Download Fin.Markets Chr01

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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Primary versus Secondary Markets
• Primary markets
– New issues of the instruments are sold to the initial
suppliers of funds (household) in exchange for funds.
These transactions are usually arranged through
investment banks (Lehman Brothers, Morgan Stanley
etc which are called underwriters.)
– The first public issue of financial instruments by a firm
is called IPOs (initial public offering) + private
placement
– Erosion in IPO processes???
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Primary versus Secondary Markets
• Secondary markets
– Buyers are the economic agents with excess fund
(consumers, business, and goverment)
– Sellers are the economic agents in need of funds.
– markets where financial instruments are traded among
investors (e.g., NYSE and Nasdaq)
– Securities brokers are the intermediaries between the
buyer and seller.
– Secondary market is available for mortgage backed
instruments (c7), F-X (c9), futures&options (c10)
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Primary versus Secondary Markets
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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 and Capital Market
Instruments (Table 1-2)
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Money Market Instruments
Outstanding, ($Bn)
3000
2500
2000
1500
1000
500
0
1990q4
Fed funds and repos
U.S. Treasury bills
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2000q4
Commercial paper
Banker's accept.
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2007q1
Negotiable CDs
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Capital Market Instruments
Outstanding, ($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
– currency today, for delivery today, at a price made today
• Forward FX
– the exchange of currencies in the future on a specific date and at a
pre-specified exchange rate
– Traditional FX forwards are available for maturities from 3 days
out to about 2 years
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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
– Depending on underlying securty price changes, the
value of the derivative security changes.
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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
– Regulations are not for poor investment choices but for investors
to have full and accurate information available about corporate
issuers.
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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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Changing Shares of FIs
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FIs Benefit Suppliers of Funds
• Reduce monitoring costs: Aggregation of
funds in an FI provides greater incentive to
collect a firm’s information and monitor
actions. (delegated monitor)
Because of the economies of scale the
average cost of collecting the information is
low. (hiring employees with superior skills
and training in monitoring)
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FIs Benefit Suppliers of Funds
• Increase liquidity and lower price risk: FIs’ act
as asset transformers. They purchase the
financial claims issued by users of funds
(mortgages, bonds, stocks) and finance these
purchases by selling financial claims to household
investers.
• FIs can diversify away some of their investment
risk. So that they can credibly fulfill its promises
to the suppliers of funds.
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-Diversification• As long as the returns on different investments are
not perfectly positively correlated, by spreading
their investments across a number of assets,
Fıs can diversify away significant amounts of
their portfolio risk.
• Researhes show that diversifying across just 15
securities can bring significant diversification
benefits to FIs and portfolio managers.
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FIs Additional Benefits to Suppliers of
Funds
• Reduce transaction costs: For instance, buying
a 100 USD broker’s report may seem hig for a
10,000 USD investment but for an FI with 10
billion of assets the cost is trivial.
• IT reduce transactions costs. No need to use a
traditional stockbroker and paying brokerage fees.
• Even some companies allow investors to buy their
stocs directly (private placement) (IBM,
Microsoft, Walt Disney, AT&T)
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FIs Benefit Suppliers of Funds
• Provide maturity intermediation: They have an
abilitity o bear the risk of mismatching the
maturities of their assets and liabilities.
• So, they also offer maturity intermediation
services to the rest of the economy.
• As a result, FIs can produce new types of
contracts with a longer maturity comparing to
short term deposits.
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FIs Benefit Suppliers of Funds
• Provide denomination intermediation: As many assets
are sold in very large denominations, individual savers can
not reach. Minimum size of a negotiable CD is 100,000
USD while commercial paper (Short term corparate dept)
packages are minimum 250,000 USD.
• By pooling the funds of many small savers, small savers
overcome constraints to buying assets imposed by large
minimum denomination size.
• Such access may allow small savers to generate higher
returns (and lower risks) on their portfolio because of
diversification.
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FIs Benefit the Overall Economy
• Federal Reserve conducts monetary
policy (The transmitters of monetary
policy): Most commonly used definition of
money supply (which indirectly impacts the
rate of inflation,) is bank deposits.
Depository institutions are instrumental in
determining the size and growth of the
money supply.
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FIs Benefit the Overall Economy
• Provides efficient credit allocation:
Depending on their preidentified roles. If
policymakers identifies that residential real
estate needs special attention, mortgage
lending becomes important (Thrifts must
have at least %65 of their assets in
mortgage related fields)
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FIs Benefit the Overall Economy
• Provide for intergenerational wealth transfers
or Time Intermediation: From your youth to old
age as well as across generations...
So, life insurance, pension funds have special tax
exempts.
• Provide payment services: Like check-clearing
and wire transfer services.
(Fedwire and CHIPS) (On any given day, over 3 trillion dollars of
payment are directed through Fedwire and CHIPS) imagine
breakdown of this system !!!
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Risks Faced by Financial Institutions
• They hold some assets that are potentially subject
to default or credit risk.
• As they expand their services to non-US
customers or even domestic customers have
business outside the US, there is foreign
exchange and country risk (sovereign risk) .
• There is a risk of mismatching their assets and
liabilities, so they are exposed to interest rate
risk
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Risks Faced by Financial Institutions
• If FIs actively trade these assets and liabilities
rather than hold them for long investments, they
are exposed to market risk or asset price risk.
• All FIs are exposed to technology risk and
operational risk as they need to use real
resources and back office support systems
(labor+technology)
• Not having enough capital may lead to
insolvency.
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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
contingent liabilities
•
•
•
•
Liquidity
Technology
Operational
Insolvency
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Risks Faced by Financial Institutions
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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
• Foreign bond markets have served as a major source
of international capital.
• Fin. Markets became global in 1980s as IT provided
immediate and cheaper access to real time data
worldwide.
• Eurodollar bonds are 80 percent of new issues in
international bond market.
Dolar denominated bonds issued mainly in London and other European Centers such as
Luxemburg. Not required to register SEC as they are not “domestic”
• The significant growt in foreign financial markets is the
result of several factors.
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Reasons of Growth in Foreign Financial
Market
• The pool of savings from foreign investors (i.e from
EU) 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
• Euro is also having a notable impact on the global
financial sytem.
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International Debt Outstanding, by Issuer
in billions of Dollars
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Financial Market Securities Holdings
While US financial marketsdominate world markets, the growth of US financial markets depends more
and more on the growth and development of other economies.
The success of other economies depends to a significant extent on their financial market development
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The Largest Banks in the World
• Competition is also increased due to global markets.
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Foreign Bank Offices Assets and Liabilities
Held in the US
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End of Chapter 1
• Thanks
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