Chapter One

Introduction
Why Study Financial Markets
and Institutions?

 Financial markets and institutions are

primary channels to allocate capital in
our society
 Proper capital allocation leads to growth in:
 Economic efficiency and opportunity

 Wealth and income

Financial Markets

 Financial markets are part of financial

systems through which funds flow
 Each market is created to satisfy specific
purposes for market participants
 Financial markets can be distinguished
along two dimensions:
 primary versus secondary markets
 money versus capital markets
Flow of Funds
 Indirect Finance: less important today
$ Financial
Lenders Intermediaries
Get 5% Pay 10%
interest interest
$
$ Receive 7% Pay 7%
interest Financial interest
Markets Borrowers
$
 Direct Finance: no middleman
Primary versus Secondary
Markets
 Primary markets
 Markets where users of funds (e.g. IBM, corporations)
raise funds by issuing new financial instruments (e.g.
stocks and bonds)
 Securities can be sold only once in a primary market
 Secondary markets
 Markets where all subsequent transaction take place
with existing financial instruments traded among
investors (e.g., exchange traded: Toronto Stock
Exchange and over-the-counter: NASDAQ)
Primary versus Secondary Markets
 Primary markets have limited general public
participation
Exchanges/OTC markets

securities Investor A (buyer)

Corporations cash securities
cash Investor B (seller)

Primary Market Secondary Market

 Secondary markets provide issuers regular

information about the security value
Primary versus Secondary
Markets
 How does the existence of secondary
markets affect primary markets?
 Secondary markets add value to society by
supporting primary markets through:
 Offer primary market purchasers liquidity for their
holdings
 Update the price/value of the primary market claims
 Reduce the cost of trading the primary market claims
 Help investors diversify portfolios to encourage
investment in the primary market
Money versus Capital Markets
 Money markets
 Markets that trade debt securities with maturities of one
year or less (e.g. CDs and 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
Money versus Capital Markets
 Based on maturities of claims:
Debt Securities Equity Securities
(Bonds) (Stock)
Maturity
Maturity greater
within 1 year
than 1 year
or less

Money Market Capital Market

Foreign Exchange (FX) Markets

 FX markets
 trading one currency for another (e.g. dollar for yen)
 Spot FX
 the immediate (i.e. one or two business days) 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
Derivative Security Markets

 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
Global Markets
 From the perspective of a given country
External Market
Internal Market (International Market,
(National Market) Offshore Market,
Euromarket)

Domestic Foreign
Market Market
 Institutionalization of financial markets: the shifting of the
financial markets from dominance by retail investors to
institutional investors
Financial Instruments
 Financial instruments are contracts granting owners
specific rights and claims on specific values
 Cash flows for most instruments are not known with
certainty. Estimating the cash flow is needed for
valuation
 Uses of financial instruments:
 Store of Value: Transfer of purchasing power into the
future
 Transfer of Risk: Transfer of risk from one person or
company to another
 A risk-averse, wealth-seeking investor prefers
financial instruments with high yields, high liquidity,
low denomination, low market risk, low default risk
and low transaction costs.
Attributes of Financial Instruments
 The names of financial instruments, securities,
or financial claims are interchangeable
 What makes a financial instrument valuable?
 Size: Payments (i.e. promises to pay at a future date)
that are larger are more value
 Timing: Payments that are made sooner are more
valuable
 Likelihood: Payments that are more likely to be
honored are more valuable
 Circumstances: Payments that are available when we
need them most are more valuable
Types of Financial Instruments
 According to the nature of claims
 Debt: bank loans, commercial papers, bonds,
mortgages, and Treasury bills
 Equity: common shares, preferred stocks
 Investment Funds: mutual funds, ETFs
 Derivative Products: options, futures, forwards, swaps
 Other Products: insurance policies
 The best way to organize financial instruments is
by whether they are used primarily as stores of
value or for trading risk knowing the distinction
between market instruments and derivative
instruments
Financial Intermediaries
 Middlemen raise money from investors and
provide financing for individuals, corporations, or
other organizations
 Examples include mutual funds, pension funds
 Serve as going-betweens savers and borrowers
 (1) engage in process of indirect finance
 (2) pooling and invest savings (i.e. borrow $1 and
lend $1)
 (3) needed because of transaction costs, different
needs and asymmetric information: higher
information and search costs for bilateral loans
Financial Institutions (FIs)

 Financial Institutions
 Institutions facilitate flow of funds (pool and invest
savings) and perform many other services (e.g.
maturity and time intermediation)
 Financial Institutions are distinguished by:
 Whether they accept insured deposits
 Depository versus non-depository financial
institutions
 Whether they receive contractual payments from
customers
Non-Intermediated Flows of Funds

Flow of Funds in a World without FIs

You borrow $1,000 from your dad

IOU or Financial
Claims
(equity and debt
instruments)
Users of Funds Suppliers of
Funds
Cash
Intermediated Flows of Funds

Flow of Funds in a World with FIs

Intermediated Financing
FIs
Users of Funds Suppliers of Funds
(brokers)

Cash FIs
Cash
(asset
transformers)
Financial Claims Financial Claims
(equity and debt securities) (deposits and insurance policies)
Special Functions of Financial
Intermediaries/Institutions
 Brokerage function
 Acting as an agent for investors:
 e.g. RBC Dominion Securities, CIBC World Markets
 Reduce costs through economies of scale
 Encourage higher rate of savings
 Asset transformer:
 Purchase primary securities by selling financial claims to
households
 These secondary securities often more marketable and desirable
 Secondary claims issued by FIs have less price risk
 FIs are cost-effective in diversifying risks
 If assets are less than perfectly correlated with each other, FIs are
able to reduce the fluctuation in the principal value of the portfolio
Simplified Balance Sheets
Non-financial vs. Financial Enterprises

Business e.g. utility Financial e.g. banks,

Firms companies, car Institutions insurance
manufacturers companies
Assets Liabilities Assets Liabilities
Real assets Primary securities Primary Secondary
(plant, (debt, equity) securities securities
machinery) (debt, equity) (deposits, insurance
policies)
Although different, financial intermediaries all have one
function in common: they purchase financial claims with one set
of characteristics from DSUs and sell financial claims with
different characteristics to SSUs. They also transform more
risky assets into less risky ones
Depository versus Non-Depository FIs

 Depository institutions:
 commercial banks, savings associations, credit unions
 Non-depository institutions
 Credit type:
 Finance companies
 Contractual:
 insurance companies, pension funds,

 Non-contractual:
 securities firms and investment banks, mutual funds.
FIs Benefit Suppliers of Funds

 Reduce monitoring costs

 Increase liquidity and lower price risk
 Reduce transaction costs
 Provide maturity intermediation
 Provide denomination intermediation
FIs Benefit the Overall Economy

 Conduit through which Bank of Canada

conducts monetary policy
 Provides efficient credit allocation
 Provide for intergenerational wealth
transfers
 Provide payment services
Regulation of Financial
Institutions
 FIs are heavily regulated to protect society at
large from market failures
 Regulations impose a burden on FIs; Canadian
regulatory changes were deregulatory in nature
 Regulators attempt to maximize social welfare
while minimizing the burden imposed by
regulation
Dynamic Trends 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
Enterprise Risk Management

 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