FNCE 4070
FINANCIAL
MARKETS
AND INSTITUTIONS
Professor Michael Palmer
Professor of Finance
University of Colorado at Boulder
Spring Semester 2011
Lecture 2: Understanding Financial Markets
and Institutions
Financial Markets and Financial
Institutions

How would you define these?

Perhaps in terms of functions?


What roles do financial markets perform?
Perhaps in terms of organizations or institutions?

What are the organizations and institutions involved in
financial markets.


Commercial organizations
Governmental organizations
Working Definitions
Financial Markets (Functions):

“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, money
markets…
Other functions to follow (see following slides).

Financial Institutions (Organizations):

Commercial entities that facilitate and manage the movement
of funds from surplus entities to final borrowers.


Commercial banks, investment banks, asset managers
(pension funds, insurance companies), hedge funds, foreign
exchange brokers…
Governmental entities that are involved in and/or regulate
financial markets


Central banks, regulatory agencies
Functions of Financial Markets

Mechanism for raising funds!


Mechanism for converting financial assets into
cash before maturity.


Done in secondary financial markets (e.g., NYSE,
OTC bond markets)
Provides the means for entities to protect their
financial/commercial positions.


Done in primary financial markets (e.g., IPOs)
Done in derivatives markets (options, futures,
forwards)
Mechanism for generating a return on
surplus funds.

Through interest, dividends, capital appreciation
Functions of Financial Markets

Allocates 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!
Provides financial signals to market participants

Interest rates, stock prices, exchange rates as measures of
market’s perception of risk and changing risk:



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 – 2011 Crisis in the Euro-zone.
Perhaps we can use financial market signals as a leading
indicator of economic activity.
January 21: General Electric (GE, +4.9%) posted better-thanexpected earnings and forecasted increasing profits in the coming
years.
Exchange Rate Signals
Stock Market as a Leading Indicator
(of Future Economic Activity) Signal
Stock Market as a Leading Indicator
(of Future Economic Activity) Signal
Stock Market as a Leading Indicator
(of Future Economic Activity) Signal
Predicting the End of a Recession

Forecasters have
noted that for the
U.S. historically
investors start
discounting a
recovering before
the end of a
recession.
Direct Versus Indirect Finance

A financial system offers two different ways for funds to
flow from investors (lenders) to borrowers:



Direct Finance involves the transfer of funds from the
initial investor to the ultimate borrower, generally
through a third party.


(1) direct flows to borrowers through financial markets, and
(2) indirect flows through financial intermediaries, such as
commercial banks, pension funds, and mutual funds.
Direct securities are sold to the public through an underwriter,
i.e., a financial firm that purchases them from the issuer with
the intention of reselling them at a profit.
Indirect Finance involves the flow of funds from the
initial investor to a financial intermediary who pools the
funds of many investors in order to relend at a markup
over the cost of the funds.

Ultimate borrowers are normally unknown to the initial investor.
Illustrating the Flow of Funds Through an Economy
Direct Financial Flows

Borrower-spenders obtaining funds directly from
lender-savers through the selling of financial
instruments (i.e., liabilities or equity shares):



Financial institutions play a role in this process:


Borrowers issuing bonds in primary markets
Borrowers issuing stock in primary markets
Investment bankers underwriting new publicly offered
issues or arranging for private placements.
However, these financial institutions do not manage
the funds of lender-savers, they simply carry out
transactions on behalf of lender-savers.

These financial institutions act as dealers, in that the
facilitate the transfer of securities from original issuers to
lender-savers.
Indirect Financial Flows


Borrower-spenders obtaining funds from financial
institutions (i.e., financial intermediaries).
Lender-savers place funds with financial institutions
who pool funds and then make decisions about
lending or investing:

Commercial banks, saving associations, credit unions


Insurance companies


Selling shares and making investments.
Hedge funds, private equity, mortgage brokers, finance
companies

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Accepting policy receipts and then making investments.
Mutual funds (UK: Unit Trusts)


Accepting deposits and then making loans.
Raising capital (debt or equity) and making investments
This process is called financial intermediation.
Reasons for Financial Intermediation:
Transactions Costs

Transactions Costs: Refers to the time and
money spent in carrying out financial
transactions.


Involves search costs and monitoring costs.
It is assumed that financial intermediaries
can reduce transactions costs because they
have critical expertise and they can also take
advantage of economies of scale.

This encourages lender-savers to place funds
in these financial intermediaries and have these
intermediaries manage their funds.
Observations on Financial Flows

Majority of funds raised by corporations is
through financial intermediaries (i.e., indirect
financing):

This is true throughout industrial world:


U.S. , U.K., Canada, Germany, France, Japan
With regard to the composition of the direct
markets, the picture is mixed in the industrial
world:


U.S. and Japan: bond markets are larger than
stock market.
France and Italy: bond and stock markets about
equal in size.
Internationalization (Globalization)
of Financial Markets

Before the mid 1980s, most financial markets were segmented
(closed) to the rest of the world.






Exception: the U.S. financial markets.
Non-US markets were also relative small by U.S. standards.
Over the last three decades, financial markets around the world
have been deregulated to allow for freer cross border capital
flows.
Additionally, the growth in savings in foreign countries has
contributed to the growth in non-U.S. financial markets (Japan
and Western Europe).
Important regional development in Europe, i.e., the formation of
the euro-zone have also contributed to the growth of non-U.S.
financial markets.
Bottom line: financial markets around the world are increasing in
importance as sources of funds and potential investment.
Implications of Financial Market
Globalization

Today foreign markets are potentially attractive
as sources of funds and opportunities for
investment. This can be summarized as follows:



Major corporations are no longer confined to their
domestic financial markets for sources of funds.
Governments are no longer confined to their
domestic markets for sources of funds.
Financial institutions and individual investors are
no longer confined to their domestic financial
markets for investments.
International Comparison of Household Financial
Asset Allocation: Differences in Risk Taking
Characteristics
180
Household financial asset allocation (average 1995-2002) % of GDP
160
140
120
Banks
100
Insurance & pension funds
Investment funds
80
Non-share securities
60
Shares & other equity
Other
40
20
0
Euro area
UK
US
Japan
Characteristics of an Efficient
Financial Market

(1) Transparent:

All participants will have access to reliable and
important information at the same time.
 Importance of trading platforms to transparency.


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Importance of financial services providers to
transparency in disseminating financial information.


How quickly is trading information made available?
Do all potential traders have access to same trading
information (bid and ask prices publicly displayed).
Dow Jones, Bloomberg, Reuters.
Central banks and central bankers also play in role
in this process by pursuing transparency in terms of
their monetary policy processes.

Web sites: http://www.bis.org/cbanks.htm
Efficient Financial Market

(2) Adequate, but Not Excessive, Regulation:

Financial markets need to have regulation which
ensures a level and fair playing field and appropriate
behavior.

Regulation needs:




To discourage insider trading, price manipulations, unethical
behavior
Provide appropriate reporting of financial information to markets.
Securities and Exchange Act of 1934 makes it unlawful for any
person "to use or employ, in connection with the purchase or sale
of any security… any manipulative or deceptive device…”
Issue for regulators: A what point does regulation
become a burden (excessive) and/or drive financial
service providers to other markets?



Cost – Benefit Analysis done by regulators.
U.S. Sarbanes Oxley Act (2002)
Regulation of hedge funds.
Efficient 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.



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Moral hazard issue
Applies to both domestic and foreign entities.
Will 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.
Substantial longer term trend changes

Quick answer: YES!!!

Volatility is one major issue facing
participants in financial markets.
Short and Long Term Interest
Rates
Changes in Stock Prices
Changes in Exchange Rates
Impact of Changes in Financial Variables

Changes in interest rates:




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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 (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).
Defining and Classifying Financial
Instruments
How would you define a financial
instrument?
 How would you classify financial
instruments and financial markets?

Definition of Financial Instruments

Financial Instrument:

(1) Instruments which represent a claim on the issuer’s (of
the financial instrument) 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.
(2) Instruments which are neither debt nor equity
based and thus belong in their own category.

Foreign Exchange
Classifications of Financial Instruments

(1) Financial instruments can also be categorized by form depending
on whether they are cash instruments or derivative instruments:

Cash instruments are financial instruments whose value is determined
directly by markets.


Derivative instruments are financial instruments which derive their value
from some other (underlying) financial instrument or variable.



Stock and bonds
Futures, forwards, options (puts and calls)
Originated in Chicago in the 1850s (CBOT) for commodities (flour, hay, corn), but
now involves financial assets as well.
(2) Alternatively, financial instruments can be categorized by "asset
class" depending on whether they are equity based (reflecting
ownership of the issuing entity) or debt based (reflecting a loan the
investor has made to the issuing entity). If debt, it can be further
categorized into short term (less than one year) or long term.


Short term: money market instruments
Long term: capital market instruments
Classification of Financial Markets

Primary Financial Market



Where new securities are sold to initial buyers (e.g., IPOs)
Important for raising new capital (involves public and private
placements and investment bankers)
Secondary Financial Market


Where securities previously issued (in primary markets) are bought
and sold (traded among investors).
Secondary markets provide liquidity for previously issued securities
– Allows for conversion of financial assets into cash before asset
matures.




Done through organized exchanges (central locations; e.g., NYSE,
LSE) or through
Over-the-counter arrangements (dealers in different locations; e.g.,
NASDAQ, and U.S. Government bond market) or through
US Government Sponsored Enterprises (GSEs): Federal National
Mortgage Association and Federal Home Loan Mortgage
Corporation.
Money and capital markets

Short term versus long term maturities of traded instruments.
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/