An Overview of Financial Markets and Institutions CHAPTER 1 An Overview of Financial Markets and Institutions

Role of the Financial System Provides for the efficient flow of funds from lenders to borrowers to finance real investment or consumption via financial markets and financial institutions. Facilitates trade in goods and services via an efficient payment system. Provides contracts for managing risk such as insurance, futures, and options.

Surplus Spending Unit (SSU) Has more income than expenditures on consumption and real investment in a period. Other terms for surplus spending unit are: lender, saver, financial investor, buyer of securities, holder of securities, and supplier of loanable funds.

Surplus Spending Unit The surplus spending unit may buy financial assets, hold more money, pay off financial liabilities issued earlier when in a deficit situation. The household sector is usually a surplus sector.

Deficit Spending Unit Has more expenditures on consumption and real investment than income in a period. Other terms for deficit spending unit are: borrower, economic investor, seller of securities, issuers of securities, and demander of loanable funds.

Deficit Spending Unit The deficit spending unit may issue financial liabilities, hold less money, sell financial assets acquired earlier when in a surplus situation. The business and government sectors are usually deficit sectors.

Financial Claims Contracts to transfer of funds from surplus to deficit spending units. Financial claims are also called financial assets and liabilities, securities, loans, financial investments. For every financial asset, there is an offsetting financial liability - total assets equal liabilities in the financial system.

Financial Claims Financial markets provides: Financing (borrowing) for DSUs in the primary markets. Financial investment (lending) for SSUs in the primary and secondary markets. Liquidity via trading financial claims in secondary markets.

Direct Financing DSUs and SSUs exchange money for financial claims. DSUs issue financial claims and SSUs buy the financial claims.

Direct Financing Brokers are match makers who bring DSUs and SSUs together. Dealers are market makers who buy securities from DSUs and sell them to SSUs. Investment bankers act as dealers in primary financial markets, buying securities from DSUs (underwriting) and selling them to SSUs in initial public offering (IPO) or private placement.

Indirect Financing or Financial Intermediation A financial intermediary writes a separate contract with the SSU (lender) and the DSU (borrower). Financial intermediaries issue direct claims to SSUs as its financial liabilities, and hold indirect claims on DSUs as its financial assets.

Benefits of Financial Intermediation Economies of scale from specialization → lower transaction and search costs for SSUs and DSUs. → easier access to financial markets. Financial intermediaries may be able to gather information about DSUs and SSUs more effectively and discretely.

Benefits of Financial Intermediation Maturity Intermediation - offer contracts with varying maturities to suit both DSUs and SSUs. Denomination Intermediation - issue contracts with varying sizes. Currency Intermediation - buy and sell financial claims denominated in various currencies.

Benefits of Financial Intermediation Liquidity Intermediation - help SSUs to store liquidity through deposits and buying money markets securities, and provide liquidity to DSUs through loans and issuing money market securities. Risk Intermediation (Diversification) - manage risk by spreading the risk over many types of financial securities (investment portfolio).

Benefits of Financial Intermediation Information Intermediation - help lenders and borrowers deal with the problems created by asymmetric information: Adverse Selection is the problem created by asymmetric information before the transaction. It occurs when potential borrowers who are the most likely to produce a bad outcome are the ones who most actively seek loans and are thus the most likely to be selected. Moral Hazard is the problem created by asymmetric information after the transaction. It is the risk that the borrower might engage in undesirable (immoral) activities that will make it less likely that the loan will be paid back.

Types of Financial Intermediaries Depository Institutions - accept deposits (demand, savings, and time deposits) from SSUs and make loans to DSUs. Commercial Banks - make consumer and business loans to DSUs. Credit Unions - accept deposits from members and make consumer loans to DSUs. Membership requires a common bond - Business employee or labour union.

Types of Financial Intermediaries Savings Institutions - issue long-term claims to SSUs in the form of insurance policies and pension fund obligations. Life Insurance Companies - issue life insurance policies and collect premiums, and purchase long-term, high-yield financial securities.

Types of Financial Intermediaries Casualty Insurance Companies - issue insurance policies and collect premiums, and purchase long-term, liquid financial securities. Pension Funds - receive contributions from employees and purchase long-term financial securities (stocks and bonds).

Types of Financial Intermediaries Investment Institutions - issue shares to SSUs and purchase financial securities. Mutual Funds - sell shares to SSUs and purchase financial securities (stocks and bonds). Money Market Mutual Funds - sell shares to SSUs and purchase money market financial securities - T-Bills, commercial papers and bank CDs.

Types of Financial Intermediaries Finance Companies - Borrow from commercial banks (loans) or from SSUs (issue commercial papers) and make consumer and business loans.

Exhibit 1.1 Transfer of Funds From Surplus to Deficit Units

Types of Financial Markets Financial markets may be classified as debt (bond) or equity (stock) markets. Debt financing is riskier than equity financing, but can lead to higher profits through “leverage”. Equity financing can lead to the “dilution” of stockholders’ equity.

Types of Financial Markets Financial markets may be classified as: Primary markets where the initial financing of DSUs occur with the help of investment bankers. Secondary markets where previously issued financial securities are traded with the help of brokers and dealers. Secondary market provides liquidity for investors and pricing for primary markets.

Types of Financial Markets Secondary markets may be organized as: Organized exchanges where buyers and sellers of securities meet in one location to conduct trades. Over-the-counter (OTC) markets, where securities trade via a computer network connecting dealers in many locations.

Types of Financial Markets Financial markets may be classified as: Money markets where short-term debt securities (maturity is less than one-year) are issued and traded. Capital markets where long-term debt securities (maturity is greater than one-year) and stocks are issued and traded.

Money Markets Short-term maturities - most under 120 days. Standardized securities - one security is a close substitute for another. High quality borrowers → low default risk. Active secondary market → High marketability providing excellent liquidity. “Wholesale” markets - Large wholesale transactions.

Money Market Economic role of money markets - markets for liquidity. Liquidity is stored in money markets by investing in securities (lending). Liquidity is bought in money markets by issuing securities (borrowing).

Capital Markets Markets for long-term claims “Retail” markets Government Bonds Corporate Bonds Common Stock Mortgages “Retail” markets Economic role of capital markets - markets for economic investment.

Risks of Financial Institutions Credit or default risk is the risk that a DSU will not pay as agreed, thus affecting the rate of return on an asset. Interest rate risk is the risk of fluctuations in a security's price or reinvestment income caused by changes in market interest rates. Liquidity risk is the risk that the financial institution’s cash inflows will not be able to meet its cash outflows.

Risks of Financial Institutions Foreign exchange risk is the risk that fluctuations in the foreign exchange rates will affect the profit of the financial institution. Political risk is the risk that actions of foreign governments or regulators will affect the profit of the financial institution.