Chapter 2 An Overview of the Financial System Money and Banking Chapter 2 An Overview of the Financial System

Learning Objectives Compare and contrast direct and indirect finance. Identify the structure and components of financial markets. List and describe the different types of financial market instruments. Summarize the roles of transaction costs, risk sharing, and information costs as they relate to financial intermediaries. List and describe the different types of financial intermediaries. Identify the reasons for and list the types of financial market regulations.

Financial Markets vs. Financial Intermediaries Financial Markets – bring savers and borrowers directly together Financial Intermediaries – bring savers and borrowers together indirectly through a middleman such as a bank

Financial Markets Channel funds from economic players that have saved surplus funds to those that have a shortage of funds Demand Funds (Investment) Excess Funds (Savings) Financial Markets (Stocks/Bonds) Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities

Structure of Financial Markets Debt Markets BONDS : Debt instruments (maturity) Contractual agreement by the borrower to pay the holder a fixed dollar amount at regular intervals (interest payments) Maturity of the instrument: number of years until expiration Short term -- less than one year Intermediate term – between 1 and 10 years Long term – more than ten year

Structure of Financial Markets Equity Markets STOCKS : Equities If an individual owns one share of common stock out of 100,000 – he owns 1/100,000 of the company Dividends – periodic payments to shareholders by the company No maturity – you can sell your stock at any time

Structure of Financial Markets Primary Market Initial stock/bond issued sold to investment banks Not well known to public Investment bank: guarantees a price for the security then sells it to the public (underwriting) Secondary Market Stocks/bonds that have already been issued are resold to the public Stock Exchanges – secondary markets for equities New York Stock Exchange Shanghai Stock Exchange London Stock Exchange When the stock is resold Person who sold the stock gets money in exchange Company that issues the stock does not

Structure of Financial Markets Secondary markets are organized in two ways: Exchanges -- buyers and sellers of securities meet in one place to conduct the trades New York Stock Exchange Over-the-counter (OTC) – dealers are ready to buy/sell securities to anyone that comes to them directly and is willing to accept their price Thanks to technology – highly competitive market

Structure of Financial Markets Money Market – short-term debt instruments (< 1 year) US Treasury Bills (1, 3, 6 month bonds) Bank Certificates of Deposit Commercial Paper Federal Funds Capital Market – longer-term debt instruments (> 1 year) and equity instruments Stocks Mortgages/Mortgage backed securities Corporate Bonds US Gov’t/Gov’t Agency Securities State/Local bonds Consumer/Commerical Loans

Money Market Instruments

Capital Market Instruments