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Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter One Introduction.

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Presentation on theme: "Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter One Introduction."— Presentation transcript:

1 Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter One Introduction

2 1-2 Why study Financial Markets and Institutions? What is Finance? It is all about money, money management. For what, how much, how to get it (debt, equity), how to use=invest it, how to allocate Markets and institutions are primary channels to allocate capital (resouces, money) in our society What is Finance? It is all about money, money management. For what, how much, how to get it (debt, equity), how to use=invest it, how to allocate Markets and institutions are primary channels to allocate capital (resouces, money) in our society

3 1-3 Why study Financial Markets and Institutions? In this text we will examine: the structure of domestic and international markets the flow of funds in domestic and international markets an overview of the strategies used to manage risks faced by investors and savers In this text we will examine: the structure of domestic and international markets the flow of funds in domestic and international markets an overview of the strategies used to manage risks faced by investors and savers

4 1-4 Financial Markets Financial markets? through which funds flow Financial markets can be distinguished along two dimensions: primary versus secondary markets Brand new securities (=instruments) are issued, An influx of capital to the issuer, existing securities traded money versus capital markets Short-term securities (short-term debt) vs. long-term securities (long-term debt, equity) Financial markets? through which funds flow Financial markets can be distinguished along two dimensions: primary versus secondary markets Brand new securities (=instruments) are issued, An influx of capital to the issuer, existing securities traded money versus capital markets Short-term securities (short-term debt) vs. long-term securities (long-term debt, equity)

5 1-5 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) little or no risk of capital loss, but low return Capital markets markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year substantial risk of capital loss, but higher promised return Money markets markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills) little or no risk of capital loss, but low return Capital markets markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year substantial risk of capital loss, but higher promised return

6 1-6 Money Market Instruments Outstanding, ($Bn)

7 1-7 Capital Market Instruments Outstanding, ($Bn)

8 1-8 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

9 1-9 Derivative Security Markets Derivative security a financial security whose payoff is linked to (i.e., “derived” from) primary security or commodity (stocks, bonds, currencies, gold, wheat, oild, etc), generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future, the main purpose of the derivatives markets is to transfer risk between market participants. Derivative security a financial security whose payoff is linked to (i.e., “derived” from) primary security or commodity (stocks, bonds, currencies, gold, wheat, oild, etc), generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future, the main purpose of the derivatives markets is to transfer risk between market participants.

10 1-10 Derivative Security Markets Selected examples of derivative securities Exchange listed derivatives Many options, futures contracts Over the counter derivatives Forward contracts Forward rate agreements Swaps Securitized loans Selected examples of derivative securities Exchange listed derivatives Many options, futures contracts Over the counter derivatives Forward contracts Forward rate agreements Swaps Securitized loans

11 1-11 Derivatives and the Crisis 1. Mortgage derivatives allowed a larger amount of mortgage credit to be created in the mid-2000s. 2. Mortgage derivatives spread the risk of mortgages to a broader base of investors. 3. Change in banking from ‘originate and hold’ loans to ‘originate and sell’ loans. Decline in underwriting standards on loans 1. Mortgage derivatives allowed a larger amount of mortgage credit to be created in the mid-2000s. 2. Mortgage derivatives spread the risk of mortgages to a broader base of investors. 3. Change in banking from ‘originate and hold’ loans to ‘originate and sell’ loans. Decline in underwriting standards on loans

12 1-12 Derivatives and the Crisis 1. Subprime mortgage losses have been quite large, 2. The “Great Recession” was the worst since the “Great Depression” of the 1930s. 1. Subprime mortgage losses have been quite large, 2. The “Great Recession” was the worst since the “Great Depression” of the 1930s.

13 1-13 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

14 1-14 Financial Institutions (FIs) Financial Institutions (major players) institutions through which suppliers channel money to users of funds Financial Institutions (major players) institutions through which suppliers channel money to users of funds

15 1-15 Asset Size and Number of Selected U.S. Financial Institutions 2010 INSTITUTION TOTAL ASSETS (BILL $) NUMBER OF FEDERALLY INSURED INSTITUTIONS Commercial Banks$12,1306,622 Savings Associations$ 1,2531,138 Credit Unions$ 8857,554 Insurance Companies$ 6,459 Private Pension Funds$ 5,661 Finance Companies$ 1,613 Mutual Funds$ 7,376 Money Market Mutual Funds$ 2,746 Data from September 2010, data sources include Federal Reserve Board, Flow of Funds Accounts, Levels Tables, FDIC Stats at a Glance and the NCUA website. The mutual funds category excludes money market funds.

16 1-16 Users of Funds (corporations) Suppliers of Funds (households) Financial Claims (equity and debt instruments) Cash Flow of Funds in a World without FIs Non-Intermediated (Direct) Flows of Funds Direct Financing

17 1-17 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 with FIs Intermediated Flows of Funds Intermediated Financing

18 1-18 Depository versus Non-Depository FIs Depository institutions: commercial banks, savings associations, savings banks, credit unions Non-depository institutions Contractual: insurance companies, pension funds, Non-contractual: securities firms and investment banks, mutual funds. Depository institutions: commercial banks, savings associations, savings banks, credit unions Non-depository institutions Contractual: insurance companies, pension funds, Non-contractual: securities firms and investment banks, mutual funds.

19 1-19 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

20 1-20 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

21 1-21 Regulation of Financial Institutions FIs are heavily regulated to protect society at large from market failures Regulations impose a burden on FIs and before the financial crisis, recent U.S. regulatory changes were 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 before the financial crisis, recent U.S. regulatory changes were deregulatory in nature Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation

22 1-22 Regulation of Financial Institutions New Dodd-Frank Bill 1. Promote robust supervision of FIs Financial Service Oversight Council to identify and limit systemic risk, Broader authority for Federal Reserve (Fed) to oversee non-bank FIs, Higher equity capital requirements, Registration of hedge funds and private equity funds. New Dodd-Frank Bill 1. Promote robust supervision of FIs Financial Service Oversight Council to identify and limit systemic risk, Broader authority for Federal Reserve (Fed) to oversee non-bank FIs, Higher equity capital requirements, Registration of hedge funds and private equity funds.

23 1-23 Regulation of Financial Institutions 1. New Dodd-Frank Bill 1. Comprehensive supervision of financial markets New regulations for securitization and over the counter derivatives Additional oversight by Fed of payment systems 2. Establishes a new Consumer Financial Protection Agency 1. New Dodd-Frank Bill 1. Comprehensive supervision of financial markets New regulations for securitization and over the counter derivatives Additional oversight by Fed of payment systems 2. Establishes a new Consumer Financial Protection Agency

24 1-24 Globalization of Financial Markets and Institutions The pool of savings from foreign investors is increasing and investors look to diversify globally 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, Global capital flows are larger than ever. BUT, a contagion effect! The pool of savings from foreign investors is increasing and investors look to diversify globally 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, Global capital flows are larger than ever. BUT, a contagion effect!

25 1-25 Appendix: FIs and the Crisis Timeline of events Home prices decline in late 2006 and early 2007 Delinquencies on subprime mortgages increase Huge losses on mortgage-backed securities (MBS) Bear Stearns fails and is bought out by J.P. Morgan Chase for $2 a share (deal had government backing). Timeline of events Home prices decline in late 2006 and early 2007 Delinquencies on subprime mortgages increase Huge losses on mortgage-backed securities (MBS) Bear Stearns fails and is bought out by J.P. Morgan Chase for $2 a share (deal had government backing).

26 1-26 Appendix: FIs and the Crisis Timeline of events September 2008, the government seizes government- sponsored mortgage agencies Fannie Mae and Freddie Mac The two had $9 billion in losses in the second half 2007 Now run by Federal Housing Finance Agency (FHFA) September 2008, Lehman Brothers files for bankruptcy; Dow drops 500 points Timeline of events September 2008, the government seizes government- sponsored mortgage agencies Fannie Mae and Freddie Mac The two had $9 billion in losses in the second half 2007 Now run by Federal Housing Finance Agency (FHFA) September 2008, Lehman Brothers files for bankruptcy; Dow drops 500 points

27 1-27 Appendix: FIs and the Crisis

28 1-28 Appendix: FIs and the Crisis

29 1-29 Appendix: Government Rescue Plan

30 1-30 Appendix: Government Rescue Plan


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