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Function of Financial Markets1. Allows transfers of funds from person or business without investment opportunities to one who has them2. Improves economic efficiency

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Financial Markets:

• Direct finance: through securities (IOU’s)• Indirect: intermediaries• Saving transaction costs (search)• Maturity, Stocks, Dividends (residual claim),

Debt, IPO’s (underwriting), Brokers, Dealers…

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Classifications of Financial Markets

1. Debt MarketsShort-term (maturity < 1 year) Money MarketLong-term (maturity > 1 year) Capital Market

2. Equity MarketsCommon stocks

1. Primary MarketNew security issues sold to initial buyers

2. Secondary MarketSecurities previously issued are bought and sold

1. ExchangesTrades conducted in central locations (e.g., New York Stock Exchange, Chicago Commodity)

2. Over-the-Counter MarketsDealers at different locations buy and sell

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Internationalization of Financial Markets

International Bond Market1. Foreign bonds – of a foreign entity denominated in home currency (German producer issues in US in $)

2. Eurobonds – denominated in foreign currency (in £ in the US)

Now larger than U.S. corporate bond market

• World Stock Markets (U.S. stock markets are no longer the largest)

• Eurocurrencies – deposited outside the home country– Eurodollars (Russia, Middle-East)

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Function of Financial Intermediaries

Financial Intermediaries1. Engage in process of indirect finance2. More important source of finance than securities markets3. Needed because of transactions costs and asymmetric

informationTransactions Costs1. Financial intermediaries make profits by reducing

transactions costs (search costs)2. Reduce transactions costs by developing expertise and

taking advantage of economies of scale (liquidity services)

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Function of Financial Intermediaries

Risk Sharing

1. Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation, by pooling of funds).

2. Also lower risk by helping people to diversify portfolios

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Asymmetric Information: Adverse Selection,and Moral HazardAdverse Selection1. Before transaction occurs2. Potential borrowers most likely to produce adverse outcomes are

ones most likely to seek loans and be selected (“gamblers” have high return & risk => need to borrow often)

Moral Hazard1. After transaction occurs2. Hazard that borrower has incentives to engage in undesirable

(immoral) activities making it more likely that won’t pay loan backFinancial intermediaries reduce adverse selection and moral

hazard problems (by developing monitoring expertise), enabling them to make profits

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Financial Intermediaries

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Regulatory Agencies

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Regulatory Agencies

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Regulation of Financial Markets

Is it good or bad? Would it work without it?

Two Main Reasons for Regulation are:

1. Increase information to investors (decrease asym. info)

A. Decreases adverse selection and moral hazard problems

B. SEC forces corporations to disclose information

2. Ensuring the soundness of financial intermediariesA. Prevents financial panics

B. Chartering, reporting requirements, restrictions on assets and activities (banks - no stocks, insider trading, etc.), deposit insurance, and anti-competitive measures