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Chapter One

Introduction

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Why study Financial Markets and Institutions?


Prudent investment and financing Prudent investment and financing requires a thorough understanding of requires a thorough understanding of
the structure of domestic and international the structure of domestic and international markets markets the flow of funds through domestic and the flow of funds through domestic and international markets international markets the strategies used to manage risks faced by the strategies used to manage risks faced by investors and savers investors and savers
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Financial Markets
Financial markets are structures Financial markets are structures through which funds flow through which funds flow Financial markets can be distinguished Financial markets can be distinguished along two dimensions along two dimensions
primary versus secondary markets primary versus secondary markets money versus capital markets money versus capital markets

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Primary versus Secondary Markets


Primary markets Primary markets
markets in which users of funds (e.g., markets in which users of funds (e.g., corporations and governments) raise funds by corporations and governments) raise funds by issuing financial instruments (e.g., stocks and issuing financial instruments (e.g., stocks and bonds) bonds)

Secondary markets Secondary markets


markets where financial instruments are traded markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq) among investors (e.g., NYSE and Nasdaq)
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Money versus Capital Markets


Money markets Money markets
markets that trade debt securities with maturities markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury of one year or less (e.g., CDs and U.S. Treasury bills) bills)

Capital markets Capital markets


markets that trade debt (bonds) and equity markets that trade debt (bonds) and equity (stock) instruments with maturities of more than (stock) instruments with maturities of more than one year one year
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Money Market Instruments Outstanding, ($Bn)


3000 2500 2000 1500 1000 500 0 1990q4 2000q4 Commercial paper Banker's accept.
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2007q1 Negotiable CDs

Fed funds and repos U.S. Treasury bills


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Capital Market Instruments Outstanding, ($Bn)


25000 20000 15000 10000 5000 0
Corporate stocks U.S. gov't agencies Bank and consumer loans
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1990q4
Mortgages

2000q4

2007q1
Corporate bonds State & local gov't bonds

Treasury securities

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Foreign Exchange (FX) Markets


FX markets FX markets
trading one currency for another (e.g., dollar for yen) trading one currency for another (e.g., dollar for yen)

Spot FX Spot FX
the immediate exchange of currencies at current the immediate exchange of currencies at current exchange rates exchange rates

Forward FX Forward FX
the exchange of currencies in the future on aaspecific the exchange of currencies in the future on specific date and at aapre-specified exchange rate date and at pre-specified exchange rate

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Derivative Security Markets


Derivative security Derivative security
a financial security whose payoff is linked to a financial security whose payoff is linked to (i.e., derived from) another security or (i.e., derived from) another security or commodity commodity generally an agreement to exchange a standard generally an agreement to exchange a standard quantity of assets at a set price on a specific date quantity of assets at a set price on a specific date in the future in the future

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Financial Market Regulation


The Securities Act of 1933 The Securities Act of 1933
full and fair disclosure and securities full and fair disclosure and securities registration registration

The Securities Exchange Act of 1934 The Securities Exchange Act of 1934
Securities and Exchange Commission (SEC) is Securities and Exchange Commission (SEC) is the main regulator of securities markets the main regulator of securities markets

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Financial Institutions (FIs)


Financial Institutions Financial Institutions
institutions through which suppliers channel institutions through which suppliers channel money to users of funds money to users of funds

Financial Institutions are distinguished Financial Institutions are distinguished by whether they accept deposits by whether they accept deposits
depository versus non-depository financial depository versus non-depository financial institutions institutions

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Flow of Funds in a World without FIs


Financial Claims (equity and debt instruments)
Users of Funds (corporations)

Suppliers of Funds (households)

Cash

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Flow ofof Funds in a World with FIs Flow Funds in a World without FIs
FIs (brokers) FIs (asset transformers)

Users of Funds

Suppliers of Funds

Cash

Cash

Financial Claims (equity and debt securities)

Financial Claims (deposits and insurance policies)

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Depository versus Non-Depository FIs


Depository institutions Depository institutions
commercial banks, savings associations, savings commercial banks, savings associations, savings banks, credit unions banks, credit unions

Non-depository institutions Non-depository institutions


insurance companies, securities firms and insurance companies, securities firms and investment banks, mutual funds, pension funds investment banks, mutual funds, pension funds

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FIs Benefit Suppliers of Funds


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

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FIs Benefit the Overall Economy


Conduit through which Federal Reserve Conduit through which Federal Reserve conducts monetary policy conducts monetary policy Provides efficient credit allocation Provides efficient credit allocation Provide for intergenerational wealth Provide for intergenerational wealth transfers transfers Provide payment services Provide payment services

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Risks Faced by Financial Institutions


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

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Regulation of Financial Institutions


FIs are heavily regulated to protect society at FIs are heavily regulated to protect society at large from market failures large from market failures Regulations impose a burden on FIs and recent Regulations impose a burden on FIs and recent U.S. regulatory changes have been U.S. regulatory changes have been deregulatory in nature deregulatory in nature Regulators attempt to maximize social welfare Regulators attempt to maximize social welfare while minimizing the burden imposed by while minimizing the burden imposed by regulation regulation
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Globalization of Financial Markets and Institutions


The pool of savings from foreign investors is The pool of savings from foreign investors is increasing and investors look to diversify globally increasing and investors look to diversify globally now more than ever before now more than ever before Information on foreign markets and investments is Information on foreign markets and investments is becoming readily accessible and deregulation across becoming readily accessible and deregulation across the globe is allowing even greater access the globe is allowing even greater access International mutual funds allow diversified foreign International mutual funds allow diversified foreign investment with low transactions costs investment with low transactions costs

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