Chapter One

Introduction

Copyright © 2015 by McGraw-Hill Education. All rights reserved.

Why Study Financial Markets
and Institutions?

l Markets and institutions are primary

channels to allocate capital in our society
l Proper capital allocation leads to growth in:
l Societal wealth

l Income

l Economic opportunity

1-2
Why Study Financial Markets
and Institutions?

l In this text we will examine:

l the structure of domestic and international
markets
l the flow of funds through domestic and
international markets
l an overview of the strategies used to manage
risks faced by investors and savers

1-3
Financial Markets

l Financial markets are one type of

structure through which funds flow
l Financial markets can be distinguished
along two dimensions:
l primary versus secondary markets
l money versus capital markets

1-4
Primary versus Secondary
Markets

l Primary markets
l markets in which users of funds (e.g.,
corporations and governments) raise funds by
issuing financial instruments (e.g., stocks and
bonds)
l Secondary markets
l markets where existing financial instruments are
traded among investors (e.g., exchange traded:
NYSE and over-the-counter: NASDAQ)

1-5
Primary versus Secondary
Markets

1-6
Primary versus Secondary
Markets

l How were primary markets affected by

the financial crisis?

l Do secondary markets add value to

society or are they simply a legalized
form of gambling?
l How does the existence of secondary markets
affect primary markets?

1-7
Money versus Capital Markets

l Money markets
l markets that trade debt securities with maturities of one
year or less (e.g., CDs and U.S. Treasury bills)
l little or no risk of capital loss, but low return
l Capital markets
l markets that trade debt (bonds) and equity (stock)
instruments with maturities of more than one year
l substantial risk of capital loss, but higher promised return
Figure 1.3

1-8
Money Market Instruments
Outstanding, ($Bn)

1-9
Capital Market Instruments
Outstanding, ($Bn)

1-10
Foreign Exchange (FX) Markets

l FX markets
l trading one currency for another (e.g., dollar for yen)
l Spot FX
l the immediate exchange of currencies at current
exchange rates
l Forward FX
l the exchange of currencies in the future on a specific date
and at a pre-specified exchange rate

1-11
Derivative Security Markets

l Derivative security
l a financial security whose payoff is linked to (i.e., “derived”
from) another security or commodity,
l generally an agreement to exchange a standard quantity
of assets at a set price on a specific date in the future,
l the main purpose of the derivatives markets is to transfer
risk between market participants.

1-12
Derivative Security Markets

l Selected examples of derivative

securities
l Exchange listed derivatives
l Many options, futures contracts
l Over the counter derivatives
l Forward contracts
l Forward rate agreements
l Swaps
l Securitized loans

1-13
Derivatives and the Crisis

1. Mortgage derivatives allowed a larger amount of

mortgage credit to be created in the mid-2000s.
l Growing importance of ‘shadow banking system’

2. Mortgage derivatives spread the risk of mortgages to a

broader base of investors.

3. Change in banking from ‘originate and hold’ loans to

‘originate and sell’ loans.
l Decline in underwriting standards on loans

1-14
Derivatives and the Crisis

1. Subprime mortgage losses were large, reaching over

$700 billion.

2. The “Great Recession” was the worst since the “Great

Depression” of the 1930s.
l Trillions $ global wealth lost, peak to trough stock prices
fell over 50% in the U.S.
l Lingering high unemployment and below trend growth in
the U.S.
l Sovereign debt levels in developed economies reached
post-war all-time highs

1-15
Financial Market Regulation

l The Securities Act of 1933

l full and fair disclosure and securities registration
l The Securities Exchange Act of 1934
l Securities and Exchange Commission (SEC) is
the main regulator of securities markets

1-16
Financial Institutions (FIs)

l Financial Institutions
l institutions through which suppliers channel money to
users of funds
l Financial Institutions are distinguished by:
l whether they accept insured deposits
l depository versus non-depository financial
institutions
l whether they receive contractual payments from
customers

1-17
Percentage Shares of Assets of Financial
Institutions in the United States, 1929–2013

1-18
Non-Intermediated (Direct)
Flows of Funds

Flow of Funds in a World without FIs

Direct Financing
Financial Claims
(equity and debt
instruments)
Users of Funds Suppliers of
(corporations) Funds
Cash (households)

1-19
Intermediated Flows of Funds

Flow of Funds in a World with FIs

Intermediated Financing
FIs
Users of Funds (brokers) Suppliers of Funds

Cash FIs
(asset Cash
transformers)
Financial Claims Financial Claims
(equity and debt securities) (deposits and insurance policies)

1-20
Depository versus Non-Depository FIs

l Depository institutions:
l commercial banks, savings associations, savings banks,
credit unions
l Non-depository institutions
l Contractual:
l insurance companies, pension funds,

l Non-contractual:
l securities firms and investment banks, mutual funds.

1-21
FIs Benefit Suppliers of Funds

l Reduce monitoring costs

l Increase liquidity and lower price risk
l Reduce transaction costs
l Provide maturity intermediation
l Provide denomination intermediation

1-22
FIs Benefit the Overall Economy

l Conduit through which Federal Reserve

conducts monetary policy
l Provides efficient credit allocation
l Provide for intergenerational wealth
transfers
l Provide payment services

1-23
Risks Faced by Financial
Institutions

l Credit l Off-balance-sheet
l Foreign exchange l Liquidity
l Country or l Technology
sovereign l Operational
l Interest rate l Insolvency
l Market
Volcker Rule: Insured
institutions may not
engage in proprietary
trading
1-24
Regulation of Financial
Institutions
l FIs are heavily regulated to protect society at
large from market failures
l Regulations impose a burden on FIs; before the
financial crisis, U.S. regulatory changes were
deregulatory in nature
l Regulators attempt to maximize social welfare
while minimizing the burden imposed by
regulation

1-25
Regulation of Financial
Institutions

l Dodd-Frank Bill
1. Promote robust supervision of FIs
l Financial Service Oversight Council to identify
and limit systemic risk,
l Broader authority for Federal Reserve (Fed) to
oversee non-bank FIs,
l Higher equity capital requirements,
l Registration of hedge funds and private equity
funds.

1-26
Regulation of Financial
Institutions

l Dodd-Frank Bill
2. Comprehensive supervision of financial markets
l New regulations for securitization and over
the counter derivatives
l Additional oversight by Fed of payment
systems

3. Establishes a new Consumer Financial

Protection Agency

1-27
Regulation of Financial
Institutions

l Dodd-Frank Bill
4. New methods to resolve non-bank financial
crises
l More oversight of Fed bailout decisions

5. Increase international capital standards and

increased oversight of international operations
of FIs.

1-28
Globalization of Financial Markets
and Institutions
l The pool of savings from foreign investors is
increasing and investors look to diversify globally now
more than ever before,
l Information on foreign markets and investments is
becoming readily accessible and deregulation across
the globe is allowing even greater access to foreign
markets,
l International mutual funds allow diversified foreign
investment with low transactions costs,
l Global capital flows are larger than ever.

1-29
Appendix: FIs and the Crisis

Timeline of events
l Home prices decline in late 2006 and early 2007

l Delinquencies on subprime mortgages increase

l Huge losses on mortgage-backed securities

(MBS) announced by institutions

l Bear Stearns fails and is bought by J.P. Morgan

Chase for $2 a share (deal had government backing)

1-30
Appendix: FIs and the Crisis

Timeline of events
l September 2008, the government seizes government-
sponsored mortgage agencies Fannie Mae and
Freddie Mac
l The two had $9 billion in losses in the second half
2007
l Now run by Federal Housing Finance Agency
(FHFA)

l September 2008, Lehman Brothers files for

bankruptcy; Dow drops 500 points

1-31
Appendix: FIs and the Crisis

Figure 1-9 The Dow Jones Industrial Average, October 2007–January

2010

1-32
Appendix: FIs and the Crisis

Figure 1-10 Overnight London Interbank Offered Rate (LIBOR),

2001–2010

1-33
Appendix: Government Rescue
Plan
Table 1-12 Federal Government Rescue Efforts through December 2009

1-34
Appendix: Government Rescue
Plan
Table 1-12 Federal Government Rescue Efforts through December 2009

1-35
Appendix: Government Rescue
Plan
Figure 1-11 Federal Funds Rate and Discount Window Rate—January
1971 through January 2010

1-36
Appendix: Government Rescue
Plan
Table 1-13 Major Items in the $787 Billion Stimulus Program as
Passed by the U.S. Congress, February 13, 2009

1-37