Overview of Market Participants and Financial Innovation CHAPTER 2 Overview of Market Participants and Financial Innovation Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Learning Objectives Participants in financial markets: central governments and agencies, municipal , supranationals, nonfinancial and financial businesses, and households. Business of financial institutions What a financial intermediary is Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Learning Objectives (continued) How do financial intermediaries provide at least one of four economic functions: maturity intermediation, risk reduction via diversification, reducing the costs of contracting and information processing, and a payments mechanism The nature of the management of assets and liabilities by financial intermediaries Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Learning Objectives (continued) How different financial institutions use differing degrees of knowledge and certainty about the amount and timing of the cash outlay of their liabilities The typical justification for governmental regulation of markets Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Learning Objectives (continued) How the government regulates financial markets through: disclosure regulation, financial activity regulation, regulation of financial institutions, and regulation of foreign participants What is meant by financial innovation and the causes of financial innovation Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The Players Governments Federal government Government-sponsored enterprises State governments Local governments Nonfinancial Corporations Ford General Electric Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Players (continued) Depository Institutions Commercial banks Savings and loan associations Savings banks Credit unions Insurance Companies Life Insurance Property and Casualty Insurance Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Players (continued) Asset Management Firms Pension Funds Regulated investment companies Exchange-traded funds Hedge funds Real estate investment trusts Collateralized debt obligations Structured finance operating companies Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Players (continued) Investment Banks Assistance in obtaining funds For investors, act as broker and dealer May be a subsidiary of Commercial banks Insurance companies Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Players (continued) Nonprofit Organizations Classified as Commercial enterprises Not-for-profit organizations Foundations endowments Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

The Players (continued) Foreign Investors Individuals Nonfinancial businesses Financial entities Supranational institutions Two or more central governments through treaties Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Financial Institutions Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Financial Institutions (continued) Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Role of Financial Intermediaries Transform financial assets and re-constitute them into different types of assets. Exchange financial assets on behalf of customers. Exchange financial assets for their own account. Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Role of Financial Intermediaries (continued) Assist in the creation of financial assets for their customers and then sell those financial assets to other market participants. Provide investment advice to other market participants. Manage the portfolios of other market participants. Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Role of Financial Intermediaries (continued) Maturity Intermediation commercial bank in essence transforms a longer-term asset into a shorter-term asset Risk Reduction via Diversification transforming more risky assets into less risky ones Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Role of Financial Intermediaries (continued) Reducing the Costs of Contracting and Information Processing Cost of the acquisition and analysis of the information about the financial asset and its issuer Cost of writing the loan contract Cost of enforcing the contract terms Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Role of Financial Intermediaries (continued) Providing a Payment Mechanism Credit cards, debit cards, electronic transfers Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Overview of Asset/Liability Management for Financial Institutions Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Overview of Asset/Liability Management for Financial Institutions (continued) Type I Liabilities Guaranteed Investment Contracts, Bonds Type II Liabilities Life Insurance Policy Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Overview of Asset/Liability Management for Financial Institutions (continued) Type III Liabilities Certificates of Deposits (CD’s) Type IV Liabilities Property and Casualty Insurance Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Regulation of Financial Markets Justification for Regulation the market, left to itself, will not produce its particular goods or services in an efficient manner and at the lowest possible cost The regulatory structure in the United States is largely the result of financial crises that have occurred at various times Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Regulation of Financial Markets (continued) Forms of Federal Government Regulation of Financial Market Disclosure Regulation Financial Activity Regulation Financial Institution Regulation Foreign Participant Regulation Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Financial Innovation Market-broadening instruments increase the liquidity of markets and the availability of funds Risk-management instruments reallocate financial risks Arbitraging instruments and processes take advantage of differences in costs and returns between markets Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Financial Innovation (continued) Price-risk-transferring innovations Credit-risk-transferring instruments Liquidity-generating innovations Credit-generating instruments Equity-generating instruments Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Financial Innovation (continued) Motivation for Financial Innovation Increased volatility of interest rates, inflation, equity prices, and exchange rates Advances in computer and telecommunication technologies Greater sophistication and educational training among professional market participants Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Financial Innovation (continued) Financial intermediary competition Incentives to get around existing regulation and tax laws Changing global patterns of financial wealth Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Securitization and Financial Innovation securitization is a process by which a financial relationship is converted into a financial transaction Loans Stocks Corporate bonds Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Summary Funds (debt or equity) can be raised by issuing obligations and investment in financial assets Financial institutions provide broker, dealer and underwriting functions Intermediaries transform corporate assets into assets attractive to the market Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Summary (continued) Investment strategies of financial institutions are determined by the type of liabilities, regulations and tax considerations Regulations can be classified by disclosure, activity, institution and foreign participation Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Summary (continued) Financial innovation can be classified by function and either process or product Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall.