Module 5 - Understanding FM and FI

5 Understanding Financial
Markets and Institutions
Mishkin, Chapters 1,2,3 & 8

Cecetti, Chapters 11
Cornett, Chapters 6,7 & 8
Understanding Financial Markets and Institutions 1

Financial
Markets

Content
1. Financial Markets
2. Roles of Financial Markets
3. Structure of Financial Markets
4. Money Markets
5. Money Market Instruments
6. Capital Markets
7. Capital Market Instruments
8. Derivatives Markets
9. Internationalization of Financial Markets
Lectures 3-4 3
Financial Markets
• Financial markets are markets in

which funds are moved from people
who have an excess of available
funds (and lack of investment
opportunities) to people who have
investment opportunities (and lack of
funds).
• Financial markets (such as bond and

stock markets) are markets in which
securities are traded.
Lectures 3-4 4
Roles of Financial Markets
• To perform the essential function of
channeling funds from economic players
that have saved surplus funds to those that
have a shortage of funds
• Direct finance: borrowers borrow funds
directly from lenders in financial markets by
selling them securities.
Lectures 3-4 5
Roles of Financial Markets
• They contribute to increase the production and the
efficiency in the overall economy.
• Financial markets provide liquidity
• Financial markets also improve the wealth of individual

participants by providing investment returns to lender-
savers and profit and/or use opportunities to borrower-
spenders
• Studies found the the relationship between financial

markets and real activity.
Lectures 3-4 6
Structure of Financial
Markets
• Debt and Equity Markets

• Primary and Secondary Markets
• Stock Exchanges
• Over-the-Counter (OTC) Markets
• Cash or spot vs. futures markets
• Private vs. public markets
• Money and Capital Markets
7 Lectures 3-4
Debt and Equity Markets
• A firm an obtain funds in a financial markets

in two ways:
- issuing a debt instrument (e.g. a bond or a
mortgage)
- issuing equities, such as common stock.
Lectures 3-4 8
Debt and Equity Markets
• A bond (a debt instrument) is a contractual agreement
by the borrower to pay the holder of the instrument
fixed dollar amounts at regular intervals (interest and
principal payments) until a specified date (the maturity
date), when a final payment is made.
 short-term (maturity < a year) ; Long-term (ten years
or longer); Intermediate-term
• Equities are claims to share in the net income (income
after expenses and taxes) and the assets of a
business. Equity often make periodic payments
(dividends) to their holders and are considered long-
term securities because they have no maturity date.
Residual claimant
Lectures 3-4 9
Primary vs. Secondary
Markets
• Primary markets are financial markets in which new

issues of a security are sold to initial buyers by the
corporation or government agency borrowing the
funds.
 underwriting, initial public offering
• Secondary markets are markets in which existing

securities are traded among investors
 Role of secondary market
Lectures 3-4 10
Stock Exchanges vs. OTC markets
• Exchanges are markets where buyers and

sellers of securities (or their agents or brokers)
meet in one central location to conduct trades
• Over-the-counter (OTC) markets are markets,

in which dealers at different locations who have
an inventory of securities stand ready to buy
and sell securities “over the counter” to anyone
who comes to them and is willing to accept
their prices
Lectures 3-4 11
Private vs. Public Markets
•
• Private Markets are markets where
transactions are negotiated between two
parties
•
• Public markets are markets in which
standardized contracts are traded in
organized exchanges
Lectures 3-4 12
Money vs. Capital Markets
• Money markets are markets for short-term,

highly liquid debt securities.
• Capital markets are markets for intermediate-

and long-term debt and corporate stocks.
Lectures 3-4 13
The Money Markets
• The securities in the money market are short
term with high
liquidity; therefore, they are close to being
“money”.
 Money market securities are usually sold in
large denominations ($1,000,000 or more)
They have low default risk
They mature in one year or less from their

issue date, although most mature in less
than 120 days
Lectures 3-4 14
Why do we need money markets?
• Investors in Money Market: Provides a

place for warehousing surplus funds for
short periods of time.
• Borrowers from money market provide

low-cost source of temporary funds.
Lectures 3-4 15
Money Market Interest Rates
Lectures 3-4 16
Participants of MMs
Lectures 3-4 17
Instruments of Money Markets
Lectures 3-4 18
Characteristics of MM Instruments
Lectures 3-4 19
Treasury Bills
• are the short-term debt intruments of the

US goverment (1-,3- or 6- month maturities)
• no interest payment, but initially be sold at
a discount price (lower price than the set
amount paid at maturity)
• no possibility of default.
Lectures 3-4 20
Treasury Bills
• Discount rate (DR)

▫ Often quoted on short-term loans and
money market
securities (such as Treasury bills)
Lectures 3-4 21
Fed Funds
• Short-term funds transferred (loaned or borrowed)

between financial institutions, usually for a period of
one day.
• Borrowing and lending of bank reserves on deposit with

the Federal Reserve
•
• Used by banks to meet short-term needs, to meet
reserve requirements.
Lectures 3-4 22
Repurchase Agreements
• These work similar to the market for fed

funds, but nonbanks can participate.
• A firm sells Treasury securities, but
agrees to buy them back at a certain date
(usually 3–14 days later) for a certain
price.
Lectures 3-4 23
Negotiable Certificates of Deposit
(CDs)
• A bank-issued security that

documents a deposit and specifies
the interest rate and the maturity
date
• Denominations range from
$100,000 to $10 million
Lectures 3-4 24
Commercial Paper
• Unsecured promissory notes, issued by corporations,

that mature in no more than 270 days.
• There are two major types of commercial

paper.
▫ Direct paper is issued mainly by large finance
companies and bank holding companies directly
to the investor.
▫ Dealer paper, or industrial paper, is issued by
security dealers on behalf of their corporate
customers (mainly nonfinancial companies and
smaller financial companies).
Lectures 3-4 25
Banker’s Acceptances
• An order to pay a specified amount to the

bearer on a given date if specified
conditions have been met, usually delivery
of promised goods.
• These are often used when buyers /

sellers of expensive goods live in different
countries.
Lectures 3-4 26
Eurodollars
• Eurodollars represent Dollar denominated

deposits held in foreign
banks.
• The market is essential since many foreign

contracts call for payment is U.S. dollars due to
the stability of the dollar, relative to other
currencies
Lectures 3-4 27
Comparing Some Money Market
Securities
Lectures 3-4 28
CAPITAL MARKETS
•Capital market instruments

are debt and equity
instruments with maturities of
greater than one year.
Lectures 3-4 29
Lectures 3-4 30
Bonds
• A bond is a promise to make periodic

coupon payments and to repay principal
at maturity; breech of this promise is an
event of default
• Carry original maturities greater than one
year so bonds are instruments of the
capital markets
• Issuers are corporations and government
units
Lectures 3-4 31
Treasury Bonds
• T-notes and T-bonds issued by the U.S. treasury to

finance the national debt and other federal government
expenditures
• Backed by the full faith and credit of the U.S.
government and are default risk free
• Pay relatively low rates of interest (yields to maturity)
• Given their longer maturity, not entirely risk free due
to interest rate fluctuations
• Coupon securities: Pay coupon interest
(semiannually), notes have maturities from 1-10 yrs,
bonds 10-30 yrs
Lectures 3-4 32
Municipal Bonds (Munis)
• Securities issued by state and local governments to

fund either temporary imbalances between operating
expenditures and receipts or to finance long-term
capital outlays for activities such as school
construction, public utility construction or transportation
systems
• Tax receipts or revenues generated are the source of
repayment
• Attractive to household investors because interest
(but not capital gains) are tax exempt
Lectures 3-4 33
Corporate Bonds
• All long-term bonds issued by

corporations
• Minimum denominations publicly
traded corporate bonds is $1,000
• Generally pay interest
semiannually
Lectures 3-4 34
Bond Ratings
• Bonds are rated by the issuer’s default

risk
• Large bond investors, traders and
managers evaluate default risk by
analyzing the issuer’s financial ratios and
security prices
• Two major bond rating agencies are
Moody’s and Standard & Poor’s (S&P)
• Bonds assigned a letter grade based on
perceived probability of issuer default
Lectures 3-4 35
Lectures 3-4 36
REVIEW
• Which of the following are long-term financial instruments?
a.
A six-month loan
b. A negotiable CD
c. A bankers acceptance
d. A U.S. Treasury bill
e. None of the answers is correct.
•
Which of the following instruments is not traded in a money market?

a.
Eurodollars
b. U.S. Treasury Bills
c. Banker's acceptances
d. Municipal bonds
e. None of the above
Lectures 3-4 37
Stocks
• • Two types of corporate stock exist

▫ Common stock
- the fundamental ownership claim in a public
corporation
▫ Preferred stock
- a hybrid security that has characteristics of
both bonds and common stock
Lectures 3-4 38
Mortgages
• Mortgages are loans to individuals or

businesses to purchase a home, land, or other
real property
• Many mortgages are securitized
▫ securities are packaged and sold as assets
backing a publicly traded or privately held debt
instrument
• Four basic categories of mortgages issued
▫ home, multifamily dwelling, commercial, and
farm
Lectures 3-4 39
Derivative markets
• Derivative markets are the markets where investors trade
derivative instruments like futures and options
• Derivatives (or contingent claims) are securities whose value
depends on the value of some other underlying security.
• Derivatives include forwards, futures, options and swaps.
• A call option is the right to buy—“call away”—a given quantity

of an underlying asset at a predetermined price, called the
strike price (or exercise price), on or before a specific date.
• There is a seller, called an option writer, and a buyer, called an
option holder.
• A put option gives the holder the right but not the obligation to
sell the underlying asset at a predetermined price on or before
a fixed date. The holder can “put” the asset in the hands of the
option writer.
Lectures 3-4 40
Financial Market Rates
• Interest Rates
- An interest rate is a promised rate of return, and
there are as many different interest rates as there are
distinct kinds of borrowing and lending
Rates of return of risky assets

• Many assets do not carry a promised rate of return
Let us consider how to measure the rate of return on
such risky assets
Financial assets normally generate two types of return
for investor: periodic income (dividends or interest
payments) and price change (capital gain/loss)
A holding period return is the return earned from
holding an asset for a single specified period of time.
Lectures 3-4 41
Financial Market Rates
Rates of return of risky assets

• Many assets do not carry a promised rate of return
Let us consider how to measure the rate of return on
such risky assets
Financial assets normally generate two types of return
for investor: periodic income (dividends or interest
payments) and price change (capital gain/loss)
A holding period return is the return earned from
holding an asset for a single specified period of time.
Lectures 3-4 42
Internationalization of Financial Markets
• Foreign Bonds: sold in a foreign country and

denominated in that country’s currency
• Eurobond: bond denominated in a currency
other than that of the country in which it is sold
• Eurocurrencies: foreign currencies deposited
in banks outside the home country
▫ Eurodollars: U.S. dollars deposited in foreign
banks
outside the U.S. or in foreign branches of U.S.
banks
Lectures 3-4 43
Characteristics of a Well-Run
Financial Market
• These markets must be designed to keep
transaction costs low.
• The information the market pools and
communicates must be both accurate and
widely available.
• Investors need protection.
Lectures 3-4 44
Further readings
• Gurley, J., and E. Shaw (1955), “Financial Aspects of Economic
Development,” American Economic Review, Vol. 45, 515-537
• Bencivenga, Valerie R., Bruce D. Smith, and Ross M. Starr. 1996. "Equity
Markets Transactions Costs, and Capital Accumulation: An Illustration." The
World Bank Economic Review 10(2):241-65.
• Levine, Ross. 1991. "Stock Markets, Growth, and Tax Policy." Journal of
Finance 46(4, September):1445-65
• Mayer, Colin. 1988. "New Issues in Corporate Finance." European Economic
Review 32:1167-88
• Devereux, Michael B., and Gregor W. Smith. 1994. "International Risk
Sharing and
Economic Growth." International Economic Review 35(4, August):535-50.
Lectures 3-4 45
Summary
Lectures 3-4 46
Financial Insitutions

Content
1. Some facts about the Depository Institutions

financial structure Insurance Companies
through out the world
Pension Funds
2. Functions of Financial
Finance Companies
Institutions
Mutual Funds
3. Asymmetric
Information Investment Banks
4. The Structure of Private Equity and
Financial Institutions Venture Capital Funds
Understanding Financial Markets and

Institutions
48
Flows of Funds Through the
Financial System
In addition to the lenders and the borrowers,
the financial system has three components:
(1)financial markets, where transactions
take place;
(2)financial intermediaries, who facilitate the
transactions;
(3)regulators of financial activities, who try to
make sure that everyone is playing fair.
In this chapter, we look at each of the
financial institutions and the motivation for
their existence.

Institutions
49
Eight Basic Facts About Financial Structural
Throughout The World
1. Stocks are not the most

important source of
external financing for
businesses.
(External funds = those
obtained from outside the
business it self)
Why is the stock market less
important than other sources
of financing in the United
States and other countries?

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50
Eight Basic Facts About Financial Structrural
2. Issuing marketable Why don't businesses use

debt and equity securities marketable securities more
is not the primary way in extensively to finance their
which businesses finance activities?
their operations.

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51
3. Indirect finance, which Why are financial

involves the intermediaries and indirect
activities of financial finance so important in
financial markets? In recent
intermediaries, is many times
years, indirect finance has
more important than direct been declining in importance.
finance, in which businesses raise Why is this happening?
funds directly from
lenders in financial markets.

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52
4. Financial What makes banks so important to

intermediaries, the workings of the financial system?
particularly banks, are Although banks remain important,
the most important their share of external funds for busi-
source of external nesses has been declining in recent
funds used to finance years. What is driving this decline?
businesses.
Why are financial markets so

5. The financial extensively regulated throughout
system is among the world?
the most heavily
regulated sectors of
the economy.

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53
6.Only large, well- established Why do only large, well-

corporations have easy access known corpora tions find
to securities markets to it easier to raise funds in
finance their activities. securities markets?
7.Collateral is a prevalent Why is collateral such an

feature of debt contracts for important feature of debt
both households and contracts?
businesses.

Institutions
54
8. Debt contracts typically are Why are debt contracts so

extremely complicated legal complex and restrictive?
documents that place
substantial restrictions on the
behavior of the borrower

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55
The Functions of Financial
Intermediaries (FI)
Financial intermediaries
accomplish their roes in a two-
step process:
1.Obtaining funds from lenders
or investors.
2.Lending or investing the funds
that they borrow to those who
need funds.

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56
The Functions of FI
• The role of financial intermediaries is to create

more favorable transaction terms than could
be realized by lenders/investors and
borrowers dealing directly with each other in
the financial market.
• Financial intermediaries include depository
institutions, non-deposit finance companies,
regulated investment companies, investment
banks, and insurance companies.

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57
The Functions of FI
•Transaction costs are a major problem in

financial markets
•Financial intermediaries have evolved to
reduce transaction costs via economies of
scale and expertise.
•Financial intermediaries allow risk sharing and
to reduce information costs.

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58
Transaction costs
•Search costs include expenses to advertise one’s
intention to sell or purchase a financial instrument
and the value of time spent in locating a
counterparty— that is, a buyer for a seller or a
seller for a buyer to the transaction.
•Information costs are costs associated with
assessing a financial instrument’s investment
attributes
 The presence of some form of financial
institutions reduces transaction costs, when there
are conditions that make it difficult for lenders or
investors of funds to deal directly with borrowers of
funds in financial markets.

Institutions
59
Economies of scale &
Expertise
Think about what would happen if commercial

banks did not exist in a financial system.
-> the lenders’/depositers’ maturity is typically
short term
-> the maturity of borrowers may be considerably
long term.

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60
Economies of scale & Expertise
In this scenario, borrowers would have to

either
(1)borrow for a shorter term in order to
match the length of time lenders are willing
to loan funds; or
(2)locate lenders that are willing to invest for
the length of the loan sought.

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61
Economies of scale &
Expertise
•Solution to the problem of high transaction costs is to
bundle the savings of many depositors together so
that they can take advantage of economies of scale.
•Bundling depositors' funds together reduces
transaction costs for each individual depositor.
•There are economies of scale that financial
intermediaries realize in contracting and
processing information about financial assets
because of the amount of funds that they
manage.

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62
Group discussion
Economies of scale & Expertise
Now please explain the economies of

scale in lowering the transaction cost in
term of a mutual fund.
Mishkin (Chapter 8, page 173)

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63
The Functions of FI
Financial Intermediaries’ low transaction
costs allow them to provide at least one of
three economic functions:
1.Maturity intermediation.
2.Risk reduction via diversification.
3.Cost reduction for contracting and
information processing.

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64
Maturity intermediation.
Example:
The commercial bank transforms a longer
term asset into a shorter-term one by giving
the borrower a loan for the length of time
sought and the depositor—who is the
lender—a financial asset for the desired
investment horizon.
 maturity intermediation

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65
Risk reduction
•Financial intermediaries also help
byproviding the means for individuals and
businesses to diversify their asset
holdings.
•Low transaction costs allow them to buy a
range of assets, pool them, and then sell
rights to the diversified pool to individuals.

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66
Risk reduction
Example: A mutual fund

Investors with a small sum to invest would find
it difficult to achieve the same degree of
diversification as a mutual fund because of their
lack of sufficient funds to buy shares of a large
number of companies.
Yet by investing in the mutual fund for the same
dollar investment, investors can achieve this
diversification, thereby reducing risk.

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67
Cost reduction for
information
•In addition to the opportunity cost of the time to
process the information about the financial asset
and its issuer, we must consider the cost of
acquiring that information. Such costs are
information-processing costs.
•FI’s low transaction costs allow to reduce the
information costs of screening and monitoring
borrowers.

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68
Asymmetric Information
•Asymmetric information- a situation that

arises when one party has a different
information set than the other.
•Adverse selection is asymmetric
information before the transaction takes
place.
•Moral hazard is asymmetric information
after the transaction takes place.

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69
Adverse Selection:
The Lemons Problem
•If quality cannot be

assessed, the buyer is
willing to pay at most a price
that reflects the average
quality.
•Sellers of good quality items
will not want to sell at the
price for average quality
•The buyer will decide not to
buy at all because all that is
Lemon and Peach
left in the market is poor
quality items.

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70
Adverse Selection
The Lemons Problem
•Owner of lemon is more than happy to

sell it; few people want to buy a lemon,
there will be few sales.
•Owner of peach knows that the car is
undervalued; he may not want to sell it.
•The used-car market will function poorly,
if at all.

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71
Adverse Selection
In the Stock Markets
If high and low quality stocks are difficult to
distinguish, potential buyers will be willing to pay
the average price.
•Owners who know their profit potential is high
and their risk is low will not offer their stock.
•Owners with low profit horizon and high risk will
be happy to sell.
•Overabundance of lemons in the stock market
will discourage lenders to enter the market.

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72
Adverse Selection
In the Bond Markets
•Adverse selection is a problem in bond markets

when default risk is significant.
•A firm may know that its true default risk is higher
or lower than the public thinks. If it is higher, then
issuing bonds is a good deal, because the firm
pays an interest rate below what it should pay
given the true risk.
•Once again, low-quality securities can flood
the market, causing it to break down.
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73
Adverse Selection
•Few bonds are likely to Adverse selection problem
sell in this market, so it explains partly Puzzle #1
will not be a good and Puzzle #2.
source of financing ▫ Puzzle #1: Stocks are not
•The presence of the the most important source
lemons problem keeps of external finance.
securities markets such ▫ Puzzle #2: Issuing
as the stock and bond marketable debt and equity
markets from being securities is not the
effective in channeling primary source of
funds from savers to financing.
borrowers

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74
Solving Adverse Selection
Private Production and Sale of Information

•Providing the information to the buyers
•If purchasers of securities can distinguish good firms from
bad, they will pay the full value of securities issued by good
firms, and good firms will sell their securities in the market.
•Private firms might collect and sell the needed information.
 Ex: Standard&Poor's, Moody's, and Value Line
•Free-rider problem would cut into their earnings and sub-
optimal information would be generated.

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75
Free rider problem
•The free-rider problem occurs when

people who do not pay for information,
take advantage of the information that
other people have paid for.
•The free-rider problem suggests that the
private sale of information will be only a
partial solution to the lemons problem.
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76
Government Regulation to Increase

Information
Government would regulate the market and require

firms to supply information. This solves the public
good problem and the political problem of having to
reveal harmful data.
•Explanation of Puzzle #5: Financial system is
the most heavily regulated sector of the
economy.

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77
Financial Intermediation
•Financial intermediaries collect information
about firms and loan them the funds
provided by their depositors. Because the
loan process is private and loans are not
traded, there is no free-rider problem.
•This explains puzzles #3 and #4: Banks are

the most important source of external funds.

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78
The role of Banks

•The less information available about firms, the
more prominent banks will be in the financial
system.
The smaller role played by securities markets leaves
a greater role for financial intermediaries such as
banks.
Puzzle #4: Banks are the most important source of
external funds.
The better known a corporation is, the more
information about its activities is available in the
marketplace.
This explains puzzle # 6: Only large, well-
established corporations have access to direct
finance.
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79
Collateral and Net Worth

•Collaleral , property promised to the lender if the bor-
rower defaults, reduces the consequences of adverse
selection because it reduces the lender's losses in the
event of a default.
•Puzzle 7: The presence of adverse selection in credit
markets thus provides an explanation for why
collateral is an important feature of debt con tracts. It
reduces the risk from lack of knowledge for the lender.
•A firm with high net worth (assets – liabilities) will be
able to pay the loan even if the business goes sour.
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80
Moral Hazard
• Moral hazard is the asymmetric information
problem that occurs after the financial
transaction takes place, when the seller of a
security may have incentives to hide
information and engage in activities that are
undesirable for the purchaser of the security.

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81
Moral Hazard in Equity Contract
The Pricipal – AgentProblem

•Equity contracts, such as common stock, are claims in the
profits.
•When managers own only a small fraction of the firm they
work for, the stockholders who own most of the firm's equity
(called the principals) are not the same people as the
managers of the firm, who are the agents of the owners.
•The principal-agent problem, which is an example of moral
hazard, arises only because a manager has more
information about his activities than the stockholder does-
that is, there is asymmetric information.

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82
Solving Moral Hazard of Equity
The Principal – Agent Problem
•The question of trust would make

savers rely more on debt instruments
than stocks.
•Board of Trustees, Board of Governors,
Board of Directors are supposed to
monitor the activities of the managers.

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83
Solving Moral Hazard
The activities of agents need to be monitored.
•Monitoring might be costly.

•Monitoring may lead to free-rider problem and
collapse.
▫ Some owners do the monitoring and others
enjoy the outcome.
•Less demand for stocks compared to
bonds.

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84
Solving Moral Hazard
Government Regulation to increase

Information
Imposing regulation to have standard accounting
principles, the government tries to make
monitoring easier.
•Venture capital firms are financial intermediaries
that monitor the activities of the firms by being
on the Board of Directors.
•Owning a stock requires monitoring; owning
a bond doesn’t. Debt is more prevalent as
external finance.

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85
Moral Hazard for Lenders
Debt Contract
•The debt contract has exactly these attributes
because it is a contractual agreement by the
borrower to pay the lender fixed dollar
amounts al periodic intervals.
•When the firm has high profits, the lender
receives the contractual payments and does
not need to know the exact profits of the firm.

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86
Debt Contract
•Net Worth and Collateral
•Monitoring and Enforcement of Restrictive Covenants
1.Covenants to discourage undesirable behavior
Loan can only be used in specific activities.
2.Covenants to encourage desirable behavior.
Life insurance may be required.
3.Covenants to keep collateral valuable.
Collateral’s value is protected by insurance.
4.Covenants to provide information.
Periodic auditing of the borrower.
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87
Financial intermediaries, particularly banks
▫ extend non-tradable loans and reduce
the problem of free-rider under
marketable debt.
▫ Reduce the costs of monitoring.

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89
The Structure of the Financial Industry
We can divide intermediaries into two broad

categories:
▫ Depository institutions,
-Take deposits and make loans
- What most people think of as banks
▫ Non-depository institutions.
-Include insurance companies, securities firms,
mutual fund companies, etc.

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91

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92
A Map of the U.S. FinancialSystem

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93
How much
each sector contributes to the
gross domestic product (GDP)?

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94
Depository institutions
•Depository institutions take deposits and
make loans
•Depository institutions include
commercial banks and thrifts.
•Thrifts include savings and loan
associations, savings banks, and credit
unions.

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95
Commercial banks
Commercial banks are the largest type of

depository institution
A commercial bank is a financial
institution that is owned by shareholders,
and engages in accepting deposits and
lending for a profit.
A bank may be owned by a bank holding
company (BHC), which is a company
that owns one or more banks.
Institutions
96
BHC in the USA
The five largest bank holding companies in the United States as
of September 30, 2009, and their total assets in billions
according to the Federal Reserve System, National Information
Center are:
Bank of America $2.253
J.P.Morgan Chase & Company $2.041
Citigroup $1.889
Wells Fargo & Company $1.229
Goldman Sachs Group $ 883

Institutions
97
Bank Fundings
•Banks are highly leveraged financial institutions,
meaning that most of their funds come from borrowing.
•One form of borrowing includes deposits.
•There are four types of deposit accounts issued by
banks:
demand deposits,
 savings deposits,
time deposits and
money market demand accounts.

Institutions
98
Nondepository Financial Institutions
Contractual Savings Institutions
Insurance Companies
Contractual savings institutions, such as

insurance companies and pension funds,
are financial intermediaries that acquire funds
at periodic intervals on a contractual basis.

Institutions
99
Insurance Companies
•Insurance companies provides various forms
of insurance and investment services to
individuals and charge a fee, called a
premium, for this service
•In general, the insurance provides a payment
to the insured (or a named beneficiary) under
conditions specified by the insurance policy
contract.

Institutions
100
Insurance Companies
Insurance companies offer two types of
insurance:
▫ Life insurance.
▫ Property and casualty insurance.
While a single company may provide
both kinds of insurance, the two
businesses operate very differently.

Institutions
101
Insurance Companies
• Life insurance comes in two basic forms.

Term life insurance provides a payment to the
policy holder’s beneficiaries in the event of the
insured’s death at any time during the policy’s term.
◦Generally renewable every year as long as
the policyholder is less than 65 years old.
Whole life insurance is a combination of term life
insurance and a savings account.
◦The policyholder pays a fixed premium over
his/her lifetime in return for a fixed benefit
when the policyholder dies

Institutions
102
Insurance Companies
•Car insurance is an example of property and casualty
insurance.
▫ It is a combination of
Property insurance on the car itself, and
Casualty insurance on the driver, who is protected against liability
for harm or injury to other people or their property.
•Holders of property and casualty insurance pay premiums in
exchange for protection during the term of the policy.

Institutions
103
Insurance Companies
Balance Sheet
On the balance sheets of insurance companies,
these promises to
policyholders show up as liabilities.
On the asset side, insurance companies hold a
combination of stocks and bonds.
Property and casualty companies profit from the
fees they charge for administering the policies they
write.
Because assets are essentially reserves against
sudden claims, they have to be liquid.
Institutions
104
Life insurance vs Proverty and
casualty insurers
◦Life insurance companies hold assets of

longer maturity than property and casualty
insurers.
▫ Because more life insurance payments will be
made well into the future, this better matches the
maturity of the companies’ assets and liabilities.
▫ As a result, life insurance companies hold
mostly bonds.

Institutions
105
Insurance Companies
• Adverse selection and moral hazard create

significant problems in the insurance market.
• A person with terminal cancer has an incentive
to buy life insurance for the largest amount
possible - that’s adverse selection.
• Without fire insurance, people would have
more fire extinguishers in their houses - that’s
moral hazard.

Institutions
106
Insurance companies
Insurance companies work hard to reduce both
adverse selection
and moral hazard.
▫ A person wanting life insurance needs a
physical exam.
▫ People who want auto insurance must
provide their driving records.
▫ Policies also include restrictive covenants
that require the insured to engage or not to
engage in certain activities.

Institutions
107
Insurance companies
Insurance companies might also require
deductibles.
▫ These require the insured to pay the initial
cost of repairing accidental damage, up to
some maximum amount.
Or they may require coinsurance.
▫ This is where the insurance company shoulders
a percentage of the claim, usually 80 or 90
percent and the insured assumes the rest.

Institutions
108
Pension fund
•A pension fund offers people the ability to
make premium payments today in exchange
for promised payments under certain future
circumstances.
▫ They provide an easy way to make sure that a
worker saves and has sufficient resources in old
age.
▫ They help savers to diversify their risk.
•By pooling the savings of many small
investors, pension funds spread the risk.

Institutions
109
Pension Funds
• People can use a variety of methods to
save for retirement, including employer
sponsored plans and individual savings
plans.
• Many employer-sponsored plans require a

person work for a certain number of years
before qualifying for benefits, a processcalled
vesting.
Institutions
110
Finance Companies
•Finance companies are in the lending business.

•They raise funds directly in the financial markets
by issuing commercial paper and securities and
then use them to make loans to individuals and
corporations.
•They borrow in large amounts but often lend in
small amounts—a process quite different from that
of banking institutions, which collect deposits in
small amounts and then often make large loans

Institutions
111
Finance Companies
Finance companies are particularly good
at:
▫ Screening potential borrowers’
creditworthiness,
▫ Monitoring their performance during the
term of the loan, and
▫ Seizing collateral in the event of a
default.

Institutions
112
Finance Companies
Most finance companies specialize
in one of three loan types:
▫ Consumer loans,
▫ Business loans, and
▫ What are called sales loans.
▫ Some also provide commercial
and home mortgages.

Institutions
113
Finance Companies
•Consumer finance firms provide small
installment loans to individual consumers.
•Business finance companies provide loans
to businesses.
▫ Business finance companies also provide
both inventory loans and accounts receivable
loans.
•Sales finance companies specialize in larger
loans for major purchases, such as automobiles.

Institutions
114
Securities Firms
Brokerage Firms,
Mutual Funds,
Investment Banks
◦The primary services of brokerage firms are:

▫ Accounting (to keep track of customers’
investment balances),
▫ Custody services (to make sure valuable
records such as stock certificates are safe),
and
▫ Access to secondary markets (in which
customers can buy and sell financial
instruments).
Institutions
115
Brokerage Firms,
Brokers also provide loans to customers who wish to
purchase stock on margin.
▫ They provide liquidity, both by offering check-writing
privileges with their investment accounts and by allowing
investors to sell assets quickly.

Institutions
116
Mutual Funds
•These financial intermediaries acquire funds by
selling shares to many individuals and use the
proceeds to purchase diversified portfolios of
stocks and bonds.
•Mutual funds allow shareholders to pool their
resources so that they can take advantage of lower
transaction costs when buying large blocks of
stocks or bonds.

Institutions
117
Mutual Funds
Provide an important service for individuals

who wish to invest funds and diversify
•Offer liquidity if they are willing to
repurchase an investor’s shares upon
request.
•Offer various different services, such as
transfers between funds and check-writing
privileges.

Institutions
118
Mutual Funds
Open-end funds:
•Are open to investment from investors at any time
•Allow investors to purchase or redeem shares at any
time
• the number of fund shares is not fixed.
•All new investments into the fund are purchased at the
•The total number of shares in the fund increases if
more investments than withdrawals are made during
the day, and vice versa.

Institutions
119
Mutual Funds
Closed-end funds:
•do not issue additional shares or redeem shares.
•the number of fund shares is fixed at the number sold at
issuance (i.e., at the time of the initial public offering).
•investors who want to sell their shares or investors who
want to buy shares must do so in the secondary market
where the shares are traded (either on an exchange or
in the over-the-counter market).

Institutions
120
Mutual Funds
Money market mutual funds:
▫ Are portfolios of money market
instruments constructed and managed by
investment companies
▫ Allow investors to participate for as little as
$1,000
▫ Usually allow check-writing privileges
•Other funds include venture capital funds,
real estate investment trust…

Institutions
121
Investment Banks
As with commercial banks, investment banks are highly
leveraged entities that play important roles in both the
primary and secondary markets.
Investment banking activities include:
Raising funds through public offerings and private
placement of securities.
Trading of securities.
Mergers, acquisitions, and financial restructuring
advising.
Merchant banking.
Securities finance and prime brokerage services.

Institutions
122
Investment Banks
Examples of bank holding companies, referred to as
bank-
affiliated investment banks, are
Banc of America Securities (a subsidiary of Bank of
America),
JPMorgan Securities (a subsidiary of JPMorgan
Chase), and
Wachovia Securities (a subsidiary of Wells Fargo),
and Goldman Sachs.

Institutions
123
Investment Banks
The underwriter guarantees the price of a new issue and
then sells it to investors at a higher price.
▫ This is a practice called placing the issue.

•The underwriter profits from the difference between the
price guaranteed to the firm that issues the security and
the price at which the bond or stock is sold to investors.

Institutions
124
Investment Banks
•Investment banks also provide advice to firms that
want to merge with or acquire other firms.
▫ Investment bankers do the research to identify

potential mergers and acquisitions and estimate the
value of the new, combined company.
•In facilitating these combinations, investment banks

perform a service to the economy.

Institutions
125
Private equity and venture capital funds
Private equity fund makes long-term investments

in companies that are not traded in public markets
•In a private equity fund, investors who are limited

partners (e.g., high-wealth individuals, pension
funds, financial institutions, and college
endowments) place their money with the managing
(general) partners who make the private equity
investments.

Institutions
126
Private equity and venture capital funds
Private equity funds are of two types
▫ Venture capital funds make investments in new
start-up businesses, often in the technology industry
▫ Capital buyout funds make investments in established

businesses, and in many cases, buy publicly traded firms
through a so-called leveraged buyout (LBO), in which the
publicly traded firm is taken private by buying all of its
shares, while financing the purchase by increasing the
leverage (debt) of the firm.

Institutions
127
Try it#: Explaination
• You decide to start a business selling covers
for smartphones in a mall kiosk. To buy
inventory, you need to borrow some funds.
Why are you more likely to take out a bank
loan than to issue bonds?
• What risks might financial institutions face
by funding long-run loans such as
mortgages to borrowers (often at fixed
interest rates) with short-term deposits from
savers?
Institutions
128

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5 Understanding Financial

Markets and Institutions

Mishkin, Chapters 1,2,3 & 8

Understanding Financial Markets and Institutions 1

Understanding Financial Markets and Institutions 2

• Financial markets are markets in

• Financial markets (such as bond and

• Financial markets provide liquidity

• Financial markets also improve the wealth of individual

• Studies found the the relationship between financial

• Debt and Equity Markets

• A firm an obtain funds in a financial markets

• Primary markets are financial markets in which new

• Secondary markets are markets in which existing

• Exchanges are markets where buyers and

• Over-the-counter (OTC) markets are markets,

• Money markets are markets for short-term,

• Capital markets are markets for intermediate-

They mature in one year or less from their

• Investors in Money Market: Provides a

• Borrowers from money market provide

• are the short-term debt intruments of the

• Discount rate (DR)

• Short-term funds transferred (loaned or borrowed)

• Borrowing and lending of bank reserves on deposit with

• These work similar to the market for fed

• A bank-issued security that

• Unsecured promissory notes, issued by corporations,

• There are two major types of commercial

• An order to pay a specified amount to the

• These are often used when buyers /

• Eurodollars represent Dollar denominated

• The market is essential since many foreign

•Capital market instruments

• A bond is a promise to make periodic

• T-notes and T-bonds issued by the U.S. treasury to

• Securities issued by state and local governments to

• All long-term bonds issued by

• Bonds are rated by the issuer’s default

Which of the following instruments is not traded in a money market?

• • Two types of corporate stock exist

• Mortgages are loans to individuals or

• A call option is the right to buy—“call away”—a given quantity

Rates of return of risky assets

Rates of return of risky assets

• Foreign Bonds: sold in a foreign country and

Understanding Financial Markets and Institutions 47

1. Some facts about the Depository Institutions

Understanding Financial Markets and

Understanding Financial Markets and

1. Stocks are not the most

Understanding Financial Markets and

2. Issuing marketable Why don't businesses use

Understanding Financial Markets and

3. Indirect finance, which Why are financial

Understanding Financial Markets and

4. Financial What makes banks so important to

Why are financial markets so

Understanding Financial Markets and

6.Only large, well- established Why do only large, well-

7.Collateral is a prevalent Why is collateral such an

Understanding Financial Markets and

8. Debt contracts typically are Why are debt contracts so