CHAPTER 1
An Overview of Financial Markets and
Institutions
Basic components of the financial system: Markets and institutions.
• Financial markets are markets for financial
instruments e.g. stocks, bonds etc, also called
financial claims or securities.
• Financial institutions (also called financial
intermediaries) facilitate flows of funds from savers
to borrowers. e.g. banks, finance companies etc.
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All Economic units can be classified in to :
• Households supply labor, demand products, and save
for the future.
• Businesses demand labor, supply products, and
invest in productive assets.
• Governments collect taxes and provide “public
goods” (e.g. education, defense).
Thus the Budget positions of any economic unit can be : Surplus or deficit or
balanced in a given budget period
• Surplus spending units ( SSUs) have income for
the period that exceeds spending, resulting in
savings.
– Other words for “SSU” are saver, lender, or
investor. Most SSUs are households.
• Deficit spending units (DSUs) have spending
for the period that exceeds income.
– Another word for “DSU” is “borrower”. Most
DSUs are businesses or governments.
Financial claims arise as SSUs lend to DSUs.
• Funds are can be transferred through IOUs
(I OWE YOU) from DSU to SSU. IOUs are
called as financial claims.
• Financial claim is liability to DSU and asset
to SSU.
• One’s liability is another’s asset: What is
payable by one is receivable by another.
• Assets arising this way are “financial
assets.” The financial system “balances”total financial assets equal total liabilities.
• SSU can hold the financial claims until maturity or
sold to someone. The ease with which a financial
asset may be sold to another SSU, is its
marketability. Ability to resell financial claims
makes them more liquid by giving SSUs choices:
• Match maturity of claim to planned investment
period;
• Buy claim with longer maturity, but sell at end of
period; or
• Buy claim with shorter maturity, then reinvest.
Exhibit 1.1 – Transfer of Funds
Method s of Financing
1. Direct Financing: The simplest way for
funds to flow.
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DSU and SSU find each other and bargain (negotiate).
SSU transfers funds directly to DSU.
DSU issues claim directly to SSU.
Preferences of both must match as to-Amount
-Maturity
-Risk
-Liquidity
Direct Financing: efficient for large transactions if preferences match.
• DSUs and SSUs “seize the day”—
DSUs fund desired projects immediately.
SSUs earn timely returns on savings.
• Direct markets are “wholesale” markets.
Transactions typically $1 million or more.
Institutional arrangements common.
Common arrangements in direct finance.
An important player in direct finance is
investment bankers(firms that help the
companies sell new debt or equity).
Investment banks services:
• Bring new securities to market
1. Origination: preparing security for sale.
2. Underwriting: helping the firm to sell the
securities generally through firm commitment.
3.Distribution:marketing and sales of the
securities.
Once the financial claim is issued
Brokers and dealers facilitates
secondary market transactions.
• Brokers : matchmakers who helps the buyers and
sellers get together and get commissions.
• Dealers :market makers, carry inventory of
securities from which they buy and sell. Dealers
can also work as matchmakers.
• Bid price : buying price.
• Ask price: selling price
• Profit =bid-ask spread
Problem with direct financing: DSUs and SSUs cannot always match
preferences.
• Not every SSU can afford “wholesale”
denominations of $1 million or more.
• DSUs and SSUs often prefer different terms to
maturity.
2.Indirect Financing (“Financial Intermediation”):
• Financial intermediaries purchase direct claims
with one set of characteristics from DSU and
transform them to indirect claims with different
set of characteristics which they sell to SSU. This
transformation process is called financial
intermediation. Disintermediation is the reverse
process (SSUs take their money from financial
institutions and invest in direct claims).
Financial intermediaries transform
claims
Comparative advantage of financial
intermediaries
• Economies of scale due to their specialization
• Low transaction costs.
• Better way of obtaining and dealing with
information.
Intermediaries perform 5 basic services as they transform claims.
• Denomination Divisibility – pool savings of many
small SSUs into large investments and vice versa.
• Currency Transformation – buy and sell financial
claims denominated in various currencies.
• Maturity Flexibility – Offer different ranges of
maturities to both DSUs and SSUs.
Intermediation Services, cont.
• Credit Risk Diversification – Assume credit risks
of DSUs; spread risk over many different types of
DSUs.(don’t put your eggs into one basket).
• Liquidity – Give SSUs and DSUs different choices
about when, to what extent, and for how long to
commit to financial relationships e.g. checking
accounts.
Benefits of financial intermediation are a primary rationale for the financial
system.
• Financial intermediaries lower the cost of
financial services as they pursue profit.
• Competition pulls interest rates down
– Financing less costly
– Projects have higher NPVs
– Investment in real assets boosts economy
4 Major types of financial intermediaries transform claims to meet various
needs.
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Deposit-type or “Depository” Institutions
Contractual Savings Institutions
Investment Funds
“Other” Institutions
1.Depository Institutions take deposits and make loans.
i. Commercial Banks
ii. Thrift Institutions e.g.:
– Savings & Loan Associations
– Savings Banks
iii. Credit Unions
1.1Commercial Banks
• Largest single class of financial institution
• Issue wide variety of deposit products checking, savings, time deposits
• Carry widely diversified portfolios of loans,
leases, government securities
• May offer trust or underwriting services
1.2Thrift Institutions
• Closely similar to commercial banks.
• Focus more on real estate loans, savings deposits,
and time deposits.
• Major provider of mortgage loans.
• Specialize in maturity and denomination
intermediation.
1.3 Credit Unions: Unique
Characteristics
• Mutual ownership -“owned” by depositors or
“members”
• “Common bond” - members must share some
meaningful common association(e.g.
employees in the same firm).
• Not-for-profit and tax – exempt.
• Restricted mostly to small consumer loans.
2. Contractual Institutions bring long-term savers and borrowers together.
• Obtain funds under long-term contractual
arrangements and invest in capital markets.
• Relatively steady inflow of funds so usually no
liquidity problems.
Examples:
2.1 Life Insurance Companies
2.2 Casualty Insurance Companies
2.3 Pension Funds
2.1 Life Insurance Companies insure against lost income at death.
• Policyholders pay premiums, which are pooled
and invested in stocks, bonds, and mortgages
• Investment earnings cover the costs and
reward the risks of the insurance company.
• Investments are liquidated to pay benefits and
are regulated less strictly than deposit type
institutions.
2.2 Casualty Insurance Companies cover property against loss or damage.
• Covers property against loss or damage.
• Casualty claims are not as predictable as
death claims
• More assets are in short-term, easily
marketable investments
• To offset low return they invest in equity
securities and municipal bonds to reduce
taxes.
2.3Pension Funds help workers plan for retirement.
• Workers and/or employers make
contributions, which are pooled and invested
in stocks, bonds, and mortgages
• Inflow is long term and outflow is predictable
so they are able to invest in higher yielding
long term securities.
3.Investment Funds :Help small investors share the benefits of large
investments and provide them denomination flexibility and default risk
intermediations.
• Mutual Funds provide intermediated access to
various capital markets
– shareholders’ money is pooled and invested in
stocks, bonds, or other securities according to
some objective
– Reduced investment risk from diversification,
economies of scale and professionalism.
• Money Market Mutual Funds (“MMMFs”) are
uninsured substitutes for deposit accounts
– MMMFs buy money market instruments
wholesale, pay investors interest, and allow
– limited check-writing
4.“Other” Financial Institutions
4.1 Finance Companies—
Make loans but do not take deposits; sell
commercial paper to investors. Types are
consumer finance, business finance and sales
finance.
4.2 Federal Agencies—
• Issue “agency securities”(debt instruments)
backed by government and lend at sub-market
rates(lower than market rates) for favored social
purposes.
• Support agriculture and housing.
• Purpose to reduce cost of funds and increase the
availability of funds.
Financial Markets are classified in several ways.
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Primary and Secondary
Organized and Over-the-Counter
Spot and Futures
Options
Foreign Exchange
International and Domestic
Money and Capital
Primary and Secondary Markets
• Primary markets are where financial claims are
“born”: DSUs receive funds, claims are first
issued
• Secondary markets are where financial claims
“live”—are resold and re-priced
– Main benefit is providing liquidity.
– Trading sets prices and yields of widely held
securities
Securities can be only sold once in a primary
market; all subsequent transactions take place in
secondary markets.
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Organized and Over-the-Counter
Markets
Organized Exchanges:
has a physical location.
– Physical trading floor and facilities available to
members of exchange, for securities listed on
exchange.
– New York Stock Exchange
– Chicago Board of Trade (futures)
Over the counter (OTC Markets): virtual (no physical
location).Trades happen through phones or using
computer system that links the dealers.
– The NASDAQ is a famous OTC market.
Spot and Futures Markets
• Spot Markets: immediate pricing, immediate
delivery.
• Futures or Forward Markets: immediate pricing,
promise of future delivery.
“Futures” contracts: standardized as to amounts,
forms, and dates; trade on organized exchanges
“Forward” contracts: individualized between
parties with particular needs
Option Markets
• It is a contract that call for conditional future delivery
of a security or commodity.
• The option holder gets a right in underlying securities
for some certain time but not an obligation.
• Main types of options: Puts (options to sell)
Calls (options to buy)
• Options on listed securities and widely held
commodities trade actively on organized exchanges.
Foreign Exchange Markets(FOREX)
• Any currency is convertible to any other at some
exchange rate
• “Forex” involves spot, future, forward, and option
markets.
International and Domestic Markets
• Help participants diversify both sources and uses of
funds
• Examples of major international markets:
Eurodollars—US dollars deposited outside U.S.
Eurobonds—bonds issued outside US but
denominated in $US
Money and Capital Markets
• Money markets: wholesale markets for short-term
debt instruments resembling money itself. Central
banks conduct monetary policy in them and uses
them to finance day-to-day operations.
• Capital markets: where “capital goods” are
permanently financed through long-term financial
instruments
(“Capital goods”—real assets held long-term to
produce wealth—land, buildings, equipment, etc.)
Money Markets
• Help participants adjust liquidity—
– DSUs borrow short-term to fund current operations
– SSUs lend short-term to avoid holding idle cash
conducts
• Common characteristics of money market
instruments—
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Short maturities (usually 90 days or less)
High liquidity (active secondary markets)
Low risk (and consequently low yield)
Dealer/OTC more than organized exchange
Examples of Major Money Market Instruments
• Treasury Bills: direct obligation from the government,
no default risk and maturity from 3 months to 1 year.
• Negotiable Certificates of Deposit: large
denomination time deposits of large commercial banks
and can be sold in secondary markets.
• Commercial Paper: unsecured promissory note of
large business an don’t have secondary markets.
• Federal Funds (“Fed Funds”):where banks make
short term unsecured loans to one another and the fed
funds rate is the interbank lending rate.
Capital Markets
• Help participants build wealth
DSUs seek long-term financing for capital projects.
SSUs seek highest possible return for given risk.
• Differences from money markets—
Long maturities (5 to 30 years)
Less liquidity
(secondary markets active but more volatile)
Higher risk in most cases
(with higher potential yield)
Traded “wholesale” and “retail” on organized
exchanges and in OTC markets
Examples of
Major Capital Market Instruments
• Common stock
• Corporate bonds: issued by large corporations,
bondholders receive fixed return and has no active
secondary market.
• Municipal bonds: issued by state and local
governments, coupon income is exempt from taxes
and has limited secondary market.
• Mortgages:secured by real estate and limited
secondary market.
Efficiency in financial markets
• Allocational Efficiency: highest/best use of funds(highest
return)
– DSUs try to fund projects with best cost/benefit ratios
– SSUs try to invest for best possible return for given
maturity and risk
• Informational Efficiency: prices reflect relevant
information
– Informationally efficient markets re-price quickly on
new information;
– Informationally inefficient markets offer opportunities
to buy “underpriced” assets or sell “overpriced” assets
• Operational Efficiency: transactions costs minimized
Risks of Financial Institutions
• Credit or default risk: risk that a DSU may not pay as
agreed. Can be managed by diversification, credit
analysis and monitoring of borrower.
• Interest rate risk: fluctuations in a security's price or
reinvestment income caused by changes in market
interest rates
• Liquidity risk: risk that a financial institution may be
unable to disburse required cash outflows, even if
essentially profitable
Risks of Financial Institutions, cont.
• Foreign exchange risk: effect of exchange rate
fluctuations on profit of financial institution
• Political risk: risk of government or regulatory action
harmful to interests of financial institution.