©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 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 1-6 McGraw-Hill/Irwin Money Market Instruments Outstanding, ($Bn)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-7 McGraw-Hill/Irwin Capital Market Instruments Outstanding, ($Bn)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-8 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 Forward FX –the exchange of currencies in the future on a specific date and at a pre-specified exchange rate FX markets –trading one currency for another (e.g., dollar for yen) Spot FX –the immediate exchange of currencies at current exchange rates Forward FX –the exchange of currencies in the future on a specific date and at a pre-specified exchange rate

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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-10 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 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-11 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 1-12 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 1-13 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 1-14 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 1-15 McGraw-Hill/Irwin FIs Benefit Suppliers of Funds Reduce monitoring costs Increase liquidity and lower price risk Reduce transaction costs Provide maturity intermediation Provide denomination intermediation Reduce monitoring costs Increase liquidity and lower price risk Reduce transaction costs Provide maturity intermediation Provide denomination intermediation

©2009, The McGraw-Hill Companies, All Rights Reserved 1-16 McGraw-Hill/Irwin FIs Benefit the Overall Economy Conduit through which Federal Reserve conducts monetary policy Provides efficient credit allocation Provide for intergenerational wealth transfers Provide payment services Conduit through which Federal Reserve conducts monetary policy Provides efficient credit allocation Provide for intergenerational wealth transfers Provide payment services

©2009, The McGraw-Hill Companies, All Rights Reserved 1-17 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 Liquidity Technology Operational Insolvency Off-balance-sheet Liquidity Technology Operational Insolvency

©2009, The McGraw-Hill Companies, All Rights Reserved 1-18 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 1-19 McGraw-Hill/Irwin Globalization of Financial Markets and Institutions The pool of savings from foreign investors 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 The pool of savings from foreign investors 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