Chapter Overview 31,188.38 on January 20.
Positive pandemic
recovery news, including strong retail sales and
The Dow Jones Industrial Average (DJIA) lower unemployment claims, pushed the index
experienced several major fluctuations tied to higher, hitting 35,625.40 on August 16, 2021.
economic crises. In the early 2000s, it fell below The momentum continued into 2022, with the
10,000 during a downturn. By July 2007, it Dow closing at an all-time high of 36,799.65 on
climbed above 13,200 but quickly dropped January 4. However, markets declined afterward
below 13,000 due to the subprime mortgage due to tighter Federal Reserve monetary policy,
credit crunch. The situation escalated into the Russia’s invasion of Ukraine, rising energy
2008 financial crisis, the worst recession since prices, and investor concerns about new COVID
the Great Depression, driving the DJIA down to variants.
7,600 in March 2009. Recovery followed, with
the index surpassing 11,000 in April 2010, Over the past 35 years, the financial services
though it did not exceed its pre-crisis high until industry has undergone major changes. In the
March 2013, closing at 14,253.77. By mid-2019, 1990s and 2000s, regulatory shifts, advances in
the DJIA rose above 27,300 before plunging technology, and financial innovation allowed
below 20,000 in March 2020 during the single firms to offer a full range of services
Coronavirus pandemic. under financial holding companies. For example,
JPMorgan Chase & Co. operates both a
In June 2016, the United Kingdom’s vote to commercial bank (JPMorgan Chase Bank) and an
leave the European Union (Brexit) triggered investment bank (JPMorgan Securities, which
sharp global market reactions. The British also sells mutual funds). Traditional boundaries
pound fell more than 11 percent to its lowest between industry sectors blurred, and
level since 1985, while the Dow Jones Industrial competition became global. Today, JPMorgan
Average dropped 610.32 points (3.4 percent). Chase is the world’s largest bank holding
Europe’s Stoxx 600 index plunged 7 percent, its company, with operations in 60 countries.
steepest decline since 2008, and Japan’s Nikkei
Stock Average fell 7.9 percent. Investors moved
toward safer assets such as U.S. bonds and Why Study Financial
gold, UK government borrowing costs rose, and
Moody’s cut the UK’s credit rating outlook to market and institutions
“negative.”
Markets and institutions are primary channels
through which capital is allocated in our society.
Brexit created significant economic uncertainty
that slowed the UK’s growth rate from 2.4 Investment and financing decisions
percent in 2015 to 1.6 percent in 2019. require managers and individual
Government estimates suggested growth could investors to understand the flow of funds
be reduced by up to 6.7 percent over 15 years. throughout the economy.
London’s financial center was hit especially Managers and individuals must also
hard, with growth at only 1.4 percent in 2018 understand the operation and structure
and nearly zero in 2019. Business investment of domestics and international financial
declined by 11 percent between 2016 and markets.
2019. International companies also began
shifting operations away from London as an
entry point into the EU economy: Barclays
Overview of Financial
moved 5,000 clients to Ireland; Goldman Sachs,
JPMorgan Chase, and Morgan Stanley
Markets
transferred about 10 percent of their clients; Financial Markets – structures through which
and Bank of America relocated 100 bankers to funds flow.
Dublin and 400 to Paris. Financial markets can be distinguished along
two major dimensions:
The COVID-19 pandemic in 2020 caused a
sudden shock to global financial markets, 1. Primary versus secondary markets
leading to a 32.5 percent drop in the Dow Jones 2. Money versus capital markets
Industrial Average (DJIA) in just over a month,
from a record 29,388.58 on February 6 to Types of Financial Markets:
19,830.01 on March 19. After three of the Primary markets – markets in which
largest single-day drops in history that spring, corporations raise funds through new
the Dow rebounded, breaking 30,000 on issues of securities.
November 24 and ending 2020 at 30,606.48. It
crossed 31,000 on January 7, 2021, reaching
Secondary markets – markets that trade
financial instruments once they are issued.
Money markets – markets that trade debt
securities or instruments with maturities of
less than one year.
Capital markets – markets that trade Capital Markets - markets that trade debt
debt and equity instruments with (stocks) and equity (bonds) instruments with
maturities of more than one year. maturities of more than one year. The major
Foreign exchange markets – markets in suppliers of capital market securities (or users
which cash flows from the sale of products of funds) are corporations and government.
or assets denominated in a foreign
currency are transacted. Foreign Exchange Markets
Derivative markets – markets in which
Foreign exchange markets – markets in
derivative securities trade.
which cash flows from the sale of products or
assets denominated in a foreign currency are
Primary Market VS. Secondary transacted.
Markets Cash flows from the sale of securities or other
Primary markets – markets in which users of assets denominated in a foreign currency
funds (e.g., corporations) raise funds through expose U.S. corporations and investors to
new issues of financial instruments, such as exchange rate risk. The amount of U.S. dollars
stocks and bonds. received depends on the exchange rate at the
time the nondollar cash flow is converted.
Secondary markets – markets in which Depreciation – if a foreign currency
financial instruments such as stocks are traded depreciates relative to the U.S. dollar
(that is rebought and resold) after being issued during the investment period, the dollar
in primary markets. Also, it offers a centralized value of cash flows will fall.
and efficient marketplace for transactions. Appreciation – if a foreign currency
Buyers - economic agents with excess appreciates relative to the U.S. dollar
funds during the investment period, the dollar
Sellers - in need of funds value of cash flows will increase.
Benefits - liquidity (ability to turn assets
into cash quickly at fair value), price Derivative Security Markets
information (helps issuers and investors Definition – markets in which derivative
evaluate value), and low transaction securities trade.
costs. Derivative security – a financial
security (futures, options, swaps,
Money Markets VS. Capital mortgage-backed) whose payoff is linked
Markets to another, previously issued security.
Agreement structure – involves two
parties exchanging a standard quantity
of an asset or cash flow at a
predetermined price and date in the
future.
Value linkage – as the value of the
underlying security changes, the value of
the derivative changes.
Financial Market Regulation
Financial instruments are subject to regulations
imposed by regulatory agencies such as the
Money Markets - markets that trade debt Securities and Exchange Commission (SEC)—
securities or instruments with maturities of less the main regulator of securities markets since
than one year. Economic agents with short term the passage of the Securities Act of 1934—as
excess supplies of funds can lend funds (buy well as the exchanges (if any) on which the
money market instruments) to economic agents instruments are traded. The main emphasis of
who have short term needs or shortage of funds SEC regulations (as stated in the Securities Act
(they sell money market instruments). of 1933) is on full and fair disclosure of
information on securities issues to actual and
potential investors.
SEC – the main regulator of securities Flow of funds without financial
markets since the Securities Act of 1934.
Disclosure – full and fair disclosure of institutions
information on securities issues to actual Flow of funds without financial institutions
and potential investors (Securities Act of - the level of funds flowing between suppliers
1933). and users of funds would be low. There are
Public issues – firms planning to issue several reasons for this:
new stocks or bonds to be sold to the
Monitoring costs – the cost and effort
public at large are required by the SEC to
of monitoring fund borrowers is high.
register their securities and fully Long-term nature – financial claims
describe the issue, including risks, in a such as mortgages, corporate stock, and
legal document called a prospectus. bonds are long-term, discouraging
suppliers of funds.
Price risk – the presence of price risk in
Overview of Financial real-world financial markets creates
uncertainty for suppliers and users of
Institutions funds.
Financial Institutions – (e.g., commercial and Unique Economic Functions
savings banks, credit unions, insurance
companies, and mutual funds) performs the Performed by Financial
essential function of channeling funds from Institutions
those with surplus funds (suppliers of funds) to
those with shortages of funds (users of funds. Because of
1. Monitoring cost
Types of Financial Institutions 2. Liquidity cost
Commercial banks - depository 3. Price risk
institutions; major assets are loans
(consumer, commercial, real estate) and
major liabilities are deposits. They also
use nondeposit sources like notes and
debentures.
Thrifts – savings associations, savings
banks, and credit unions. Similar to
commercial banks but loans are
concentrated in one segment (real
estate or consumer).
Insurance companies – protect
individuals and corporations from
adverse events. Life insurance covers
death, illness, retirement; property
casualty covers accidents, theft, fire,
liability.
Securities firms & Investment banks
– help firms issue securities and engage
in brokerage and trading.
Finance companies – make loans to
individuals and businesses; do not Monitoring Costs
accept deposits, rely on short-and long-
The Problem with Direct Investing:
term debt for funding.
For individual investors, keeping a close
Investment funds – pool financial
resources of individuals/companies and eye on how their money is being used by
invest in diversified portfolios of assets. a borrower is both difficult and expensive.
Pension funds – offer savings plans for
The Power of Pooling: By collecting
retirement; contributions are tax-exempt
money from many small investors, a
until withdrawal.
Financial technology – use technology Financial Institution (FI) gains the
to deliver financial solutions, competing resources and a much larger financial
with traditional methods. stake, which gives them a stronger
incentive to monitor borrowers effectively.
Professional Expertise: Because they
operate on a large scale, FIs can hire
highly skilled professionals to handle the large-scale corporate debt—that usually
complex task of gathering information and require high minimum buy-ins.
supervising fund users.
Delegated Monitoring: FIs act as
Risks Incurred by Financial
"delegated monitors" for their clients. This Institutions
solves the "free-rider" problem, where
individual investors might otherwise wait
FI’s face various types of risks:
for someone else to do the hard work of Default risks (credit risk)
monitoring while they reap the benefits
Foreign exchange risk and country
Liquidity & Risk (sovereign) risk
Asset Transformation: FIs act as Interest rate risk
"asset transformers" by purchasing Market risk, or asset price risk
"primary" securities (like mortgages or Off-balance sheet risk
corporate bonds) and turning them into Liquidity risk
"secondary" securities (like bank Technology and operational risk
deposits or insurance policies) that are Insolvency risk
more attractive to everyday investors.
Enhanced Liquidity: FIs offer products Economic Functions FIs Provide to
that are much easier for investors to turn
back into cash compared to direct
the Financial System
investments. For example, a bank The Transmission of Monetary
deposit can be withdrawn immediately, Policy: Banks and other depository
whereas selling a complex bond might institutions act as the primary channel
take time and involve more risk. for the Federal Reserve to control the
Risk Absorption: The FI takes on the money supply and influence national
risk of the long-term, illiquid assets it economic growth.
buys, while providing safe, liquid options
to its customers. Credit Allocation: FIs are vital for
The Role of Diversification: FIs can funding specific sectors that society
safely offer these liquid products deems important, such as agriculture
because they diversify. By spreading and housing, often with
their investments across many different encouragement or specialized structures
areas that don't all behave the same from the government.
way, they reduce their overall risk and Intergenerational Wealth Transfers:
can more accurately predict their These institutions enable people to
returns. This makes their promise of move wealth across time, such as
safety to small investors credible. saving during their working years for
retirement through life insurance and
Additional Benefits FIs Provide to pension funds.
Suppliers of Funds
Payment Services: FIs provide the
Reduced Transaction Cost: Financial essential infrastructure for moving
institutions (FIs) benefit from money, including wire transfers and
economies of scale, allowing them to check clearing, which are necessary for a
gather information and execute trades functional economy.
far more cheaply than a single person
could. Managing Risks and Regulation
Maturity Intermediation: FIs are Risks Incurred by Financial
better equipped than individuals to Institutions: FIs are exposed to a wide
manage the risk of having mismatched variety of dangers, including credit
timelines between their assets and defaults, interest rate shifts,
liabilities, such as using short-term liquidity shortages, and technological
deposits to fund long-term mortgages. failures.
Denomination Intermediation: By Regulation of Financial Institutions:
pooling money from many small Because FI failures can trigger global
investors, FIs allow people to access recessions, governments regulate them
expensive financial instruments—like to ensure stability and protect
depositors, though this adds
"regulatory burden" to the institutions.
a
The Global Nature of Finance
Financial markets have shifted from being
Enterprise Risk Management (ERM): domestic-focused to being a tightly
Modern FIs have moved toward looking integrated global network.
at risk as a unified portfolio rather
than separate categories, emphasizing a While the United States still holds
firm-wide culture of risk awareness. the top spot in terms of stock exchange
size and debt market volume,
Evolution and Market Trends international markets in regions like
Europe, Japan, and Shanghai are
Trends in the United States: Since
expanding rapidly.
1948, there has been a massive shift
away from traditional banks and toward In the debt sector specifically, the
investment companies and pension United Kingdom and the United
funds, which now hold a much larger States are the dominant forces,
share of total financial assets. collectively issuing a significant portion
of the world's debt securities.
Rise of Financial Services Holding
Companies: Following the 1999
Financial Services Modernization
The Surge in Cross-Border
Act, different types of financial firms Investment
(banking, insurance, and securities) were
There has been a massive expansion in
allowed to merge, leading to the
foreign investment activity within U.S.
dominance of massive, full-service
markets, and vice versa, over the past thirty
holding companies.
years.
Shift in Banking Models: Leading up
Between 1992 and 2021, the value of
to the 2008 crisis, banks moved from an
U.S. debt held by foreign investors and
"originate and hold" model to "originate
foreign debt held by U.S. investors grew
and distribute," where they sold off
by trillions of dollars.
loans rather than keeping them, which
reduced their incentive to monitor This interconnectedness means the U.S.
borrower risk economy is now reliant on the
health of foreign economies.
The Impact of Fintech
Financial Institutions (FIs) are the
Fintech: Technology-driven innovation is
essential "middlemen" that make this
creating new business models, such as
global integration possible by managing
mobile payments and real-time
high-level risks like liquidity,
transfers, that compete directly with
monitoring costs, and price
traditional banking.
volatility.
Blockchain and Decentralization:
Competition has become global; for
Technologies like blockchain allow for the
instance, while four of the world's ten
direct exchange of value without
largest banks are American, U.S.
needing a traditional middleman,
institutions must now compete directly
potentially making some current
with powerful foreign banks for
financial structures redundant
market share.
The Global Ripple Effect of
Globalization of
Market Volatility
Financial Markets and Because markets are so connected, economic
Institutions problems in the United States now cause
immediate "shocks" to financial systems
U.S markets are the world’s largest, but worldwide.
international markets have been seen The 2007 credit crisis serves as a
primary example: when U.S. mortgage
lenders began to fail, it triggered a
domino effect that caused stock
markets to crash across Asia (Japan,
Hong Kong, South Korea) and Europe
(UK, Germany) almost instantly.
This demonstrates that investor fear in
one region can lead to a global selloff,
proving that local financial stability is
now tied to global economic growth.