Role of Financial Markets and Institutions-CHAPTER 1.pptx

C
ROLE OF FINANCIAL
MARKETS AND
INSTITUTIONS

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Financial Markets and Institutions
11th Edition
by Jeff Madura

■ describe the types of financial markets that
facilitate the flow of funds
■ describe the types of securities traded within
financial markets
■ describe the role of financial institutions within
financial markets
■ explain how financial institutions were exposed to
the credit crisis
3
1 Role of Financial Markets and Institutions
Chapter Objectives

Financial Market
A market in which financial assets (securities) such
as stocks and bonds can be purchased or sold.
Funds are transferred in financial markets when
one party purchases financial assets previously
held by another party.
4

Role of Financial Markets
Financial markets transfer funds from those who have excess funds to those
who need funds.
 Surplus units: participants who receive more money than they spend, such
as investors.
 Deficit units: participants who spend more money than they receive, such
as borrowers.
 Securities: represent a claim on the issuers
 Debt securities - debt (also called credit, or borrowed funds) incurred by the
issuer.
 Equity securities - (also called stocks) represent equity or ownership in the
firm.
5

Function of Financial Markets
.
Flow of Funds Through the Financial System

Segments of Financial Markets
1. Direct Finance
• Borrowers borrow directly from lenders in financial markets by
selling financial instruments which are claims on the borrower’s
future income or assets
2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable funds and
loan opportunities) by issuing financial instruments which are
claims on the borrower’s future income or assets

Accommodating Corporate Finance Needs: The financial markets serves as the
mechanism whereby corporations (acting as deficit units) can obtain funds
from investors (acting as surplus units).
Accommodating Investment Needs: Financial institutions serve as
intermediaries to connect the investment management activity with the
corporate finance activity. (Exhibit 1.1)
8

Exhibit 1.1 How Financial Markets Facilitate Corporate Finance and
Investment Management
9

Overview of Financial Markets
Broad Classifications of Financial Markets
Money versus Capital Markets
Primary versus Secondary Markets
Organized versus Over-the-Counter Markets

Types of Financial Markets
Financial markets can be distinguished by the maturity structure and
trading structure of its securities
Money versus capital markets
The flow of short-term funds is facilitated by money markets
The flow of long-term funds is facilitated by capital markets
Primary versus secondary markets
Primary markets facilitate the issuance of new securities
e.g., the sale of new corporate stock or new Treasury securities
Secondary markets facilitate the trading of existing securities
e.g., the sale of existing stock
Securities traded in secondary markets should be liquid
11

Primary versus Secondary Markets
 Primary markets - facilitate the issuance of new securities
 Secondary markets - facilitate the trading of existing securities, which
allows for a change in the ownership of the securities
 Liquidity is the degree to which securities can easily be liquidated (sold)
without a loss of value.
 If a security is illiquid, investors may not be able to find a willing buyer for it in
the secondary market and may have to sell the security at a large discount just
to attract a buyer.
12

Types of Financial Markets (cont’d)
Organized versus over-the-counter markets
A visible marketplace for secondary market transactions is an
organized exchange
Some transactions occur in the over-the-counter (OTC) market (a
telecommunications network)
Knowledge of financial markets is power
Decide which markets to use to achieve our investment goals or
financing needs
Decide which markets to use as part of your job
Avoid common mistakes in investing and borrowing
13

Securities Traded in Financial Markets
Money market securities
Money market securities are debt securities with a maturity of one year or less
Characteristics:
Liquid
Low expected return
Low degree of risk
14

Capital market securities
Capital market securities are those with a maturity of more than one year or no maturity period.
Bonds and mortgages
Stocks
Capital market securities have a higher expected return and more risk than money market securities
15

Bonds and mortgages
Bonds are long-term debt obligations issued by corporations and government agencies
Mortgages are long-term debt obligations created to finance the purchase of real estate
Bonds and mortgages specify the amount and timing of interest and principal payments
16

Stocks
Stocks (equity) are certificates representing partial ownership in corporations
Investors may earn a return by receiving dividends and capital gains
Stocks have a higher expected return and higher risk than long-term debt securities
17

Derivative securities
Derivative securities are financial contracts whose values are derived
from the values of underlying assets
Speculating with derivatives allow investors to benefit from increases
or decreases in the underlying asset
Risk management with derivatives generates gains if the value of the
underlying security declines
18

Primary vs. Secondary Markets
PRIMARY
New Issue of Securities
Exchange of Funds for Financial
Claim
Funds for Borrower; an IOU (I Owe
you) for Lender
SECONDARY
Trading Previously Issued Securities
No New Funds for Issuer
Provides Liquidity for Seller

Money vs. Capital Markets
Money
Short-Term, < 1 Year
High Quality Issuers
Debt Only
Primary Market Focus
Liquidity Market--Low Returns
Capital
Long-Term, >1Yr
Range of Issuer Quality
Debt and Equity
Secondary Market Focus
Financing Investment--Higher
Returns

Organized vs. Over-the-Counter
Markets
Organized
Visible Marketplace
Members Trade
Securities Listed
Kuala Lumpur Stock
Exchange
OTC
Wired Network of
Dealers
No Central, Physical
Location
All Securities Traded
off the Exchanges

Securities can be classified as money market securities, capital market
securities, or derivative securities.
Money Market Securities
 Money markets facilitate the sale of short-term debt securities by deficit
units to surplus units.
 Debt securities that have a maturity of one year or less.
23

Capital Market Securities - facilitate the sale of long-term securities by deficit
units to surplus units.
 Bonds - long-term debt securities issued by the Treasury, government agencies,
and corporations to finance their operations.
 Mortgages - long-term debt obligations created to finance the purchase of real
estate.
 Mortgage-backed securities - debt obligations representing claims on a
package of mortgages.
 Stocks - represent partial ownership in the corporations that issued them.
24

Derivative Securities - financial contracts whose values are derived from the
values of underlying assets
 Speculation - allow an investor to speculate on movements in the value of the
underlying assets without having to purchase those assets.
 Risk management - financial institutions and other firms can use derivative
securities to adjust the risk of their existing investments in securities.
25

Valuation of Securities
 Impact of information on valuation
 Estimate future cash flows by obtaining information that may influence a
stock’s future cash flows. (Exhibit 1.2)
 Use economic or industry information to value a security
 Use published opinions about the firm’s management to value a security.
 Impact of the internet on valuation
 More timely pricing
 More accurate pricing
 More informative pricing
26

Valuation of Securities (cont.)
 Impact of Behavioral Finance on Valuation
 Various conditions can affect investor psychology. Behavioral finance can
sometimes explain the movements of a security’s price.
 Behavioral Finance - the application of psychology to make financial decisions.
 Uncertainty Surrounding Valuation of Securities
 Limited information leads to uncertainty in the valuation of securities.
27

Exhibit 1.2 Use of Information to Make Investment Decisions
28

Role of Financial Institutions
Financial institutions are needed to resolve the limitations caused by market
imperfections such as limited information regarding the creditworthiness of
borrowers.
Role of depository institutions - Depository institutions accept deposits
surplus units and provide credit to deficit units through loans and purchases
of securities.
 Offer liquid deposit accounts to surplus units
 Provide loans of the size and maturity desired by deficit units
 Accept the risk on loans provided
 Have more expertise in evaluating creditworthiness
 Diversify their loans among numerous deficit units
29

Role of Depository Institutions (cont.)
 Commercial Banks
 The most dominant type of depository institution
 Transfer deposit funds to deficit units through loans or
purchase of debt securities
 Federal Funds Market - facilitates the flow of funds between
depository institutions
 Savings Institutions
 Also called thrift institutions and include Savings and Loans
(S&Ls) and Savings Banks
 Concentrate on residential mortgage loans
 Credit Unions
 Nonprofit organizations
 Restrict business to CU members with a common bond
30

Role of Non-depository Institutions
 Finance companies - obtain funds by issuing securities and lend the funds to
individuals and small businesses.
 Mutual funds - sell shares to surplus units and use the funds received to
purchase a portfolio of securities.
 Securities firms - provide a wide variety of functions in financial markets.
(Broker, Underwriter, Dealer, Advisory)
 Insurance companies - provide insurance policies that reduce the financial
burden associated with death, illness, and damage to property. Charge
premiums and invest in financial markets.
 Pension funds – manage funds until they are withdrawn for retirement
31

Comparison of Roles among Financial Institutions
 Institutional Role as a Monitor of Publicly Traded Firms
 Financial institutions facilitate the flow of funds from individual surplus
units (investors) to deficit units. (Exhibit 1.3)
 Financial institutions also serve as monitors of publicly traded firms.
 By serving as activist shareholders, they can help ensure that managers of publicly held
corporations are making decisions that are in the best interests of the shareholders.
32

Exhibit 1.3 Comparison of Roles among Financial Institutions
33

Exhibit 1.4 Summary of Institutional Sources and Uses of Funds
34

Exhibit 1.5 Organizational Structure of a Financial Conglomerate
35

Financial Market Regulation
1. To Promote Efficiency
1. High level of competition
Efficient payments mechanism
Low cost risk management contracts
Why Government Regulation?

2. To Maintain Financial Market Stability
Prevent market crashes
Prevent Inflation--Monetary policy
Prevent Excessive Risk Taking by Financial Institutions

3. To Provide Consumer Protection
Provide adequate disclosure
Set rules for business conduct
4. To Pursue Social Policies
Transfer income and wealth
Allocate saving to socially desirable areas
Housing
Student loans

Financial Market Globalization
5. Increased international funds flow
Increased disclosure of information
Reduced transaction costs
Reduced foreign regulation on capital flows
Increased privatization
Results: Increased financial integration--capital flows to highest expected risk-
adjusted return

Comparison of Roles among Financial
Institutions
40
Individual
Surplus Units
Depository
Institutions
Finance
Companies
Mutual Funds Deficit Units
Deposits
Purchase
Securities
Purchase Shares
Policyholders
Employers
Employees
Insurance
Companies
Pension Funds
Premiums
Employee
Contributions

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