2. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter One Introduction

3. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-3 Why study Financial Markets and Institutions? They are the cornerstones of the overall financial system in which financial managers operate Individuals use both for investing Corporations and governments use both for financing They are the cornerstones of the overall financial system in which financial managers operate Individuals use both for investing Corporations and governments use both for financing

4. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-4 Overview of Financial Markets Primary Markets versus Secondary Markets Money Markets versus Capital Markets Foreign Exchange Markets Primary Markets versus Secondary Markets Money Markets versus Capital Markets Foreign Exchange Markets

5. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-5 Primary Markets versus Secondary Markets Primary Markets –markets in which users of funds (e.g. corporations, 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, NASDAQ) Primary Markets –markets in which users of funds (e.g. corporations, 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, NASDAQ)

6. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-6 Money Markets versus Capital Markets Money Markets –markets that trade debt securities with maturities of one year or less (e.g. CD’s, 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. CD’s, U.S. Treasury bills) Capital Markets –markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year

7. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-7 Money Market Instruments Outstanding, 1990-2001 ($Bn)

8. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-8 Capital Market Instruments Outstanding, 1990-2001 ($Bn)

9. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-9 Foreign Exchange Markets “FX” markets deal in trading one currency for another (e.g. dollar for yen) The “spot” FX transaction involves the immediate exchange of currencies at the current exchange rate The “forward” FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate “FX” markets deal in trading one currency for another (e.g. dollar for yen) The “spot” FX transaction involves the immediate exchange of currencies at the current exchange rate The “forward” FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate

10. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-10 Overview of Financial Institutions Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds (e.g. banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, pension funds)

11. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-11 Flow of Funds in a World without FIs: Direct Transfer Users of Funds (Corporations) Suppliers of Funds (Households) Financial Claims (Equity and debt instruments) Cash Example: A firm sells shares directly to investors without going through a financial institution.

12. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-12 Flow of Funds in a world with FIs: Indirect transfer Users of Funds FI (Brokers) FI (Asset transformers) Suppliers of Funds Financial Claims (Equity and debt securities) Financial Claims (Deposits and insurance policies) Cash

13. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-13 Types of FIs Commercial banks –depository institutions whose major assets are loans and major liabilities are deposits Thrifts –depository institutions in the form of savings and loans, credit unions Insurance companies –financial institutions that protect individuals and corporations from adverse events Commercial banks –depository institutions whose major assets are loans and major liabilities are deposits Thrifts –depository institutions in the form of savings and loans, credit unions Insurance companies –financial institutions that protect individuals and corporations from adverse events (continued)

14. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-14 Securities firms and investment banks –financial institutions that underwrite securities and engage in securities brokerage and trading Finance companies –financial institutions that make loans to individuals and businesses Mutual Funds –financial institutions that pool financial resources and invest in diversified portfolios Pension Funds –financial institutions that offer savings plans for retirement Securities firms and investment banks –financial institutions that underwrite securities and engage in securities brokerage and trading Finance companies –financial institutions that make loans to individuals and businesses Mutual Funds –financial institutions that pool financial resources and invest in diversified portfolios Pension Funds –financial institutions that offer savings plans for retirement

15. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-15 Services Performed by Financial Intermediaries Monitoring Costs –aggregation of funds provides greater incentive to collect a firm’s information and monitor actions Liquidity and Price Risk –provide financial claims to savers with superior liquidity and lower price risk Monitoring Costs –aggregation of funds provides greater incentive to collect a firm’s information and monitor actions Liquidity and Price Risk –provide financial claims to savers with superior liquidity and lower price risk (continued)

16. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-16 Transaction Cost Services –transaction costs are reduced through economies of scale Maturity Intermediation –greater ability to bear risk of mismatching maturities of assets and liabilities Denomination Intermediation –allow small investors to overcome constraints imposed to buying assets imposed by large minimum denomination size Transaction Cost Services –transaction costs are reduced through economies of scale Maturity Intermediation –greater ability to bear risk of mismatching maturities of assets and liabilities Denomination Intermediation –allow small investors to overcome constraints imposed to buying assets imposed by large minimum denomination size

17. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-17 Services Provided by FIs Benefiting the Overall Economy Money Supply Transmission –Depository institutions are the conduit through which monetary policy actions impact the economy in general Credit Allocation –often viewed as the major source of financing for a particular sector of the economy (e.g. farming and real estate) Money Supply Transmission –Depository institutions are the conduit through which monetary policy actions impact the economy in general Credit Allocation –often viewed as the major source of financing for a particular sector of the economy (e.g. farming and real estate) (continued)

18. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-18 Intergenerational Wealth Transfers –life insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the next Payment Services –efficiency with which depository institutions provide payment services directly benefits the economy Intergenerational Wealth Transfers –life insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the next Payment Services –efficiency with which depository institutions provide payment services directly benefits the economy Services Provided by FIs Benefiting the Overall Economy

19. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-19 Risks Faced by Financial Institutions Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Off-Balance-Sheet Risk Technology Risk Operational Risk Country or Sovereign Risk Insolvency Risk Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Off-Balance-Sheet Risk Technology Risk Operational Risk Country or Sovereign Risk Insolvency Risk

20. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-20 Regulation of Financial Institutions FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interest In an attempt to prevent their failure and the failure of financial markets overall FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interest In an attempt to prevent their failure and the failure of financial markets overall

21. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-21 Globalization of Financial Markets and Institutions Financial Markets became more global as the value of stocks traded in foreign markets soared Foreign bond markets have served as a major source of international capital Globalization also evident in the derivative securities market Financial Markets became more global as the value of stocks traded in foreign markets soared Foreign bond markets have served as a major source of international capital Globalization also evident in the derivative securities market

22. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1-22 Factors Leading to Significant Growth in Foreign Markets The pool of savings from foreign investors has increased International investors have turned to U.S. and other markets to expand their investment opportunities Information on foreign investments and markets is now more accessible (e.g. internet) Some mutual funds allow ability to invest in foreign securities with low transaction costs Deregulation has enhanced globalization of capital flows The pool of savings from foreign investors has increased International investors have turned to U.S. and other markets to expand their investment opportunities Information on foreign investments and markets is now more accessible (e.g. internet) Some mutual funds allow ability to invest in foreign securities with low transaction costs Deregulation has enhanced globalization of capital flows