CONTENTS

CAPITAL ALLOCATION PROCESSFINANCIAL MARKETS FINANCIAL INSITUTIONS FINANCIAL REGULATIONS STOCK MARKET

Capital allocation processDirect Transfer

Business Savers

Securities (Stocks/Bonds)

Cash

Investment Bank

Investment Bank

Business SaversSecurities

Cash

Securities

Cash

Financial Intermediary

Financial Intermediary

Business Savers

Business’s

SecuritiesCash Cash

Intermediary’s

Securities

Segments of Financial Markets

• Direct Financing– Funds are transferred directly from ultimate savers to ultimate borrowers

• Indirect Financing– A financial "intermediary" transforms financial claims with one set of characteristics into

financial claims with other characteristics e.g. deposits are used to make loans.

WHAT IS FINANCIAL MARKETS? WHY STUDY FINANCIAL MARKETS? FUNCTIONS OF FINANCIAL MARKETS TYPES OF FINANCIAL MARKETS INSTRUMENTS TRADED IN

FINANCIAL MARKETS?

Financial Markets

What is Financial Markets?

Financial markets perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds

At any point in time in an economy, there are individuals or organizations with excess amounts of funds, and others with a lack of funds they need for example to consume or to invest.

Exchange between these two groups of agents is settled in financial markets

The first group is commonly referred to as lenders, the second group is commonly referred to as the borrowers of funds.

What is Financial Markets? (cont’d)

Financial Market: is market place for selling financial securities: stocks, bonds and derivatives.

A security is a piece of paper that represents the investor’s rights to certain prospects or property and the conditions under which he or she may exercise those rights.

Stock or share represents ownership right in the corporationBond is a debt instrument issued by corporations who borrow money.Derivative: is a security that derives its value from the value of another

security

Why study financial markets?

Financial markets, such as bond and stockmarkets, are crucial in our economy.

1. These markets channel funds from savers to investors, thereby promoting economic efficiency.

2. Market activity affects personal wealth, the behavior of business firms, and economy as a whole

Well functioning financial markets, such as the bond market, stock market, and foreign exchange market, are key factors in producing high economic growth.

Functions of financial markets

A Financial Market is a market in which financial assets (securities) can be purchased or sold.

Financial markets facilitate transfers of funds from person or business without investment opportunities (i.e., “Lender-Savers”, or “Surplus Unit”) to those who have investment opportunities (i.e., “Borrower-Spenders”, or “Deficit Unit”).

Functions of Financial markets (cont’d)

Borrowing and Lending Financial markets channel funds from households, firms, governments

and foreigners that have saved surplus funds to those who encounter a shortage of funds (for purposes of consumption and investment)

Price Determination Financial markets determine the prices of financial assets. The

secondary market herein plays an important role in determining the prices for newly issued assets

Types of financial marketsSpot vs future market:

Spot market: assets are delivered immediately

Future market: participants agree today to buy or sell an asset at some future dateMoney vs capital market:

Money assets: short term financial assets are traded

Capital market: long term financial assets are tradedPrimary vs secondary market:

Primary market: market where financial assets are sold for the first time

Secondary market: market for previously sold financial assets

Instruments traded in financial market

• Money market securities:– Money market securities are debt securities with a maturity of one year

or less– Characteristics:

• Liquid• Low expected return• Low degree of risk

Securities Traded in Money Markets

Treasury Bills.Certificate of Deposit (CDs).Commercial Papers.Eurodollar Deposits.Banker’s Acceptance. Federal Funds.Repurchase Agreements.

Securities Traded in Financial Markets(cont’d)

• Capital Market Securities:– Capital market securities are those with a maturity of more than one

year• Bonds and mortgages• Stocks

– Capital market securities have a higher expected return and more risk than money market securities

Securities Traded in Capital Markets

• Treasury Notes and Bonds.• Municipal Bonds.• Corporate Bonds.• Mortgages. • Commons Stocks. • Preferred Stocks.

Securities Traded in Financial Markets (cont’d)

• Bonds and Mortgages:– Bonds are long-term debt obligations issued by corporations and

government agencies– Mortgages are long-term debt obligations created to finance the purchase

of real estate– Bonds and mortgages specify the amount and timing of interest and

principal payments.

Securities Traded in Financial Markets (cont’d)

• Stocks:– Stocks (equity) are certificates representing partial ownership in

corporations– Investors may earn a return by receiving dividends and capital gains– Stocks have a higher expected return and higher risk than long-term debt

securities

Securities Traded in Financial Markets (cont’d)

• Derivative Securities:– Derivative securities are financial contracts whose values are derived

from the values of underlying assets– Speculating with derivatives allow investors to benefit from increases or

decreases in the underlying asset– Risk management with derivatives generates gains if the value of the

underlying security declines

Financial institutions

What are Financial Institutions?Why study financial institutions? Function of financial InstitutionsTypes of Financial InstitutionsRole of financial institutions in financial markets

What are financial institutions?

Financial institutions are businesses which offer multiple services in banking and finance. The services customers receive may include savings and checking accounts, loans, investments and financial counseling. The benefits consumers gain by using financial institutions includes convenience, cost savings, safety and security.

Any classification of financial institutions is ultimately somewhat arbitrary, since financial markets are subject to high dynamics and frequent innovation. Thus, we roughly use four categories:BrokersDealersInvestment banksFinancial intermediaries

What are financial institutions? (cont’d)

Brokers are agents who match buyers with sellers for a desired transaction. A broker does not take position in the assets she/he trades (i.e.

does not maintain inventories of those assets) Brokers charge commissions on buyers and/or sellers using their

services Examples: Real estate brokers, stock brokers

Like brokers, dealers match sellers and buyers of financial assets. Dealers, however, take position in their assets, their trading As opposed to charging commission, dealers obtain their

What are financial institutions? (cont’d)

profits from buying assets at low prices and selling them at high prices

A dealer’s profit margin, the so-called bid-ask spread is the difference between the price at which a dealer offers to sell an asset (the asked price) and the price at which a dealer offers to buy an asset (the bid price

Examples: Dealers in U.S. government bonds, Nasdaq stock dealers

Investment Banks Investment banks assist in the initial sale of newly issued

securities (e.g. IPOs)

What are financial institutions? (cont’d)

Investment banks are involved in a variety of services for their customers, such as advice, sales assistance and underwriting of issuances

Examples: Morgan-Stanley, Goldman Sachs, ...Lehman Brothers ..(Before Crisis 2008)

Financial Intermediaries Financial intermediaries match sellers and buyers indirectly

through the process of financial asset transformation. As opposed to three above mentioned institutions. they buy a

specific kind of asset from borrowers –usually a long term loan contract – and sell a different financial asset to savers –usually some sort of highly-liquid short-run claim.

What are financial institutions? (cont’d)

Although securities markets receive a lot of media attention, financial intermediaries are still the primary source of funding for businesses.

Even in the United States and Canada, enterprises tend to obtain funds through financial intermediaries rather than through securities markets.

Other than historic reasons, this prevalence results from a variety of factors.

Why study financial institutions?

Financial Institutions are the institutions that make financial markets work“Financial Institutions are the intermediaries, that take funds from the people

who save and lend it to people who have productive investment opportunities”.

Function of Financial Institutions: Indirect Finance

Lower transaction costs Economies of scale Liquidity services

Since transaction costs are reduced, financial intermediaries are able to provide customers with additional liquidity services, such as checking accounts which can be used as methods of payment or deposits which can be liquidated any time while still bearing some interest.

Reduce Risk Risk Sharing (Asset Transformation) Diversification

Function of Financial Institutions: Indirect Finance (cont’d)

Through the process of asset transformation not only maturities, but also the risk of an asset can change: A financial intermediary uses funds it acquires (e.g. through deposits) and often turns them into a more risky asset (e.g. a larger loan). The risk then is spread out between various borrowers and the financial intermediary itself.

The process of risk sharing is further augmented through diversification of assets (portfolio-choice), which involves spreading out funds over a portfolio of assets with different types of risk

Reduce Asymmetric Information Asymmetric Information in financial markets - one party often does

not know enough about the other party to make accurate decisions.

Functions of Financial institutions: Indirect Finance (cont’d)

Adverse Selection (before the transaction)—more likely to select risky borrower Moral Hazard (after the transaction)—less likely borrower will repay loan => Financial intermediaries are important in the production of information. They help

reduce informational asymmetries about some unobservable quality of the borrower for example through screening, monitoring or rating of borrowers, Net worth and collateral.

Finally, some financial intermediaries specialize on services such as management of payments for their customers or insurance contracts against loss of supplied funds.

Through all of these channels financial intermediaries increase market efficiency from an economic point of view.

Types of financial institutions

Investment banks Commercial banks Credit unions Pension funds Life insurance companies Mutual funds Hedge funds

Types of financial institutions(cont)

• Commercial Banks:– Are the most dominant depository institution– Offer a wide variety of deposit accounts– Transfer deposited funds by providing direct loans or purchasing debt

securities– Serve both the public and the private sector– it helps the Federal reserve system to expand or control the money

supply

Types of financial institutions(cont’d)

• Investment banks: helping how to design security to attract investor

buy themselves sell on behalf company and ensure them in generating capital

Risk for bank • Credit Unions:

– Are nonprofit organizations– Restrict their business to credit union members– Tend to be much smaller than other depository institutions

Types of financial institutions(cont’d)

• Mutual Funds:– a mutual fund is registered with the SEC, and can be sold to an unlimited number of investors.– Mutual funds may advertise freely– Sell shares to surplus units– Use funds to purchase a portfolio of securities

Hedge funds: Most hedge funds are not registered and can only be sold to carefully defined

sophisticated investors Usually a hedge fund will have a maximum of either 100 or 500 investors hedge funds may not advertise freely Unregulated funds

Types of financial institutions(cont’d)

• Insurance Companies:– Provide insurance policies to individuals and firms for death, illness, and

damage to property– Charge premiums (annually)– Invest in stocks or bonds issued by corporations

Types of financial institutions(cont’d)

• Pension Funds:– Offered by most corporations and government agencies– Manage funds until they are withdrawn from the retirement account– Invest in stocks or bonds issued by corporations or in bonds issued by

the government

Market Efficiency

• When security prices fully reflect all available information, the markets for those securities are said to be efficient.

• When Markets are inefficient, investors can use available information ignored by the market to earn abnormally high returns on their investments.

Financial Regulations

Why regulate financial markets? Financial markets are among the most regulated markets in modern

economies.

The first reason for this extensive regulation is to increase the information available to investors (and, thus, to protect them).

The second reason is to ensure the soundness of the financial system.

Financial Regulations (cont’d)

Increasing information available to investors

As mentioned above, asymmetric information can cause severe problems in financial markets (Risk behavior, insider trades,....)

Certain regulations are supposed to prohibit agents with superior information from exploiting less informed agents.

In the U.S. the stock-market crash of 1929 led to the establishment of the Securities and Exchange Commission (SEC), which requires companies involved in the issuance of securities to disclose certain information relevant to their stockholders. The SEC further prohibits insider trades

Financial Regulations (cont’d)

Even more devastating consequences from asymmetric information manifest themselves in collapses of the entire financial system – so called financial panics.

Financial panics occur if providers of funds on a large scale withdraw their funds in a brief period of time from the financial system leading to a collapse of the system. These panics can produce enormous damage to an economy.

Examples of some recent panics are the crises in the Asian Tiger states, Argentina or Russia. The United States, while spared for most of the second half of 20 th century, has a long tradition of financial crises throughout the 19th century up to the Great Depression

Financial Regulations (cont’d)

Solutions for ensuring the soundness of financial intermediaries

Restrictions on entry Disclosure Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates

The Stock Market

Two types of stock markets:Organized Exchanges

NYSE AMEX

Over-the-Counter NASDAQ

Organized Security Exchanges

Formal organizations with physical locations where auction markets are conducted in designated (“listed”) securities.

The New York Stock Exchange (NYSE) is a stock exchange located at 11 Wall Street in lower Manhattan, New York City, USA. It is the world's largest stock exchange.

Over-the-Counter (OTC)

A large collection of brokers and dealers, connected electronically to trade securities not listed on the organized exchanges.

Characteristics of OTC markets: The relatively few market makers (dealers) that hold inventories of OTC

securities The thousands of brokers that who act as agents in bringing dealers

together with investors The electronic network that links it all together.

Over-the-Counter (OTC)

Bid Price: price at which dealer is willing to buy the issue.

Asked Price: price at which dealer is willing to sell the issue.

Prices are continuously updated to reflect changes in supply and demand.

Bid/Ask Spread: represents dealers profit

ANY QUESTIONS?