit units: participants who spend more
money than they receive, such as borrowers.
Securities: represent a claim on the issuers

Debt securities - debt (also called credit, or

borrowed funds) incurred by the issuer.
Equity securities - (also called stocks) represent
equity or ownership in the firm.
15

Role of financial markets

Accommodating Corporate Finance
Needs: The financial markets serves as
the mechanism whereby corporations
(acting as deficit units) can obtain funds
from investors (acting as surplus units).
Accommodating Investment Needs:
Financial institutions serve as
intermediaries to connect the investment
management activity with the corporate
finance activity.
16

Economic role of financial

markets
To determine the price or required
rate of return of an asset; aka price
discovery.
To provide a mechanism to sell an
asset; aka liquidity.
To reduce the search and information
costs associated with investing; aka
transaction costs.

Primary versus secondary markets

Primary markets - facilitate the
issuance of new securities
Secondary markets - facilitate the
trading of existing securities, which
allows for a change in the ownership of
the securities
Liquidity is the degree to which
securities can easily be liquidated
(sold) without a loss of value.
18

Securities traded in financial markets

Securities can be classified as money market
securities, capital market securities, or
derivative securities.

Money market securities

Money markets facilitate the sale of
short-term debt securities by deficit
units to surplus units.
Debt securities that have a maturity
of one year or less.
19

Capital market securities

Facilitate the sale of long-term
securities by deficit units to surplus
units. Include:
Bonds - long-term debt securities
issued by the Treasury, government
agencies, and corporations to
finance their operations.
Stocks - represent partial ownership
in the corporations that issued
them.
20

Derivative securities
Financial contracts whose values are
derived from the values of underlying
assets. Used in risk management and
in speculation. Include:
Options
Calls
Puts
Futures
Swaps
21

Classification of financial
markets
Debt vs. Equity (nature of claim).
Money market vs. Capital market
(maturity).
Primary vs. Secondary (seasoning).
Cash/Spot v. Derivatives (delivery).
Auction vs. OTC vs. intermediated
(structure).

Financial market
participation
Households
Businesses
Governments
Regulators
Protection needed?

Securities Regulations
The Securities Act of 1933 was intended to
ensure complete disclosure of relevant financial
information on publicly offered securities and to
prevent fraudulent practices in selling these
securities.
The Securities Exchange Act of 1934
extended the disclosure requirements to
secondary market issues.
The Sarbanes-Oxley Act required that firms
provide more complete and accurate financial
information.
24

Pricing financial assets

Equal to the
present value of all
expected future
cash flows.
Expected rate of
return.
Risk of expected
cash flow.

Types of investment risks

Market prices
fluctuate, but also
consider:
Purchasing power
risk, aka inflation
risk.
Default risk, aka
credit risk.
Exchange rate risk,
aka currency risk.

International Securities
Transactions
Financial markets vary greatly across the
world in terms of:
Degree of financial market development
Volume of funds transferred from surplus
to deficit units
Foreign Exchange Market - International
financial transactions normally require the
exchange of currencies. The foreign
exchange market facilitates this exchange.
27

Role of Financial Institutions

Role of depository institutions - Depository
institutions accept deposits from surplus units and
provide credit to deficit units through loans and
purchases of securities.
Offer liquid deposit accounts to surplus units
Provide loans of the size and maturity desired by
deficit units
Accept the risk on loans provided
Have more expertise in evaluating
creditworthiness
Diversify their loans among numerous deficit units
28

Role of Depository Institutions (cont.)

Commercial Banks
The most dominant type of depository institution
Transfer deposit funds to deficit units through
loans or purchase of debt securities
Federal Funds Market - facilitates the flow of funds
between depository institutions

Savings Institutions
Also called thrift institutions and include Savings
and Loans (S&Ls) and Savings Banks
Concentrate on residential mortgage loans

Credit Unions
Nonprofit organizations
Restrict business to CU members with a common
bond
29

Role of Non-depository Institutions

Finance companies - obtain funds by issuing
securities and lend the funds to individuals
and small businesses.
Mutual funds - sell shares to surplus units
and use the funds received to purchase a
portfolio of securities.
Securities firms - provide a wide variety of
functions in financial markets. (Broker,
Underwriter, Dealer, Advisory)
Insurance companies - provide insurance
policies that reduce the financial burden
associated with death, illness, and damage to
property. Charge premiums and invest in
financial markets.
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Summary of Institutional Sources and Uses of Funds

31

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