Chapter One

Introduction

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 Why study Financial Markets and
Institutions?

• They are the cornerstones of the

overall financial system in which
financial managers operate
• Individuals use both for investing
• Corporations and governments use
both for financing

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 Overview of Financial Markets

• Primary Markets versus Secondary

Markets
• Money Markets versus Capital
Markets
• Foreign Exchange Markets

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 Primary Markets versus Secondary
Markets

• Primary Markets
– markets in which users of funds (e.g.
corporations, 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, NASDAQ)

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 Money Markets versus Capital Markets

• Money Markets
– markets that trade debt securities with
maturities of one year or less (e.g. CD’s, 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, 1990-2004 ($Bn)
2000

1500

1000

500

0
1990 2000 2004

Commercial paper Fed Funds and Repo U.S. T-bills

Negotiable CDs Banker's accept.

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 Capital Market Instruments
Outstanding, 1990-2004 ($Bn)
20000

15000

10000

5000

0
1990 2000 2004
Corporate stocks Mortgages Corporate bonds

Treasury Securities State & Local Govt. bonds U.S. Govt agencies

Bank and consumer loans

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 Foreign Exchange Markets

• “FX” markets deal in trading one currency

for another (e.g. dollar for yen)
• The “spot” FX transaction involves the
immediate exchange of currencies at the
current exchange rate
• The “forward” FX transaction involves the
exchange of currencies at a specified date in
the future and at a specified exchange rate

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 Derivative Security Markets

• The markets in which derivative

securities trade.
• Derivative Security
– An agreement between two parties to exchange
a standard quantity of an asset at a
predetermined price on a specified date in the
future.

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 Overview of Financial Institutions

• Institutions that perform the essential

function of channeling funds from those
with surplus funds to those with shortages
of funds (e.g. banks, thrifts, insurance
companies, securities firms and
investment banks, finance companies,
mutual funds, pension funds)
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 Flow of Funds in a World without FIs:
Direct Transfer
Financial Claims
(Equity and debt
instruments)
Suppliers of
Users of Funds
Funds
(Corporations)
(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
Users of Funds Suppliers of Funds
(Brokers)

Cash FI
Cash
(Asset
transformers)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and insurance policies)

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 Types of FIs

• Commercial banks
– depository institutions whose major assets are
loans and major liabilities are deposits
• Thrifts
– depository institutions in the form of savings
and loans, credit unions
• Insurance companies
– financial institutions that protect individuals
and corporations from adverse events

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

• Monitoring Costs
• Liquidity and Price Risk
• Transaction Cost Services
• Maturity Intermediation
• Denomination Intermediation

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 Services Provided by FIs Benefiting the
Overall Economy

• Money Supply Transmission

• Credit Allocation
• Intergenerational Wealth Transfers
• Payment Services

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 Risks Faced by Financial Institutions

• Interest Rate Risk

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

• FIs provide vital financial services to

all sectors of the economy; therefore,
their regulation is in the public interest
• In an attempt to prevent their failure
and the failure of financial markets
overall

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 Globalization of Financial Markets and
Institutions

• Financial Markets became more

global as the value of stocks traded in
foreign markets soared
• Foreign bond markets have served as
a major source of international capital
• Globalization also evident in the
derivative securities market
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 Factors Leading to Significant Growth
in Foreign Markets
• The pool of savings from foreign investors has
increased
• International investors have turned to U.S. and other
markets to expand their investment opportunities
• Information on foreign investments and markets is
now more accessible (e.g. internet)
• Some mutual funds allow ability to invest in foreign
securities with low transaction costs
• Deregulation has enhanced globalization of capital
flows
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