1. Chapter 2 An Overview of the Financial System

2. © 2013 Pearson Education, Inc. All rights reserved.2-2 Function of Financial Markets Perform the essential function of channeling funds from economic players that have saved__ _______to those that have a ________of funds _____________: borrowers borrow funds directly from lenders in financial markets by selling them securities. _____________: borrowers borrow funds indirectly from lenders through the financial intermediaries in financial.

3. © 2013 Pearson Education, Inc. All rights reserved.2-3 Figure 1 Flows of Funds Through the Financial System

4. © 2013 Pearson Education, Inc. All rights reserved.2-4 Function of Financial Markets (cont’d) Promotes economic efficiency by producing an efficient allocation of capital, which increases production. Eg. Directly improve the well-being of consumers by allowing them to time purchases better. Eg.

5. © 2013 Pearson Education, Inc. All rights reserved.2-5 Structure of Financial Markets Debt and Equity Markets –Debt instruments (maturity) Note: __________ is the number of years until the instrument’s expiration date. –Equities (dividends)

6. © 2013 Pearson Education, Inc. All rights reserved.2-6 Primary and Secondary Markets __________ Markets : I nvestment Banks underwrite securities. __________ Markets:  Brokers are agents of investors who match buyers with sellers securities.  Dealers link buyers and sellers by buying and selling securities at stated prices. Structure of Financial Markets

7. © 2013 Pearson Education, Inc. All rights reserved.2-7 Structure of Financial Markets (cont’d) Exchanges and Over-the-Counter (OTC) Markets in Secondary Market structure. –Exchanges: NYSE, Chicago Board of Trade. –OTC Markets: Foreign exchange, Federal funds.

8. © 2013 Pearson Education, Inc. All rights reserved.2-8 Money and Capital Markets Money markets deal in short-term debt instruments. Capital markets deal in longer-term debt and equity instruments Structure of Financial Markets (cont’d)

9. © 2013 Pearson Education, Inc. All rights reserved.2-9 Money Market Instruments 1. 2. 3. 4. 5.

10. © 2013 Pearson Education, Inc. All rights reserved.2-10 Table 1 Principal Money Market Instruments

11. © 2013 Pearson Education, Inc. All rights reserved.2-11 Capital Market Instruments 1. Stocks 2. Mortgages and Mortgage Backed Securities http://www.youtube.com/watch?v=qqUGoVez8xg 3. Corporate Bonds 4. US Government Securities / US Government Agency Securities 5. State and Local Government Bonds 6. Consumer and Commercial Bank Bonds

12. © 2013 Pearson Education, Inc. All rights reserved.2-12 Table 2 Principal Capital Market Instruments

13. © 2013 Pearson Education, Inc. All rights reserved.2-13 Internationalization of Financial Markets _______ Bonds: sold in a foreign country and denominated in that country’s currency ________: bond denominated in a currency other than that of the country in which it is sold Eurocurrencies: foreign currencies deposited in banks outside the home country –Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks World Stock Markets –Also help finance the federal government

14. © 2013 Pearson Education, Inc. All rights reserved.2-14 Function of Financial Intermediaries: Indirect Finance Lower transaction costs (time and money spent in carrying out financial transactions) –Economies of scale –Liquidity services Reduce the exposure of investors to risk –Risk Sharing (Asset Transformation) –Diversification

15. © 2013 Pearson Education, Inc. All rights reserved.2-15 Function of Financial Intermediaries: Indirect Finance (cont’d) Deal with asymmetric information problems  (Before the transaction) >> Adverse Selection: try to avoid selecting the risky borrower. Gather information about potential borrower.  (after the transaction) >> Moral Hazard: ensure borrower will not engage in activities that will prevent him/her to repay the loan. Sign a contract with restrictive covenants. Conclusion:

16. © 2013 Pearson Education, Inc. All rights reserved.2-16 Table 3 Primary Assets and Liabilities of Financial Intermediaries

17. © 2013 Pearson Education, Inc. All rights reserved.2-17 Regulation of the Financial System To increase the information available to investors: –Reduce adverse selection and moral hazard problems –Reduce insider trading (SEC).

18. © 2013 Pearson Education, Inc. All rights reserved.2-18 Regulation of the Financial System (cont’d) To ensure the soundness of financial intermediaries: –Restrictions on entry (chartering process). –Disclosure of information. –Restrictions on Assets and Activities (control holding of risky assets). –Deposit Insurance (avoid bank runs). –Limits on Competition (mostly in the past): Branching Restrictions on Interest Rates

19. © 2013 Pearson Education, Inc. All rights reserved.2-19 Table 5 Principal Regulatory Agencies of the U.S. Financial System