Power Point Slides for:
Financial Institutions, Markets, &
Money, 10th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Vladimir Kotomin,
University of Wisconsin—Eau Claire
and
Lanny R. Martindale,
Texas A&M University
Copyright 2008 John Wiley & Sons, Inc.Copyright© 2006 John
Wiley & Sons, Inc.
CHAPTER 1
An Overview of Financial Markets and
Institutions
The Financial System
Provides for efficient flow of funds from
saving to investment by bringing savers and
borrowers together via financial markets
and financial institutions.
Exhibit 1.1 – Transfer of Funds
Basic components of the financial system: Markets and institutions.
Financial markets are markets for financial
instruments, also called financial claims or
securities.
Financial institutions (also called financial
intermediaries) facilitate flows of funds from
savers to borrowers.
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Economic units with financial needs: Households, Businesses,
Governments.
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).
Budget positions creating financial needs of economic units:
Surplus or deficit.
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.
SSU’s claim against DSU 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.
Marketability: Ease with which a financial asset may be sold to
another SSU.
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.
Direct Financing: The simplest way for
funds to flow.
DSU and SSU find each other and bargain
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.
Institutional arrangements common in direct finance.
Private placements are simplest.
Investment bankers “underwrite” new issues
of securities.
Brokers and dealers bring buyers and sellers
of direct claims together.
Private placements are simplest.
DSU sells whole security issue to one
investor or investor group.
Advantages include speed and low
transactions costs.
Investment bankers “underwrite” new issues of securities.
Buy entire issues of securities from DSUs
Find SSUs to buy securities at higher price
Profit from difference - “underwriting
spread”
Brokers and dealers
Brokers buy or sell at best possible price for
their clients.
Dealers “make markets” by carrying
inventories of securities.
buy at “bid price;” sell at “ask price”
“Bid-ask spread” is dealer’s gross profit
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.
Indirect Financing (“Financial Intermediation”):
Financial intermediaries “transform”
claims:
raise funds by issuing claims to SSUs;
use funds to buy claims issued by DSUs.
Claims can have unmatched characteristics:
SSU has claim against intermediary;
Intermediary has claim against DSU.
Financial intermediaries transform claims
Familiar forms of financial intermediation
Commercial Banking
Insurance
Commercial Banks
Take deposits and make loans Depositors are SSUs
Borrowers are DSUs.
Insurance Companies
Issue policies, collect premiums, and invest
in stocks and bonds.
Policyholders are SSUs;
Businesses or governments are DSUs.
Benefits of financial intermediation are a primary rationale for the
financial system.
Financial intermediaries lower the cost of financial
services as they pursue profit.
Financial intermediaries perform 5 basic services
as they transform claims.
Intermediaries lower the cost of financial services as they pursue
profit.
3 sources of comparative advantage:
Economies of scale
Transaction cost control
Risk management expertise
Competition pulls interest rates down
Financing less costly
Projects have higher NPVs
Investment in real assets boosts economy
Intermediaries perform 5 basic services as they transform
claims.
Denomination Divisibility – pool savings of many
small SSUs into large investments.
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.
Liquidity – Give SSUs and DSUs different
choices about when, to what extent, and for how
long to commit to financial relationships.
4 Major types of financial intermediaries transform claims to meet
various needs.
Deposit-type or “Depository” Institutions
Contractual Savings Institutions
Investment Funds
“Other” Institutions
Depository Institutions take deposits and make loans.
Commercial Banks
Thrift Institutions
Savings & Loan Associations
Savings Banks
Credit Unions
Commercial 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
Thrift Institutions
Closely resemble commercial banks
Focus more on real estate loans, savings deposits,
and time deposits
Credit Unions: Unique Characteristics
Mutual ownership -“owned” by depositors
or “members”
“Common bond” - members must share
some meaningful common association
Not-for-profit and tax - exempt
Restricted mostly to small consumer loans
Contractual Institutions bring long-term savers and borrowers
together.
Life Insurance Companies
Casualty Insurance Companies
Pension Funds
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.
Casualty Insurance Companies cover property against loss or
damage.
Sources and uses of funds resemble those of
life insurers, but
Casualty claims are not as predictable as
death claims; so
More assets are in short-term, easily
marketable investments
Pension Funds help workers plan for retirement.
Workers and/or employers make
contributions, which are pooled and
invested in stocks, bonds, and mortgages
Net of administrative costs, investment
earnings are reinvested and compounded
Retirement benefits replace paychecks (at
least partly)
Investment Funds help small investors share the benefits of large
investments.
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
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
“Other” Financial Institutions
Finance Companies—
Make loans but do not take deposits; raise
loanable funds in commercial paper market and
from shareholders
Federal Agencies—
Issue “agency securities” backed by government
and lend at sub-market rates for favored social
purposes
Exhibit 1.2—Major Financial Intermediaries
Exhibit 1.3—
Major Financial Intermediaries: Sources & Uses of Funds
Financial Markets are classified in several ways.
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 repriced
Claims become more liquid because SSUs
can set their own holding periods
Trading sets prices and yields of widely held
securities
Organized and Over-the-Counter Markets
Organized Exchanges: physical, relatively
exclusive.
Physical trading floor and facilities available to
members of exchange, for securities listed on
exchange.
New York Stock Exchange
Chicago Board of Trade (futures)
OTC Markets: virtual, relatively inclusive.
Decentralized network available to any licensed dealer
willing to buy access and obey rules, for wide range of
securities.
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
Rights in underlying securities or commodities—
writer grants owner some exclusive right for some
certain time
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
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
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
Common characteristics of money market
instruments—
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
Negotiable Certificates of Deposit
Commercial Paper
Federal Funds (“Fed Funds”)
Exhibit 1.4—Major Money Market Instruments
Money Market Balance Sheet Position of Major Participants
INSTRUMENT
Treasury bills
Agency securities
Negotiable CDs
Commercial paper
Banker’s acceptances
Federal Funds
Repurchase agreements
COMMERCIAL
BANKS
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FEDERAL
RESERVE
SYSTEM
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TREASURY
DEPARTMENT
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INVESTMENT
BANKS,
DEALERS,
AND BROKERS
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CORPORATIONS
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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
Municipal bonds
Mortgages
Exhibit 1.5—Major Capital Market Instruments
Efficiency in financial markets
Allocational Efficiency: highest/best use of funds
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 reprice 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
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.