1. © 2004 Pearson Addison-Wesley. All rights reserved 2-1 Function of Financial Markets 1. Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency

2. © 2004 Pearson Addison-Wesley. All rights reserved 2-2 Function of Financial Markets Allocation of funds to productive opportunities. Transfer of funds over life horizon. Empirical Evidence I: King and Levin (1993) find that the relative size of financial sector is positively related to growth. Empirical Evidence II: Galindo, Schiantarelli and Weiss (2002) find that financial liberalizations are followed by improved capital allocations.

3. © 2004 Pearson Addison-Wesley. All rights reserved 2-3 Classifications of Financial Markets I By Financial Instruments 1.Debt Markets Short-term (maturity < 1 year) Long-term (maturity > 10 year) 2.Equity Markets Common stocks (owner a residual claimant) The value of debt instruments was $20 trillion in 2002 while the value of equity was $11 trillion.

4. © 2004 Pearson Addison-Wesley. All rights reserved 2-4 Classifications of Financial Markets II 1.Primary Market (often behind closed doors) New security issues sold to initial buyers 2.Secondary Market Securities previously issued are bought and sold Investment Bank. Role of Brokers and Dealers. Liquidity and Valuation Provided by the Secondary Market.

5. © 2004 Pearson Addison-Wesley. All rights reserved 2-5 Classifications of Financial Markets III By Organization of Secondary Market 1.Exchanges Trades conducted in central locations (NYSE,ASE) 2.Over-the-Counter (OTC) Markets Dealers at different locations buy and sell U.S. Gov’t Bond Market Organized as an OTC market with 40 or so dealers.

6. © 2004 Pearson Addison-Wesley. All rights reserved 2-6 Classifications of Financial Markets IV By Maturity 1.Money Market (< 1 year debt instruments) 2.Capital Market (longer term debt and equity).

7. © 2004 Pearson Addison-Wesley. All rights reserved 2-7 Internationalization of Financial Markets International Bond Market 1. Foreign bonds 2. Eurobonds Now larger than U.S. corporate bond market World Stock Markets U.S. stock markets are no longer always the largest: Japan sometimes larger

8. © 2004 Pearson Addison-Wesley. All rights reserved 2-8 Function of Financial Intermediaries Financial Intermediaries 1.Engage in process of indirect finance 2.More important source of finance than securities markets 3.Needed because of transactions costs and asymmetric information

9. © 2004 Pearson Addison-Wesley. All rights reserved 2-9 Transactions Costs Transaction costs, the time and money spent in carrying out financial transactions. Financial intermediaries make profits by reducing transactions costs Reduce transactions costs by developing expertise and taking advantage of economies of scale

10. © 2004 Pearson Addison-Wesley. All rights reserved 2-10 Function of Financial Intermediaries Risk Sharing 1.Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation). 2.Also lower risk by helping people to diversify portfolios

11. © 2004 Pearson Addison-Wesley. All rights reserved 2-11 Asymmetric Information: Adverse Selection,and Moral Hazard Adverse Selection (hidden information) 1.Before transaction occurs 2.Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected Moral Hazard (hidden action) 1.After transaction occurs 2.Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

12. © 2004 Pearson Addison-Wesley. All rights reserved 2-12 Financial Intermediaries Depository Institutions (banks) accept deposits from individuals and institutions and make loans. Contractual savings institutions acquire funds at periodic intervals on a contractual basis. (liquidity not as important issue as banks.) Investment Intermediaries.

13. 2-13 Financial Intermediaries

14. © 2004 Pearson Addison-Wesley. All rights reserved 2-14 Size of Financial Intermediaries

15. © 2004 Pearson Addison-Wesley. All rights reserved 2-15 Methods to Ensure Soundness 1.Restrictions on entry 2.Disclosure 3.Restrictions on assets and liabilities 4.Deposit Insurance 5.Limits on Competition 6.Restrictions on Interest rates

16. 2-16 Regulatory Agencies

17. 2-17 Regulatory Agencies

18. © 2004 Pearson Addison-Wesley. All rights reserved 2-18 Regulation of Financial Markets Two Main Reasons for Regulation 1.Increase information to investors A.Decreases adverse selection and moral hazard problems B.SEC forces corporations to disclose information 2.Ensuring the soundness of financial intermediaries A.Prevents financial panics B.Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anti- competitive measures