Chapter One

Introduction
 Why study Financial Markets and
Institutions?

•• They
They are
are the
the cornerstones
cornerstones of of the
the
overall
overall financial
financial system
system inin which
which
financial
financial managers
managers operate
operate
•• Individuals
Individuals use
use both
both for
for investing
investing
•• Corporations
Corporations and and governments
governments use use
both
both for
for financing
financing

1-2
 Overview of Financial Markets

•• Primary
Primary Markets
Markets versus
versus Secondary
Secondary
Markets
Markets
•• Money
Money Markets
Markets versus
versus Capital
Capital
Markets
Markets
•• Foreign
Foreign Exchange
Exchange Markets
Markets

1-3
 Primary Markets versus Secondary
Markets

•• Primary
Primary Markets
Markets
–– markets
markets inin which
which users
users of
of funds
funds (e.g.
(e.g.
corporations,
corporations, governments)
governments) raiseraise funds
funds by
by
issuing
issuing financial
financial instruments
instruments (e.g.
(e.g. stocks
stocks and
and
bonds)
bonds)
•• Secondary
Secondary Markets
Markets
–– markets
markets where
where financial
financial instruments
instruments are
are traded
traded
among
among investors
investors (e.g.
(e.g. NYSE,
NYSE, NASDAQ)
NASDAQ)

1-4
Money Markets versus Capital Markets

•• Money
Money Markets
Markets
–– markets
markets that
that trade
trade debt
debt securities
securities with
with
maturities
maturities of
of one
one year
year or
or less
less (e.g.
(e.g. CD’s,
CD’s, U.S.
U.S.
Treasury
Treasury bills)
bills)
•• Capital
Capital Markets
Markets
–– markets
markets that
that trade
trade debt
debt (bonds)
(bonds) and
and equity
equity
(stock)
(stock) instruments
instruments with
with maturities
maturities of
of more
more
than
than one
one year
year

1-5
 Money Market Instruments
Outstanding, 1990-2004 ($Bn)
2000

1500

1000

500

0
1990 2000 2004

Commercial paper Fed Funds and Repo U.S. T-bills

Negotiable CDs Banker's accept.

1-6
 Capital Market Instruments
Outstanding, 1990-2004 ($Bn)
20000

15000

10000

5000

0
1990 2000 2004
Corporate stocks Mortgages Corporate bonds

Treasury Securities State & Local Govt. bonds U.S. Govt agencies

Bank and consumer loans

1-7
 Foreign Exchange Markets

•• “FX”
“FX” markets
markets deal
deal inin trading
trading oneone currency
currency
for
for another
another (e.g.
(e.g. dollar
dollar for
for yen)
yen)
•• The
The “spot”
“spot” FX
FX transaction
transaction involves
involves the
the
immediate
immediate exchange
exchange of of currencies
currencies at at the
the
current
current exchange
exchange rate
rate
•• The
The “forward”
“forward” FXFX transaction
transaction involves
involves the
the
exchange
exchange ofof currencies
currencies at at aa specified
specified date
date in
in
the
the future
future and
and at
at aa specified
specified exchange
exchange rate
rate
1-8
 Derivative Security Markets

•• The
The markets
markets in in which
which derivative
derivative
securities
securities trade.
trade.
•• Derivative
Derivative Security
Security
–– An
An agreement
agreement between
between twotwo parties
parties to
to exchange
exchange
aa standard
standard quantity
quantity of
of an
an asset
asset at
at aa
predetermined
predetermined price
price on
on aa specified
specified date
date in
in the
the
future.
future.

1-9
 Overview of Financial Institutions

•• Institutions
Institutions that
that perform
perform the the essential
essential
function
function ofof channeling
channeling fundsfunds from
from those
those
with
with surplus
surplus funds
funds toto those
those with
with shortages
shortages
of
of funds
funds (e.g.
(e.g. banks,
banks, thrifts,
thrifts, insurance
insurance
companies,
companies, securities
securities firms
firms and
and
investment
investment banks,
banks, finance
finance companies,
companies,
mutual
mutual funds,
funds, pension
pension funds)
funds)
1-10
 Flow of Funds in a World without FIs:
Direct Transfer
Financial Claims
(Equity and debt
instruments)
Users of Funds Suppliers of
(Corporations) Funds
(Households)
Cash

Example: A firm sells shares directly to investors without

going through a financial institution.

1-11
 Flow of Funds in a world with FIs:
Indirect transfer

FI
Users of Funds Suppliers of Funds
(Brokers)

Cash FI
(Asset Cash
transformers)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and insurance policies)

1-12
 Types of FIs

•• Commercial
Commercial banks banks
–– depository
depository institutions
institutions whose
whose major
major assets
assets are
are
loans
loans and
and major
major liabilities
liabilities are
are deposits
deposits
•• Thrifts
Thrifts
–– depository
depository institutions
institutions inin the
the form
form of
of savings
savings
and
and loans,
loans, credit
credit unions
unions
•• Insurance
Insurance companies
companies
–– financial
financial institutions
institutions that
that protect
protect individuals
individuals
and
and corporations
corporations from
from adverse
adverse events
events

(continued)
1-13
•• Securities
Securities firms
firms andand investment
investment banksbanks
–– financial
financial institutions
institutions that
that underwrite
underwrite securities
securities
and
and engage
engage inin securities
securities brokerage
brokerage and
and trading
trading
•• Finance
Finance companies
companies
–– financial
financial institutions
institutions that
that make
make loans
loans to
to
individuals
individuals and
and businesses
businesses
•• Mutual
Mutual Funds
Funds
–– financial
financial institutions
institutions that
that pool
pool financial
financial
resources
resources and
and invest
invest in
in diversified
diversified portfolios
portfolios
•• Pension
Pension Funds
Funds
–– financial
financial institutions
institutions that
that offer
offer savings
savings plans
plans for
for
retirement
retirement
1-14
 Services Performed by Financial
Intermediaries

•• Monitoring
Monitoring Costs
Costs
•• Liquidity
Liquidity and
and Price
Price Risk
Risk
•• Transaction
Transaction Cost
Cost Services
Services
•• Maturity
Maturity Intermediation
Intermediation
•• Denomination
Denomination Intermediation
Intermediation

1-15
Services Provided by FIs Benefiting the
Overall Economy

•• Money
Money Supply
Supply Transmission
Transmission
•• Credit
Credit Allocation
Allocation
•• Intergenerational
Intergenerational Wealth
Wealth Transfers
Transfers
•• Payment
Payment Services
Services

1-16
 Risks Faced by Financial Institutions

•• Interest
Interest Rate
Rate Risk
Risk
•• Foreign
Foreign Exchange
Exchange Risk
Risk
•• Market
Market Risk
Risk
•• Credit
Credit Risk
Risk
•• Liquidity
Liquidity Risk
Risk
•• Off-Balance-Sheet
Off-Balance-Sheet Risk
Risk
•• Technology
Technology Risk
Risk
•• Operational
Operational Risk
Risk
•• Country
Country oror Sovereign
Sovereign Risk
Risk
•• Insolvency
Insolvency Risk
Risk
1-17
 Regulation of Financial Institutions

•• FIs
FIs provide
provide vital
vital financial
financial services
services toto
all
all sectors
sectors ofof the
the economy;
economy; therefore,
therefore,
their
their regulation
regulation is is in
in the
the public
public interest
interest
•• In
In an
an attempt
attempt to to prevent
prevent their
their failure
failure
and
and the
the failure
failure of
of financial
financial markets
markets
overall
overall

1-18
Globalization of Financial Markets and
Institutions

•• Financial
Financial Markets
Markets became
became more
more
global
global as
as the
the value
value ofof stocks
stocks traded
traded in
in
foreign
foreign markets
markets soared
soared
•• Foreign
Foreign bond
bond markets
markets havehave served
served as
as
aa major
major source
source of
of international
international capital
capital
•• Globalization
Globalization also
also evident
evident in
in the
the
derivative
derivative securities
securities market
market
1-19
 Factors Leading to Significant Growth
in Foreign Markets
•• The
The pool
pool of
of savings
savings from
from foreign
foreign investors
investors has
has
increased
increased
•• International
International investors
investors have
have turned
turned toto U.S.
U.S. and
and other
other
markets
markets to
to expand
expand their
their investment
investment opportunities
opportunities
•• Information
Information on on foreign
foreign investments
investments and and markets
markets isis
now
now more
more accessible
accessible (e.g.
(e.g. internet)
internet)
•• Some
Some mutual
mutual funds
funds allow
allow ability
ability to
to invest
invest in
in foreign
foreign
securities
securities with
with low
low transaction
transaction costs
costs
•• Deregulation
Deregulation hashas enhanced
enhanced globalization
globalization of of capital
capital
flows
flows
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