This document introduces financial markets and institutions. It defines financial markets as structures through which funds flow and distinguishes between primary and secondary markets as well as money and capital markets. It also describes various financial instruments, regulation, risks faced by financial institutions, and the benefits they provide. Finally, it discusses the globalization of financial markets and institutions.

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Chapter One
Introduction

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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

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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

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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)
• Secondary markets
– markets where financial instruments are traded
among investors (e.g., NYSE and Nasdaq)
• Primary markets
– markets in which users of funds (e.g.,
corporations and governments) raise funds by
issuing financial instruments (e.g., stocks and
bonds)
• Secondary markets
– markets where financial instruments are traded
among investors (e.g., NYSE and Nasdaq)

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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)
• Capital markets
– markets that trade debt (bonds) and equity
(stock) instruments with maturities of more
than one year
• Money markets
– markets that trade debt securities with
maturities of one year or less (e.g., CDs and
U.S. Treasury bills)
• Capital markets
– markets that trade debt (bonds) and equity
(stock) instruments with maturities of more
than one year

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Money Market Instruments
Outstanding, ($Bn)
0
500
1000
1500
2000
2500
3000
1990q4 2000q4 2007q1
Fed funds and repos Commercial paper Negotiable CDs
U.S. Treasury bills Banker's accept.

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Capital Market Instruments
Outstanding, ($Bn)
0
5000
10000
15000
20000
25000
1990q4 2000q4 2007q1
Corporate stocks Mortgages Corporate bonds
U.S. gov't agencies Treasury securities State & local gov't bonds
Bank and consumer loans

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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

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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

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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

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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

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Users of Funds
(corporations)
Suppliers of
Funds
(households)
Financial Claims
(equity and debt
instruments)
Cash
Flow of Funds in a World without FIsFlow of Funds in a World without FIs

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Users of Funds
FIs
(brokers)
FIs
(asset
transformers)
Suppliers of Funds
Financial Claims
(equity and debt securities)
Financial Claims
(deposits and insurance policies)
Cash Cash
Flow of Funds in a World without FIsFlow of Funds in a World with FIs

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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

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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

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FIs Benefit the Overall Economy
• Conduit through which Federal Reserve
conducts monetary policy
• Provides efficient credit allocation
• Provide for intergenerational wealth
transfers
• Provide payment services
• Conduit through which Federal Reserve
conducts monetary policy
• Provides efficient credit allocation
• Provide for intergenerational wealth
transfers
• Provide payment services

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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

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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

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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