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Function of Financial Markets Basic Function: Channeling of funds from savers
(households, firms and government) toborrowers, including investors
Borrowers can borrow directly from savers, sayhouseholds, by selling them securities (financialinstruments) e.g. selling bonds via the bondmarkets.
Historically, the indirect route was being adoptedof going through a financial institution say abank. The world is now changing with the biggerborrowers taking the direct route more often.
This disintermediation has huge implications for
the players involved
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Blurring of the Distinction
In the context of what we have just discussed,think of the dramatic way in which the businessmix of the financial institutions say in the US has
changed over the past few decades theblurring of the distinction between the productsoffered by the commercial banks, investmentbanks and insurance companies
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Threat perceived by Indianbanks during the 90s
With the stock markets picking up hugemomentum in the 90s, the commercial bankshad felt gravely threatened. They felt that theywould get bypassed on account ofdisintermediation, with Mutual Funds &insurance Companies, taking away theresources and the big borrowers going direct tothe market
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Look at what actually happened in Indiaduring the last decade, 1999-2009
The aggregate loan book of commercial bankswent up from Rs 4 trillion to Rs 29.41 trillion
CD ratio of the banks went up from 53.3% to
70.3%The assets and net profits of Axix Bank, ICICI &
HDFC Bank went up by much more than 10times and the assets and net profits of SBI, PNB
and BOB went up by more than 3 to 4 times.
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Structure of Financial MarketsDebt and Equity Markets
Most common way of raising money in the market is by issuing adebt instrument a bond or a mortgage
Short term maturity of less than one year
Intermediate term of maturity between one and ten years
Long term maturity of ten years or longer
The other - less used - option is of issuing equity
Total value of equities in the US has fluctuated between $1 and $20trillion since the 70s
The value of the debt instruments ($35.1 trillion at the end of 2004)was more than 50% larger than the value of equities in the US($15.9 trillion at the end of 2004)
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Structure of Financial MarketsPrimary and Secondary Markets
Primary Market Investment Bank assists in the sale of securities
in the primary market. It does it by underwritingsecurities it guarantees a price for a
corporations securities and then arranges to sellthem to the public
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Primary and Secondary Markets Secondary Market NYSE is the best known example of an exchangeAs per Wikipedia, as at the end of 2008, the size of the
international bond market was an estimated $67.0trillion, of which the size of the outstanding U.S. bondmarket was $33.5 trillion.Nearly all of the $923 billion average daily tradingvolume (as of early 2007) in the U.S. bond market takesplace between broker-dealers and large institutions in adecentralized, over-the-counter (OTC) market. However,a small number of bonds, primarily corporate, are listedon exchanges.
Other examples are foreign exchange markets, futuresmarkets and options markets Brokers, as agents of investors, and dealers, who buy
and sell securities, are important players in thesecondary markets
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Structure of Financial MarketsExchanges and Over-the-counter Markets
Organized exchanges
NYSE for stocks, and CBOT (Chicago Boardof Trade) for commodities, like wheat, corn,
silver, gold, are best known examples oforganized exchanges
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Exchanges and Over-the-counter Markets
OTC market
The other way of organizing a secondary market is tohave an OTC market, in which dealers at differentlocations have an inventory of different securities andstand ready to buy and sell securities overthe counterto anyone who comes to them and is willing to accepttheir prices. Because the OTC dealers are in computercontact and know the prices set by one another, theOTC market is very competitive, and not very different inthis regard from a market with an organized exchange
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Structure of Financial MarketsMoney and Capital Markets
Money market: Only short term debt instruments(original maturity of less than 1 year) are traded
Capital market: Market in which longer term
debt (original maturity of one year or greater)and equity instruments are traded
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Internationalization of Financial Markets
Before the 80s, the US financial markets weremuch larger than markets outside the US
In recent years the dominance of US marketshas been disappearing
American corporations and banks are now morelikely to tap international capital markets to raisefunds and American investors seek investment
opportunities abroad Similarly, corporations from other countries raise
funds from Americans, and foreigners havebecome important investors in the US
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Foreign Bonds
Foreign bonds are sold in a foreign country andare denominated in that countrys currency.
For example, if a German carmaker sells a bond
in the US, denominated in USD, it will be aforeign bond
As another example, a large percentage of USrailroads built in the 19th century were financed
by sale of foreign bonds in Britain
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Euro Bond
Euro Bond: A bond denominated in the currencyother than that of the country, in which it is sold.
An example: A bond denominated in USD sold
in London
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Eurocurrencies/Eurodollars
Eurocurrencies are foreign currencies that aredeposited in banks, outside of the home country
The most important of the eurocurrencies, the
eurodollars, are US dollars deposited in foreignbanks outside the US, or in foreign branches ofUS banks
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The Euro confusion
A bond denominated in euros is called aeurobond only if it is sold outside the countriesthat have adopted the euro
In fact, most bonds issued by euro zone entitiesare not denominated in euros but insteaddenominated in USD
Eurodollars have nothing to do with euros, or for
that matter with Europe, but are instead USdollars deposited in banks outside the US
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World Stock markets
While NYSE had been the leading SE for a longtime, currently the list is headed by NYSE-Euronext. The relative importance of the other
major markets has been growing Nasdaq OMX, Tokyo SE, Shanghai, Shenzhen,
London are among the other major stockexchanges
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Financial Intermediation
The process of moving funds from savers toborrowers
While the media focus is on the securities
markets, in particular the stock markets, thefinancial intermediaries are a far more importantsource of finance for corporations
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Transaction costs & economies of scale
Financial intermediaries can substantially reducetransaction costs because they have developedthe expertise and their large size enables them
to take advantage of economies of scale
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Risk Sharing
Financial Intermediaries promote risk sharing byhelping individuals to diversify
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Asymmetric informationAn additional reason for the importance of financial intermediaries
What is asymmetric information?An additional reason for the importance offinancial intermediaries is that in financialmarkets, one party often does not know enough
about the other party to make accurate decisions.This inequality is called asymmetric information.
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Problems arising due to asymmetric information
Adverse selection is the problem created by asymmetric
information before the transaction occurs. An example of the above: all other things being equal,
you as a lender are more likely to entertain a worse riskas it would be more persistent in chasing you for loanthan a better risk
Moral hazard is the problem created by asymmetricinformation after the transaction occurs
An example of that would be a borrower engaging inundesirable activity from a lenders point of view
Financial Intermediaries can alleviate these problems bydeveloping processes for better assessment of creditrisks and monitoring loans
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Financial Intermediaries 1. Depository Institutions (In US these are Commercial Banks and
thrifts)
Commercial Banks Savings & Loans Associations
Mutual Savings Banks
Credit Unions
2. Contractual Savings Institutions
Life Insurance Companies Fire & casualty Insurance companies
Pension funds & Government Retirement Funds
3. Investment Intermediaries
Finance Companies
Mutual Funds
Money Market Mutual Funds
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Regulation of the US Financial System
The financial system is among the most regulated sectors of the USeconomy
The main regulatory agencies/subjects of regulation are:
Securities & Exchange Commission-organized exchanges & fin mkts Commodities Futures & Trading Commission-futures exchanges
Office of the Controller of the Currency-federally chartered com banks
National Credit Union Administration-federally chartered credit unions
State Bkg & Insurance Commissions-state chartered dep institutions
Federal Deposit insurance Corporation-Com banks, mutual savingbanks, savings and loans associations
Office of Thrift supervision-savings and loans associations
Federal Reserve System-All depository institutions
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Why regulations? Increasing the information available to investors
The stock market crash of 1929 led to the Securities Act of 1933and establishment of the SEC
The SEC requires corporations issuing securities to disclosecertain information, restricts trading by the largest stockholders(known as insiders) in the corporation
Ensuring the soundness of financial intermediaries Regulations have been imposed on the intermediaries in regard to
restrictions on their entry into business, disclosures by them,restrictions on assets & activities, insurance of deposits by FDIC(created in 1934) & other agencies, limits on opening of branches
and locations, restrictions on interest rates
Improving control of monetary policy
Reserve requirements etc.