Chapter 1

FINANCIAL MARKETS &

INSTITUTIONS
FINANCIAL MARKETS

Is a market in which financial assets such

as stocks and bonds are traded.
They facilitate the flow of funds, allowing
financing and investing.
Financial markets transfer funds from
those who have excess funds to those who
need funds
Participants of the market:
◦ Households
◦ Firms
◦ Government agencies
The ones providing funds to financial
markets are called Surplus Units-
(households)
Participants who use financial markets to
obtain funds are called Deficit Units
Security:
A certificate that represents a claim on the
issuer.

How do deficit units work:

◦ They issue (sell) securities to surplus units IN
order to obtain funds
TYPES OF FINANCIAL MARKETS

Primary versus secondary markets

New securities are issued in primary markets,
while existing securities are traded in
secondary markets.
– Facilitate the Trading of Existing Securities
– Provide Liquidity
– Continuous Information
– Makes it easy for firms to raise Funds
Money versus Capital Markets
Financial markets that facilitate the flow
of short-term funds (with maturities less
than one year) are known as money
markets,
While those that facilitate the flow of
long-term funds are known as capital
markets.
Organized versus Over-the-Counter
Markets
Some secondary stock market
transactions occur at an organized
exchange, which is a visible market place
for secondary market transactions.
Over the counter market is a
telecommunication network for market
transactions
Securities traded in Financial Markets
Equity securities represent ownership in
business.
Debt securities represent IOU’S, investors
who purchase these securities are
creditors.
While equity securities typically have no
maturity, debt securities have maturities
ranging from one day top twenty years or
longer.
Securities traded
Money market securities:
◦ Are debt securities that have a maturity of one
year or less.
◦ Have a high degree of liquidity,
◦ Low expected return.
MONEY MARKET ISSUED BY INVESTORS MATURITIES SECONDARY
SECURITITES MARKET
TRADING
TRESURY BILLS FEDERAL HOUSEHOLDS, ONE YEAR OR LESS HIGH
GOVERNMENT FIRM, FINANCIAL
INSTITUTIONS

CERTIFICATE OF BANKS AND HOUSEHOLDS 7DAYS-5 YEARS OR NONEXISTENT

DEPOSITS SAVING LONGER
INSTITUTIONS

NEGOTIABLE CD’S BANKS AND FIRMS 2 WEEKS- 1 YEAR MODERATE

SAVING
INSTITUTIONS

COMMERCIAL BANK HOLDING FIRMS 1 DAY- 270 DAYS LOW

PAPER COMPANIES,
FINANCING
COMPANIES

EURODOLLAR BANKS LOCATED FIRMS AND 1 DAY- 1 YEAR NON EXISTENT

DEPOSITS OUTSIDE US GOVERNMENTS

BANKER’S BANKS FIRMS 30 DAYS- 270 DAYS HIGH

ACCEPTANCES

FEDERAL FUNDS DEPOSITORY DEPOSITORY 1 DAY- 7 DAYS NON EXISTENT

INSTITUTIONS INSTITUTIONS

REPURCHASE FIRMS AND FIRMS AND 1 DAY- 15 DAYS NON EXISTENT

AGREEMENTS FINANCIAL FINANCIAL
INSTITUTIONS INSTITUTIONS
CAPITAL MARKET SECURITIES
Securities with a maturity of more than one year.
◦ Bonds and mortgages: are long term debt obligations
issued by corporations and government.
◦ Mortgages are debt obligations to finance real estate
◦ Stocks represent partial ownership in the firms that
issue them, they have no maturity and serve as long-
term source of funds.
CAPITAL ISSUED BY INVESTORS MATURITIES SECONDARY
MARKET MARKET
SECURITITES TRADING
TRESURY NOTES FEDERAL HOUSEHOLDS, 3-30 YEARS HIGH
AND BONDS GOVERNMENT FIRM, FINANCIAL
INSTITUTIONS
MUNICIPAL STATE AND HOUSEHOLD AND 10-30 YEARS MODERATE
BONDS LOCAL FIRMS
GEVERNMENT
CORPORATE FIRMS HOUSEHOLD AND 10-30 YEARS MODERATE
BONDS FIRMS
MORTGAGES INDIVIDUAL AND FINANCIAL 10-30 YEARS MODERATE
FIRMS INSTITUTIONS
EQUITY FIRMS HOUSEHOLDS NO MATURITY HIGH
SECURITIES AND FIRMS
Role of Financial Markets and
Institutions
Even if markets are efficient, this does not imply that
individual or institutional investors should ignore the
various investment instruments available.

Investors normally intend to balance the objective of high

return with their particular preference for low default risk
and adequate liquidity.

As time passes, new information about economic

conditions and corporate performance becomes available.

Announcements that do not contain any new valuable

information will not elicit a market response.
Financial institutions are required to
resolve the problems caused by market
imperfections
They match up buyers and sellers of
securities, breakdown securities to the
desired size of an investor.
Depository institutions are the major type
of financial intermediary which accept
deposits from surplus units and provide
credit to deficit units
Depository institutions
1. Commercial Banks:
 They serve surplus units by offering a wide variety of deposit
accounts, and they transfer deposited funds to deficit units by
providing direct loans or purchasing securities.

2. Saving Institutions:
 Like commercial Banks, savings and loan associations offer deposit
accounts to surplus units and then channel these deposits to deficit
units.
 S&L’s have concentrated on residential mortgage loans, while
commercial banks have concentrated on commercial loans.
 Saving Banks are similar to savings and loan associations, except
that they have more diversified uses of funds.
3. Credit Unions:
 Credit unions differ from commercial banks and savings
institutions in that:
 They are non-profit
 They restrict their business to the credit union members,
who share a common bond.
Functions of Non Depository Financial
Institutions

1. Finance Companies:
Most finance companies obtain funds by issuing securities,
then lend the funds to individuals and small businesses.

2. Mutual Funds:

Mutual Funds sell shares to surplus units and use the funds
received to purchase a portfolio of securities.
By purchasing shares of mutual funds and money market
mutual funds, small savers are able to invest in a diversified
portfolio of securities with a relatively small amount of funds.
3. Securities Firms:
Some securities Firms use their information resources
to act as a broker, executing securities transactions
between two parties. The fee is reflected in the
difference between their bid and ask quotes.
Furthermore, securities firms often act as dealers,
making a market in specific securities by adjusting
their inventory of securities.

4. Pension Funds:
Many corporations and government agencies offer
pension plans to their employees in which funds are
periodically contributed by the employees, their
employees or both.
5. Insurance Companies:

 Insurance companies receive premiums in exchange for

insurance policies payable upon death, illness, or
accidents and use the funds to purchase a variety of
securities.
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Exposure of Financial Institutions to Risk
Bonds and mortgages are subject to interest rate risk,
whereby prices of existing bonds or mortgages decline in
response to an increase in interest rates.

Stocks are subject to market risk, whereby the stock market

experiences lower prices in response to adverse economic
conditions or pessimistic expectations of investors.

Alltypes of securities dominated in foreign currencies are

subject to exchange rate risk, in which the currencies
dominating the securities depreciate against the investor’s
home currency.