Chapter 2
Overview of Market Participants &
Financial innovation
Learning Objective







Participants in Financial Markets
Business of Financial institutions
Financial Intermediary
Economic functions of Financial
Intermediaries
Asset & Liability management of
Financial institutions
Government Regulations
Primary reasons for financial
innovation
Classification of Entities







Central governments
Agencies of central government
Municipal governments
Supranational
Non- financial businesses
Financial enterprises
households
Classification of Entities




Central governments
Debt obligations issued by central
Governments carry full faith & credit of the
borrowing Government.
Agencies of central government
Federally related institutions, Government
sponsored enterprises
Municipal governments
Supranational
An organization that is formed by two or
more central governments through
international treaties.
Classification of Entities
Non- financial businesses
Corporations & non-corporate
business
 Financial enterprises
 households

Classification of Entities
Financial intermediaries
 Depository institutions-commercial
banks, S&L associations and credit
unions
 Insurance companies
 Pension funds
Classification of Entities
Financial Enterprises





Exchanging financial assets on behalf of
customers. (Brokers)
Exchanging financial assets for their
own account. (Dealers)
Assisting in creation of financial assets
for their customers and then selling
those financial assets to other market
participants. (Underwriting)
Providing investment advice to other
market participants.
Managing portfolios of other market
participants.
Role of Financial
Intermediaries



Obtain funds by issuing financial claims
against themselves to market participants,
then investing those funds.
Direct investments- investments made by the
financial intermediaries. (assets can be loans
/or securities)
Transform financial assets that are less
desirable for a large part of the public into
other financial assets(their own liabilities )
which are more widely preferred by the
public.
Role of Financial
Intermediaries




This transformation involves four
basic economic functions:
Maturity intermediation
Risk reduction and diversification
Reducing the costs of contracting
and information processing
Providing a payment mechanism
Nature of Liabilities
Liability Type
Amount of
cash outlay
Timing of cash
outlay
Type I
Known
Known
Type II
Known
Uncertain
Type III
Uncertain
Known
Type IV
Uncertain
Uncertain
Nature of Liabilities
Type I liabilities:
 Fixed deposit account
 Guaranteed investment contract
(GIC) issued by the insurance
companies

Type II:
 Life insurance policy

Nature of Liabilities
Type III liabilities:
 Floating rate Certificate of deposits
issued by the depository institutions

Type IV liabilities:
 Automobile and home insurance
policies

Liquidity Needs

Uncertainty about timing and
amount of cash outlays

Potential for the depositor or policy
holder to withdraw cash early.
Liquidity Needs
Reduction in cash inflows:
 Depository institutions- inability to
obtain deposits
 Insurance companies- reduced
premium because of the cancellation
of policies
 Investment companies- not being
able to find new buyers for shares.
Regulation OF Financial
Markets
Disclosure Regulation
 Financial Activity Regulation
 Regulation of Financial Institutions
 Regulation of Foreign Participants

Financial Innovation
Categorizations of Financial Innovation
 Market-broadening Instruments- Increase
liquidity of markets and availability of
funds by attracting new investors and
offering new opportunities for borrowers
 Risk- management instruments
reallocate risk to those who are less risk
averse.
Financial Innovation

Arbitraging instruments and processesenable investors and borrowers to take
advantage of differences in costs and
returns between markets.
Motivation for Financial
Innovation
Causes of Financial Innovation

Increased volatility of interest rates , inflation , equity prices
and exchange rates

Advances in computer and telecommunication technologies

Greater sophistication and educational training among
professional market partcipants

Financial intermediary competition

Incentives to get around existing regulation and tax laws

Changing global patterns of financial wealth..