Economy & Finance

Role of financial markets and institutions ch.1 (uts)

1. Chapter 1 Role of Financial Markets and InstitutionsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson…
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  • 1. Chapter 1 Role of Financial Markets and InstitutionsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 1
  • 2. Chapter Outline We examine the role of the financial system in an advanced economy. Topics include:  Function of Financial Market  Structure of Financial Market  Types of financial markets  Securities traded in financial markets  Global financial markets 2
  • 3. Function of Financial Markets A financial market is a market in which financial assets (securities) can be purchased or sold Financial markets facilitate transfers of funds from person or business without investment opportunities (i.e., “Lender-Savers”, or “Surplus Unit”) to those who have them (i.e., “Borrower- Spenders”, or “Deficit Unit”) 3
  • 4. Segments of Financial Markets Direct Financing  Funds are transferred directly from ultimate savers to ultimate borrowers Indirect Financing A financial "intermediary" transforms financial claims with one set of characteristics into financial claims with other characteristics e.g. deposits are used to make loans. 4
  • 5. Transfer of Funds onFinancial Market 5
  • 6. Function of Financial Intermediaries Provide customers with liquidity service Help to repackage the risk  Willing to create and sell assets with lesser risk to one party in order to buy assets with greater risk form another party  This process is referred to as asset transformation 6
  • 7. 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 7
  • 8. Types of Financial 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 8
  • 9. 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 9
  • 10. Securities Traded in FinancialMarkets 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 10
  • 11. Securities Traded in FinancialMarkets (cont’d) Capital market securities  Capital market securities are those with a maturity of more than one year  Bonds and mortgages  Stocks  Capitalmarket securities have a higher expected return and more risk than money market securities 11
  • 12. Securities Traded in FinancialMarkets (cont’d) 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 12
  • 13. Securities Traded in FinancialMarkets (cont’d) 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 13
  • 14. Securities Traded in FinancialMarkets (cont’d) 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 14
  • 15. Role of Financial Institutions inFinancial Markets (cont’d) Role of depository institutions  Depository institutions accept deposits from surplus units and provide credit to deficit units  Depository institutions are popular because:  Deposits are liquid  They customize loans  They accept the risk of loans  They have expertise in evaluating creditworthiness  They diversify their loans 15
  • 16. Role of Financial Institutions inFinancial Markets (cont’d) Commercial banks  Are the most dominant depository institution  Offer a wide variety of deposit accounts  Transfer deposited funds by providing direct loans or purchasing debt securities  Serve both the public and the private sector 16
  • 17. Role of Financial Institutions inFinancial Markets (cont’d) Savings institutions  Includesavings and loan associations (S&Ls) and savings banks  Are mostly owned by depositors (mutual)  Concentrate on residential mortgage loans Credit unions  Are nonprofit organizations  Restrict their business to credit union members  Tend to be much smaller than other depository institutions 17
  • 18. Role of Financial Institutions inFinancial Markets (cont’d) Role of nondepository financial institutions  Nondepository institutions generate funds from sources other than deposits  Finance companies  Obtain funds by issuing securities  Lend funds to individuals and small businesses 18
  • 19. Role of Financial Institutions inFinancial Markets (cont’d) Mutual funds  Sellshares to surplus units  Use funds to purchase a portfolio of securities  Some focus on capital market securities (e.g., stocks or bonds)  Money market mutual funds concentrate on money market securities 19
  • 20. Role of Financial Institutions inFinancial Markets (cont’d) Securities firms  Broker function  Execute securities transactions between two parties  Charge a fee in the form of a bid-ask spread  Investment banking function  Underwrite newly issued securities  Dealer function  Securities firms make a market in specific securities by adjusting their inventory 20
  • 21. Role of Financial Institutions inFinancial Markets (cont’d) Insurance companies  Provide insurance policies to individuals and firms for death, illness, and damage to property  Charge premiums  Invest in stocks or bonds issued by corporations 21
  • 22. Role of Financial Institutions inFinancial Markets (cont’d) Pension funds  Offered by most corporations and government agencies  Manage funds until they are withdrawn from the retirement account  Invest in stocks or bonds issued by corporations or in bonds issued by the government 22
  • 23. Comparison of Roles amongFinancial Institutions Deposits Depository Institutions Purchase Individual FinanceSurplus Units Securities Companies Purchase Shares Mutual Funds Deficit Units Premiums InsurancePolicyholders Companies Employee Employers Contributions Pension Funds Employees 23
  • 24. Overview of Financial Institutions Competition between financial institutions  Financial institutions should operate to maximize the value of their owners  Present value of future cash flows  Depends on:  Growth and profitability  Degree of risk 24
  • 25. Overview of Financial Institutions(cont’d) Consolidation of financial institutions  Reduction in regulations has resulted in more opportunities to capitalize on:  Economies of scale  Economies of scope  Mergers have resulted in financial conglomerates  Consolidation may increase expected cash flows or reduce risk, or both 25
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