1. Overview of the Financial System
Introduction (Part 2)
Overview of the Financial System

2. Last Lecture Lender-Savers vs Borrower-spenders Direct Finance
Function of financial Markets
Debt vs Equity Instruments
Primary vs Secondary Markets

3. Structure of Financial Markets: Exchanges & OTC Markets
Secondary Markets may be categorized based on the market in which securities are traded:
Exchanges—where buyers and sellers of securities (or their brokers) meet in a central location to conduct trades.
E.g. of Stock exchanges: NYSE & AMEX.
E.g. of a commodities exchange is CBOT (trades corn, wheat, silver, and other raw materials)
Over-the-counter (OTC) markets—dealers at different locations have inventory of securities and stand ready to sell the securities “over the counter” to anyone who is willing to accept their prices.
OTC parties are electronically linked. Transactions are done through computer contact.
E.g. of an OTC: Nasdaq (National Association of Securities Dealers Automated Quotation System)

4. Exchanges & OTC Markets
Larger firms tend to trade on exchanges
Smaller firms tend to trade in OTC markets.
Bonds are generally traded on the OTC
Other financial instruments such as certificates of deposits, federal funds, bankers acceptances, and foreign exchange instruments are traded on the OTC.
The U.S. government bond market, with a larger trading volume than NYSE, is set up as an OTC market.
Forty or so dealers establish a ‘market’ in these securities by standing ready to buy and sell U.S. government bonds.

5. A Few Facts
Although the average person is more aware of the stock market than any other financial market, the size of the debt market is often substantially larger than the size of the equities market:
The value of debt instruments was $43.4 trillion at the end of 2006.
The value of equities was $19.3 trillion at the end of 2006.

6. Structure of Financial Markets: Money & Capital Markets
Markets may also be categorized based on the maturity of securities that are traded there-in:
Money Market—market in which only short-term debt instruments are traded.
Less than 1 year to maturity
Money markets tend to be more liquid since the securities are more widely traded than longer-termed securities.
Corporations & banks tend to use the money market to earn interest on surplus funds that they expect to have temporarily.
Money markets tend to have smaller fluctuations in prices than long-term securities, thus they are safer.
E.g. Treasury bills

7. Structure of Financial Markets: Money & Capital Markets
Capital Markets—markets in which longer-term debt & equity instruments are traded.
E.g. stocks and long-term bonds
Capital market securities are often held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future.

8. International Financial Markets
The growing internationalization (or globalization) of financial markets has become an important trend.
Before the 1980s, U.S. financial markets were much larger than financial markets outside the U.S., but in recent years the dominance of U.S. markets has been disappearing.
The extraordinary growth of foreign financial markets has been the result of:
large increases in the pool of savings in foreign countries such as Japan, as well as
the deregulation of foreign financial markets.
Hence foreign financial markets are able to expand their activities.

9. International Financial Markets
American corporations and banks are now more likely to tap into international capital markets to raise funds.
American investors often seek investment opportunities abroad.
Foreign corporations and banks raise funds from Americans, and foreigners have become important investors in the U.S.

10. International Financial Markets
Foreign Bonds—bonds sold in a foreign country and are denominated in that country’s currency.
E.g. If the German automaker Porsche sells a bond in the U.S. that is denominated in U.S. dollars.
E.g. If U.S.-based firm Walmart issues bonds in Mexico denominated in Mexican pesos.
Foreign bonds have been important instruments in the United States.
Indeed, a large percentage of U.S. railroads built in the 19th century were financed by sales of foreign bonds in Britain.

11. International Financial Markets
Eurobonds—bonds denominated in a currency other than that of the country in which they are sold.
E.g. A bond denominated in U.S. dollar being sold in London.
E.g. A bond denominated in euros being sold in Brazil.
About 80% of the new issues in the international bond market are Eurobonds. The market for these securities has grown rapidly.
The Eurobond market is now larger than the U.S. corporate bond market.

12. International Financial Markets
Eurocurrencies—foreign currencies deposited in banks outside of the home country.
A variant of the Eurobond.
E.g. Mexican pesos deposited in Switzerland
E.g. U.S. dollars deposited in a British bank in London.
Eurodollars are the most important type of Eurocurrencies. They are U.S.$ deposited in foreign banks outside of the U.S. or in foreign branches of U.S. banks.

13. International Financial Markets
Because the short-term eurodollar deposits earn interest, they are similar to short-term Eurobonds.
American banks borrow Eurodollar deposits from other banks or from their own foreign branches.
Indeed, Eurodollars are now an important source of funds for American banks (over $190 billion outstanding).

14. You’d better recognize!
Attention
You’d better recognize!
Note: do not confuse the term euro with Eurobond, Eurocurrency, and Eurodollars.
Euro is the name of the currency of many European countries.
A bond denominated in Euros is a eurobond only if it is sold outside of the countries that have the euro as their official currency.
In fact, most Eurobonds are not denominated in euros but are denominated in U.S. dollars

15. Stock Indexes (or Indices)
Stock market index—the average performance of a composite of stocks.
E.g. of indices representing market performance:
Dow Jones Industrial Average (U.S.)—the average value of 30 large industrial stocks. E.g. GM, Exxon, and Goodyear.
S&P 500 (U.S.)—average value of the performance of 500 large companies in the U.S.
Nikkei 300 (Japan)—average performance of the largest 300 shares traded on the Tokyo Stock Exchange.
Hang Seng (Hong Kong)—average performance of the 33 largest companies making up about 70% of the Hong Kong Stock Exchange.
Financial Times Stock Exchange (FTSE or Footsie)—the 100 share index in London.

16. World Stock Markets Examples:
Tokyo Stock Exchange
Toronto Stock Exchange
Mexican Exchange
Lima Stock Exchange
Bermuda Stock Exchange
Jamaica Stock Exchange
Until recently, the U.S. stock market was by far the largest in the world.
Foreign stock exchanges have grown in value and stature in the world economy.
The increased interest in foreign stocks has prompted the development of many U.S. mutual funds that invest in foreign stock markets.
U.S. investors watch the performance of the DOW as well as the NIKKEI 300.

17. World Stock Markets
The internationalization of financial markets has led to foreigners providing funds to the U.S. federal government and to U.S. corporations.
Without these foreign funds, the U.S. economy would have grown far less rapidly in the last 20 years.
The internationalization of financial markets is also leading the way to a more integrated world economy in which flows of goods and technology between countries are commonplace.

18. Next we will discuss: Indirect Finance;
End of Lecture
Next we will discuss:
Indirect Finance;
Functions of Financial Intermediaries;
Types of Financial Intermediaries; and
Regulation of the financial system