©2009, The McGraw-Hill Companies, All Rights Reserved Chapter One Introduction

©2009, The McGraw-Hill Companies, All Rights Reserved 1-2 McGraw-Hill/Irwin Why study Financial Markets and Institutions? Prudent 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 Prudent 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-3 McGraw-Hill/Irwin FINANCIAL SYSTEM Financial markets Financial institutions & İndividuals Financial assets (instruments, securities) Rules and regulations

©2009, The McGraw-Hill Companies, All Rights Reserved 1-4 McGraw-Hill/Irwin Financial Markets Financial markets are structures through which funds flow. Financial markets consist of - fund suppliers or lenders - fund demanders or borrowers - financials instruments (fin assets, securities) - financial institutions (intermediaries) Financial markets are structures through which funds flow. Financial markets consist of - fund suppliers or lenders - fund demanders or borrowers - financials instruments (fin assets, securities) - financial institutions (intermediaries)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-5 McGraw-Hill/Irwin Types of Financial Markets Money market Foreign exchange market Stock market Bonds and bills market Derivatives market Gold market

©2009, The McGraw-Hill Companies, All Rights Reserved 1-6 McGraw-Hill/Irwin Types of Fınancıal Markets cont. Financial markets can be distinguished along three dimensions –primary versus secondary markets –money versus capital markets –organized versus over the counter markets

©2009, The McGraw-Hill Companies, All Rights Reserved 1-7 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) 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)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-8 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 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-9 McGraw-Hill/Irwin Organized versus Over the Counter (OTC) Markets Organized markets -Have a central physical location -Commission -Registration is required -Controlling system: Formal -Customers’ orders provide liquidity -Listing Organized markets -Have a central physical location -Commission -Registration is required -Controlling system: Formal -Customers’ orders provide liquidity -Listing OTC markets -No physical location -No commission -No need for registration -Any controlling system: Informal -Dealers -No listing (except NASDAQ) OTC markets -No physical location -No commission -No need for registration -Any controlling system: Informal -Dealers -No listing (except NASDAQ)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-10 McGraw-Hill/Irwin Money Market Instruments Outstanding, ($Bn)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-11 McGraw-Hill/Irwin Capital Market Instruments Outstanding, ($Bn)

©2009, The McGraw-Hill Companies, All Rights Reserved 1-12 McGraw-Hill/Irwin Foreign Exchange (FX) Markets FX markets –trading one currency for another (e.g., dollar for yen) Spot FX –the immediate exchange of currencies at current exchange rates Forward FX –the exchange of currencies in the future on a specific date and at a pre-specified exchange rate FX markets –trading one currency for another (e.g., dollar for yen) Spot FX –the immediate exchange of currencies at current exchange rates Forward FX –the exchange of currencies in the future on a specific date and at a pre-specified exchange rate

©2009, The McGraw-Hill Companies, All Rights Reserved 1-13 McGraw-Hill/Irwin Derivative Security Markets Derivative security –a financial security whose payoff is linked to (i.e., “derived” from) another security or commodity –generally an agreement between two parties to exchange a standard quantity of assets at a predetermined price on a specific date in the future Derivative security –a financial security whose payoff is linked to (i.e., “derived” from) another security or commodity –generally an agreement between two parties to exchange a standard quantity of assets at a predetermined price on a specific date in the future

©2009, The McGraw-Hill Companies, All Rights Reserved 1-14 McGraw-Hill/Irwin The Role (Economic Functions)of Financial Markets 1.They provide a mechanism for determinig the price of financial assets: Price discovery process, Efficiency of Financial Markets. 2.They make assets more liquid. 3.They reduce cost of exchanging assets: Search costs, Information costs.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-15 McGraw-Hill/Irwin Financial Institutions (FIs) Financial Institutions –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 Financial Institutions –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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-16 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 Depository institutions –commercial banks, savings associations, savings banks, credit unions Non-depository institutions –insurance companies, securities firms and investment banks, mutual funds, pension funds

©2009, The McGraw-Hill Companies, All Rights Reserved 1-17 McGraw-Hill/Irwin Users of Funds (corporations) Suppliers of Funds (households) Financial Claims (equity and debt instruments) Cash Flow of Funds in a World without FIs Flow of Funds in a World without FIs: Direct Transfer

©2009, The McGraw-Hill Companies, All Rights Reserved 1-18 McGraw-Hill/Irwin Users of Funds FIs (brokers) FIs (asset transformers) Suppliers of Funds Financial Claims (equity and debt securities) Financial Claims (deposits and insurance policies) Cash Flow of Funds in a World without FIs Flow of Funds in a World with FIs: Indirect Transfer

©2009, The McGraw-Hill Companies, All Rights Reserved 1-19 McGraw-Hill/Irwin Services that are provided by FIs 1.Transform fin. assets acquired into assets that are more attractive to the public. (Fin. Intermediaries) 2.Exchange fin. Assets on the behalf of others (Brokers) 3.Exchange fin. Assets for their own. (Dealers) 4.Assists in the creation of fin. assets for their customers and then sell these fin. assets to others.(underwriting) 5.Provide inv. advices 6.Provide portfolio management

©2009, The McGraw-Hill Companies, All Rights Reserved 1-20 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 Increase liquidity and lower price risk Reduce transaction costs Provide maturity intermediation Provide denomination intermediation

©2009, The McGraw-Hill Companies, All Rights Reserved 1-21 McGraw-Hill/Irwin FIs Benefit the Overall Economy Conduit through which Federal Reserve conducts monetary policy Provides efficient credit allocation Provide for intergenerational wealth transfers Provide payment services Conduit through which Federal Reserve conducts monetary policy Provides efficient credit allocation Provide for intergenerational wealth transfers Provide payment services

©2009, The McGraw-Hill Companies, All Rights Reserved 1-22 McGraw-Hill/Irwin Risks Faced by Financial Institutions Credit Foreign exchange Country or sovereign Interest rate Market Credit Foreign exchange Country or sovereign Interest rate Market Off-balance-sheet Liquidity Technology Operational Insolvency Off-balance-sheet Liquidity Technology Operational Insolvency

©2009, The McGraw-Hill Companies, All Rights Reserved 1-23 McGraw-Hill/Irwin Financial Assets An asset is any possession that has value in exchange. Tangible-intangible assets Financial assets= Financial Instruments=Securities are intangible assets. Issuer: The entitiy that agrees to make future cash payments. Investor: The owner of the financial asset.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-24 McGraw-Hill/Irwin Examples of Fin. Assets The bond issed by the Turkish governmnet The bond issued by Koç Holding An automibile loan. A home mortgage. Common Stock issued by a company.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-25 McGraw-Hill/Irwin Debt vs Equity Claims Debt Claims (Debt Instruments)= Fixed Income securities= Bonds Equity Claims (Residual claims)=Common Stock There are also preferred stock, convertible bonds.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-26 McGraw-Hill/Irwin The Role of Financial Assets Fin Assets has two economic functions; 1. Transfering of funds who have surplus of funds to those who need funds to invest in tangible assets. 2. Transferring funds in such a way that redistributes the unavoidable risk associated with the CF generated by the tangible assets among those seeking and those providing the funds.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-27 McGraw-Hill/Irwin Regulation of Financial Institutions FIs are heavily regulated to protect society at large from market failures Regulations impose a burden on FIs and recent U.S. regulatory changes have been deregulatory in nature Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation FIs are heavily regulated to protect society at large from market failures Regulations impose a burden on FIs and recent U.S. regulatory changes have been deregulatory in nature Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation

©2009, The McGraw-Hill Companies, All Rights Reserved 1-28 McGraw-Hill/Irwin Globalization of Financial Markets and Institutions The pool of savings from foreign investors 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 The pool of savings from foreign investors 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

©2009, The McGraw-Hill Companies, All Rights Reserved 1-29 McGraw-Hill/Irwin Globalization of Financial Markets and Institutions cont. Foreign Markets: Foreigners can issue securities in other country markets, subject to national regulations. For example, Japanese firms can issue dollar-dominated securities in the United States but they must follow U.S. regulations, which apply to nationals and foreigners alike.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-30 McGraw-Hill/Irwin Globalization of Financial Markets and Institutions cont. International (Off shore or Euro) Market: Securities are issued outside the jurisdiction of any country. The motivation for foreign and Eurodollar is that many underdeveloped nations simply do not have a sizable capital market to meet their funds needs. Also Eurodollar loans are often less expensive since institutions holding such funds are not hampered by regulations.

©2009, The McGraw-Hill Companies, All Rights Reserved 1-31 McGraw-Hill/Irwin Financial Innovation Categorizations of Financial Innovation; -Market-broadening Instruments -Risk management instruments, -Arbitraging instruments

©2009, The McGraw-Hill Companies, All Rights Reserved 1-32 McGraw-Hill/Irwin Motivation for Financial Innovation 1.Increased volatility of interest rates, inflation, equity prices, exchange rates. 2.Advances in computer&telecomminication technologies. 3.Greater sophistication and educational training among professional market participants. 4.Financial intermediary competition. 5.Incentives to get around existing regulation and tax laws. 6.Changing global patterns of financial wealth

©2009, The McGraw-Hill Companies, All Rights Reserved 1-33 McGraw-Hill/Irwin Asset Securitization It involves tha collection or pooling of loans and sale of securities backed by those loans.