©2009, The McGraw-Hill Companies, All Rights Reserved Chapter One Introduction

©2009, The McGraw-Hill Companies, All Rights Reserved 1-2 McGraw-Hill/Irwin 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 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-3 McGraw-Hill/Irwin 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 Financial markets are structures through which funds flow Financial markets can be distinguished along two dimensions –primary versus secondary markets –money versus capital markets

©2009, The McGraw-Hill Companies, All Rights Reserved 1-4 McGraw-Hill/Irwin 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) 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)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-5 McGraw-Hill/Irwin 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??? 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???

©2009, The McGraw-Hill Companies, All Rights Reserved 1-6 McGraw-Hill/Irwin 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) 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)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-7 McGraw-Hill/Irwin

©2009, The McGraw-Hill Companies, All Rights Reserved 1-8 McGraw-Hill/Irwin Primary versus Secondary Markets

©2009, The McGraw-Hill Companies, All Rights Reserved 1-9 McGraw-Hill/Irwin 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 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-10 McGraw-Hill/Irwin Money and Capital Market Instruments (Table 1-2)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-11 McGraw-Hill/Irwin Money Market Instruments Outstanding, ($Bn)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-12 McGraw-Hill/Irwin Capital Market Instruments Outstanding, ($Bn)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-13 McGraw-Hill/Irwin 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 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-14 McGraw-Hill/Irwin 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. 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-15 McGraw-Hill/Irwin 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. 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-16 McGraw-Hill/Irwin 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 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-17 McGraw-Hill/Irwin Users of Funds (corporations) Suppliers of Funds (households) Financial Claims (equity and debt instruments) Cash Flow of Funds in a World without FIs

©2009, The McGraw-Hill Companies, All Rights Reserved 1-18 McGraw-Hill/Irwin Users of Funds FIs (brokers) FIs (asset transformers) Suppliers of Funds Financial Claims (equity and debt securities) Financial Claims (deposits and insurance policies) Cash Flow of Funds in a World without FIsFlow of Funds in a World with FIs

©2009, The McGraw-Hill Companies, All Rights Reserved 1-19 McGraw-Hill/Irwin 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 Depository institutions –commercial banks, savings associations, savings banks, credit unions Non-depository institutions –insurance companies, securities firms and investment banks, mutual funds, pension funds

©2009, The McGraw-Hill Companies, All Rights Reserved 1-20 McGraw-Hill/Irwin Changing Shares of FIs

©2009, The McGraw-Hill Companies, All Rights Reserved 1-21 McGraw-Hill/Irwin 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)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-22 McGraw-Hill/Irwin 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. 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-23 McGraw-Hill/Irwin -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. 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-24 McGraw-Hill/Irwin 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) 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)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-25 McGraw-Hill/Irwin 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. 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-26 McGraw-Hill/Irwin 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. 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-27 McGraw-Hill/Irwin 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-28 McGraw-Hill/Irwin 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)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-29 McGraw-Hill/Irwin 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 !!! 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 !!!

©2009, The McGraw-Hill Companies, All Rights Reserved 1-30 McGraw-Hill/Irwin 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 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-31 McGraw-Hill/Irwin 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. 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-32 McGraw-Hill/Irwin Risks Faced by Financial Institutions Credit Foreign exchange Country or sovereign Interest rate Market Credit Foreign exchange Country or sovereign Interest rate Market Off-balance-sheet contingent liabilities Liquidity Technology Operational Insolvency Off-balance-sheet contingent liabilities Liquidity Technology Operational Insolvency

©2009, The McGraw-Hill Companies, All Rights Reserved 1-33 McGraw-Hill/Irwin Risks Faced by Financial Institutions

©2009, The McGraw-Hill Companies, All Rights Reserved 1-34 McGraw-Hill/Irwin 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 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-35 McGraw-Hill/Irwin 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. 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-36 McGraw-Hill/Irwin 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. 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.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-37 McGraw-Hill/Irwin International Debt Outstanding, by Issuer in billions of Dollars

©2009, The McGraw-Hill Companies, All Rights Reserved 1-38 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-39 McGraw-Hill/Irwin The Largest Banks in the World Competition is also increased due to global markets.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-40 McGraw-Hill/Irwin Foreign Bank Offices Assets and Liabilities Held in the US

©2009, The McGraw-Hill Companies, All Rights Reserved 1-41 McGraw-Hill/Irwin End of Chapter 1 Thanks