Chapter One

Introduction

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Why study Financial Markets and

Institutions?
They
They are
are the
the cornerstones
cornerstones of
of the
the
overall
overall financial
financial system
system in
in which
which
financial
financial managers
managers operate
operate
Individuals
Individuals use
use both
both for
for investing
investing
Corporations
Corporations and
and governments
governments use
use
both
both for
for financing
financing
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Overview of Financial Markets

Primary
Primary Markets
Markets versus
versus Secondary
Secondary
Markets
Markets
Money
Money Markets
Markets versus
versus Capital
Capital
Markets
Markets
Foreign
Foreign Exchange
Exchange Markets
Markets
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Primary Markets versus Secondary

Markets
Primary
Primary Markets
Markets
markets
markets in
in which
which users
users of
of funds
funds (e.g.
(e.g.
corporations,
corporations, governments)
governments) raise
raise funds
funds by
by
issuing
issuing financial
financial instruments
instruments (e.g.
(e.g. stocks
stocks and
and
bonds)
bonds)

Secondary
Secondary Markets
Markets
markets
markets where
where financial
financial instruments
instruments are
are traded
traded
among
among investors
investors (e.g.
(e.g. NYSE,
NYSE, NASDAQ)
NASDAQ)
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Money Markets versus Capital Markets

Money
Money Markets
Markets
markets
markets that
that trade
trade debt
debt securities
securities with
with
maturities
maturities of
of one
one year
year or
or less
less (e.g.
(e.g. CDs,
CDs, U.S.
U.S.
Treasury
Treasury bills)
bills)

Capital
Capital Markets
Markets
markets
markets that
that trade
trade debt
debt (bonds)
(bonds) and
and equity
equity
(stock)
(stock) instruments
instruments with
with maturities
maturities of
of more
more
than
than one
one year
year
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Money Market Instruments

Outstanding, 1990-2004 ($Bn)

1-7

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Capital Market Instruments

Outstanding, 1990-2004 ($Bn)

1-8

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Foreign Exchange Markets

FX
FX markets
markets deal
deal in
in trading
trading one
one currency
currency
for
for another
another (e.g.
(e.g. dollar
dollar for
for yen)
yen)
The
The spot
spot FX
FX transaction
transaction involves
involves the
the
immediate
immediate exchange
exchange of
of currencies
currencies at
at the
the
current
current exchange
exchange rate
rate
The
The forward
forward FX
FX transaction
transaction involves
involves the
the
exchange
exchange of
of currencies
currencies at
at aa specified
specified date
date in
in
the
the future
future and
and at
at aa specified
specified exchange
exchange rate
rate
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Derivative Security Markets

The
The markets
markets in
in which
which derivative
derivative
securities
securities trade.
trade.
Derivative
Derivative Security
Security
An
An agreement
agreement between
between two
two parties
parties to
to exchange
exchange
aa standard
standard quantity
quantity of
of an
an asset
asset at
at aa
predetermined
predetermined price
price on
on aa specified
specified date
date in
in the
the
future.
future.

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Overview of Financial Institutions

Institutions
Institutions that
that perform
perform the
the essential
essential
function
function of
of channeling
channeling funds
funds from
from those
those
with
with surplus
surplus funds
funds to
to those
those with
with shortages
shortages
of
of funds
funds (e.g.
(e.g. banks,
banks, thrifts,
thrifts, insurance
insurance
companies,
companies, securities
securities firms
firms and
and
investment
investment banks,
banks, finance
finance companies,
companies,
mutual
mutual funds,
funds, pension
pension funds)
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
Example: A firm sells shares directly to investors without
going through a financial institution.
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Flow of Funds in a world with FIs:

Indirect transfer
FI
(Brokers)

Users of Funds

Cash

Suppliers of Funds

FI
(Asset
transformers)

Financial Claims
(Equity and debt securities)

Cash

Financial Claims
(Deposits and insurance policies)

1-13

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Types of FIs
Commercial
Commercial banks
banks
depository
depository institutions
institutions whose
whose major
major assets
assets are
are
loans
loans and
and major
major liabilities
liabilities are
are deposits
deposits
Thrifts
Thrifts
depository
depository institutions
institutions in
in the
the form
formof
ofsavings
savings
and
and loans,
loans, credit
credit unions
unions
Insurance
Insurance companies
companies
financial
financial institutions
institutions that
that protect
protect individuals
individuals
and
and corporations
corporations from
fromadverse
adverse events
events
(continued)

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 Securities
Securities firms
firms and
and investment
investment banks
banks
financial
financial institutions
institutions that
that underwrite
underwrite securities
securities
and
and engage
engage in
in securities
securities brokerage
brokerage and
and trading
trading
Finance
Finance companies
companies
financial
financial institutions
institutions that
that make
make loans
loans to
to
individuals
individuals and
and businesses
businesses
Mutual
Mutual Funds
Funds
financial
financial institutions
institutions that
that pool
pool financial
financial
resources
resources and
and invest
invest in
in diversified
diversified portfolios
portfolios
Pension
Pension Funds
Funds
financial
financial institutions
institutions that
that offer
offer savings
savings plans
plans for
for
retirement
retirement
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Services Performed by Financial

Intermediaries
Monitoring
Monitoring Costs
Costs
Liquidity
Liquidity and
and Price
Price Risk
Risk
Transaction
Transaction Cost
Cost Services
Services
Maturity
Maturity Intermediation
Intermediation
Denomination
Denomination Intermediation
Intermediation
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Services Provided by FIs Benefiting the

Overall Economy
Money
Money Supply
Supply Transmission
Transmission
Credit
Credit Allocation
Allocation
Intergenerational
Intergenerational Wealth
Wealth Transfers
Transfers
Payment
Payment Services
Services

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Risks Faced by Financial Institutions

Interest
Interest Rate
Rate Risk
Risk
Foreign
Foreign Exchange
Exchange Risk
Risk
Market
Market Risk
Risk
Credit
Credit Risk
Risk
Liquidity
Liquidity Risk
Risk
Off-Balance-Sheet
Off-Balance-Sheet Risk
Risk
Technology
TechnologyRisk
Risk
Operational
Operational Risk
Risk
Country
Country or
orSovereign
Sovereign Risk
Risk
Insolvency
Insolvency Risk
Risk
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Regulation of Financial Institutions

FIs
FIs provide
provide vital
vital financial
financial services
services to
to
all
all sectors
sectors of
of the
the economy;
economy; therefore,
therefore,
their
their regulation
regulation isis in
in the
the public
public interest
interest
In
In an
an attempt
attempt to
to prevent
prevent their
their failure
failure
and
and the
the failure
failure of
of financial
financial markets
markets
overall
overall
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Globalization of Financial Markets and

Institutions
Financial
Financial Markets
Markets became
became more
more
global
global as
as the
the value
value of
of stocks
stocks traded
traded in
in
foreign
foreign markets
markets soared
soared
Foreign
Foreign bond
bond markets
markets have
have served
served as
as
aa major
major source
source of
of international
international capital
capital
Globalization
Globalization also
also evident
evident in
in the
the
derivative
derivative securities
securities market
market
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Factors Leading to Significant Growth

in Foreign Markets
The
The pool
pool of
of savings
savings from
from foreign
foreign investors
investors has
has
increased
increased
International
International investors
investors have
have turned
turned to
to U.S.
U.S. and
and other
other
markets
markets to
to expand
expand their
their investment
investment opportunities
opportunities
Information
Information on
on foreign
foreign investments
investments and
and markets
markets isis
now
now more
more accessible
accessible (e.g.
(e.g. internet)
internet)
Some
Some mutual
mutual funds
funds allow
allow ability
ability to
to invest
invest in
in foreign
foreign
securities
securities with
with low
low transaction
transaction costs
costs
Deregulation
Deregulation has
has enhanced
enhanced globalization
globalization of
of capital
capital
flows
flows
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