2. ©2007, The McGraw-Hill Companies, All Rights Reserved Chapter One Introduction

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-3 McGraw-Hill/Irwin 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. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-4 McGraw-Hill/Irwin 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. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-5 McGraw-Hill/Irwin 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. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-6 McGraw-Hill/Irwin 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. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-7 McGraw-Hill/Irwin Money Market Instruments Outstanding, 1990-2004 ($Bn)

8. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-8 McGraw-Hill/Irwin Capital Market Instruments Outstanding, 1990-2004 ($Bn)

9. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-9 McGraw-Hill/Irwin 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. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-10 McGraw-Hill/Irwin Derivative Security Markets The markets in which derivative securities trade. Derivative Security –An agreement between two parties to exchange a standard quantity of an asset at a predetermined price on a specified date in the future. The markets in which derivative securities trade. Derivative Security –An agreement between two parties to exchange a standard quantity of an asset at a predetermined price on a specified date in the future.

11. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-11 McGraw-Hill/Irwin 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)

12. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-12 McGraw-Hill/Irwin 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.

13. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-13 McGraw-Hill/Irwin 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

14. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-14 McGraw-Hill/Irwin 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)

15. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-15 McGraw-Hill/Irwin 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

16. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-16 McGraw-Hill/Irwin Services Performed by Financial Intermediaries Monitoring Costs Liquidity and Price Risk Transaction Cost Services Maturity Intermediation Denomination Intermediation Monitoring Costs Liquidity and Price Risk Transaction Cost Services Maturity Intermediation Denomination Intermediation

17. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-17 McGraw-Hill/Irwin Services Provided by FIs Benefiting the Overall Economy Money Supply Transmission Credit Allocation Intergenerational Wealth Transfers Payment Services Money Supply Transmission Credit Allocation Intergenerational Wealth Transfers Payment Services

18. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-18 McGraw-Hill/Irwin 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

19. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-19 McGraw-Hill/Irwin 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

20. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-20 McGraw-Hill/Irwin 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

21. ©2007, The McGraw-Hill Companies, All Rights Reserved 1-21 McGraw-Hill/Irwin 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