1. ©2009, The McGraw-Hill Companies, All Rights Reserved Chapter One Introduction

2. ©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

3. ©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

4. ©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) –Through financial institutions called investment bank –IPO: the first public issue of financial instruments by a firm Primary markets –markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds) –Through financial institutions called investment bank –IPO: the first public issue of financial instruments by a firm

5. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-5 McGraw-Hill/Irwin Primary versus Secondary Markets Secondary markets –markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq) –Provide the opportunity to trade securities at their market values quickly with varying risk- return characteristics –Derivative security: a financial security whose payoffs are linked to other, previously issued securities Secondary markets –markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq) –Provide the opportunity to trade securities at their market values quickly with varying risk- return characteristics –Derivative security: a financial security whose payoffs are linked to other, previously issued securities

6. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-6 McGraw-Hill/Irwin Primary versus Secondary Markets Secondary markets –Derivative security: A financial security whose payoffs are linked to other, previously issued securities Secondary markets –Derivative security: A financial security whose payoffs are linked to other, previously issued securities

7. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-7 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) –Most U.S. money markets are over-the-counter (OTC) markets. –OTC: markets that don’t operate in a specific fixed location Money markets –markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills) –Most U.S. money markets are over-the-counter (OTC) markets. –OTC: markets that don’t operate in a specific fixed location

8. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-8 McGraw-Hill/Irwin Money versus Capital Markets Money markets instruments –Issued by corporations & governments to obtain short-term funds –For example: T-bills, commercial paper, negotiable certificates Money markets instruments –Issued by corporations & governments to obtain short-term funds –For example: T-bills, commercial paper, negotiable certificates

9. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-9 McGraw-Hill/Irwin Money versus Capital Markets Capital markets –markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year –With longer maturity, instruments experience wider price fluctuations in the secondary markets Capital markets –markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year –With longer maturity, instruments experience wider price fluctuations in the secondary markets

10. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-10 McGraw-Hill/Irwin Money versus Capital Markets Capital markets instruments –For example: corporate stocks, mortgages, and bonds Capital markets instruments –For example: corporate stocks, mortgages, and bonds

11. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-11 McGraw-Hill/Irwin Money Market Instruments Outstanding, ($Bn)

12. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-12 McGraw-Hill/Irwin Capital Market Instruments Outstanding, ($Bn)

13. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-13 McGraw-Hill/Irwin Foreign Exchange (FX) Markets FX markets –trading one currency for another (e.g., dollar for yen) –Financial managers have to understand how events and movements in financial markets in other countries affect the profitability and performance of a corporate –Foreign currency exchange rates are flexible (demand & supply ) FX markets –trading one currency for another (e.g., dollar for yen) –Financial managers have to understand how events and movements in financial markets in other countries affect the profitability and performance of a corporate –Foreign currency exchange rates are flexible (demand & supply )

14. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-14 McGraw-Hill/Irwin Foreign Exchange (FX) Markets 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 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

15. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-15 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

16. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-16 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

17. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-17 McGraw-Hill/Irwin Financial Market Regulation Securities and Exchange Commission: –Register the public securities –Monitor trading –Prevent the inside information –Full and accurate information available –Impose regulations to reduce excessive price fluctuations Securities and Exchange Commission: –Register the public securities –Monitor trading –Prevent the inside information –Full and accurate information available –Impose regulations to reduce excessive price fluctuations

18. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-18 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

19. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-19 McGraw-Hill/Irwin Financial Institutions (FIs) Direct transfer –A corporation sells its stock or debt directly to investors without going through a financial institution Indirect transfer –A transfer of funds between suppliers and users of funds through a financial intermediary Direct transfer –A corporation sells its stock or debt directly to investors without going through a financial institution Indirect transfer –A transfer of funds between suppliers and users of funds through a financial intermediary

20. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-20 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

21. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-21 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

22. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-22 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

23. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-23 McGraw-Hill/Irwin FIs Benefit Suppliers of Funds Reduce monitoring costs –Superior skills and training –Alleviates the “free-rider” problem –Delegated monitor: an economic agent appointed to act on behalf of smaller investors in collecting information and/or investing fund on their behalf Reduce monitoring costs –Superior skills and training –Alleviates the “free-rider” problem –Delegated monitor: an economic agent appointed to act on behalf of smaller investors in collecting information and/or investing fund on their behalf

24. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-24 McGraw-Hill/Irwin FIs Benefit Suppliers of Funds Increase liquidity and lower price risk –Asset transformers: financial claims issued by an FI that are more attractive to investors than are the claims directly issued by corporations –FI purchase the financial claims issued by users of funds and finance these purchases by selling financial claims to investors –FI claims have liquidity attributes Increase liquidity and lower price risk –Asset transformers: financial claims issued by an FI that are more attractive to investors than are the claims directly issued by corporations –FI purchase the financial claims issued by users of funds and finance these purchases by selling financial claims to investors –FI claims have liquidity attributes

25. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-25 McGraw-Hill/Irwin FIs Benefit Suppliers of Funds Increase liquidity and lower price risk –Diversify: the ability of an economic agent to reduce risk by holding a number of securities in a portfolio –Diversification allows an FI to predict more accurately expected return and risk on its investment portfolio > credibly promises to the suppliers to provide highly liquid claims with little price risk Increase liquidity and lower price risk –Diversify: the ability of an economic agent to reduce risk by holding a number of securities in a portfolio –Diversification allows an FI to predict more accurately expected return and risk on its investment portfolio > credibly promises to the suppliers to provide highly liquid claims with little price risk

26. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-26 McGraw-Hill/Irwin FIs Benefit Suppliers of Funds Reduce transaction costs –Economies of scale: cost of reduction in trading and other transaction services results from increased efficiency when FI perform these services –Etrade and private placement Reduce transaction costs –Economies of scale: cost of reduction in trading and other transaction services results from increased efficiency when FI perform these services –Etrade and private placement

27. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-27 McGraw-Hill/Irwin FIs Benefit Suppliers of Funds Provide maturity intermediation –Ability to bear the risk of mismatching the maturity of their assets and liabilities than can small savers Provide denomination intermediation –By pooling the funds of many small savers Provide maturity intermediation –Ability to bear the risk of mismatching the maturity of their assets and liabilities than can small savers Provide denomination intermediation –By pooling the funds of many small savers

28. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-28 McGraw-Hill/Irwin FIs Benefit the Overall Economy Provides efficient credit allocation –The major source of financing for particular sector Provide for intergenerational wealth transfers –Important to country social well-being Provides efficient credit allocation –The major source of financing for particular sector Provide for intergenerational wealth transfers –Important to country social well-being

29. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-29 McGraw-Hill/Irwin Credit Risk –Risk that promised cash flows from loans and securities held by FIs may not be paid in full Foreign exchange risk –Risk that exchange rate changes can affect the value of an FI’s assets and liabilities located abroad Credit Risk –Risk that promised cash flows from loans and securities held by FIs may not be paid in full Foreign exchange risk –Risk that exchange rate changes can affect the value of an FI’s assets and liabilities located abroad Risks Faced by Financial Institutions

30. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-30 McGraw-Hill/Irwin Country or sovereign risk –Repayments from foreign borrowers may be interrupted because of interference from foreign governments Market risk –Incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other assets price Country or sovereign risk –Repayments from foreign borrowers may be interrupted because of interference from foreign governments Market risk –Incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other assets price Risks Faced by Financial Institutions

31. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-31 McGraw-Hill/Irwin Liquidity risk –Requiring an FI to liquidate assets in a very short period of time and at low price Technology risk –Technological investment do not produce anticipated cost saving Insolvency risk –May not have capital to offset a sudden decline in the value of its assets Liquidity risk –Requiring an FI to liquidate assets in a very short period of time and at low price Technology risk –Technological investment do not produce anticipated cost saving Insolvency risk –May not have capital to offset a sudden decline in the value of its assets Risks Faced by Financial Institutions

32. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-32 McGraw-Hill/Irwin Risks Faced by Financial Institutions Credit (default) Foreign exchange Country or sovereign Interest rate Market Credit (default) Foreign exchange Country or sovereign Interest rate Market Off-balance-sheet Liquidity Technology Operational Insolvency Off-balance-sheet Liquidity Technology Operational Insolvency

33. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-33 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

34. ©2009, The McGraw-Hill Companies, All Rights Reserved 1-34 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