Chapter 2

Overview of the
Financial Markets
Who are These Central Bankers and
Where are their Central Banks?
 Who are These Central Bankers and
Where are Their Central Banks?
Federal Reserve (1913)
Washington, DC
Fed funds rate: 0.0 – 0.25;
Inflation target: 2% (2.3%)

Bank of England (1694)

London, U.K.
Bank Rate: 0.5%; Inflation target:
Sir Mervyn King 2% (3%)
Ben Bernanke
Bank of Japan (1882)
Masaaki Shirakawa Tokyo, Japan
Uncollateralized Overnight Call
Rate: 0 - 0.1%; Inflation Target
1% (0.4%)

European Central Bank (1998)

Frankfurt, Germany
Main Refinancing Rate: 2%;
Inflation Target: “Below, but close
Mario Draghi to 2%” (2.4%)
Financial Markets and Financial
Institutions
 How might we study these?
 Terms of specific functions?
 What are Functions of financial markets and financial
institutions?
 Terms of organizations and institutions that
participate in financial markets
 Commercial organizations (commercial banks, investment
banks, pension funds, mutual funds, financial service
providers, etc.).
 Governmental organizations (Central banks, regulatory
organizations --- SEC; FSA)
 Private credit ratings organizations (S&P, Moody’s, Fitch)
 Function of Financial
Markets
 Typical text book definition: “Markets
through which entities with surplus
(excess) financial funds transfer those
surplus funds to entities who have a
shortage (shortfall) of available funds.”
 Stock markets, bond markets, mortgage
markets, Treasury securities, commercial
paper market.
 Functions of Financial
Markets
1- Mechanism for Raising Funds!
 Done in primary financial markets (e.g.,

IPOs --Facebook) with the assistance of

investment banking firms.
2- Mechanism for Converting financial assets
into cash before maturity.
 Done in secondary financial markets

(e.g., NYSE, OTC bond markets)

 Functions of Financial Markets
3- Provides the means for entities to protect
(Hedge) their financial/commercial positions.
 Done in derivatives markets

(options, futures, forwards, credit default

swaps)
4- Mechanism for Generating a return on
surplus funds (Investing).
 Return occurs through interest, dividends,

capital appreciation
 Functions of Financial
Markets
5- Allocates “limited” financial resources
among competing users.
 And, we assume, if done so in the most

efficient manner (i.e., to the most

productive users):
 The process will improve economic
efficiency and
 Result in highest possible economic growth!
 Functions of Financial Markets
6- Provides financial signals to market participants
 Interest rates, stock prices, exchange rates as
measures of market’s perception of risk and changing
risk assessments:
 Stock prices and interest rates may tell us something about
the market’s assessment of companies, financial institutions,
and even overall financial markets: 2008 credit crisis.
 Exchange rates and government interest rate spreads may
tell us something about the market’s assessment of
countries or regions): 2010 – 2012 Crisis in the Euro-zone.
 Perhaps we can use financial market signals as a
leading indicator of economic activity.
 Yield curves, stock prices, central bank rates
Classification of Financial Markets
 Primary Financial Market
 The financial market in which new issues of a security, such as a
bond or a stock, are sold to initial buyers by a corporation or a
government.
 Important financial institution that assists in the initial sale of securities in
the primary market are investment banks. They do this by “underwriting
securities,” i.e., (usually) guaranteeing a price for a corporation’s
securities and then selling them to the public (an IPO).
 Thus, primary financial markets are important for Raising New
Capital.
 Secondary Financial Market
 The financial market in which securities that have been
previously issued can be resold. The New York Stock Exchange
(NYSE) and National Association of Securities Dealers
Automated Quotation System (NASDAQ) are examples for
secondary markets.
 Secondary markets provide Liquidity for previously issued securities:
 Liquidity refers to the ease of conversion of a financial asset into cash (prior to
maturity if there is a maturity date) and how stable the price of the asset is
while being held in a form other than cash.
Classification
Money Markets
of Financial Markets
 The financial markets for short-term debt instruments (generally those
with original maturity of one year or less). As we will see, shorter term
securities have smaller fluctuations in prices than long-term securities,
making them “safer” to invest as well as highly liquid.
 Commercial banks use Treasury bills for their “secondary reserves” to meet
deposit withdrawals and increases in loan demands.
 Corporations and banks use the money market to earn interest on
surplus working capital and to finance working capital shortages.
Institutions, such as money market mutual funds, specialize in acquiring
these assets.
 Money market instruments include: U.S Treasury bills, Commercial
Paper, Bank Certificates of Deposit, and Bankers’ Acceptances.
 Capital Markets
 The financial market for longer-term debt (generally those with maturities
greater than one year) and equity (common stock).
 Long term securities are often held by financial intermediaries such as
insurance companies and pension funds, which have less uncertainty
about the amount of funds they will need in the future.
 These assets are also less liquid (in terms of price stability) than money market
instruments.
 Capital market instruments include: Common Stock, U.S Treasury
bonds, Corporate bonds, and Mortgages
Flow of Funds Through a
Financial System
 Indirect Finance:
 Funds that flow through financial intermediaries, such as
depository institutions, insurance companies and mutual funds.
These institutions work as a channel of indirect financing by
pooling saver funds then invest (or lending) those funds
through to businesses and others that need them.
 Direct Finance:
 Funds that flow directly lenders to borrowers with the
assistance of institutions that provide brokerage services
(research and advice, retirement planning, tax tips, execution of
trades) . These institutions work as a channel of direct financing,
in which businesses and governments can raise funds directly
from lenders in financial markets (IPOs).
Flow of Funds Through a
Financial System
 Why are Financial Intermediaries
Important in Financial Markets?
 Transaction cost: Refers to the time and money spent in carrying out
financial transactions. Financial intermediaries can substantially reduce
transaction costs because they have developed expertise in lowering them, and
because their large size allows them to take advantage of economies of scale.
 Risk sharing: Financial intermediaries sell assets with risk characteristics that
people are comfortable with and then use the funds to purchase other assets that
may have far more risk. This process of risk sharing is called asset
transformation; i.e., risky assets are turned into safer assets for investors.
Another way of risk sharing provided was through diversification; financial
intermediaries invest in a collection of assets whose return do not always move
together, with the result that overall risk is lower than for individual assets.

 Asymmetric information (i.e., where one party has more or better information):
Financial intermediaries are usually better at credit risk screening than
individuals, therefore reducing losses due to wrong investment decision making.
They have developed expertise in monitoring the parties they lend to, thus
reducing losses due to moral risk.
 Moral Risk: The tendency to take on more risk because of the perception that one is
protected from the consequences of doing so.
 Classification of Financial Assets
 (1) Financial assets which represent a claim
on the issuer’s future income and/or assets.
Examples include:
 Bonds: Debt instruments with a contractual
agreement (indenture specifies interest
payment, maturity date, etc.).
 Common Stocks: Instruments representing an
ownership position in a corporation (note this
does not represent a “legal” claim such as a
bond).
 (2) Instruments which are neither debt nor equity based
and thus belong in their own category.
 Foreign Exchange
Classifications of Financial Assets
 Cash instruments are financial assets whose
value is determined directly by financial markets.
 Stock and bonds

 Derivative instruments are financial assets

which derive their value from some other
(underlying) financial instrument (i.e., called the
underlying asset) or variable.
 Futures, forwards, options (puts and calls)
 This market originated in Chicago in the 1850s
(CBOT) for commodities (flour, hay, corn), but
now involves financial assets as well.
Characteristics of a Well Functioning
Financial Market
 (1) Transparency:
 Condition whereby all participants will have
access to reliable and important information at the
same time.
 Importance of financial services providers to
transparency in publishing financial information.
 Dow Jones, Bloomberg, Reuters.
 Importance of reliable accounting data.
 Importance of trading platforms to transparency.
 How quickly is trading information made available?
 Do all potential traders have access to same trading
information (bid and ask prices publicly displayed).
Well Functioning Financial Market
 (2) Adequate Regulation:
 Financial markets need to have regulation which
ensures a level and fair playing field and appropriate
behavior.
 Regulation needs to:
 Encourage quick and full disclosure
 Provide appropriate reporting of financial information to markets
 Discourage unethical behavior: insider trading, price
manipulations. ‫التالعب في االسعار‬
 Issue for regulators:
 A what point does regulation become a cost (excessive)
and/or drive financial service providers to other markets?
 Perhaps regulators need to use a cost – benefit analysis
approach.
 Beginning with the Great Depression of the 1930s,
the U.S. has gone through a series of financial market
regulatory changes.
Real GDP and Inflation During the
Great Depression
Real GDP (1929 = 100) CPI, % Change, YonY
The Unemployment Rate and Bank
Failures During the Great Depression
U.S. Unemployment Rate Number of Banks (1,000’s)
U.S. Financial Market Regulation: the
Aftermath of the Great Depression
 The Policy Responses to the Great Depression
 Over 10,000 banks failed during the Great Depression which
began in October 1929 and continuing until March 1933.
Government policy makers believed the collapse of the financial
system contributed to the length and depth of the recession.
 In February 1932, Congress passed the Banking Act of 1932.
Senator Carter Glass and Representative Henry Steagall coauthored
the legislation, which became known as the Glass-Steagall Act.
 The Glass-Steagall Act contained several provisions which shaped
the financial landscape in the United States for about 50 years.
 (1) The act established nationwide deposit insurance.
 (2) The act separated commercial from investment banking.
The act required commercial banks to sell their securities affiliates
within one year.
 (3) The Act prohibited banks from paying interest on demand
deposits.
U.S. Financial Market Regulation:
In the 1930s
 Another series of acts in response to the Great Depression
regulated stock exchanges and securities markets.
 In 1933, Congress passed the Securities Act, which established
federal regulation of securities issues. In 1934, Congress passed
the Securities Exchange Act which established the Securities and
Exchange Commission (SEC) to regulate the issuance,
purchase, and sale of securities, particularly equities and debt
instruments. The act required all public companies to submit
periodic financial statements under penalty of perjury.
 Securities and Exchange Act of 1934 also made it unlawful for any
person "to use or employ, in connection with the purchase or sale of any
security… any manipulative or deceptive device” (including insider
trading).
 In 1936, Congress passed the Commodities Exchange Act
which required all commodities futures and options to be
traded on organized exchanges.
Pressure to Loosen U.S. Financial
Market Regulation: 1980s and
 Financial markets operated calmly from the 1940s to
1990s
the early 1980s. However, During the 1980s and
1990s, the structure of financial regulation in the
United States changed dramatically.
 Impetus for change came from three directions.
 (1) First, free-market thinking increasingly prevailed in policy
debates.
 (2) Second, globalization forced financial institutions in the United
States to compete in ever more competitive international markets
against institutions operating in more permissive regulatory
environments. U.S. institutions incessantly lobbied to loosen
regulations and level the playing field.
 (3) Third, during the 1970s, the S&L industry collapsed.
 Policy makers felt the Savings & Loan failure had resulted, in
part, from over-regulation, specifically limiting the interest rate (at
6%) which these institutions could offer on their deposit accounts.
When interest rose above 6% these institutions became
insolvent.
Shift to Regulation in the 1980s and
1990s
 Changes in regulations in the 1980s and 1990s
tended reduced restrictions on the operations of
financial institutions, allowing them to enter new
lines of business.
 Since the Banking Act of 1932, banks were prevented
from engaging in “universal banking,” or banking in both
commercial and investment industries. The passage of
the Gramm-Leach-Bliley Act of 1999 removed the
barriers between the banking sectors of commercial,
investment, and insurance, effectively overturning the
Glass-Steagall Act.
 Additional acts phased in the paying of interest on
checking accounts and eliminated any interest rate
ceilings on savings and time deposits.
Response to Corporate Abuse:
- ‫سوء استخدام الشركات‬Passage of SOX in 2002
 The Public Company Accounting Reform and Investor
Protection Act of 2002, more commonly referred to as
Sarbanes-Oxley (SOX), was passed in July 2002 after several
prominent companies were involved in financial bankruptcies:
Enron, Worldcom, Xerox, Adelphia, HealthSouth, and others”
 SOX contains three main components.
 First, in an attempt to provide market participants with access to identical
information and a level playing field, SOX “forbids preferential
disclosures to market analysts.”
 Second, in an attempt to create accountability and monitoring within
corporations, SOX requires the CEO and CFO of all publicly traded
corporations to sign the financial statements that they submit to the SEC,
opening them up to criminal penalties for perjury should the forms prove
fraudulent. In addition, SOX requires publicly traded companies have an
independent board of directors.
 Third, SOX mandated “more monitoring by accountants, in addition to
monitoring by independent directors.
Response to 2007-09 Financial
Crisis: Passage: Dodd-Frank in 2010
 The Dodd-Frank Wall Street Reform and Consumer Protection
Act, commonly known as Dodd-Frank, is comprised of several
unrelated regulations. The Act passed in July 2010 in response to
the 2007 – 2009 financial crisis.
 One prominent aspect of Dodd-Frank is the Volcker Rule (named after
the former Federal Reserve chairman who proposed it). While it is still in
the discussion stage, the essential elements are as follows:
 The Volcker rule is an attempt to separate investment banking, private equity and
proprietary trading (hedge fund) sections of financial institutions from their
consumer lending arms.
 The Volcker rule would restrict the ability of banks whose deposits are federally
insured from trading for their own benefit by prohibiting an insured depository
institution and its affiliates from: engaging in “proprietary trading”; acquiring or
retaining any equity, partnership, or other ownership interest in a hedge fund or
private equity fund; and sponsoring a hedge fund or a private equity fund.
 The Volcker rule would ban banks from making speculative bets with firm money,
but includes an exemption for trades done to hedge risk.
 In essence, the rule would return some restrictions on proprietary trading by
commercial banks that were lifted when the Glass-Steagall Act was rescinded.
Well Functioning Financial Market
 (3) Competition:
 Markets need to be structured and regulated so as to
offer easy access and exit.
 Not segmenting financial service providers.
 Not overly protecting (or rescuing) poorly run firms.
 Moral hazard issue (“too big to fail” or government guarantees).
 Competition applies to both domestic and foreign
entities.
 Goal: To ensure best prices and services for end
users.
 (4) Market Structure which Allows for Innovation:
 To provide needed new services and new product
development.
 Allow financial service providers to respond to needs of end
users.
 Development of derivative products in the 1970s through today.
Major Issue Facing Participants in
Financial Markets
 Are the prices of financial instruments potentially
unstable? How volatile are they? Are they
subject to?
 Quick and large short term moves.
 Larg longer term trend changes
 Quick answer: YES!!!
 Volatility is one major issue facing
participants in financial markets.
Interest Rates
Annual Data YoY _ Year over Year
Corporate AAA Total Return
Changes in Stock Prices
Annual Data YoY
Changes in Exchange Rates
Impact of Changes in Financial Variables
 Changes in interest rates:
 Affect the cost of borrowing (end users and intermediaries)
 Influence the returns (and profit margins) to interest sensitive
financial institutions (e.g., banks) and the borrowings/investments
of non-financial sectors (household and companies).
 Affect asset prices (bonds, stocks, foreign exchange).
 Impact on the M&A market (Mergers and Acquisitions)
(leveraging activities)
 Impact on mortgage markets.
 Changes in stock prices:
 Affect the economy’s perception of wealth:
 Influence spending decisions (through the “wealth effect”).
 Affect the IPO market and M&A market (P/E multiples)
 Changes in exchange rates:
 Affect the competitive position of global firms, exporters and
importers.
 Affect the returns to global investment funds (mutual funds, pension
funds).
 Signals from the Stock Market
 Forecasters have noted
that for the U.S., investors
start discounting the end of
an expansion and the
beginning of a recovery in
advance of the business
cycle turning point.
 Study by Jeremy Siegel:
 38 of the 41 U.S. recessions (or
93%) over the period1802 to
1990 have be preceded by an
8% decline in the stock market.
 The S&P 500 is one of the 10
measures in the Conference
Board’s monthly Leading
Indicator Index for the U.S.
 http://
www.conference-board.org/data
/bcicountry.cfm?cid=1
Stock Market as a Leading Indicator:
1968-1983
Stock Market as a Leading Indicator:
1989-1992
Stock Market as a Leading Indicator:
1997-2011
Appendix 1

Useful Websites for Stock Prices

and Exchange Rates
Stock Prices

 For long term historical views go to:

 http://moneycentral.msn.com/investor/charts/
chartdl.aspx?Symbol=%24INDU&CP=0&PT=
5

 For a view of what’s happening now go to:

 http://bloomberg.com/
 Or:
 http://finance.yahoo.com/marketupdate?u
Exchange Rates

 Go to:
 http://fx.sauder.ubc.ca/
 http://www.fxstreet.com/