2.WEEK
INTRODUCTION TO FINANCIAL
MARKETS, INSTITUTIONS AND
INSTRUMENTS
©2009, The McGraw-Hill Companies, All Rights Reserved
Why study Financial Markets
and Institutions?
 Prudent investment and financing
requires a full understanding of



the structure of domestic and international
markets
the flow of funds through domestic and
international markets
the strategies used to manage risks faced by
investors and savers
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FINANCIAL SYSTEM
 Financial markets
 Financial institutions & İndividuals
 Financial assets (instruments, securities)
 Rules and regulations
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Financial Markets
 Financial markets are structures through
which funds flow.
 Financial markets consist of
- fund suppliers or lenders
- fund demanders or borrowers
- financials instruments (fin assets, securities)
- financial institutions (intermediaries)
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Types of Financial Markets
 Money market
 Foreign exchange market
 Stock market
 Bonds and bills market
 Derivatives market
 Gold market
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Types of Fınancıal Markets cont.
 Financial markets can be
distinguished along three
dimensions
 primary
versus secondary markets
 money versus capital markets
 organized versus over the counter
markets
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Primary versus Secondary Markets
 Primary markets

markets in which users of funds (e.g.,
corporations and governments) raise funds by
issuing financial instruments (e.g., stocks and
bonds)
 Secondary markets

markets where financial instruments are
traded among investors (e.g., NYSE and
Nasdaq)
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Money versus Capital Markets
 Money markets

markets that trade debt securities with
maturities of one year or less (e.g., CDs and
U.S. Treasury bills)
 Capital markets

markets that trade debt (bonds) and equity
(stock) instruments with maturities of more
than one year
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Organized versus Over the Counter (OTC)
Markets
Organized markets
-
Have a central physical
location
Commission
Registration is required
Controlling system: Formal
Customers’ orders provide
liquidity
Listing
OTC markets
-
No physical location
No commission
No need for registration
Any controlling system:
Informal
Dealers
No listing (except
NASDAQ)
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Money Market Instruments Outstanding,
($Bn)
3000
2500
2000
1500
1000
500
0
1990q4
Fed funds and repos
U.S. Treasury bills
2000q4
Commercial paper
Banker's accept.
2007q1
Negotiable CDs
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Capital Market Instruments Outstanding,
($Bn)
25000
20000
15000
10000
5000
0
1990q4
2000q4
2007q1
Corporate stocks
Mortgages
Corporate bonds
U.S. gov't agencies
Treasury securities
State & local gov't bonds
Bank and consumer loans
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Foreign Exchange (FX) Markets
 FX markets
 trading one currency for another (e.g., dollar for yen)
 Spot FX
 the immediate exchange of currencies at current
exchange rates
 Forward FX
 the exchange of currencies in the future on a specific
date and at a pre-specified exchange rate
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Derivative Security Markets
 Derivative security


a financial security whose payoff is linked to
(i.e., “derived” from) another security or
commodity
generally an agreement between two parties
to exchange a standard quantity of assets at
a predetermined price on a specific date in
the future
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The Role (Economic Functions)of Financial
Markets
They provide a mechanism for determinig
the price of financial assets: Price discovery
process, Efficiency of Financial Markets.
2. They make assets more liquid.
3. They reduce cost of exchanging assets:
Search costs, Information costs.
1.
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Financial Institutions (FIs)
 Financial Institutions

institutions through which suppliers channel
money to users of funds
 Financial Institutions are distinguished by
whether they accept deposits

depository versus non-depository financial
institutions
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Depository versus Non-Depository FIs
 Depository institutions

commercial banks, savings associations,
savings banks, credit unions
 Non-depository institutions

insurance companies, securities firms and
investment banks, mutual funds, pension
funds
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Flow of Funds in a World without FIs:
Direct Transfer
Financial Claims
(equity and debt
instruments)
Users of Funds
(corporations)
Suppliers of
Funds
(households)
Cash
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Flow of Funds in a World with FIs
FIs
(brokers)
Users of Funds
Cash
Suppliers of Funds
FIs
(asset
transformers)
Financial Claims
(equity and debt securities)
Cash
Financial Claims
(deposits and insurance policies)
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Services that are provided by FIs
1.
2.
3.
4.
5.
6.
Transform fin. assets acquired into assets that are more
attractive to the public. (Fin. Intermediaries)
Exchange fin. Assets on the behalf of others (Brokers)
Exchange fin. Assets for their own. (Dealers)
Assists in the creation of fin. assets for their customers and
then sell these fin. assets to others.(underwriting)
Provide inv. advices
Provide portfolio management
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FIs Benefit Suppliers of Funds
 Reduce monitoring costs
 Increase liquidity and lower price risk
 Reduce transaction costs
 Provide maturity intermediation
 Provide denomination intermediation
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FIs Benefit the Overall Economy
 Conduit through which Federal Reserve
conducts monetary policy
 Provides efficient credit allocation
 Provide for intergenerational wealth
transfers
 Provide payment services
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Risks Faced by Financial Institutions
 Credit
 Off-balance-sheet
 Foreign exchange
 Liquidity
 Country or
 Technology
sovereign
 Interest rate
 Market
 Operational
 Insolvency
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Financial Assets
 An asset is any possession that has value in
exchange.
 Tangible-intangible assets
 Financial assets= Financial
Instruments=Securities are intangible assets.
 Issuer: The entitiy that agrees to make future
cash payments.
 Investor: The owner of the financial asset.
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Examples of Fin. Assets
 The bond issed by the Turkish governmnet
 The bond issued by Koç Holding
 An automibile loan.
 A home mortgage.
 Common Stock issued by a company.
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Debt vs Equity Claims
 Debt Claims (Debt Instruments)= Fixed
Income securities= Bonds
 Equity Claims (Residual claims)=Common
Stock
 There are also preferred stock, convertible
bonds.
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The Role of Financial Assets
 Fin Assets has two economic functions;
1. Transfering of funds who have surplus of funds to
those who need funds to invest in tangible assets.
2. Transferring funds in such a way that redistributes the
unavoidable risk associated with the CF generated by
the tangible assets among those seeking and those
providing the funds.
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Regulation of Financial Institutions
 FIs are heavily regulated to protect society at
large from market failures
 Regulations impose a burden on FIs and recent
U.S. regulatory changes have been deregulatory
in nature
 Regulators attempt to maximize social welfare
while minimizing the burden imposed by
regulation
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Globalization of Financial Markets and
Institutions
 The pool of savings from foreign investors is increasing
and investors look to diversify globally now more than
ever before
 Information on foreign markets and investments is
becoming readily accessible and deregulation across
the globe is allowing even greater access
 International mutual funds allow diversified foreign
investment with low transactions costs
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Globalization of Financial Markets and
Institutions cont.
 Foreign Markets: Foreigners can issue
securities in other country markets, subject to
national regulations. For example, Japanese
firms can issue dollar-dominated securities in
the United States but they must follow U.S.
regulations, which apply to nationals and
foreigners alike.
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Globalization of Financial Markets and
Institutions cont.
International (Off shore or Euro) Market:
 Securities are issued outside the jurisdiction of any
country.
 The motivation for foreign and Eurodollar is that
many underdeveloped nations simply do not have a
sizable capital market to meet their funds needs. Also
Eurodollar loans are often less expensive since
institutions holding such funds are not hampered by
regulations.
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Financial Innovation
Categorizations of Financial Innovation;
- Market-broadening Instruments
- Risk management instruments,
- Arbitraging instruments
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Motivation for Financial Innovation
1.
2.
3.
4.
5.
6.
Increased volatility of interest rates, inflation, equity
prices, exchange rates.
Advances in computer&telecomminication
technologies.
Greater sophistication and educational training
among professional market participants.
Financial intermediary competition.
Incentives to get around existing regulation and tax
laws.
Changing global patterns of financial wealth
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Asset Securitization
It involves tha collection or pooling of loans and
sale of securities backed by those loans.
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