Chapter One

Introduction

©2009, The McGraw-Hill Companies, All Rights

 Learning Objectives

•• This
This chapter
chapter aims
aims to
to provide:
provide:
–– An
An overview
overview ofof financial
financial markets.
markets.
–– An
An overview
overview ofof financial
financial institutions.
institutions.
–– The
The reasons
reasons behind
behind thethe Globalization
Globalization ofof
financial
financial markets
markets as as well
well as
as financial
financial
institutions.
institutions.

McGraw-Hill/Irwin 1-2 ©2009, The McGraw-Hill Companies, All Rights

 Why study Financial Markets ?

•• Financial
Financial markets
markets inin the
the economy
economy asas aa
whole.
whole.
•• Investment
Investment and
and financing
financing decisions
decisions require
require
aa thorough
thorough understanding
understanding of of
–– the
the structure
structure and
and the
the operations
operations of
of domestic
domestic
and
and international
international markets
markets
–– the
the flow
flow of
of funds
funds through
through domestic
domestic andand
international
international markets
markets
–– the
the strategies
strategies used
used to
to manage
manage risks
risks faced
faced by
by
investors
investors and
and savers
savers
McGraw-Hill/Irwin 1-3 ©2009, The McGraw-Hill Companies, All Rights
 Financial Markets
Definition

•• Financial
Financial markets
markets are
are structures
structures
through
through which
which funds
funds flow
flow

•• Or,
Or, in
in other
other words,
words, we we can
can say
say that
that
financial
financial market
market isis the
the place
place or
or structure
structure
through
through which
which financial
financial assets
assets (Stocks,
(Stocks,
Bonds)
Bonds) can
can be
be traded.
traded.

McGraw-Hill/Irwin 1-4 ©2009, The McGraw-Hill Companies, All Rights

 Types of Financial Markets

•• FMs
FMs are
are created
created to
to satisfy
satisfy aa particular
particular
preferences
preferences for
for market
market participants.
participants.

•• Different
Different preferences
preferences for
for different
different market
market
participants
participants results
results in
in the
the existence
existence of
of
different
different markets.
markets.

McGraw-Hill/Irwin 1-5 ©2009, The McGraw-Hill Companies, All Rights

 Types of Financial Markets

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

McGraw-Hill/Irwin 1-6 ©2009, The McGraw-Hill Companies, All Rights

 Primary versus Secondary Markets

•• Primary
Primary markets
markets
–– markets
markets inin which
which users
users of
of funds
funds (e.g.,
(e.g.,
corporations
corporations and
and governments)
governments) raise raise funds
funds
by
by issuing
issuing new
new financial
financial instruments
instruments (e.g., (e.g.,
stocks
stocks and
and bonds)
bonds) issued
issued for
for the
the first
first time.
time.
–– Transactions
Transactions in in primary
primary market
market are are
arranged
arranged through
through FIsFIs known
known as as investment
investment
bankers
bankers (servers
(servers asas intermediaries
intermediaries between
between
the
the issuing
issuing corporations
corporations and and investors).
investors).
McGraw-Hill/Irwin 1-7 ©2009, The McGraw-Hill Companies, All Rights
 Primary versus Secondary Markets
(Cont.)
–– The
The issuance
issuance of of new
new securities
securities isis done
done by:
by:
1-
1- Public
Public offering
offering (an(an offer
offer of
of sale
sale of
of the
the
entire
entire issue
issue to
to public
public investors
investors atat large)
large)
2-
2- Private
Private placement
placement (( sale
sale of
of the
the securities
securities toto
specific
specific investor/s
investor/s ;; institutional
institutional investors)
investors)
-- Primary
Primary market
market securities
securities include
include issues
issues of
of
equity
equity byby firms
firms initially
initially going
going public
public andand
the
the issue
issue of
of additional
additional equity
equity oror debt
debt
instruments
instruments of of already
already publicly
publicly traded
traded
firms.
firms.
McGraw-Hill/Irwin 1-8 ©2009, The McGraw-Hill Companies, All Rights
 Primary versus Secondary Markets
(Cont.)
•• Secondary
Secondary markets
markets
–– markets
markets where
where already
already existed
existed financial
financial
instruments
instruments areare traded
traded among
among investors
investors (e.g.,
(e.g.,
NYSE
NYSE andand Nasdaq);
Nasdaq); facilitate
facilitate the
the trading
trading of
of
existing
existing securities.
securities.
–– They
They provide
provide aa centralized
centralized market
market place
place where
where
economic
economic agents
agents cancan transact
transact quickly
quickly and
and
efficiently
efficiently (saving
(saving searching
searching costs).
costs).

McGraw-Hill/Irwin 1-9 ©2009, The McGraw-Hill Companies, All Rights

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

McGraw-Hill/Irwin 1-10 ©2009, The McGraw-Hill Companies, All Rights

 Money versus Capital Markets

•• Money
Money markets
markets
–– markets
markets that that trade
trade debt
debt securities
securities with
with
maturities
maturities of of one
one year
year or
or less
less (e.g.,
(e.g., CDs
CDs and
and
U.S.
U.S. Treasury
Treasury bills).
bills).
–– There
There isis no no specific
specific location
location for
for money
money market;
market;
itit isis known
known asas Over-the-Counter
Over-the-Counter (OTC). (OTC).
–– The
The fluctuations
fluctuations inin the
the prices
prices ofof these
these
instruments
instruments isis quitequite small.
small.

McGraw-Hill/Irwin 1-11 ©2009, The McGraw-Hill Companies, All Rights

 Money versus Capital Markets (Cont.)

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

McGraw-Hill/Irwin 1-12 ©2009, The McGraw-Hill Companies, All Rights

 Foreign Exchange (FX) Markets

•• FX
FX markets
markets
–– The
Themarket
marketthat
thatfacilitate
facilitatethe
thetrading
tradingof
ofone
onecurrency
currency
for
foranother
another(e.g.,
(e.g.,dollar
dollarfor
foryen)
yen)
•• Spot
Spot FX
FX
–– the
theimmediate
immediateexchange
exchangeof
ofcurrencies
currenciesatatcurrent
current
exchange
exchangerates
rates
•• Forward
Forward FX
FX
–– the
theexchange
exchangeof ofcurrencies
currenciesin
inthe
thefuture
futureon
onaaspecific
specific
date
dateand
andatataapre-specified
pre-specifiedexchange
exchangerate
rate

McGraw-Hill/Irwin 1-13 ©2009, The McGraw-Hill Companies, All Rights

 Derivative Security Markets

•• Derivative
Derivative security
security
–– aa financial
financial security
security whose
whose payoff
payoff isis linked
linked toto
(i.e.,
(i.e., “derived”
“derived” from) from) another
another previously
previously issuedissued
securities
securities security
security oror commodity
commodity
–– Generally;
Generally; itit involves
involves an
an agreement
agreement between
between
two
two parties
parties to to exchange
exchange aa standard
standard quantity
quantity of of
assets
assets atat aa set
set price
price on
on aa specific
specific date
date in in the
the
future
future

McGraw-Hill/Irwin 1-14 ©2009, The McGraw-Hill Companies, All Rights

 Financial Market Regulation

•• The
The Securities
Securities Exchange
Exchange Act
Act of
of 1934
1934

–– Securities
Securities and
and Exchange
Exchange Commission
Commission (SEC)
(SEC) isis the
the
main
main regulator
regulator of
of securities
securities markets
markets (most
(most of
of
regulations
regulations imposed
imposed byby this
this agency).
agency).

McGraw-Hill/Irwin 1-15 ©2009, The McGraw-Hill Companies, All Rights

 Financial Market Regulation (Cont.)

•• The
The main
main emphasis
emphasis of
of SEC
SEC regulations
regulations isis on:
on:
–– securities
securities registration
registration
–– full
full and
and fair
fair disclosure
disclosure of of information
information on on securities
securities
issued
issued to
to actual
actual and
and potential
potential investors.
investors.
–– Monitor
Monitor trading
trading toto ensure
ensure no
no trading
trading isis taking
taking place
place
based
based on
on inside
inside information
information
–– Reduce
Reduce price
price fluctuations
fluctuations e.g.
e.g. Circuit
Circuit breakers.
breakers.

McGraw-Hill/Irwin 1-16 ©2009, The McGraw-Hill Companies, All Rights

 Financial Institutions (FIs)

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

McGraw-Hill/Irwin 1-17 ©2009, The McGraw-Hill Companies, All Rights

 Financial Institutions (FIs)

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

McGraw-Hill/Irwin 1-18 ©2009, The McGraw-Hill Companies, All Rights

 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 finds
McGraw-Hill/Irwin 1-19 ©2009, The McGraw-Hill Companies, All Rights
 Flow of Funds in a World without Fis
Flow of Funds in a World without FIs
(Cont.)
•• In
In this
this world,
world, the
the flow
flow of
of funds
funds will
will be
be at
at
the
the lowest
lowest level.
level. Why???
Why???
–– Monitoring
Monitoring Costs:Costs:
–– incurred
incurred by by supplies
supplies when
when they
they monitor
monitor the
the use
use
of
of their
their fund;
fund; make
make sure
sure that
that users
users of
of fund
fund do
do
not
not waste
waste it.
it.
–– Such
Such monitoring
monitoring isis costly;
costly; itit requires
requires time,
time,
expenses
expenses and and effort
effort to
to collect
collect information.
information.

McGraw-Hill/Irwin 1-20 ©2009, The McGraw-Hill Companies, All Rights

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

All
All of
of this
this will
will results
results in
in lower
lower level
level of
of fund
fund flow
flow
McGraw-Hill/Irwin 1-21 ©2009, The McGraw-Hill Companies, All Rights
 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)
McGraw-Hill/Irwin 1-22 ©2009, The McGraw-Hill Companies, All Rights
 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.

1-23 ©2009, The McGraw-Hill Companies, All Rights

 Flow
Role of FIs
Funds
in Cost
in a World
Reduction
without
(Cont.)
FIs
•• Reduce
Reduce monitoring
monitoring costs
costs
–– FI
FIcan
canreduce
reducethese
thesecosts
coststhrough
throughtheir
theirrole
roleas
as
delegated
delegatedmonitor
monitor
–– Aggregation
Aggregationof offunds
fundsininan
anFI.
FI.
–– FI
FInow
nowhas
hasaagreater
greaterincentives
incentivestotoHIRE
HIRE
employees
employeesto tocollect
collectinformation
informationandandmonitor
monitorthe the
action
actionof
ofthe
thefirm.
firm.
–– Even
Eventhere
therewill
willbe
becosts,
costs,the
theaverage
averagecost
costofof
collecting
collectinginformation
informationisislower
lower(Economies
(Economiesof of
scale
scalein
inobtaining
obtaininginformation)
information)
McGraw-Hill/Irwin 1-24 ©2009, The McGraw-Hill Companies, All Rights
 Flow
Role of FIs
Funds
in Cost
in a World
Reduction
without
(Cont.)
FIs
•• Increase
Increase liquidity
liquidity and
and lower
lower price
price risk
risk
–– FIs
FIsprovide
providesecondary
secondaryclaims
claimsthat
thathave
haveless
lessprice
price
risk,
risk,and
andhave
havesuperior
superiorliquidity
liquidityattributes,
attributes,via
via
acting
actingasasAsset
AssetTransformer
Transformer
–– Demand
Demanddeposits
depositsand
andother
otherclaims
claimssuch
suchasasshares
shares
in
inMutual
MutualFunds
Fundsare
aremore
moreliquid.
liquid.

–– BUT,
BUT,HowHowcan
canFI
FIovercome
overcomethe
theliquidity
liquidityand
and
price
pricerisk
riskwhen
wheninvesting
investingdirectly
directlyin inprimary
primary
assets???
assets???
McGraw-Hill/Irwin 1-25 ©2009, The McGraw-Hill Companies, All Rights
 Flow
Role of FIs
Funds
in Cost
in a World
Reduction
without
(Cont.)
FIs
•• FIs,
FIs, have
have the
the ability
ability to
to diversify
diversify away
away
portfolio
portfolio risk.
risk.
–– They
Theycan
canexploit
exploitthe
thelaw
lawof
oflarge
largenumber
numberin
in
making
makingtheir
theirinvestment
investmentdecisions.
decisions.

–– Thus,
Thus, through
throughdiversification
diversificationFIs
FIscan
canpredict
predict
accurately
accuratelythe
thereturn
returnand
andrisk
riskon
ontheir
theirportfolios
portfolios
and
andthen
thencan
canfulfill
fulfillthe
thepromise
promisetotoprovide
providehighly
highly
liquid
liquidclaims
claimstotosuppliers
suppliersofoffund.
fund.

McGraw-Hill/Irwin 1-26 ©2009, The McGraw-Hill Companies, All Rights

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

••Reduce
Reduce transaction
transaction costs.
costs.
–– As
Asin
ininformation
informationcollection,
collection,FIs
FIsprovide
providepotential
potential
economies
economiesofofscale
scalein
intransaction
transactioncosts.
costs.

–– FI
FIcan
canpurchase
purchaseassets
assetsin
inlarge
largequantities.
quantities.

McGraw-Hill/Irwin 1-27 ©2009, The McGraw-Hill Companies, All Rights

 Flow
Additional
of FundsBenefits
in a World
of FIs
without
(Cont.)FIs
•• Provide
Provide Maturity
Maturity ..
–– FI
FIhave
havegreater
greaterability
abilitytotobear
bearthetherisk
riskofof
mismatching
mismatchingthe thematurities
maturitiesofoftheir
theirassets
assets& &
liabilities.
liabilities.
–– Thus,
Thus,offer
offermaturity
maturityintermediation
intermediationservices
servicestotothe
the
whole
wholeeconomy.
economy.
–– Example:
Example:issueissuelarge-term
large-termmortgage
mortgageloansloanswhile
whilestill
still
raising
raisingfund
fundwith
withshort-term
short-term liabilities
liabilitiesi.e.
[Link].
deposits.
–– FIs
FIsface
faceinterest
interestrate
raterisk,
risk,but
butthey
theycan
canmanage
managethisthis
through
throughhedging
[Link]
loansales,
sales,securitization.
securitization.
McGraw-Hill/Irwin 1-28 ©2009, The McGraw-Hill Companies, All Rights
 Flow
Additional
of FundsBenefits
in a World
of FIs
without
(Cont.)FIs
•• Provide
Provide denomination
denomination intermediation.
intermediation.
–– Many
Manyassets
assetsare
aresold
soldin
inaavery
verylarge
largedenominations.
denominations.
–– Individual
Individualinvestors
investorscan’t
can’tinvest
investin
inthese
thesedirectly.
directly.
–– Through
Throughbuying
buyingFIs’
FIs’claims
claims(e.g.
([Link]
sharesininmutual
mutual
funds)
funds)individual
individualinvestors
investorscan
canhave
haveindirect
indirectaccess
access
to
tothese
theseinstruments
instrumentstotogenerate
generatehigher
higherreturns.
returns.

McGraw-Hill/Irwin 1-29 ©2009, The McGraw-Hill Companies, All Rights

 FIs Benefit the Overall Economy

•• FIs
FIs perform
perform services
services that
that improve
improve the
the
operations
operations of
of financial
financial system
system as
as aa whole.
whole.
•• Money
Money supply
supply Transmission:
Transmission:
–– Deposit
Depositaccounts
accountsareareaasignificant
significantcomponents
componentsof of
the
themoney
moneysupply,
supply,which
whichaffect
affectthe
therate
rateof
of
inflation.
inflation.
–– So,
So,depository
depositoryinstitutions
institutionsplay
playand
andimportant
importantrole
role
in
inmonetary
monetarypolicy.
policy.
–– Through
Throughsetting
settingreserve
reserverequirements.
requirements.
McGraw-Hill/Irwin 1-30 ©2009, The McGraw-Hill Companies, All Rights
 FIs Benefit the Overall Economy
(Cont.)
•• Credit
Credit Allocation
Allocation ::
–– FIs
FIsare
areviewed
viewedasasthe
themajor
majorsource
sourceof
offinancing
financingfor
for
particular
particularsectors
sectorsof
ofthe
theeconomy
economywhich
whicharearepre-
pre-
identified
identifiedasasbeing
beingin
inspecial
specialneed
needof
offinancing.
financing.
–– e.g.
[Link]
realestate
estatesector,
sector,Farming.
Farming.

McGraw-Hill/Irwin 1-31 ©2009, The McGraw-Hill Companies, All Rights

 FIs Benefit the Overall Economy
(Cont.)
•• Intergenerational
Intergenerational Wealth
Wealth Transfers
Transfers ::
–– FIs,
FIs,such
suchasaslife
lifeinsurance
insurancecompanies
companies& &pension
pension
funds,
funds,provide
providesavers
saverswith
withthe
theability
abilitytototransfer
transfer
wealth
wealthfrom
fromoneonegeneration
generationtotoanother
another(i.e.
([Link]
from
their
theiryouth
youthtotoold
oldage).
age).
–– e.g.
[Link]
pensionfunds
fundsoffer
offersavings
savingsplan
planthrough
through
which
whichfund
fundparticipants
participantsaccumulate
accumulatetax taxexempt
exempt
savings
savingsduring
duringtheir
theirworking
workingyearyearbefore
before
withdrawing
withdrawingthem themduring
duringtheir
theirretirement
retirementyears.
years.

McGraw-Hill/Irwin 1-32 ©2009, The McGraw-Hill Companies, All Rights

 FIs Benefit the Overall Economy
(Cont.)
•• payment
payment services
services ::
–– The
Theefficiency
efficiencywith
withwhich
whichFIs
FIs(e.g.
([Link]
depository
institutions)
institutions)provide
providepayments
paymentsservices
servicesdirectly
directly
benefits
benefitsthe
theeconomy.
economy.
–– Such
Suchasascheck
checkclearing
clearingand
andwire
wiretransfer
transferservices.
services.

McGraw-Hill/Irwin 1-33 ©2009, The McGraw-Hill Companies, All Rights

 Risks Faced by Financial Institutions

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

McGraw-Hill/Irwin 1-34 ©2009, The McGraw-Hill Companies, All Rights

 Globalization of Financial Markets and
Institutions
•• Even
Eventhough
thoughUSA
USAfinancial
financialmarkets
marketsare
arelarger
largerinin
their
theirsize
sizeand
andtrading
tradingvalue
valuecompared
comparedwith
withtheir
their
counterparts,
counterparts,Foreign
Foreignfinancial
financialmarkets
marketsgrow
grow
significantly.
significantly.
•• The
Thepool
poolof
ofsavings
savingsfrom
fromforeign
foreigninvestors
investorsisis
increasing
increasing
•• investors
investorslook
looktotodiversify
diversifyglobally
globallynow
nowmore
morethan
than
ever
everbefore
beforeby
byturning
turningtheir
theirattention
attentiontoward
towardUSAUSA
and
andforeign
foreignmarkets.
markets.

McGraw-Hill/Irwin 1-35 ©2009, The McGraw-Hill Companies, All Rights

 Globalization of Financial Markets and
Institutions
•• Information
Informationononforeign
foreignmarkets
marketsand
andinvestments
investmentsisis
becoming
becomingreadily
readilyaccessible
accessible
•• The
Thederegulation
deregulationacross
acrossthe
theglobe
globeisisallowing
allowingeven
even
greater
greateraccess
access
•• The
Theintroduction
introductionofofthe
theEURO;
EURO;ititbecame
becamethethemost
most
important
importantcurrency
currencyfor
forinternational
internationaltransactions.
transactions.

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