Chapter ObjectivesDescribe the types of financial markets

Describe the role of financial institutions with financial markets

Identify the types of financial institutions that facilitate transactions

Overview of Financial MarketsFinancial markets provide for financial intermediation--financial savings (Surplus Units) to investment (Deficit Units)Financial markets provide payments systemFinancial markets provide means to manage risk

Financial Market: a market in which financial assets (securities) such as stocks and bonds can be purchased or sold

Broad Classifications of Financial Markets

Money versus Capital Markets

Primary versus Secondary Markets

Organized versus Over-the-Counter MarketsOverview of Financial Markets

Primary vs. Secondary MarketsPRIMARYNew Issue of Securities

Exchange of Funds for Financial Claim

Funds for Borrower; an IOU for LenderSECONDARYTrading Previously Issued Securities

No New Funds for Issuer

Provides Liquidity for Seller

Money vs. Capital MarketsMoneyShort-Term, < 1 Year

High Quality Issuers

Debt Only

Primary Market Focus

Liquidity Market--Low ReturnsCapitalLong-Term, >1Yr

Range of Issuer Quality

Debt and Equity

Secondary Market Focus

Financing Investment--Higher Returns

Organized vs. Over-the-Counter MarketsOrganizedVisible Marketplace

Members Trade

Securities Listed

New York Stock ExchangeOTCWired Network of Dealers

No Central, Physical Location

All Securities Traded off the Exchanges

Money Market SecuritiesDebt securities Only

Capital market securitiesDebt and equity securities

Derivative SecuritiesFinancial contracts whose value is derived from the values of underlying assetsUsed for hedging (risk reduction) and speculation (risk seeking)Securities Traded in Financial Markets

Debt vs. Equity Securities

Debt Securities: Contractual obligations (IOU) of Debtor (borrower) to Creditor (lender)Investor receives interestCapital gain/loss when soldMaturity date

Debt vs. Equity Securities

Equity Securities: Claim with ownership rights and responsibilitiesInvestor receives dividends if declaredCapital gain/loss when soldNo maturity dateneed market to sell

Valuation of SecuritiesValue a function of:Future cash flowsWhen cash flows are receivedRisk of cash flowsPresent value of cash flows discounted at the market required rate of returnValue determined by market demand/supplyValue changes with new information

Investor Assessment of New InformationExhibit 1.3

Security prices reflect available information

New information is quickly included in security prices

Investors balance liquidity, risk, and return needs Financial Market Efficiency

Financial Market Regulation

To Promote Efficiency

High level of competition

Efficient payments mechanism

Low cost risk management contractsWhy Government Regulation?

To Maintain Financial Market StabilityPrevent market crashesCircuit breakersFederal Reserve discount window

Prevent Inflation--Monetary policy

Prevent Excessive Risk Taking by Financial Institutions

Financial Market RegulationWhy Government Regulation?

To Provide Consumer ProtectionProvide adequate disclosureSet rules for business conductTo Pursue Social PoliciesTransfer income and wealthAllocate saving to socially desirable areasHousingStudent loansFinancial Market RegulationWhy Government Regulation?

Financial Market GlobalizationIncreased international funds flowIncreased disclosure of informationReduced transaction costsReduced foreign regulation on capital flowsIncreased privatizationResults: Increased financial integration--capital flows to highest expected risk-adjusted return

Role of Financial Institutions in Financial MarketsInformation processingServe special needs of lenders (liabilities) and borrowers (assets)By denomination and termBy risk and returnLower transaction costServe to resolve problems of market imperfection

Role of Financial Institutions in Financial MarketsTypes of Depository Financial InstitutionsCommercialBanks$5 TrillionTotal Assets

Savings Institutions$1.3 TrillionTotal AssetsCredit Unions$.5 TrillionTotal Assets

Types of Nondepository Financial Institutions

Insurance companiesMutual fundsPension fundsSecurities companiesFinance companiesSecurity pools

Role of Nondepository Financial InstitutionsFocused on capital marketLonger-term, higher risk intermediationLess focus on liquidityLess regulationGreater focus on equity investments

Trends in Financial InstitutionsRapid growth of mutual funds and pension fundsIncreased consolidation of financial institutions via mergersIncreased competition between financial InstitutionsGrowth of financial conglomerates

Global Expansion by Financial InstitutionsInternational expansionInternational mergersImpact of the single European currencyEmerging markets