Financial Markets and

Institutions

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1

 Financial Markets and
Institutions
Lecture Outline:
• Why Study Financial Markets
and Institutions?
• Functions of Financial Markets
• Structure of Financial Markets
• Types of Financial Markets
• Securities Traded in Financial Markets

2
 Why Study Financial Markets?

 Financial markets, such as bond and stock

markets, are crucial in our economy.
1. These markets channel funds from savers to
investors, thereby promoting economic efficiency.
2. Market activity affects personal wealth, the behavior
of business firms, and economy as a whole.

3
 Why Study Financial Markets?
Debt Markets & Interest Rates

• Debt markets, or bond markets, allow governments,

corporations, and individuals to borrow to finance
activities.
• In this market, borrowers issue a security, called a
bond, that promises the timely payment of interest and
principal over some specific time horizon.
• The interest rate is the cost of borrowing.

4
 Why Study Financial Markets?
The Stock Market

• The stock market is the market where common

stock (or other stocks), representing ownership in a
company, are traded.
• Companies initially sell stock (in the primary
market) to raise money. But after that, the stock is
traded among investors (secondary market).

5
 Why Study Financial Markets?
The Foreign Exchange Market

• The foreign exchange market is where international

currencies trade and exchange rates are set.
• Although most people know little about this market, it
has a daily volume around $1 trillion!

6
 Why Study Financial Institutions?

We will also spend considerable time discussing

financial institutions—the corporations,
organizations, and networks that operate the so-called
“marketplaces.” (The Financial System)
1. Why Financial Markets are structured the way they
are?
– Helps get funds from savers to investors
2. The Role of Banks and Other Financial Institutions
– Includes the role of insurance companies, pension funds,
etc.

7
 Why Study Financial Institutions?

3. Financial Innovation
– Focusing on the improvements in technology and its
impact on how financial products are delivered.

4. Managing Risk in Financial Institutions

– Focusing on risk management in the financial institution.

8
 Function of Financial Markets

• A Financial Market is a market in which financial

assets (securities) can be purchased or sold.

• Financial markets facilitate transfers of funds from

person or business without investment opportunities
(i.e., “Lender-Savers”, or “Surplus Unit”) to those who
have investment opportunities (i.e., “Borrower-
Spenders”, or “Deficit Unit”).

9
 How is Funds Transferred
between Savers and Borrowers?

• Direct transfers
• Investment
banks
• Financial
intermediaries

10
Three Ways to Transfer Financial
Capital in the Economy

11
 1- Direct Transfer

Firms sell securities directly to savers who

have the money and want to achieve higher
return on them.
New business formation is a good example
of this process at work.
The new business may go directly to savers
called venture capitalists who may take an
equity if they expect success.

12
 Direct Finance: Financial Markets

 Borrowers borrow directly from lenders in financial

markets by selling financial instruments (securities) (
bonds and stocks) which are claims on the borrower’s
future income or assets.

 These securities are assets for those who buy them

and liabilities for those who issue or sell them.

13
 2- Indirect Finance: Using Investment
Banks

Functions of the Investment Bank

A- Underwriting: by buying the securities and resell
them on behalf of the corporation.
The difference between the price the corporation
gets and the public offering price is the
underwriter’s spread.
The process is risky and therefore a syndicate is
formed.
B- Distribution
C- Advising
14
 2- Indirect Finance: Using Investment
banks
 The managing investment-banking forms a
syndicate of several investment bankers.

 The syndicate buys the entire shares from the firm

in need of funds and sells it at a higher price.

 The security passes through the investment

banking firm and not transformed into a different
security.

15
 3- Indirect Finance: Financial
Intermediaries
– Borrowers borrow indirectly from lenders via
financial intermediaries (e.g. commercial banks).

– The financial intermediary collects the savings

and issues its own (indirect) securities in
exchange for these savings.

– The FI uses the funds to acquire the business

firm’s (direct) securities, such as stocks and
bonds.

16
Transfer of Funds on
Financial Market

17
 The Relationship between the
Corporation and the Financial Markets

 Internal funds are not sufficient.

1. The corporation has to go outside and raise
capital from the financial markets.

2. Funds are invested by the corporation.

3. Cash from investments is reinvested, given

back to investors, repurchasing stock, and
paid in taxes.

18
 The Corporation and the Financial
Markets (Direct)
Firm
Firm issues securities (A) Financial
markets

Invests
in assets
(B)
Retained
cash flows (F)

Short-term debt
Long-term debt
Current assets
Fixed assets Equity shares
Cash flow Dividends and
from firm’s assests (C) debt payments (E)

Taxes (D)

Government
and other
stakeholders
19
 Types of Financial Markets

• Financial markets can be distinguished by the maturity

structure and trading structure of its securities
• Money versus capital markets:
– The flow of short-term funds is facilitated by
money markets (money markets, such as
commercial banks).
– The flow of long-term funds is facilitated by capital
markets

20
 Types of Financial Markets

• Primary versus secondary markets

– Primary markets facilitate the issuance of new
securities -This called Initial Public Offering (IPO).
• e.g., the sale of new corporate stock
– Secondary markets facilitate the trading of
existing securities
• e.g., the sale of existing stock

21
 Primary versus Secondary Markets

Secondary Market:
• Provides the means for the transfer of
ownership of securities.
• Provide liquidity, making it easy to buy and sell
the securities of the companies
• Establish a price for the securities

22
 Types of Financial Markets (cont’d)
Secondary Markets:

• Organized versus over-the-counter

markets:
– A visible marketplace for secondary market
transactions is an organized exchange.
– Some transactions occur in the over-the-
counter (OTC) market (a
telecommunications network).

23
 Benefits of Organized Stock
Exchange
• Providing continuous market: continuous
prices and execution of orders.

• Establishing and publicizing fair security

prices.
• Helping business organizations raise new
capital.

24
 Over the Counter (OTC)
• The price the dealer is willing to pay is a bid
price.

• The price at which the dealer is willing to sell is

the asked price (asked).

• The difference between the bid and ask prices is

called the spread and the difference is the main
source of profit/loss for the dealer.
25
 Securities Traded in Financial
Markets

• Money market securities:

– Money market securities are debt securities with a
maturity of one year or less
– Characteristics:
• Liquid
• Low expected return
• Low degree of risk

26
 Securities Traded in Financial
Markets (cont’d)

• Capital Market Securities:

– Capital market securities are those with a maturity
of more than one year
• Bonds and mortgages
• Stocks
– Capital market securities have a higher expected
return and more risk than money market securities.

27
 Securities Traded in Financial
Markets (cont’d)

• Bonds and Mortgages:

– Bonds are long-term debt obligations issued by
corporations and government agencies.
– Mortgages are long-term debt obligations created to
finance the purchase of real estate.
– Bonds and mortgages specify the amount and
timing of interest and principal payments.

28
 Securities Traded in Financial
Markets (cont’d)

• Stocks:
– Stocks (equity) are certificates representing partial
ownership in corporations.
– Investors may earn a return by receiving dividends
and capital gains.
– Stocks have a higher expected return and higher
risk than long-term debt securities.

29
 Valuation of Securities in
Financial Markets
• The valuation of a security is measured as the
present value of its expected cash flows,
discounted at a rate that reflects the uncertainty
of the cash flows (Risk).

30
 Market Efficiency

• When security prices fully reflect all available

information, the markets for those securities are said to
be efficient.
• When Markets are inefficient, investors can use
available information ignored by the market to earn
abnormally high returns on their investments.

31
 Market Efficiency

• Impact of Asymmetric Information:

• A firm’s managers possess information about its
financial condition that is not available to investors.
• This situation is referred to as asymmetric information.
• An asymmetric information problem may still exist if
some of the information provided by the firm’s
managers cannot be trusted.

32
 Financial Market Regulations

• Financial Markets are regulated to ensure that the

participants are treated fairly.
• Many regulations were enacted in response to
fraudulent practices.
• So, we need a fair disclosure!

33
 Comparison of Roles among
Financial Institutions
Deposits
Depository
Institutions

Purchase
Individual Finance
Surplus Units Securities Companies

Purchase Shares
Mutual Funds Deficit Units

Premiums Insurance
Policyholders
Companies

Employee
Employers Contributions
Pension Funds
Employees
34
The End

35
 Homework

1. What are financial intermediaries, and

what economic functions do they perform?

2. What is an investment banker, and what

major functions does he or she perform?

36