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Function of Financial Markets
• Perform the essential function of channeling funds from economic players that havesaved surplus funds to those that have a shortage of funds
• Promotes economic efficiency by producingan efficient allocation of capital, which increases production
• Directly improve the well-being of consumers by allowing them to time purchases better
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Structure of Financial Markets
• Debt and Equity Markets
• Primary and Secondary MarketsInvestment Banks underwrite securities in primary marketsBrokers and dealers work in secondary markets
• Exchanges and Over-the-Counter (OTC) Markets
• Money and Capital MarketsMoney markets deal in short-term debt instrumentsCapital markets deal in longer-term debt and equity instruments
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Internationalization of Financial Markets
• Foreign Bonds—sold in a foreign country and denominated in that country’s currency
• Eurobond—bond denominated in a currency other than that of the country in which it is sold
• Eurocurrencies—foreign currencies deposited in banks outside the home country
Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
• World Stock Markets
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Function of Financial Intermediaries: Indirect Finance
• Lower transaction costsEconomies of scaleLiquidity services
• Reduce RiskRisk Sharing (Asset Transformation)Diversification
• Asymmetric InformationAdverse Selection (before the transaction)—more likely to select risky borrowerMoral Hazard (after the transaction)—less likely borrower will repay loan
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Regulation of the Financial System
• To increase the information available to investors:Reduce adverse selection and moral hazard problemsReduce insider trading
• To ensure the soundness of financial intermediaries:Restrictions on entryDisclosureRestrictions on Assets and ActivitiesDeposit InsuranceLimits on CompetitionRestrictions on Interest Rates