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Ch01 madora


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Ch01 madora

  1. 1. Chpter 1 Role of Financial Markets and Institutions Introduction The financial system is the collection of markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other securities are traded, interest rates are determined, and financial services are produced and delivered around the world. Chapter Objectives Describe the types of financial markets Describe the role of financial institutions with financial markets Identify the types of financial institutions that facilitate transactions ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Overview of Financial Markets Surplus Spending Unit Financial Market: a market in which financial assets (securities) such as stocks and bonds can be purchased or sold Deficit Spending Unit Has more cash income flow than expenditure on consumption and real investments in a period of time. The surplus then is allocated to the financial sector. Other terms for surplus unit are saver, lender, buyer of financial assets, financial investor, supplier of loanable funds, buyer of securities. •Has more expenditures on consumption and real goods (investment) in the real sector than income during a period of time. •The deficit unit must participate (borrow) in the financial sector to balance cash inflows with outflows. Financial markets provide for financial intermediation--financial savings (Surplus Units) to investment (Deficit Units) Financial markets provide payments system Financial markets provide means to manage risk Deficit Spending Unit Cash Users of Funds Surplus Spending Unit Suppliers of Funds Financial Claims ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Indirect Financial Investment or Intermediation Financing A financial "intermediary" writes a separate contract with the SSU (bank depositor) and DSU (auto loan), providing each some economic value. Financial intermediaries hold direct claims on DSUs as financial assets and issue indirect financial claims to SSUs as liabilities. ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Types of Financial Markets Markets may be differentiated by maturity Money market Capital market. Markets may be differentiated by when a security is sold. Primary market Secondary markets FI (Brokers) Users of Funds Suppliers of Funds Markets may be differentiated by how or where they are traded Organized exchanges Over-the-counter (OTC) market Markets may be differentiated by Location Cash FI (Asset transformers) Financial Claims (Equity and debt securities) D I O Cash Financial Claims (Deposits and insurance policies) ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Markets may be differentiated by being original or derived F O S ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ 1
  2. 2. Overview of Financial Markets Money Market Participants Broad Classifications of Financial Markets Instrument Principal Issuer Principal Investor Treasury bills U.S. Treasury Federal funds Repurchase agreement Negotiable CDs Commercial banks FRS, Comm banks Brokers and dealers Other Fis Comm banks Other FIs, Corps Commercial banks Banker’s acceptances Commercial banks FRS, Comm banks Brokers and dealers Other FIs, Corps Commercial banks FRS, Comm banks Brokers and dealers Other FIs, Corps Brokers and dealers Corporations Brokers and dealers Corps, Other FIs Comm banks, Corps Brokers and dealers Money versus Capital Markets Primary versus Secondary Markets Commercial Paper Organized versus Over-the-Counter Markets ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ The Capital Market Instrument Typical Maturities ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Primary vs. Secondary Markets Principal Borrowers Corporations Secondary Market Corporate Stock — Mortgages 15 to 30 years Home owners and others Corporate bonds 2 to 30 years Corporations Active U.S. government securities Notes Bonds 2 to 10 years 30 years (currently) U.S. government U.S. government Very active Very active Very active for large corporations PRIMARY SECONDARY New Issue of Securities Trading Previously Issued Securities Exchange of Funds for Financial Claim No New Funds for Issuer Funds for Borrower; an IOU for Lender Provides Liquidity for Seller Moderately active U.S. government agency securities Up to 30 years Municipals 2 to 30 years U.S. government agency Some activity State and local governments Active ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Organized vs. Over-the-Counter Over- theMarkets Money vs. Capital Markets Money Short-Term, < 1 Year High Quality Issuers Debt Only Primary Market Focus Liquidity Market--Low Returns ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Capital Long-Term, >1Yr Range of Issuer Quality Debt and Equity Secondary Market Focus Financing Investment-Higher Returns ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Organized Visible Marketplace Members Trade Securities Listed New York Stock Exchange OTC Wired Network of Dealers No Central, Physical Location All Securities Traded off the Exchanges ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ 2
  3. 3. Securities Traded in Financial Markets Money Market Securities Debt vs. Equity Securities Debt Securities: Contractual obligations (IOU) of Debtor (borrower) to Creditor (lender) Debt securities Only Investor receives interest Capital gain/loss when sold Maturity date Capital market securities Debt and equity securities Derivative Securities Financial contracts whose value is derived from the values of underlying assets Used for hedging (risk reduction) and speculation (risk seeking) ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Types of Financial Markets, cont. Debt vs. Equity Securities Equity Securities: Claim with ownership rights and responsibilities Spot and futures markets--variation in timing of delivery and payment. Items traded in the market for immediate delivery and payment are traded in the spot market. When delivery at a specific price(payment) is not "spot," a "futures” or “forward” market transaction has occurred. Investor receives dividends if declared Capital gain/loss when sold No maturity date—need market to sell Futures contracts are traded on organized exchanges. Forward contracts are traded over the counter. ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Types of Financial Markets, cont. ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Types of Financial Markets, cont. Option markets trade contracts specifying price and conditional delivery of a quantity of asset for a specific period of time. A call option is an option to buy; a put is an option to sell. Options are traded on major security and commodity exchanges as well as in various overthe-counter markets. ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Foreign exchange markets. Foreign exchange, the value of one currency relative to another, is traded in the foreign exchange market. Foreign exchange is traded in the spot, forward, futures, and option markets. ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ 3
  4. 4. The Role of Derivatives Valuation of Securities Derivative Securities Financial contracts whose value is derived from the values of underlying assets Used for hedging (risk reduction) and speculation (risk seeking) Speculation Value a function of: Future cash flows When cash flows are received Risk of cash flows Present value of cash flows discounted at the market required rate of return Value determined by market demand/supply Value changes with new information Hedging ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Investor Assessment of New Information ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Financial Market Efficiency Security prices reflect available information Economic Conditions Industry Conditions Impact of Future Cash Flows Evaluation of Security Pricing Firm Specific Information Investor Decision to Trade New information is quickly included in security prices Investors balance liquidity, risk, and return needs Exhibit 1.3 ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Financial Market Regulation ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Financial Market Regulation Why Government Regulation? Why Government Regulation? To Maintain Financial Market Stability To Promote Efficiency Prevent market crashes Circuit breakers Federal Reserve discount window High level of competition Efficient payments mechanism Low cost risk management contracts Prevent Inflation--Monetary policy Prevent Excessive Risk Taking by Financial Institutions ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ 4
  5. 5. Financial Market Regulation Financial Market Globalization Increased international funds flow Why Government Regulation? 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 To Provide Consumer Protection Provide adequate disclosure Set rules for business conduct To Pursue Social Policies Transfer income and wealth Allocate saving to socially desirable areas Housing Student loans ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Foreign Exchange Markets ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Foreign Exchange Market Currency Trading To offer currency conversion e.g. A trader from Chase Securities buys Japanese yen To facilitate international trade e.g. Performance dealership acquires Deutsche mark for importing BMWs The market for immediate exchange is known as the spot market. Trading between banks makes up what is often referred to as the interbank market. To transfer purchasing power e.g. Kuwaiti tourists travelling in Umelgaiwain To aggregate information e.g. Value of British pound drops in frantic trading after the government announced a larger than expected deficit ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Price agreed/ paid between + buyer and seller Bonds delivered by seller to buyer ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Foreign Exchange Market Problems facing an individual lender: The forward market for currencies enables an MNC to lock in the exchange rate (called a forward rate) at which it will buy or sell a currency. High costs of determining the creditworthiness of borrowers. Lack of diversification. Loan maturity mismatch with borrowers. Loan size mismatch with borrowers. Price agreed between buyer and seller Buyer pays forward price. ‫ﻳﻮﺳﻒ دﺷﺘﻲ‬ Seller delivers bonds. ‫د. اﺣﻤﺪ‬ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ 5
  6. 6. Role of Financial Institutions in Financial Markets The Role of Intermediaries Information processing Serve special needs of lenders (liabilities) and borrowers (assets) Risk Intermediation Maturity Intermediation Denomination Intermediation Economies of Scale Convenience By denomination and term By risk and return Lower transaction cost Serve to resolve problems of market imperfection ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ The Role of Financial Institutions Temporal and size intermediation Borrower Lender 30-year 3-month $100,000 <-------- S&L--------> $10,000 fixed-rate C.D. mortgage indexed to prime Intermediaries help to facilitate the flow of funds in the financial marketplace. Securities $$ Financial Institution Securities $$ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Financial Intermediation ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Financial Intermediation Example 1 Example 2 $$ Businesses Commercial loans Checking accounts Insurance policies $$ Insurance Company Commercial Bank Households $$ Households Businesses Stocks, Bonds ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ $$ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ 6
  7. 7. Types of Financial Intermediaries Role of Financial Institutions in Financial Markets Deposit-Type Institutions Types of Depository Financial Institutions Commercial Banks Thrift Institutions Credit Unions Contractual Savings Institutions Life Insurance Companies Casualty Insurance Companies Pension Funds Investment Funds Commercial Banks $5 Trillion Total Assets Other Types of Financial Intermediaries Savings Institutions $1.3 Trillion Total Assets Credit Unions $.5 Trillion Total Assets Finance Companies Federal Agencies ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Types of Financial Institutions Types of Financial Institutions Commercial Banks Savings and Loans Credit Unions Commercial Banks Savings and Loans Savings and loans’ primary purpose is to take in deposits from households and to lend funds for home mortgages. Credit Unions are owned by depositors (actually share owners) who are individuals, not businesses. Credit Unions take in funds and primarily make personal loans. ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Types of Financial Institutions ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Types of Financial Institutions Finance Companies Insurance Companies Finance Companies Non-bank firms that borrow funds to make short and medium term loans to higher risk borrowers. Receive premiums for insurance policies. This pool of funds is used to reimburse policyholders who incur losses that are covered under the policy . Life Insurers: Insure against financial hardship caused by death. Property and Casualty: Insure against damage to person and property (health, autos, homes, theft, earthquake, etc.) ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ 7
  8. 8. Role of Nondepository Financial Institutions Types of Financial Institutions Finance Companies Insurance Companies Pension Funds Workers and/or employers contribute funds for the pension fund to invest. The accumulated funds are used to pay benefits at retirement. Focused on capital market Longer-term, higher risk intermediation Less focus on liquidity Less regulation Greater focus on equity investments ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Global Expansion by Financial Institutions Trends in Financial Institutions Rapid growth of mutual funds and pension funds Increased consolidation of financial institutions via mergers Increased competition between financial Institutions Growth of financial conglomerates ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ International expansion International mergers Impact of the single European currency Emerging markets ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ Agency problems within corporations: corporations: Solutions to agency problems within corporations Conflict of interests between management and stockholders. Conflict of interests between stockholders and bondholders. Conflict of interests between old and new stockholders. Corporate law: provides a cost-efficient means for providing general features common to all contracts. Corporate governance: responsibilities of the board of directors include dealing with management-incentive problems. Capital market: takeovers and other ownership restructuring can mitigate conflict of interest problems. ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬ 8