Chapter II
Financial Markets,
Money Markets and
Institutions
Overview – financial markets & institutions
Maximisation of
shareholder wealth
Investment decision Financing decision Dividend decision
Financial Financial
markets institutions
Slide 2
Financial Intermediation
• A financial intermediary is a party bringing
together providers and users of finance.
• A financial intermediary is an institution which
links lenders with borrowers, by obtaining
deposits from lenders and then re-lending them
to borrowers.
Slide 3
Financial institutions
Financial
intermediaries
Merchant banks
Investors Pension funds Company
Insurance companies
Slide 4
Financial Intermediaries
• Have lower transaction costs
– Allows small lenders and borrowers to enter the market
– Very costly to write a loan contract
• Economies of scales
– Financial intermediaries write many loans, the average cost of
doing so is much small than one individual writing one loan
• Liquidity Services
– Banks offer checking and savings accounts which all
customers to earn interest on their savings, but also have
access to their money to purchase goods and services
Slide 5
The benefits of financial intermediation
• Convenient ways in which a lender can save money.
• FI’s also provide a ready source of funds for borrowers.
• They can aggregate or package the amounts lent by savers
and lend on to borrowers in different amounts.
• By pooling the funds of large numbers of people, some financial
institutions are able to give investors access to diversified
portfolios covering a varied range of different securities.
• Financial Intermediaries, most importantly, provide maturity
transformation.
Slide 6
Financial markets
disintermediation
Investors Financial intermediary Company
Slide 7
Function of Financial Markets
Perform the essential function of channeling funds from
economic players that have saved surplus funds to those
that have a shortage of funds
Promotes economic efficiency by producing an
efficient allocation of capital, which increases
production
Directly improve the well-being of consumers by
allowing them to time purchases better
Slide 8
Financial markets
Year 0 Year1 Year5 Year10
Short term
Medium term
Long term
Slide 9
Classification by financing methods
B/S
Borrowing from Indirect
financial company financing
Liabilities Borrowed
capital Financing
Corporate bond from
outside
Direct
Assets financing
Issued stock
Owners’
Equity
Owners’
capital
Retained Financing from
earnings inside
Slide 10
Direct Finance
• Financial Markets
– Borrowers borrow directly from lenders by issuing
financial instruments
• Claims on future income/assets
Assets for lender
Liability for the seller
• Repayment promises
– Allow individuals to come together and improve
efficiency
• Allow many individuals to make investments that
otherwise are not available (education, housing, …)
Slide 11
Bond
Issuer of
Bonds
Maturity
Date
Contractual
Interest
Rate
Face or
Slide 12 Par Value
Financial markets
Financial
markets
Money Capital
markets markets
Slide 13
Financial markets
Securities Securities
Firms Investors Investors
Fund Fund
Primary Market Secondary Market
Slide 14
Primary Market
Fund Payment
Securities Issuer General Investor
(Fund Demander) (Fund Supplier)
Ex. Corporation, Government Securities Ex. Individual, Institutional
Delivery
Payment Subscription
Intermediary
(Underwriter)
Ex. Securities Firm, Bank
Underwriting Fund, Merchant Bank Sales
Slide 15
Secondary Market
Regulatory Organization
Buying Selling
Investor Broker Exchange Broker
Investor
Securities Depository
Regulation & Supervision Cash Flow Securities
Slide 16
Money markets
• Treasury bills
• Certificates of deposit
• Commercial paper
• Bills of exchange
• Interbank market
Slide 17
Money Market Instruments
• United States Treasury Bills
– 1, 3, and 6 month maturities
– Pay a set amount at maturity, no interest payment,
but are sold at a discount (Saving Bond)
• Negotiable Bank Certificates of Deposit
– Debt instrument sold by banks to depositors
– Make regular interest payments until maturity
– At maturity, return the original purchase price
Slide 18
Money Market Instruments
• Commercial Paper
– Short-term debt issued by large banks and well-
known corporations
– Make no interest payments, but sell at a discount
– Trade on a secondary market
– Has a minimum denomination of $100,000
– Has a typical maturity between 20 and 270 days
– Is typically not purchased directly by individual
investors
– Is typically unsecured
Slide 19
Money Market Instruments
• Banker’s Acceptance
– Is a bank draft, similar to a check, issued by a firm,
– Payable at some future date
– Stamped “accepted” by the firm’s bank, which then
guarantees that it will be paid.
– Often arise in the process of international trade
– Allows firms to purchase goods abroad, the funds
are guaranteed even if the corporation goes bankrupt
– Make no interest payments, but sell at a discount.
– Trade on a secondary market.
Slide 20
Money Market Instruments
• Federal Funds
– Typically overnight loans made by banks to other
banks
– Usually occurs when a bank falls below its required
reserve amount
Slide 21
Money Market Instruments
• Repurchase Agreements (repos)
– Short-term loans, less than two week maturity
– A large firm may have excess funds it wants to lend
for a week. The firm will buy treasury bills from the
bank with an agreement that the bank will
repurchase the t-bills in one weeks time.
– The firm gets a small interest payment and the bank
gets the use of the firms funds
Slide 22
The capital markets
• Capital markets are markets for trading in long-
term finance, in the from of long-term financial
instruments such as equities and corporate
bonds.
• The stock markets serve two main purposes.
– Primary markets
– Secondary markets
Slide 23
Capital markets
• Debentures / loan notes
• Shares – main market
• Bonds
Slide 24
Capital markets
• Stocks
– Equity claims on the net income and assets of a
corporation
• Mortgages
– Loans to households or firms to purchase housing,
land, or other real estate structures
– The structural/land serves as collateral
– The mortgage market is the biggest debt market in
the U.S
Slide 25
Participants in Bond Markets
Financial Institutions Market Makers
Governments Dealers
Corporations Brokers
Issuers Intermediaries
Credit Rating
Investors
Agencies
S&P’s Institutions
Moody’s Individuals
Others Investment-grade bonds
Speculative-grade bonds
(Junk Bonds): below BBB (Baa)
Slide 26
Bond
• Corporate Bonds
– Intermediate and Long-term bonds issued by corporations
with strong credit ratings
– Sends an interest payments twice a year
– Pays off the face value of the bond at maturity
• U.S. Government Securities
– Long-term debt instruments issued by the U.S. Treasury to
finance the government deficit
– Treasury Note : Currently issued with maturities of 2, 5, and
10 years; hence intermediate-term debt.
– Treasury Bonds : Before October 2001, issued with maturity
of 30 years, hence long-term debt.
– Make regular interest payments twice per year and return a
Slide 27
fixed amount at maturity.
How Risky Is Your Bonds?
Medium
High (Investment) Poor
Grades Grades Speculative Grades
Moody's Aaa, Aa A, Baa Ba, B Caa to C
Standard & Poor's AAA, AA A, BBB BB, B CCC to D
Slide 28
Slide 29
International money and capital markets
• International money and capital markets are
available for larger companies wishing to raise
larger amounts of finance.
• Larger companies are able to borrow funds on
the Eurocurrency markets (which are
international money markets) and on the
markets for Eurobonds (international capital
markets).
Slide 30