Chapter One

Introduction

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 Learning Objectives

• This chapter aims to provide:

– An overview of financial markets.
– An overview of financial institutions.
– The reasons behind the Globalization of
financial markets as well as financial
institutions.

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 Why study Financial Markets ?

• Financial markets in the economy as a

whole.
• Investment and financing decisions require
a thorough understanding of
– the structure and the operations 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
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 Financial Markets
Definition

• Financial markets are structures

through which funds flow

• Or, in other words, we can say that

financial market is the place or structure
through which financial assets (Stocks,
Bonds) can be traded.

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 Types of Financial Markets

• FMs are created to satisfy a particular

preferences for market participants.

• Different preferences for different market

participants results in the existence of
different markets.

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 Types of Financial Markets

• Financial markets can be distinguished

along two dimensions
– Trading structure (i.e. transactions); primary
versus secondary markets
– Maturity structure; money versus capital
markets

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 Primary versus Secondary Markets

• Primary markets
– markets in which users of funds (e.g.,
corporations and governments) raise funds
by issuing new financial instruments (e.g.,
stocks and bonds) issued for the first time.
– Transactions in primary market are
arranged through FIs known as investment
bankers (servers as intermediaries between
the issuing corporations and investors).

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 Primary versus Secondary Markets
(Cont.)
– The issuance of new securities is done by:
1- Public offering (an offer of sale of the
entire issue to public investors at large)
2- Private placement ( sale of the securities to
specific investor/s ; institutional investors)
- Primary market securities include issues of
equity by firms initially going public and
the issue of additional equity or debt
instruments of already publicly traded
firms.
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 Primary versus Secondary Markets
(Cont.)
• Secondary markets
– markets where already existed financial
instruments are traded among investors (e.g.,
NYSE and Nasdaq); facilitate the trading of
existing securities.
– They provide a centralized market place where
economic agents can transact quickly and
efficiently (saving searching costs).

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 Primary versus Secondary Markets
(Cont.)
• Secondary markets offer benefits to both
investors (suppliers of fund) and issuers (i.e.
users of fund).
– Investors can trade securities at their market
value quickly and purchase securities with
different risk-return characteristics.
– Issuers can obtain information about the
current market value of their securities.

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 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).
– There is no specific location for money market;
it is known as Over-the-Counter (OTC).
– The fluctuations in the prices of these
instruments is quite small.

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 Money versus Capital Markets (Cont.)

• Capital markets
– markets that trade debt (bonds) and equity
(stock) instruments with maturities of more
than one year.
– Wider price fluctuations.
– The size of MKT value of Capital MKT
instruments depend on: MKT price and number
of securities

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 Foreign Exchange (FX) Markets

• FX markets
– The market that facilitate the trading of 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

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 Derivative Security Markets

• Derivative security
– a financial security whose payoff is linked to
(i.e., “derived” from) another previously issued
securities security or commodity
– Generally; it involves an agreement between
two parties to exchange a standard quantity of
assets at a set price on a specific date in the
future

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 Financial Market Regulation

• The Securities Exchange Act of 1934

– Securities and Exchange Commission (SEC) is the

main regulator of securities markets (most of
regulations imposed by this agency).

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 Financial Market Regulation (Cont.)

• The main emphasis of SEC regulations is on:

– securities registration
– full and fair disclosure of information on securities
issued to actual and potential investors.
– Monitor trading to ensure no trading is taking place
based on inside information
– Reduce price fluctuations e.g. Circuit breakers.

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 Financial Institutions (FIs)

• Financial Institutions
– institutions that perform the essential function
of channeling funds from those with surplus
funds to those with shortages of funds ; i.e.
through which suppliers channel money to
users of funds.

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 Financial Institutions (FIs)

• Financial Institutions are distinguished

by whether they accept deposits
– depository versus (commercial banks, savings
associations, savings banks, credit unions )
– non-depository financial institutions (insurance
companies, securities firms and investment
banks, mutual funds, pension funds)

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 Flow of Funds in a World without FIs
To understand the important economic function of FI
play in the operations of FM; imagine the real world
in this situation
Financial Claims
(equity and debt
instruments)
Users of Funds Suppliers of
(corporations) Funds
(households)
Cash
This represents the direct flow of funds
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 Flow of Funds in a World without Fis
Flow of Funds in a World without FIs
(Cont.)
• In this world, the flow of funds will be at
the lowest level. Why???
– Monitoring Costs:
– incurred by supplies when they monitor the use
of their fund; make sure that users of fund do
not waste it.
– Such monitoring is costly; it requires time,
expenses and effort to collect information.

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 Flow of Funds in a World without Fis
Flow of Funds in a World without FIs
(Cont.)
– Liquidity Costs:
– Long-term maturities of financial claims issued by
users of fund.
– Price Risk:
– The risk the suppliers of fund will face upon the
sale of securities; the risk that the asset’s sale price
will be lower than its purchase price.

All of this will results in lower level of fund flow

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 Flow
FlowofofFunds
Fundsinina aWorld
Worldwithout
with FIs
FIs
Thus, fund suppliers prefer to hold the financial claims issued
by FI, that is, there will be indirect transfer of fund to ultimate
user via FI.
Users of Funds FIs
(brokers) Suppliers of Funds

Cash Cash
FIs
(asset
transformers)
Financial Claims Financial Claims
(equity and debt securities) (deposits and insurance policies)
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 Role of FIs in Cost Reduction

• The ability of FIs in performing these

functions highlights the fact that FIs are
better in resolving the costs facing suppliers
of funds.

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 Flow
Role of FIs
Funds
in Cost
in a World
Reduction
without
(Cont.)
FIs

• Reduce monitoring costs

– FI can reduce these costs through their role as
delegated monitor
– Aggregation of funds in an FI.
– FI now has a greater incentives to HIRE
employees to collect information and monitor the
action of the firm.
– Even there will be costs, the average cost of
collecting information is lower (Economies of
scale in obtaining information)
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 Flow
Role of FIs
Funds
in Cost
in a World
Reduction
without
(Cont.)
FIs

• Increase liquidity and lower price risk

– FIs provide secondary claims that have less price
risk, and have superior liquidity attributes, via
acting as Asset Transformer
– Demand deposits and other claims such as shares
in Mutual Funds are more liquid.

– BUT, How can FI overcome the liquidity and price

risk when investing directly in primary assets???

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 Flow
Role of FIs
Funds
in Cost
in a World
Reduction
without
(Cont.)
FIs

• FIs, have the ability to diversify away

portfolio risk.
– They can exploit the law of large number in
making their investment decisions.

– Thus, through diversification FIs can predict

accurately the return and risk on their portfolios
and then can fulfill the promise to provide highly
liquid claims to suppliers of fund.

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 Flow of
Additional
Funds in Benefits
a World of
without
FIs FIs

•Reduce transaction costs.

– As in information collection, FIs provide potential
economies of scale in transaction costs.

– FI can purchase assets in large quantities.

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 Flow
Additional
of FundsBenefits
in a World
of FIs
without
(Cont.)FIs

• Provide Maturity Intermediation.

– FI have greater ability to bear the risk of
mismatching the maturities of their assets &
liabilities.
– Thus, offer maturity intermediation services to the
whole economy.
– Example: issue large-term mortgage loans while still
raising fund with short-term liabilities i.e. deposits.
– FIs face interest rate risk, but they can manage this
through hedging e.g. loan sales, securitization.
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 Flow
Additional
of FundsBenefits
in a World
of FIs
without
(Cont.)FIs

• Provide denomination intermediation.

– Many assets are sold in a very large denominations.
– Individual investors can’t invest in these directly.
– Through buying FIs’ claims (e.g. shares in mutual
funds) individual investors can have indirect access
to these instruments to generate higher returns.

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 FIs Benefit the Overall Economy

• FIs perform services that improve the

operations of financial system as a whole.
• Money supply Transmission:
– Deposit accounts are a significant components of
the money supply, which affect the rate of
inflation.
– So, depository institutions play and important role
in monetary policy.
– Through setting reserve requirements.
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 FIs Benefit the Overall Economy
(Cont.)
• Credit Allocation :
– FIs are viewed as the major source of financing for
particular sectors of the economy which are pre-
identified as being in special need of financing.
– e.g. real estate sector, Farming.

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 FIs Benefit the Overall Economy
(Cont.)
• Intergenerational Wealth Transfers :
– FIs, such as life insurance companies & pension
funds, provide savers with the ability to transfer
wealth from one generation to another (i.e. from
their youth to old age).
– e.g. pension funds offer savings plan through
which fund participants accumulate tax exempt
savings during their working year before
withdrawing them during their retirement years.

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 FIs Benefit the Overall Economy
(Cont.)
• payment services :
– The efficiency with which FIs (e.g. depository
institutions) provide payments services directly
benefits the economy.
– Such as check clearing and wire transfer services.

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 Risks Faced by Financial Institutions

• Credit • Off-balance-sheet
• Foreign exchange • Liquidity
• Country or • Technology
sovereign • Operational
• Interest rate • Insolvency
• Market

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 Globalization of Financial Markets and
Institutions
• Even though USA financial markets are larger in
their size and trading value compared with their
counterparts, Foreign financial markets grow
significantly.
• The pool of savings from foreign investors is
increasing
• investors look to diversify globally now more than
ever before by turning their attention toward USA
and foreign markets.

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 Globalization of Financial Markets and
Institutions
• Information on foreign markets and investments is
becoming readily accessible
• The deregulation across the globe is allowing even
greater access
• The introduction of the EURO; it became the most
important currency for international transactions.

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