Chapter One Introduction

Why study Financial Markets and Institutions? Careful and far sighted investment and financing requires a full understanding of the structure of domestic and international markets the flow of funds through domestic and international markets the strategies used to manage risks faced by investors and savers McGraw-Hill/Irwin

Before Financial Markets.... The financial system is the collection of markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other securities are traded, interest rates are determined, and financial services are produced and delivered around the world. McGraw-Hill/Irwin

Financial Markets Financial markets are structures through which funds flow Financial markets can be distinguished along two dimensions primary versus secondary markets money versus capital markets McGraw-Hill/Irwin

Primary versus Secondary Markets Primary markets markets in which users of funds (e.g., corporations and 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 and Nasdaq) McGraw-Hill/Irwin

Primary versus Secondary Markets Primary markets New issues of the instruments are sold to the initial suppliers of funds (household) in exchange for funds. These transactions are usually arranged through investment banks (Lehman Brothers, Morgan Stanley etc which are called underwriters.) The first public issue of financial instruments by a firm is either through IPOs (initial public offering) and/or private placement, Erosion in IPO processes??? Spinning.. & biased .... McGraw-Hill/Irwin

Primary versus Secondary Markets Buyers are the economic agents with excess fund (consumers, business, and goverment) Sellers are the economic agents in need of funds. markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq) Securities brokers are the intermediaries between the buyer and seller. Secondary market is available for mortgage backed instruments (c7), F-X (c9), futures&options (c10) McGraw-Hill/Irwin

McGraw-Hill/Irwin

Primary versus Secondary Markets McGraw-Hill/Irwin

Money versus Capital Markets Money markets markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills) Capital markets markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year McGraw-Hill/Irwin

Money and Capital Market Instruments (Table 1-2) McGraw-Hill/Irwin

Money Market Instruments Outstanding, ($Bn) McGraw-Hill/Irwin

Capital Market Instruments Outstanding, ($Bn) McGraw-Hill/Irwin

Foreign Exchange (FX) Markets Events and movements in financial markets in other countries affect the profitability and performance of your own company. FX markets trading one currency for another (e.g., dollar for yen) Spot FX the immediate exchange of currencies at current exchange rates currency today, for delivery today, at a price made today Forward FX the exchange of currencies in the future on a specific date and at a pre-specified exchange rate Traditional FX forwards are available for maturities from 3 days out to about 2 years McGraw-Hill/Irwin

Derivative Security Markets a financial security whose payoff is linked to (i.e., “derived” from) another security or commodity generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future Depending on underlying security price changes, the value of the derivative security changes. McGraw-Hill/Irwin

Financial Market Regulation The Securities Act of 1933 full and fair disclosure and securities registration The Securities Exchange Act of 1934 Securities and Exchange Commission (SEC) is the main regulator of securities markets in the USA in Saudi Arabia Capital Market Authority (CMA) Regulations are not for poor investment choices but for investors to have full and accurate information available about corporate issuers. McGraw-Hill/Irwin

Financial Institutions (FIs) institutions through which suppliers channel money to users of funds Financial Institutions are distinguished by whether they accept deposits depository versus non-depository financial institutions From Chapter 11 through 18 discusses the various types of FIs McGraw-Hill/Irwin

Flow of Funds in a World without FIs Financial Claims (equity and debt instruments) Suppliers of Funds (households) Users of Funds (corporations) Cash Direct transfer Monitoring Requirement, Liquidity, price risk McGraw-Hill/Irwin

Flow of Funds in a World with FIs Flow of Funds in a World without FIs Flow of Funds in a World with FIs FIs (brokers) (asset transformers) Users of Funds Suppliers of Funds Cash Cash Financial Claims (equity and debt securities) Financial Claims (deposits and insurance policies) Indirect Transfer McGraw-Hill/Irwin

Depository versus Non-Depository FIs Depository institutions commercial banks, savings associations, savings banks, credit unions Non-depository institutions insurance companies, securities firms and investment banks, mutual funds, pension funds McGraw-Hill/Irwin

Changing Shares of FIs McGraw-Hill/Irwin

FIs Benefit Suppliers of Funds Reduce monitoring costs Increase liquidity and lower price risk Reduce transaction costs Provide maturity intermediation Provide denomination intermediation Reduce monitoring costs: Aggregation of funds in an FI provides greater incentive to collect a firm’s information and monitor actions. (delegated monitor to act on fund suppliers behalf) Because of the economies of scale [cost advantages that a business obtains due to expansion] the average cost of collecting the information is low. (hiring employees with superior skills and training in monitoring) Example: A bank collecting funds and giving loans... McGraw-Hill/Irwin

FIs Benefit Suppliers of Funds Increase liquidity and lower price risk: FIs’ act as asset transformers. They purchase the financial claims (mortgages, bonds, stocks) issued by users of funds and finance these purchases by selling financial claims to household investers. Being less risky and more liquid guaranteed in an FI. How? FIs can diversify away some of their investment risk. So that they can credibly fulfill its promises to the suppliers of funds. McGraw-Hill/Irwin

-Diversification- As long as the returns on different investments are not perfectly positively correlated, by spreading their investments across a number of assets, Fıs can diversify away significant amounts of their portfolio risk. Researhes show that diversifying across just 15 securities can bring significant diversification benefits to FIs and portfolio managers. McGraw-Hill/Irwin

FIs Additional Benefits to Suppliers of Funds Reduce transaction costs: For instance, buying a 100 USD broker’s report may seem high for a 10,000 USD investment but for an FI with 10 billion of assets the cost is trivial. IT reduce transactions costs. No need to use a traditional stockbroker and paying brokerage fees. Even some companies allow investors to buy their stocs directly (private placement) (IBM, Microsoft, Walt Disney, AT&T) McGraw-Hill/Irwin

FIs Benefit Suppliers of Funds Provide maturity intermediation: They have an abilitity to bear the risk of mismatching the maturities of their assets and liabilities. So, they also offer maturity intermediation services to the rest of the economy. As a result, FIs can produce new types of contracts with a longer maturity comparing to short term deposits. McGraw-Hill/Irwin

FIs Benefit Suppliers of Funds Provide denomination intermediation: As many assets are sold in very large denominations, individual savers can not reach. Minimum size of a negotiable CD is 100,000 USD while commercial paper (Short term corparate dept) packages are minimum 250,000 USD. By pooling the funds of many small savers, small savers overcome constraints to buying assets imposed by large minimum denomination size. Such access may allow small savers to generate higher returns (and lower risks) on their portfolio because of diversification. McGraw-Hill/Irwin

FIs Benefit the Overall Economy The transmitters of monetary policy: SAMA/Fed. Reserve/Central Banks conducts monetary policy) Most commonly used definition of money supply (which indirectly impacts the rate of inflation,) is bank deposits. Depository institutions are involved in determining the size and growth of the money supply. McGraw-Hill/Irwin

FIs Benefit the Overall Economy Provides efficient credit allocation: Depending on their pre-identified roles, if policymakers identifies that residential real estate needs special attention, mortgage lending becomes important (Some specific banks in the US (thrifts) must have at least %65 of their assets in mortgage related fields) Saudi Arabian Agricultural Bank (www.saab.com.sa) McGraw-Hill/Irwin

FIs Benefit the Overall Economy Provide for intergenerational wealth transfers or Time Intermediation: From your youth to old age as well as across generations... So, life insurance, pension funds have special tax exempts. Provide payment services: Like check-clearing and wire transfer services. (Fedwire and CHIPS) (On any given day, over 3 trillion dollars of payment are directed through Fedwire and CHIPS) imagine breakdown of this system !!! McGraw-Hill/Irwin

Risks Faced by Financial Institutions They hold some assets that are potentially subject to default or credit risk. As they expand their services to non-US customers or even domestic customers have business outside the US, there is foreign exchange and country risk (sovereign risk) . There is a risk of mismatching their assets and liabilities, so they are exposed to interest rate risk McGraw-Hill/Irwin

Risks Faced by Financial Institutions If FIs actively trade these assets and liabilities rather than hold them for long investments, they are exposed to market risk or asset price risk. All FIs are exposed to technology risk and operational risk as they need to use real resources and back office support systems (labor+technology) Not having enough capital may lead to insolvency. McGraw-Hill/Irwin

Risks Faced by Financial Institutions Credit Foreign exchange Country or sovereign Interest rate Market Off-balance-sheet contingent liabilities Liquidity Technology Operational Insolvency McGraw-Hill/Irwin

Risks Faced by Financial Institutions McGraw-Hill/Irwin

Regulation of Financial Institutions FIs are heavily regulated to protect society at large from market failures Bank failures may destroy household savings and restrict a firm’s access to credit. Insurance company failures may leave household members totally exposed in old age to the cost of catastrophic illnesses and to sudden drops in income on retirement. Regulations impose a burden on FIs and recent regulatory changes (in the US or almost anywhere) have been deregulatory in nature Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation McGraw-Hill/Irwin

Globalization of Financial Markets and Institutions Foreign bond markets have served as a major source of international capital. Fin. Markets became global in 1980s as IT provided immediate and cheaper access to real time data worldwide. Eurodollar bonds are 80 percent of new issues in international bond market. Dolar denominated bonds issued mainly in London and other European Centers such as Luxemburg. Not required to register SEC as they are not “domestic” The significant growt in foreign financial markets is the result of several factors. McGraw-Hill/Irwin

Reasons of Growth in Foreign Financial Market The pool of savings from foreign investors (i.e from EU) is increasing and investors look to diversify globally now more than ever before Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access International mutual funds allow diversified foreign investment with low transactions costs Euro is also having a notable impact on the global financial sytem. McGraw-Hill/Irwin

International Debt Outstanding, by Issuer in billions of Dollars McGraw-Hill/Irwin

Financial Market Securities Holdings While US financial markets dominate world markets, the growth of US financial markets depends more and more on the growth and development of other economies. The success of other economies depends to a significant extent on their financial market development McGraw-Hill/Irwin

The Largest Banks in the World Competition is also increased due to global markets. McGraw-Hill/Irwin

Foreign Bank Offices Assets and Liabilities Held in the US McGraw-Hill/Irwin

End of Chapter 1, Finally... Thanks McGraw-Hill/Irwin

End of Chapter 1, Finally... How does the location of the money market differ from that of the capital market? The capital markets are more likely to be characterized by actual physical locations such as the New York Stock Exchange or the American Stock Exchange. Money market transactions are more likely to occur via telephone, wire transfers, and computer trading. McGraw-Hill/Irwin

End of Chapter 1, Finally... What are the major instruments traded in capital market? The major instruments traded in capital markets are corporate stocks, residential mortgages, commercial and farm mortgages, corporate bonds, Treasury notes and bonds, state and local government bonds, U.S. government owned agencies, U.S. government sponsored agencies, and bank and consumer loans. McGraw-Hill/Irwin

End of Chapter 1, Finally... What services do FIs provide to the financial system? Money Supply Transmission - Depository institutions are the pipe through which monetary policy actions impact the rest of the financial system and the economy in general. Credit Allocation - FIs are often viewed as the major, and sometimes only, source of financing for a particular sector of the economy, such as farming and residential real estate. Intergenerational Wealth Transfers - FIs, especially life insurance companies and pension funds, provide savers the ability to transfer wealth from one generation to the next. Payment Services - The efficiency with which depository institutions provide payment services McGraw-Hill/Irwin