©2007, The McGraw-Hill Companies, All Rights Reserved 1-1 McGraw-Hill/Irwin 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 1-2 McGraw-Hill/Irwin Historical Drivers of Change in Financial Markets Financial institutions (FI’s) were approaching a full cycle –Banks were originally “full service” Performed all financial services –1930’s collapse led to separation of some of these services –70’s & 80’s new services come into being e.g. brokerage funds, mutual funds –We were coming into an era where one FI offered all services again Citigroup for example This trend may be interrupted by the scandals of 2002 Innovation is also driving change in the industry Asset securitization Derivative securities Internationalization of financial services

©2007, The McGraw-Hill Companies, All Rights Reserved 1-3 McGraw-Hill/Irwin Current Drivers of Change in Financial Markets Technological innovation is currently a major driver of change in the industry Asset securitization The growth of derivative securities Globalization of financial services

©2007, The McGraw-Hill Companies, All Rights Reserved 1-4 McGraw-Hill/Irwin Globalization of Financial Markets and Institutions Financial Markets have become 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 is also evident in the derivative securities market Financial Markets have become 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 is also evident in the derivative securities market

©2007, The McGraw-Hill Companies, All Rights Reserved 1-5 McGraw-Hill/Irwin Financial Markets Financial Markets defined –Structures or arenas through which funds flow Financial Markets are comprised of two sectors - Primary & Secondary

©2007, The McGraw-Hill Companies, All Rights Reserved 1-6 McGraw-Hill/Irwin Primary Markets –Borrowers or users of funds (corps) raise funds through issuance of financial instruments –Suppliers of funds exchange cash for financial instruments issued in the primary market –Generally, primary market transactions are facilitated by FI’s called investment banks –Morgan Stanley, Lehman Bros, CSFB, Merrill, Goldman, etc. –Security issuer can minimize risk by engaging in “Firm commitment underwriting” Investment bank buys entire issue, assuming the risk of not selling it all Issuer gets a guaranteed cashflow

©2007, The McGraw-Hill Companies, All Rights Reserved 1-7 McGraw-Hill/Irwin Primary Markets continued –Primary Market securities include: Equity offerings (stocks) –Initial public offerings (IPO’s) –Additional equity offerings (aka secondary offerings) Debt offerings (bonds) –Primary Market transactions are often collaborative Syndicates (groups of investment banks) underwrite the issuance –Spreads risk –Enhances distribution

©2007, The McGraw-Hill Companies, All Rights Reserved 1-8 McGraw-Hill/Irwin Secondary Markets Secondary markets defined –A market that trades securities after they are issued. Original security issuers are not involved in secondary market transactions –Transactions involve buyers, sellers and brokers Secondary markets have two primary components –Equity markets (stocks) –Fixed income markets (bonds) Benefits of secondary markets –For investors (suppliers of funds) Liquidity - able to turn the asset into cash relatively easily Diversification - mitigate risk by purchasing securities from many issuers

©2007, The McGraw-Hill Companies, All Rights Reserved 1-9 McGraw-Hill/Irwin Secondary Markets continued Benefits of secondary markets –For original issuers (users of funds) How their securities are currently trading will tell them much about: –How well they are using the funds raised from previous issues –How successful they would be in issuing instruments now –What it would cost them to issue securities now Example - Fixed Income - Household Finance –Context for spread volatility Slow economy hurting profitability Recently fined $484 million for “predatory lending practices” Speculation about “aggressive accounting” practices –November 2002 announcement of a merge with HSBC

©2007, The McGraw-Hill Companies, All Rights Reserved 1-10 McGraw-Hill/Irwin Household Financial Example February 2007 Treasury currently 2.68%

©2007, The McGraw-Hill Companies, All Rights Reserved 1-11 McGraw-Hill/Irwin Money Markets vs. Capital Markets Both (primary &secondary) markets are segmented according to maturity: –Money Markets Maturities one year or less Fixed Income (debt) only –Capital Markets Maturities greater than one year Fixed Income & Equity (Debt & Stocks) –Some of the largest sectors of the Capital Markets »Stocks »Mortage-backed securities »Corporate and Agency Debt issuance

©2007, The McGraw-Hill Companies, All Rights Reserved 1-12 McGraw-Hill/Irwin Money Market Instruments Outstanding, ($Bn)

©2007, The McGraw-Hill Companies, All Rights Reserved 1-13 McGraw-Hill/Irwin Capital Market Instruments Outstanding, ($Bn)

©2007, The McGraw-Hill Companies, All Rights Reserved 1-14 McGraw-Hill/Irwin Exchange based and OTC markets Exchange based market –A market located in a particular location Orders must arrive at that location to be executed Equity markets have historically been exchange based, Nasdaq is changing this characteristic Examples –New York Stock Exchange –Chicago Mercantile Exchange –Chicago Board of Trade Over the counter market (OTC) –Markets that have no particular location, transactions occur through a network of brokers/buyers/sellers linked by telephones and computer networks Fixed income markets are over the counter markets

©2007, The McGraw-Hill Companies, All Rights Reserved 1-15 McGraw-Hill/Irwin 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 “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

©2007, The McGraw-Hill Companies, All Rights Reserved 1-16 McGraw-Hill/Irwin 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. 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.

©2007, The McGraw-Hill Companies, All Rights Reserved 1-17 McGraw-Hill/Irwin 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)

©2007, The McGraw-Hill Companies, All Rights Reserved 1-18 McGraw-Hill/Irwin Flow of Funds in a World without FIs: Direct Transfer Users of Funds (Corporations) Suppliers of Funds (Households) Financial Claims (Equity and debt instruments) Cash Example: A firm sells shares directly to investors without going through a financial institution.

©2007, The McGraw-Hill Companies, All Rights Reserved 1-19 McGraw-Hill/Irwin Flow of Funds in a world with FIs: Indirect transfer Users of Funds FI (Brokers) FI (Asset transformers) Suppliers of Funds Financial Claims (Equity and debt securities) Financial Claims (Deposits and insurance policies) Cash

©2007, The McGraw-Hill Companies, All Rights Reserved 1-20 McGraw-Hill/Irwin 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 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)

©2007, The McGraw-Hill Companies, All Rights Reserved 1-21 McGraw-Hill/Irwin 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 1-22 McGraw-Hill/Irwin Services Performed by Financial Intermediaries Monitoring Costs Liquidity and Price Risk Transaction Cost Services Maturity Intermediation Denomination Intermediation Monitoring Costs Liquidity and Price Risk Transaction Cost Services Maturity Intermediation Denomination Intermediation

©2007, The McGraw-Hill Companies, All Rights Reserved 1-23 McGraw-Hill/Irwin Services Provided by FIs Benefiting the Overall Economy Money Supply Transmission Credit Allocation Intergenerational Wealth Transfers Payment Services Money Supply Transmission Credit Allocation Intergenerational Wealth Transfers Payment Services

©2007, The McGraw-Hill Companies, All Rights Reserved 1-24 McGraw-Hill/Irwin Risks Faced by Financial Institutions Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Technology Risk Operational Risk Country or Sovereign Risk Insolvency Risk Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Technology Risk Operational Risk Country or Sovereign Risk Insolvency Risk

©2007, The McGraw-Hill Companies, All Rights Reserved 1-25 McGraw-Hill/Irwin 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 1-26 McGraw-Hill/Irwin Securities and Exchange Commission (SEC) Primary regulatory agency –Firms planning new security issuance must comply with disclosure criteria imposed by the SEC –The SEC is concerned with ensuring that all investors are given accurate and timely information on which to make investment decisions –The SEC is not concerned with helping investors avoid bad investment decisions

©2007, The McGraw-Hill Companies, All Rights Reserved 1-27 McGraw-Hill/Irwin Financial Market Regulation SEC also interested in “damping” large price fluctuations in securities markets - examples include: –“Circuit breakers” Cessation of trading when prices fluctuate in excess of % thresholds –“Curbs” When prices fluctuate in excess of % thresholds trading is delayed until a counter-trend trade is executed Private placements do not fall under SEC oversight –Private placements defined Securities not available to the public that are sold to a few large, sophisticated investors