Chapter One

Introduction to
Financial Markets
and Institutions

©2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written
consent of McGraw-Hill Education.
 Why Study Financial Markets and
Institutions? 1

Markets and institutions are primary channels to

allocate capital in our society.

• Proper capital allocation leads to growth in:

• Societal wealth.
• Income.
• Economic opportunity.

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 Why Study Financial Markets and
Institutions? 1

Question 1:

Suppose you have shares of stock of Jollibee or corporate bonds

and you are in dire need of cash for your current consumption,
where do you go?

Question 2:

How do you think Jollibee and other institutional borrowers

were able to raise this huge amount of capital to finance its long-
term projects?
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 Financial Markets

• Financial markets are one type of structure

through which funds flow.

• Financial markets can be distinguished along two

dimensions:
• primary versus secondary markets.
• money versus capital markets.

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 Primary versus Secondary Markets 1

Primary markets.
• Markets in which users of funds (e.g., corporations) raise
funds by issuing new financial instruments (e.g., stocks
and bonds).
Secondary markets.
• Markets where existing financial instruments are traded
among investors (e.g., exchange traded: NYSE and over-
the-counter: NASDAQ).

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 Primary versus Secondary Markets 2

Figure 1-2 Primary and secondary Market Transfer of

Funds Time Line

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 Primary Markets 1

What is underwriting?

• Underwriting is the process through which an institution

takes on a financial risk for entities that need financing
(either through debt or equity) for a fee.

• The underwriter (usually an investment bank) guarantees

that the users of funds will be able to raise the required
amount of capital it needs.

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 Primary Markets 1

What is underwriting?

• The underwriter sets the offer price, as well as the total

number of securities to be issued by the fund user (based
on a prospectus).

• The underwriter then buys the securities from the

original issuer and then resell it to potential investors.

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 Primary Markets 1

What is underwriting?

• The underwriter is therefore subject to price risk, or the

risk that it may not be able to resell the securities at a
price it had paid to the fund users.

• The underwriter may assume risk for the shortfall.

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 Primary Markets 1

What are examples of primary market

transactions?

• Initial public offering (IPO), or the first public issue of a

financial instrument by a firm.

• Normally, underwriters are willing to accept the risks

involved in an IPO due to the fact that most IPOs are
oversubscribed, where demand is greater than the
supply.
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 Primary Markets 1

What are examples of primary market

transactions?

• Issuance of additional securities by previously publicly-

listed entity

• Normally, these additional securities come from its

unissued capital.

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 Secondary Markets 1

What are characteristics of secondary market

transactions?

• It provides an avenue for investors to sell their

financial instruments at its fair value (liquidity)

• It also provides potential fund users who were

not able to capitalize on the IPO to have access to
financing.
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 Secondary Markets 1

What are characteristics of secondary market

transactions?

• Secondary markets increase the flow of capital by

providing access to fund users to raise financing,
and for savers to invest their surplus fund to earn
returns outside of the original issuance.

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 Secondary Markets 1

What are characteristics of secondary market

transactions?

• The original issuer of the securities is not directly

involved in the secondary market transactions,
meaning, the cash flows will not flow to them
anymore.

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 Secondary Markets 1

What are characteristics of secondary market

transactions?

• However, secondary market transactions benefits

the original issuer in terms of:
 Obtaining valuable information about the
corporation’s value, as perceived by the investors
(also known as market capitalization)
 Helpful in raising additional capital in the future.
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 Money versus Capital Markets

Money markets.
• Markets that trade debt securities with maturities of one year or
less (e.g., CDs and U.S. Treasury bills).
• little or no risk of capital loss, but low return.

Capital markets.
• Markets that trade debt (bonds) and equity (stock) instruments with
maturities of more than one year.
• substantial risk of capital loss, but higher promised return.
Figure 1.3

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 Money Market Instruments
Outstanding, ($Tn)
Figure 1-4 Money Market Instruments Outstanding.

Source: Federal Board, “Financial Accounts of the United States,” Statistical

Releases, Washington, DC, various issues, www.federalreserve.gov.
Access the long description slide. 1-17
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 Capital Market Instruments
Outstanding, ($Tn)
Figure 1-5 Capital Market Instruments Outstanding.

Source: Federal Reserve Board, “Financial Accounts of the United States,” Statistical
Releases, Washington, DC, various issues. www.federalreserve.gov.
Access the long description slide. 1-18
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 Money versus Capital Markets

• When interest rates are rising, both businesses and

consumers will cut back on spending, as it will be
more expensive to borrow money. This will cause
earnings to fall and it may have a negative impact on
investors. Therefore, stock prices drop.

• On the other hand, when interest rates have fallen

significantly, consumers and businesses will increase
spending, causing stock prices to rise.
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 Foreign Exchange (FX) Markets

FX markets.
• trading one currency for another (e.g., dollar for yen).

Spot FX.
• the immediate exchange of currencies at current exchange rates.

Forward FX.
• the exchange of currencies in the future on a specific date and at a
pre-specified exchange rate.

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 Derivative Security Markets 1

Derivative security.

• A financial security whose payoff is linked to (i.e., “derived” from)

another, previously issued security such as a security traded in
capital or foreign exchange markets.
• Generally an agreement to exchange a standard quantity of assets at a
set price on a specific date in the future.

• The main purpose of the derivatives markets is to transfer risk

between market participants.

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 Derivative Security Markets 2

Selected examples of derivative securities.

• Exchange listed derivatives.
• Many options, futures contracts.
• Over the counter derivatives.
• Forward contracts.
• Forward rate agreements.
• Swaps.
• Securitized loans.

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 Financial Market Regulation

The Securities Act of 1933.

• Full and fair disclosure and securities registration.

The Securities Exchange Act of 1934.

• Securities and Exchange Commission (SEC) is the main
regulator of securities markets.

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 Financial Market Regulation

Objective of regulation of financial markets:

• Advocate full and fair disclosure of information on

securities issues to actual and potential investors.

• Protect investors by ensuring they have all the available

information needed in making important investment
decisions.

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 Financial Institutions (FIs)

Financial Institutions.
• Institutions through which suppliers channel money to users
of funds.

Financial Institutions are distinguished by:

• Whether they accept insured deposits.
• Depository versus non-depository financial institutions.
• Whether they receive contractual payments from customers.

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 Non-Intermediated (Direct) Flows of
Funds

Flow of Funds in a World without FIs

Direct Financing
Financial Claims (equity and debt instruments)

Access the long description slide. 1-26

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 Non-Intermediated (Direct) Flows
of Funds

• What are the disadvantages of direct transfer of

funds?

• Costly monitoring of the fund users’ performance

(need of an agent who will do the monitoring on
behalf of the investors)

• Illiquid (need of an avenue to convert these securities

to cash if the need arises or an agent that will create
new liquid securities)
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 Non-Intermediated (Direct) Flows
of Funds

• What are the disadvantages of direct transfer of

funds?

• Not being able to convert it to cash and hold it for a

long period of time, it is subject to various risks (need
of an agent who is willing to manage these risks
incorporated in these securities)

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 Intermediated Flows of Funds

Flow of Funds in a World with FIs.

Access the long description slide.

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 Depository versus Non-Depository FIs

Depository institutions:
• commercial banks, savings associations, savings banks, credit
unions.
Non-depository institutions.
• Contractual:
• insurance companies, pension funds,
• Non-contractual:
• securities firms and investment banks, mutual funds.

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 FIs Benefit Suppliers of Funds

• Reduce monitoring costs.

• Financial institutions act as delegated monitors, or an

economic agent appointed to act on behalf of smaller
investors in collecting information and/or investing funds on
their behalf.

• FIs pool funds from various retail and institutional clients

(fund suppliers) to meet the capital needed by fund users.

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 FIs Benefit Suppliers of Funds

• Provide increased liquidity

• Financial institutions act as asset transformers, where FIs

purchases financial claims by fund users (e.g. stocks or bonds)
and repackaging it by selling new types of securities (or also
known as secondary securities), which are more liquid.

• For example, mutual funds buy shares of stock of various

companies. The mutual fund then issues shares of the fund to
potential investors. You are an investor of the mutual fund
and not of the companies whose shares of stock make up
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 FIs Benefit Suppliers of Funds

• Examples of increased liquidity provided by FIs

• Mutual funds buy treasury or high-quality corporate bonds or

equities of various companies and pool it in a fund. The mutual
fund then issues shares of the fund to potential investors.

• Banks allow policyholders to borrow against their insurance

policies. The insurance policy serves as a collateral for the loan.

• Insurance companies allow policyholders to withdraw a portion

of the policy’s cash surrender value for current consumption.

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 FIs Benefit Suppliers of Funds

• Reduce transaction costs.

• Through “economies of scale”, where the cost of trading and

transaction services are reduced due to the FIs’ increased
efficiency and overall expertise in performing these services.

• Transaction costs arising from issuance of secondary

securities, or collecting information from the fund users are
minimized.

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 FIs Benefit Suppliers of Funds

• Reduce investment risks.

• Ever wonder why banks and other FIs can extend long-term
loans (e.g. 10 years) to an institutional borrower when the
sources of funds are coming from deposits (which can be
withdrawn on demand)?

• The answer lies on two factors: asset transformation and

portfolio diversification

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 FIs Benefit Suppliers of Funds

• Reduce investment risks.

• Through asset transformation, deposits received from clients

are then invested into higher earning securities of varying
risks and maturities.

• Through portfolio diversification, FIs bear the risk of

mismatching maturities, together with the other risks
involved (e.g. credit, liquidity, interest rate, etc.), by holding a
number of different securities in a portfolio.

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 FIs Benefit Suppliers of Funds

• Provide denomination intermediation.

• If Company A needs P100 million to finance its expansion

project, it will be difficult to find a supplier of funds who will
be able to provide this amount in full.

• If Saver B has excess cash to invest, she is discouraged to

invest in Company A’s expansion project because she does
not have enough funds to invest.

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 FIs Benefit Suppliers of Funds

• Provide denomination intermediation.

• FIs play a key role in this situation by pooling a large number

of investors who individually, may not meet the minimum
denomination for this investment.

• Therefore, FIs help small savers overcome constraints to

buying assets imposed by large minimum denomination size.

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 FIs Benefit the Overall Economy

• Conduit through which Federal Reserve conducts

monetary policy.

• Banks being accepted by the public as widely used

medium of exchange in the economy.

• FIs, especially banks, aid in the efficient flow of money

in the economy.

• Various FIs also aid the central bank in effectively

carrying out its monetary policies.
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 FIs Benefit the Overall Economy

• Provides efficient credit allocation.

• FIs being a major source of financing by different

entities in different industries.

• Reduced risk as opposed to unregulated sources of

financing (e.g. pautang, “5-6”, loan sharks)

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 FIs Benefit the Overall Economy

• Provide for intergenerational wealth transfers.

• Ability of savers to transfer wealth from their youth to

old age, as well as across generations is also of great
importance to a country’s social well-being.

• Examples are insurance and pension or retirement

funds.

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 FIs Benefit the Overall Economy

• Provide payment services.

• Provide efficient method of payment by reducing

transaction costs through economies of scale.

• 24/7 online banking which includes payment and wire

transfer services.

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 Risks Faced by Financial Institutions

• Credit. • Off-balance-sheet.
• Foreign exchange. • Liquidity.
• Country or sovereign. • Technology.
• Interest rate. • Operational.
• Market. • Insolvency.

Volcker Rule: Insured

institutions may not engage in
proprietary trading
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 Regulation of Financial Institutions

• FIs are heavily regulated to protect society at large from

market failures.

• Regulations impose a burden on FIs; before the financial

crisis, U.S. regulatory changes were deregulatory in
nature.

• Regulators attempt to maximize social welfare while

minimizing the burden imposed by regulation.

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 Regulation of Financial Institutions

• A society with unregulated FIs may lead to adverse

effects such as widespread capital flight and bank runs,
which may ultimately lead to the collapse of the financial
system, and the nation’s economy, in general.

• FIs, however, are subjected to regulatory risk, or a risk

that a new or a change in regulations or legislation may
adversely affect an entity.

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 Regulation of Financial Institutions

• Regulations such as increase in minimum capital

requirements, restriction as to the products and services
to be offered by FIs, reduction in transaction fees which
may affect FIs total revenue, etc.

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 Recent Trends in Financial Institutions

• Rise of financial services holding companies

• Entities that perform directly or indirectly all financial

services (e.g. investment banking, commercial banking,
securities, insurance) through its subsidiaries.

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 Recent Trends in Financial Institutions

• J.P. Morgan Chase & Co.

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 Recent Trends in Financial Institutions

• The shift away from risk measurement and

management

• A shift in its business model from “originate and hold”

to “originate and distribute”

• “Originate and distribute” involves factoring without

recourse or selling of loans which sell the debt and the
rights to service the loan.
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 Recent Trends in Financial Institutions

• The shift away from risk measurement and

management

• Adverse impact of this trend is the 2008 U.S. Subprime

Mortgage Crisis

• The economy relies on financial institutions to act as

specialists in risk measurement and management.

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 Recent Trends in Financial Institutions

• Enterprise risk management.

• Recognizes the importance of managing the combined

impact of the full spectrum of risks as an interrelated
risk portfolio.

• Popularity rose as a result of the failure of advanced

risk measurement and management systems to detect
exposures that led to the financial crisis.

• Stresses importance of building a strong risk culture.

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 Globalization of Financial Markets and
Institutions

• The pool of savings from foreign investors is increasing and

investors look to diversify globally now more than ever
before.
• Information on foreign markets and investments is becoming
readily accessible and deregulation across the globe is
allowing even greater access to foreign markets.
• International mutual funds allow diversified foreign
investment with low transactions costs.
• Global capital flows are larger than ever.

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 Globalization of Financial Markets and
Institutions

The globalization of financial markets and institutions

emphasizes the need for interdependence on the performance
of each financial markets and institutions, as well as the success
of each country’s fiscal and monetary policies and the
development of each country’s financial system.

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 Globalization of Financial Markets and
Institutions
U.S. Financial Assets Held by Foreign Investors
($16.8 trillion as of first quarter of 2015)

U.S. Government Securities

42% (e.g. Treasury bills and bonds)

19% U.S. Corporate Bonds

38% U.S. Corporate Equities

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 Globalization of Financial Markets and
Institutions

Foreign Financial Assets Held by U.S. Investors

($9.8 trillion as of first quarter of 2015)

23% Foreign bonds

69% Foreign corporate equities

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 Globalization of Financial Markets and
Institutions

Top 10 largest banks in the world (per total assets)

(Assets as of December 31, 2019 per S&P Global)

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