Chapter One
Introduction
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Why study Financial Markets
and Institutions?
• Prudent investment and financing
requires a thorough 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 Markets
• Financial markets are structures through
which funds flow
• Financial markets can be distinguished
along two dimensions
– primary versus secondary markets
– money versus capital 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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Money Market Instruments
Outstanding, ($Bn)
3000
2500
2000
1500
1000
500
0
1990q4
Fed funds and repos
U.S. Treasury bills
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2000q4
Commercial paper
Banker's accept.
1-6
2007q1
Negotiable CDs
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Capital Market Instruments
Outstanding, ($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 to exchange a standard
quantity of assets at a set price on a specific
date in the future
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Financial Market Regulation
• The Securities Act of 1933
– full and fair disclosure and securities
registration
• The Securities Exchange Act of 1934
– Securities and Exchange Commission (SEC) is
the main regulator of securities markets
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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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Flow of Funds in a World without FIs
Financial Claims
(equity and debt
instruments)
Users of Funds
(corporations)
Suppliers of
Funds
(households)
Cash
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Flow
FlowofofFunds
Fundsinina aWorld
Worldwithout
with FIs
FIs
FIs
(brokers)
Users of Funds
Cash
FIs
(asset
transformers)
Financial Claims
(equity and debt securities)
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Suppliers of Funds
Cash
Financial Claims
(deposits and insurance policies)
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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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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
• Foreign exchange
• Country or
sovereign
• Interest rate
• Market
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•
•
•
•
•
Off-balance-sheet
Liquidity
Technology
Operational
Insolvency
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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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