1. Chapter 2 An Overview of the Financial System

2. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-2 Function of Financial Markets Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds Promotes economic efficiency by producing an efficient allocation of capital, which increases production Directly improve the well-being of consumers by allowing them to time purchases better

3. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-3 Direct finance and Indirect finance Direct finance – funds are directly transferred from lenders to borrowers Indirect finance – financial intermediaries receive funds from savers and lend them to borrowers  Securities are assets for the holder and liabilities for the issuer

4. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-4 1.Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency

5. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-5 Structure of Financial Markets Debt and Equity Markets  Debt instruments – contractual obligation to pay the holder fixed payments at specified dates (e.g., mortgages, bonds, car loans, student loans)  Short-term debt instruments have a maturity of less than one year  Intermediate-term debt instruments have a maturity between 1 and 10 years  Long-term debt instruments have a maturity of ten or more years  Equity – sale of ownership share (owners are residual claimants).  Owners of stock may receive dividends

6. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-6 Structure of Financial Markets Primary and Secondary Markets  Primary market = financial market in which newly issued securities are sold.  Secondary market = financial market in which previously owned securities are sold.  Investment Banks underwrite securities in primary markets  Brokers and dealers work in secondary markets Broker – match buyers and sellers Dealers – buy and sell securities

7. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-7 Structure of Financial Markets Roles of Secondary Markets  Increase liquidity of financial assets  Determine security prices that help determine the price of securities in primary markets Exchanges and Over-the-Counter (OTC) Markets  Exchange – buyers and sellers meet in one central location (e.g., NYSE or Chicago Board of Trade)  Over-the-counter market – transactions take place in multiple locations through dealers

8. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-8 Structure of Financial Markets Money and Capital Markets  Money markets deal in short-term debt instruments  Capital markets deal in intermediate and longer-term debt and equity instruments

9. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-9 Financial Market Instruments Money Market Instruments  US treasury bills: 1-, 3-, 6-month maturities, discounted; no default risk  Negotiable bank certificates of deposit (NCD): transferable in the secondary markets, large denominations  Commercial paper (CP): issued by large banks or well-known corporations, growing fast, direct finance; largest instrument  Banker’s Acceptances: can be resold in the secondary markets, use abroad in international trade  Repurchase Agreements (repos): treasury bills are used to serve as collateral, <2 weeks  Federal (Fed) funds: overnight loan b/w banks of their deposits at Fed

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11. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-11 Financial Market Instruments Capital Market Instruments  Stocks: largest instruments, hold by individuals (1/2), pensions, mutual funds, and insurance companies  Mortgages: 3 government agencies, FNMA (Fannie Mae), GNMA (Ginnie Mae), FHLMC (Freddie Mac)  Corporate bonds: convertible or non-convertible  US government securities: issued by US Treasury, most liquid security  US government agency securities: issued by other US gov’t agencies, e.g., FNMA, GNMA…  State and local government bonds: also called municipal bonds, interest-exemption  Consumer and bank commercial loans

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13. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-13 Internationalization of Financial Markets Foreign Bonds—sold in a foreign country and denominated in that country’s currency Foreign bonds may be used to avoid exchange-rate risk Eurobond—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  London, Tokyo and other foreign stock exchanges have grown in importance

14. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-14 Function of Financial Intermediaries: Indirect Finance Lower transaction costs  Economies of scale  Liquidity services Reduce Risk  Risk Sharing (Asset Transformation)  Diversification Asymmetric Information  Adverse Selection (before the transaction)—more likely to select risky borrower  Moral Hazard (after the transaction)—less likely borrower will repay loan

15. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-15 Function of Financial Intermediaries: Indirect Finance Adverse Selection: Individuals who are willing to accept a financial (or other) contract are of lower “ quality ” than a typical individual in the population 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: The existence of a contract causes one party to alter their behavior in a manner detrimental to the other party 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

16. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-16 Types of financial intermediaries Depository institutions  Commercial banks  Savings and Loan Associations  Mutual savings banks  Credit unions Contractual savings institutions  Life insurance companies  Fire and casualty insurance companies  Pension funds and government retirement funds Investment intermediaries  Finance companies  Mutual funds  Money market mutual funds  Investment banks

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19. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-19 Regulation of the Financial System Two Main Reasons for Regulation ( Financial sector is one of the most heavily regulated sectors of the economy ) To increase the information available to investors:  Reduce adverse selection and moral hazard problems  SEC forces corporations to disclose information to reduce insider trading To ensure the soundness of financial intermediaries:  Restrictions on entry  Disclosure Laws (SEC)  Restrictions on Assets and Activities  Deposit Insurance  Limits on Competition  Restrictions on Interest Rates (no longer in effect)

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