chapter 1 an overview of financial markets and institutions
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CHAPTER 1
An Overview of Financial Markets and Institutions
Copyright© 2003 John Wiley and Sons, Inc.
Role of the Financial System
Provides for the efficient flow of funds from lenders to borrowers to finance real investment or consumption via financial markets and financial institutions.Facilitates trade in goods and services via an efficient payment system.Provides contracts for managing risk such as insurance, futures, and options.
Copyright© 2003 John Wiley and Sons, Inc.
Surplus Spending Unit (SSU)
Has more income than expenditures on consumption and real investment in a period.
Other terms for surplus spending unit are: lender, saver, financial investor, buyer of securities, holder of securities, and supplier of loanable funds.
Copyright© 2003 John Wiley and Sons, Inc.
Surplus Spending Unit
The surplus spending unit may buy financial assets, hold more money, pay off financial liabilities issued earlier when in a deficit situation.
The household sector is usually a surplus sector.
Copyright© 2003 John Wiley and Sons, Inc.
Deficit Spending Unit
Has more expenditures on consumption and real investment than income in a period.
Other terms for deficit spending unit are: borrower, economic investor, seller of securities, issuers of securities, and demander of loanable funds.
Copyright© 2003 John Wiley and Sons, Inc.
Deficit Spending Unit
The deficit spending unit may issue financial liabilities, hold less money, sell financial assets acquired earlier when in a surplus situation.
The business and government sectors are usually deficit sectors.
Copyright© 2003 John Wiley and Sons, Inc.
Financial Claims
Contracts to transfer of funds from surplus to deficit spending units.
Financial claims are also called financial assets and liabilities, securities, loans, financial investments.
For every financial asset, there is an offsetting financial liability - total assets equal liabilities in the financial system.
Copyright© 2003 John Wiley and Sons, Inc.
Financial Claims
Financial markets provides:Financing (borrowing) for DSUs in the primary markets.
Financial investment (lending) for SSUs in the primary and secondary markets.
Liquidity via trading financial claims in secondary markets.
Copyright© 2003 John Wiley and Sons, Inc.
Direct Financing
DSUs and SSUs exchange money for financial claims.
DSUs issue financial claims and SSUs buy the financial claims.
Copyright© 2003 John Wiley and Sons, Inc.
Direct Financing
Brokers are match makers who bring DSUs and SSUs together. Dealers are market makers who buy securities from DSUs and sell them to SSUs.
Investment bankers act as dealers in primary financial markets, buying securities from DSUs (underwriting) and selling them to SSUs in initial public offering (IPO) or private placement.
Copyright© 2003 John Wiley and Sons, Inc.
Indirect Financing or Financial Intermediation
A financial intermediary writes a separate contract with the SSU (lender) and the DSU (borrower).Financial intermediaries issue direct claims to SSUs as its financial liabilities, and hold indirect claims on DSUs as its financial assets.
Copyright© 2003 John Wiley and Sons, Inc.
Benefits of Financial Intermediation
Economies of scale from specialization → lower transaction and search costs for SSUs and DSUs. → easier access to financial markets.Financial intermediaries may be able to gather information about DSUs and SSUs more effectively and discretely.
Copyright© 2003 John Wiley and Sons, Inc.
Benefits of Financial Intermediation
Maturity Intermediation - offer contracts with varying maturities to suit both DSUs and SSUs.Denomination Intermediation - issue contracts with varying sizes.Currency Intermediation - buy and sell financial claims denominated in various currencies.
Copyright© 2003 John Wiley and Sons, Inc.
Benefits of Financial Intermediation
Liquidity Intermediation - help SSUs to store liquidity through deposits and buying money markets securities, and provide liquidity to DSUs through loans and issuing money market securities.
Risk Intermediation (Diversification) - manage risk by spreading the risk over many types of financial securities (investment portfolio).
Copyright© 2003 John Wiley and Sons, Inc.
Benefits of Financial Intermediation
Information Intermediation - help lenders and borrowers deal with the problems created by asymmetric information:
Adverse Selection is the problem created by asymmetric information before the transaction. It occurs when potential borrowers who are the most likely to produce a bad outcome are the ones who most actively seek loans and are thus the most likely to be selected.Moral Hazard is the problem created by asymmetric information after the transaction. It is the risk that the borrower might engage in undesirable (immoral) activities that will make it less likely that the loan will be paid back.
Copyright© 2003 John Wiley and Sons, Inc.
Types of Financial Intermediaries
Depository Institutions - accept deposits (demand, savings, and time deposits) from SSUs and make loans to DSUs.
Commercial Banks - make consumer and business loans to DSUs.
Credit Unions - accept deposits from members and make consumer loans to DSUs.
• Membership requires a common bond - Business employee or labour union.
Copyright© 2003 John Wiley and Sons, Inc.
Types of Financial Intermediaries
Savings Institutions - issue long-term claims to SSUs in the form of insurance policies and pension fund obligations.
Life Insurance Companies - issue life insurance policies and collect premiums, and purchase long-term, high-yield financial securities.
Copyright© 2003 John Wiley and Sons, Inc.
Types of Financial Intermediaries
Casualty Insurance Companies - issue insurance policies and collect premiums, and purchase long-term, liquid financial securities.
Pension Funds - receive contributions from employees and purchase long-term financial securities (stocks and bonds).
Copyright© 2003 John Wiley and Sons, Inc.
Types of Financial Intermediaries
Investment Institutions - issue shares to SSUs and purchase financial securities.
Mutual Funds - sell shares to SSUs and purchase financial securities (stocks and bonds).Money Market Mutual Funds - sell shares to SSUs and purchase money market financial securities - T-Bills, commercial papers and bank CDs.
Copyright© 2003 John Wiley and Sons, Inc.
Types of Financial Intermediaries
Finance Companies - Borrow from commercial banks (loans) or from SSUs (issue commercial papers) and make consumer and business loans.
Copyright© 2003 John Wiley and Sons, Inc.
Exhibit 1.1 Transfer of Funds From Surplus to Deficit Units
Copyright© 2003 John Wiley and Sons, Inc.
Types of Financial Markets
Financial markets may be classified as debt (bond) or equity (stock) markets.
Debt financing is riskier than equity financing, but can lead to higher profits through “leverage”.
Equity financing can lead to the “dilution” of stockholders’ equity.
Copyright© 2003 John Wiley and Sons, Inc.
Types of Financial Markets
Financial markets may be classified as:Primary markets where the initial financing of DSUs occur with the help of investment bankers.Secondary markets where previously issued financial securities are traded with the help of brokers and dealers. Secondary market provides liquidity for investors and pricing for primary markets.
Copyright© 2003 John Wiley and Sons, Inc.
Types of Financial Markets
Secondary markets may be organized as:Organized exchanges where buyers and sellers of securities meet in one location to conduct trades.
Over-the-counter (OTC) markets, where securities trade via a computer network connecting dealers in many locations.
Copyright© 2003 John Wiley and Sons, Inc.
Types of Financial Markets
Financial markets may be classified as:Money markets where short-term debt securities (maturity is less than one-year) are issued and traded.
Capital markets where long-term debt securities (maturity is greater than one-year) and stocks are issued and traded.
Copyright© 2003 John Wiley and Sons, Inc.
Money Markets
Short-term maturities - most under 120 days.
Standardized securities - one security is a close substitute for another.
High quality borrowers → low default risk.
Active secondary market → High marketability providing excellent liquidity.
“Wholesale” markets - Large wholesale transactions.
Copyright© 2003 John Wiley and Sons, Inc.
Money Market
Economic role of money markets - markets for liquidity.
Liquidity is stored in money markets by investing in securities (lending).
Liquidity is bought in money markets by issuing securities (borrowing).
Copyright© 2003 John Wiley and Sons, Inc.
Capital Markets
Markets for long-term claimsGovernment BondsCorporate BondsCommon StockMortgages
“Retail” marketsEconomic role of capital markets - markets for economic investment.
Copyright© 2003 John Wiley and Sons, Inc.
Risks of Financial Institutions
Credit or default risk is the risk that a DSU will not pay as agreed, thus affecting the rate of return on an asset.Interest rate risk is the risk of fluctuations in a security's price or reinvestment income caused by changes in market interest rates.Liquidity risk is the risk that the financial institution’s cash inflows will not be able to meet its cash outflows.
Copyright© 2003 John Wiley and Sons, Inc.
Risks of Financial Institutions
Foreign exchange risk is the risk that fluctuations in the foreign exchange rates will affect the profit of the financial institution.
Political risk is the risk that actions of foreign governments or regulators will affect the profit of the financial institution.