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CHAPTER 1
An Overview of Financial
Markets and Institutions
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The F inancial System
Provides for efficient flow of funds from
saving to investment by bringing savers and
borrowers together via financial markets
and financial institutions.
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Exhibit 1.1Transfer of Funds
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Basic components of the f inancial system:Markets andinstitutions.
Financial markets are markets forfinancial
instruments, also calledfinancial claims or
securities.
Financial institutions (also calledfinancial
intermediaries) facilitate flows of funds from
savers to borrowers.
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Economic units with f inancial needs:Households, Businesses,
Governments.
Households supply labor, demand products, and
save for the future.
Businesses demand labor, supply products, and
invest in productive assets.Governmentscollect taxes and provide public
goods (e.g. education, defense).
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Budget positions creating financial needs of economic units:
Surplus ordeficit.
Surplus spending units (SSUs) have incomefor the period that exceeds spending,resulting insavings.
Other words for SSU aresaver, lender, orinvestor. Most SSUs are households.
Deficit spending units (DSUs) havespending for the period that exceeds
income.Another word for DSU is borrower. MostDSUs are businesses or governments.
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Financial claims arise as SSUs lend to DSUs.
SSUs claim against DSU is liability toDSU and asset to SSU.
Ones liability is anothers asset: What ispayable by one is receivable by another.
Assets arising this way are financialassets.The financial system balances-total financial assets equal total liabilities.
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Marketability: Ease with which a f inancial asset may be sold to
another SSU.
Ability to resell financial claims makes them
more liquid by giving SSUs choices:
Match maturity of claim to planned investment
period;
Buy claim with longer maturity, but sell at end of
period; or
Buy claim with shorter maturity, then reinvest.
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Di rect F inancing: The simplest way for
funds to flow.
DSU and SSU find each other and bargainSSU transfers funds directly to DSU
DSU issues claim directly to SSU
Preferences of both must match as to--Amount
-Maturity
-Risk
-Liquidity
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Di rect F inancing: eff icient for large transactions if preferences
match.
DSUs and SSUs seize the dayDSUs fund desired projects immediately.
SSUs earn timely returns on savings.
Direct markets are wholesale markets.
Transactions typically $1 million or more.
Institutional arrangements common.
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Pr ivate placements are simplest.
DSU sells whole security issue to one
investor or investor group.
Advantages include speed and low
transactions costs.
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Investment bankersunderwrite new issues of securities.
Buy entire issues of securities from DSUs
Find SSUs to buy securities at higher price
Profit from difference - underwriting
spread
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Brokers anddealers
Brokers buy or sell at best possible price fortheir clients.
Dealers make markets by carryinginventories of securities.
buy at bid pr ice; sell at ask pr iceBid-ask spread is dealers gross profit
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Problem with direct financing: DSUs and SSUs cannot always match
preferences.
Not every SSU can afford wholesale
denominations of $1 million or more.
DSUs and SSUs often prefer different terms
to maturity.
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Indirect Financing (Financial Intermediation):
Financial intermediariestransform
claims:
raise funds by issuing claims to SSUs;
use funds to buy claims issued by DSUs.
Claims can have unmatched characteristics:
SSU has claim against intermediary;
Intermediary has claim against DSU.
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F inancial intermediaries transform claims
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Famil iar forms of f inancial intermediation
Commercial Banking
Insurance
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Commercial Banks
Take deposits and make loans -
Depositors are SSUs
Borrowers are DSUs.
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I nsurance Companies
Issue policies, collect premiums, and invest
in stocks and bonds.
Policyholders are SSUs;
Businesses or governments are DSUs.
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Benefits of f inancial intermediation are a primary rationale for the
f inancial system.
Financial intermediaries lower the cost of financial
services as they pursue profit.
Financial intermediaries perform 5 basic services
as they transform claims.
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I ntermediar ies lower the cost of financial services as they pursue
profit.
3 sources of comparative advantage:
Economies of scaleTransaction cost controlRisk management expertise
Competition pulls interest rates down
Financing less costly
Projects have higher NPVsInvestment in real assets boosts economy
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I ntermediaries perform 5 basic services as they transformclaims.
Denomination Divisibi l i typool savings of many
small SSUs into large investments.
Currency Transformationbuy and sell financialclaims denominated in various currencies.
Maturi ty F lexibil ityOffer different ranges ofmaturities to both DSUs and SSUs.
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4 M j t f f i i l i t di i t f l i t t
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4 Major types of f inancial intermediar ies transform claims to meet
var ious needs.
Deposit-type or Depository Institutions
Contractual Savings Institutions
Investment Funds
Other Institutions
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Depository I nsti tutions take deposits and make loans.
Commercial Banks
Thrift InstitutionsSavings & Loan AssociationsSavings Banks
Credit Unions
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Commercial Banks
Largest single class of financial institution
Issue wide variety of deposit products -
checking, savings, time deposits
Carry widely diversified portfolios of loans,leases, government securities
May offer trust or underwriting services
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Thr if t I nstitutions
Closely resemble commercial banks
Focus more on real estate loans, savings deposits,
and time deposits
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Credit Unions: Unique Character istics
Mutual ownership -owned by depositors
or members
Common bond - members must share
some meaningful common association
Not-for-profit and tax - exempt
Restricted mostly to small consumer loans
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Contractual I nsti tuti ons bring long-term savers and borr owers
together.
Life Insurance Companies
Casualty Insurance Companies
Pension Funds
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L ife I nsurance Companies insure against lost income at death.
Policyholders pay premiums, which are
pooled and invested in stocks, bonds, andmortgages
Investment earnings cover the costs and
reward the risks of the insurance company
Investments are liquidated to pay benefits.
C l t I C i t i t l
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Casual ty I nsurance Companies cover property against loss or
damage.
Sources and uses of funds resemble those oflife insurers, but
Casualty claims are not as predictable asdeath claims; so
More assets are in short-term, easily
marketable investments
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Pension Funds help workers plan for reti rement.
Workers and/or employers makecontributions, which are pooled andinvested in stocks, bonds, and mortgages
Net of administrative costs, investmentearnings are reinvested and compounded
Retirement benefits replace paychecks (atleast partly)
I nvestment F unds help small investors share the benefi ts of large
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I nvestment F unds help small investors share the benefi ts of large
investments.
Mutual Fundsprovide intermediated access to
various capital marketsshareholders money is pooled and invested instocks, bonds, or other securities according tosome objective
Money Market Mutual Funds(MMMFs) areuninsured substitutes for deposit accounts
MMMFs buy money market instrumentswholesale, pay investors interest, and allow
limited check-writing
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Other Financial Institutions
Finance Companies
Make loans but do not take deposits; raiseloanable funds in commercial paper market andfrom shareholders
Federal Agencies
Issue agency securities backed by governmentand lend at sub-market rates for favored social
purposes
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F inancial Markets are classif ied in several ways.
Primary and Secondary
Organized and Over-the-Counter
Spot and Futures
Options
Foreign Exchange
International and Domestic
Money and Capital
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Primary and Secondary Markets
Primary marketsare where financial claims are
born: DSUs receive funds, claims are firstissued
Secondary marketsare where financial claimsliveare resold and repriced
Claims become more liquid because SSUscan set their own holding periodsTrading sets prices and yields of widely held
securities
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Organized and Over-the-Counter Markets
Organized Exchanges:physical, relatively
exclusive.Physical trading floor and facilities available tomembers of exchange, for securities listed onexchange.
New York Stock Exchange
Chicago Board of Trade (futures)
OTC Markets: virtual, relatively inclusive.
Decentralized network available to any licensed dealerwilling to buy access and obey rules, for wide range ofsecurities.The NASDAQ is a famous OTC market.
S t d F t M k t
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Spot and Futures Markets
Spot Markets: immediate payment for immediate
delivery
Futuresor Forward Markets: immediatepayment for promise of future delivery
Futures contracts: standardized as to amounts,forms, and dates; trade on organized exchanges
Forward contracts: individualized between
parties with particular needs
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Option Markets
Rights in underlying securities or commoditieswriter grants owner some exclusive right for somecertain time
Main types of options: Puts(options to sell)Calls(options to buy)
Options on listed securities and widely heldcommodities trade actively on organizedexchanges
F i E h M k t
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Foreign Exchange Markets
Any currency is convertible to any other at some
exchange rate
Forex involves spot, future, forward, and option
markets
I t ti l d D ti M k t
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I nternational and Domestic Markets
Help participants diversify both sources and uses
of funds
Examples of major international markets:
EurodollarsUS dollars deposited outside U.S.Eurobondsbonds issued outside US but
denominated in $US
M d C it l M k t
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Money and Capital Markets
Money markets: wholesale markets for short-term
debt instruments resembling money itself
Capital markets:where capital goods are
permanently financed through long-term financial
instruments(Capital goodsreal assets held long-term toproduce wealthland, buildings, equipment, etc.)
M M k t
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Money Markets
Help participants adjust liquidityDSUs borrow short-term to fund currentoperations
SSUs lend short-term to avoid holding idle cash
Common characteristics of money marketinstrumentsShort maturities (usually 90 days or less)
High liquidity (active secondary markets)
Low risk (and consequently low yield)Dealer/OTC more than organized exchange
Examples of Major Money Market Instruments
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Examples of Major Money Market Instruments
Treasury Bills
Negotiable Certificates of Deposit
Commercial Paper
Federal Funds (Fed Funds)
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Money Market BalanceSheet Position of Major Participants
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Money Market Balance Sheet Position of Major Participants
COMMERCIALBANKS
FEDERALRESERVESYSTEM
TREASURYDEPARTMENT
INVESTMENTBANKS,
DEALERS,AND BROKERS CORPORATIONS
INSTRUMENT A L A L A L A L A L
Treasury bills
Agency securities Negotiable CDs Commercial paper Bankers acceptances Federal Funds Repurchase agreements
C it l M k t
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Capital Markets
Help participants build wealth
DSUs seek long-term financing for capital projectsSSUs seek highest possible return for given risk
Differences from money marketsLong maturities (5 to 30 years)
Less liquidity(secondary markets active but more volatile)
Higher risk in most cases(with higher potential yield)
Traded wholesale and retail on organized
exchanges and in OTC markets
Examples of
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p
Major Capital M arket Instruments
Common stock
Corporate bonds
Municipal bonds
Mortgages
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Eff iciency in f inancial markets
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Eff iciency in f inancial markets
Al locational Ef f iciency:highest/best use of funds
DSUs try to fund projects with best cost/benefit ratios
SSUs try to invest for best possible return for givenmaturity and risk
I nformational Ef f iciency:prices reflect relevantinformation
Informationally efficient markets reprice quickly onnew information;
informationally inefficient markets offer opportunitiesto buy underpriced assets or sell overpriced assets
Operational Eff iciency:transactions costs minimized
Risks of F inancial I nstitutions
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Risks of F inancial I nstitutions
Creditor default r isk: risk that a DSU may not
pay as agreed
I nterest rate r isk: fluctuations in a security's priceor reinvestment income caused by changes inmarket interest rates
L iquidity r isk: risk that a financial institution maybe unable to disburse required cash outflows, evenif essentially profitable
Risks of F inancial I nstitutions cont
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Risks of F inancial I nstitutions, cont.
Foreign exchange risk: effect of exchange ratefluctuations on profit of financial institution
Political r isk: risk of government or regulatory
action harmful to interests of financial institution.