Chapter 1 FINANCIAL MARKETS & INSTITUTIONS

FINANCIAL MARKETS Is a market in which financial assets such as stocks and bonds are traded. They facilitate the flow of funds, allowing financing and investing. Financial markets transfer funds from those who have excess funds to those who need funds

Participants of the market: Households Firms Government agencies The ones providing funds to financial markets are called Surplus Units- (households) Participants who use financial markets to obtain funds are called Deficit Units

How do deficit units work: Security: A certificate that represents a claim on the issuer. How do deficit units work: They issue (sell) securities to surplus units IN order to obtain funds

TYPES OF FINANCIAL MARKETS Primary versus secondary markets New securities are issued in primary markets, while existing securities are traded in secondary markets. Facilitate the Trading of Existing Securities Provide Liquidity Continuous Information Makes it easy for firms to raise Funds

Money versus Capital Markets Financial markets that facilitate the flow of short-term funds (with maturities less than one year) are known as money markets, While those that facilitate the flow of long-term funds are known as capital markets.

Organized versus Over-the-Counter Markets Some secondary stock market transactions occur at an organized exchange, which is a visible market place for secondary market transactions. Over the counter market is a telecommunication network for market transactions

Securities traded in Financial Markets Equity securities represent ownership in business. Debt securities represent IOU’S, investors who purchase these securities are creditors. While equity securities typically have no maturity, debt securities have maturities ranging from one day top twenty years or longer.

Securities traded Money market securities: Are debt securities that have a maturity of one year or less. Have a high degree of liquidity, Low expected return.

MONEY MARKET SECURITITES ISSUED BY INVESTORS MATURITIES SECONDARY MARKET TRADING TRESURY BILLS FEDERAL GOVERNMENT HOUSEHOLDS, FIRM, FINANCIAL INSTITUTIONS ONE YEAR OR LESS HIGH CERTIFICATE OF DEPOSITS BANKS AND SAVING INSTITUTIONS HOUSEHOLDS 7DAYS-5 YEARS OR LONGER NONEXISTENT NEGOTIABLE CD’S FIRMS 2 WEEKS- 1 YEAR MODERATE COMMERCIAL PAPER BANK HOLDING COMPANIES, FINANCING COMPANIES 1 DAY- 270 DAYS LOW EURODOLLAR DEPOSITS BANKS LOCATED OUTSIDE US FIRMS AND GOVERNMENTS 1 DAY- 1 YEAR NON EXISTENT BANKER’S ACCEPTANCES BANKS 30 DAYS- 270 DAYS FEDERAL FUNDS DEPOSITORY INSTITUTIONS 1 DAY- 7 DAYS REPURCHASE AGREEMENTS FIRMS AND FINANCIAL INSTITUTIONS 1 DAY- 15 DAYS

CAPITAL MARKET SECURITIES Securities with a maturity of more than one year. Bonds and mortgages: are long term debt obligations issued by corporations and government. Mortgages are debt obligations to finance real estate Stocks represent partial ownership in the firms that issue them, they have no maturity and serve as long- term source of funds.

CAPITAL MARKET SECURITITES ISSUED BY INVESTORS MATURITIES SECONDARY MARKET TRADING TRESURY NOTES AND BONDS FEDERAL GOVERNMENT HOUSEHOLDS, FIRM, FINANCIAL INSTITUTIONS 3-30 YEARS HIGH MUNICIPAL BONDS STATE AND LOCAL GEVERNMENT HOUSEHOLD AND FIRMS 10-30 YEARS MODERATE CORPORATE BONDS FIRMS MORTGAGES INDIVIDUAL AND FIRMS FINANCIAL INSTITUTIONS EQUITY SECURITIES HOUSEHOLDS AND FIRMS NO MATURITY

Role of Financial Markets and Institutions Even if markets are efficient, this does not imply that individual or institutional investors should ignore the various investment instruments available. Investors normally intend to balance the objective of high return with their particular preference for low default risk and adequate liquidity. As time passes, new information about economic conditions and corporate performance becomes available. Announcements that do not contain any new valuable information will not elicit a market response.

Financial institutions are required to resolve the problems caused by market imperfections They match up buyers and sellers of securities, breakdown securities to the desired size of an investor.

Depository institutions are the major type of financial intermediary which accept deposits from surplus units and provide credit to deficit units

Depository institutions 1. Commercial Banks: They serve surplus units by offering a wide variety of deposit accounts, and they transfer deposited funds to deficit units by providing direct loans or purchasing securities. 2. Saving Institutions: Like commercial Banks, savings and loan associations offer deposit accounts to surplus units and then channel these deposits to deficit units. S&L’s have concentrated on residential mortgage loans, while commercial banks have concentrated on commercial loans. Saving Banks are similar to savings and loan associations, except that they have more diversified uses of funds.

3. Credit Unions: Credit unions differ from commercial banks and savings institutions in that: They are non-profit They restrict their business to the credit union members, who share a common bond.

Functions of Non Depository Financial Institutions 1. Finance Companies: Most finance companies obtain funds by issuing securities, then lend the funds to individuals and small businesses. 2. Mutual Funds: Mutual Funds sell shares to surplus units and use the funds received to purchase a portfolio of securities. By purchasing shares of mutual funds and money market mutual funds, small savers are able to invest in a diversified portfolio of securities with a relatively small amount of funds.

3. Securities Firms: Some securities Firms use their information resources to act as a broker, executing securities transactions between two parties. The fee is reflected in the difference between their bid and ask quotes. Furthermore, securities firms often act as dealers, making a market in specific securities by adjusting their inventory of securities. 4. Pension Funds: Many corporations and government agencies offer pension plans to their employees in which funds are periodically contributed by the employees, their employees or both.

5. Insurance Companies: Insurance companies receive premiums in exchange for insurance policies payable upon death, illness, or accidents and use the funds to purchase a variety of securities.

Employee contributions Individual surplus units Depository institutions Deficit units Mutual funds Finance companies Policyholders Employers and employees Insurance companies Deposits Purchase securities Purchase shares Premiums Employee contributions

Exposure of Financial Institutions to Risk Bonds and mortgages are subject to interest rate risk, whereby prices of existing bonds or mortgages decline in response to an increase in interest rates. Stocks are subject to market risk, whereby the stock market experiences lower prices in response to adverse economic conditions or pessimistic expectations of investors. All types of securities dominated in foreign currencies are subject to exchange rate risk, in which the currencies dominating the securities depreciate against the investor’s home currency.