1. 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.

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

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

11. 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.

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

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

14. 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.

15. 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.

16. 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.

17. 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.

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

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

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.