Chap. 1 The Study of Financial Markets Financial Markets – A Definition: –Markets in which funds are transferred between savers (investors) and borrowers –Funds are transferred from Surplus Units (Savers, Investors) to Deficit Units (Borrowers) –Examples of Each: Surplus Units = Households and Investment Groups Deficit Units = Financial, Non-Fin. Corps. and Individuals –This promotes greater market efficiency (i.e. lowers transaction and search cost)

Chap. 1 The Study of Financial Markets Debt Markets and Interest Rates –Financial Instruments (Securities) A Claim on the Issuers Future Income and or Assets Financial claims are also called financial assets/ liabilities, securities, loans, and investments –Assets An Owned Financial Claim or Piece of Property For every financial asset, there is an offsetting financial liability

Chap. 1 The Study of Financial Markets Debt Markets and Interest Rates –Bond Markets (Debt Markets) Bond – A debt security promising to make payments over a specified period of time –The Rate of Interest Interest Rate – The price or cost of borrowing money expressed as a percentage Interest rates are determined in the Bond/Debt Markets

Chap. 1 The Study of Financial Markets Interest Rates and Financial Institutions –Interest Rates directly effect the performance of Financial Institutions –Example: If a bank issues short term CD’s during a period of rising interest rates what might happen to the bank’s cash flow assuming that assets are constant or declining? –Int. Rates can differ b/w Time to Maturity

Chap. 1 The Study of Financial Markets The Stock Market –Stock: A security representing a claim of ownership in a corporations earnings and assets –Primary Market Initial Public Offering (IPO) Seasoned Equity Offering (SEO) –Secondary Market NYSE, AMEX, NASDAQ

Chap. 1 The Study of Financial Markets The Foreign Exchange Market –Allows funds from one country to be transferred to another country –Implicit in this definition is the conversion of one currency for another (i.e. Euros to Dollars) Foreign Exchange Rate –The price of one country’s currency relative to another country’s ( Can$ per 1 US)

Chap. 1 The Study of Financial Markets The Foreign Exchange Market –Fluctuation in exchange rates between currency’s lead to a variety of economic impacts –Example: When the US Dollar is strong (expensive) relative to other currencies, American Consumers can buy abroad cheaper than they can domestically. However US firms may suffer as exports decline.

Chap. 1 The Study of Financial Markets Financial Institutions –Central Banks The government or quasi-government agency tasked with managing monetary policy In the US this agency is known as the Federal Reserve System (or the Fed) –Monetary Policy Management of interest rates and the money supply (M1, M2, M3, MZM)

Chap. 1 The Study of Financial Markets Financial Institutions –Banks – An institution that accepts deposits and makes loans –Types of Banking Institutions Commercial Banks Savings and Loan Associations Mutual Savings Banks Credit Unions

Chap. 1 The Study of Financial Markets

Financial Institutions –Other Types of Financial Institutions Investment Banks Mutual Funds Pension Funds Insurance Companies Finance Companies Government Agencies (HUD, Dept. Ag.)

Chap. 1 The Study of Financial Markets

Financial Intermediation –A financial "intermediary" writes a separate contract with the Investor (bank depositor) and Borrower (auto loan) –Financial intermediaries hold direct claims on Borrowers as financial assets and issue indirect financial claims to Investors as liabilities

Chap. 1 The Study of Financial Markets Advantages of Financial Intermediation –Economies of scale from specialization –Transaction and search costs are lowered –Financial intermediaries may be able to gather borrower information more effectively and discreetly

Chap. 1 The Study of Financial Markets Services of Financial Intermediation –Denomination Divisibility - Issue varying sized contracts of assets and liabilities –Currency Transformation - buying and selling financial claims denominated in various currencies –Maturity Flexibility - Offer contracts with varying maturities to suit both Borrowers and Investors

Chap. 1 The Study of Financial Markets Services of Financial Intermediation –Credit Risk Diversification - Assume credit risks of Borrowers and keep the risks manageable by spreading the risk over many varied types of Borrowers (loan portfolios) –Liquidity - Provide a place to store liquidity for Investors (deposits); a place to find (borrow) liquidity for Borrowers

Chap. 1 The Study of Financial Markets

Financial Innovation –The Advent of Electronic Banking/Investing ATM’s Smart Cards and Point of Sale Transactions Telephone Banking Web Bill Payment & Account Access Electronic/Internet Securities Trading –Can lead to higher profits for FI’s and lower costs for Investors and Borrowers

Chap. 1 The Study of Financial Markets Managing Risk in Financial Institutions Types of Risk –Credit or default risk - the risk that a borrower will not pay as agreed, thus affecting the rate of return on a loan or security –Interest rate risk - the risk of fluctuations in a security's price or reinvestment income caused by changes in market interest rates –Liquidity risk - the risk that a financial institution will be unable to generate sufficient cash flow to meet required cash outflows

Chap. 1 The Study of Financial Markets Managing Risk in Financial Institutions Types of Risk (Cont’d) –Foreign exchange risk -the risk that foreign exchange rates will vary in the future affecting the profit of a financial institution –Political risk - the cost or variation in returns caused by actions of governments or regulators

Chap. 1 The Study of Financial Markets Managing Risk in Financial Institutions –Financial Instruments for Risk Management Forwards Futures Options Swaps