Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter One Introduction.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill /Irwin

Chapter OneIntroduction

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill /Irwin 1-3

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

• 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


Overview of Financial Markets

• Primary Markets versus Secondary Markets

• Money Markets versus Capital Markets

• Foreign Exchange Markets

• Primary Markets versus Secondary Markets

• Money Markets versus Capital Markets

• Foreign Exchange Markets


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)

• 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)


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

• 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


Money Market Instruments Outstanding, 1990-2001 ($Bn)

0200400600800

1000120014001600

1990 1995 2001

Commercial paper Fed Funds and Repo U.S. T-bills

Negotiable CDs Banker's accept.

0200400600800

1000120014001600

1990 1995 2001

Commercial paper Fed Funds and Repo U.S. T-bills

Negotiable CDs Banker's accept.


Capital Market Instruments Outstanding, 1990-2001 ($Bn)

0

5000

10000

15000

20000

1990 1995 2001

Corporate stocks Residential MortgagesComm/farm mortgages Corporate bondsTreasury Securities State & Local Govt. bondsU.S. Govt.-owned agencies U.S. Govt.-sponsored agenciesBank and consumer loans

0

5000

10000

15000

20000

1990 1995 2001

Corporate stocks Residential MortgagesComm/farm mortgages Corporate bondsTreasury Securities State & Local Govt. bondsU.S. Govt.-owned agencies U.S. Govt.-sponsored agenciesBank and consumer loans


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

• “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


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)

• 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)


Flow of Funds in a World without FIs: Direct Transfer

Users of Funds(Corporations)

Suppliers of Funds

(Households)

Financial Claims(Equity and debt

instruments)

Cash

Example: A firm sells shares directly to investors without goingthrough a financial institution.


Flow of Funds in a world with FIs: Indirect transfer

Users of FundsFI

(Brokers)

FI(Asset

transformers)

Suppliers of Funds

Financial Claims(Equity and debt securities)

Financial Claims(Deposits and insurance policies)

Cash Cash


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

• 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)


• 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

• 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


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

• 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)


• 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

• 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


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)

• 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)


• 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

• 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

Services Provided by FIs Benefiting the Overall Economy


Risks Faced by Financial Institutions

• Interest Rate Risk• Foreign Exchange Risk• Market Risk• Credit Risk• Liquidity Risk• Off-Balance-Sheet Risk• Technology Risk• Operational Risk• Country or Sovereign Risk• Insolvency Risk

• Interest Rate Risk• Foreign Exchange Risk• Market Risk• Credit Risk• Liquidity Risk• Off-Balance-Sheet Risk• Technology Risk• Operational Risk• Country or Sovereign Risk• Insolvency Risk


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

• 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


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

• 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


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

• 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

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter One Introduction.

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