Power Point Slides for:

Financial Institutions, Markets, &

Money, 10th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Vladimir Kotomin,
University of Wisconsin—Eau Claire
and
Lanny R. Martindale,
Texas A&M University

Copyright 2008 John Wiley & Sons, Inc.Copyright© 2006 John

Wiley & Sons, Inc.
CHAPTER 1

An Overview of Financial Markets and

Institutions
 The Financial System

Provides for efficient flow of funds from

saving to investment by bringing savers and
borrowers together via financial markets
and financial institutions.
Exhibit 1.1 – Transfer of Funds
 Basic components of the financial system: Markets and institutions.

Financial markets are markets for financial

instruments, also called financial claims or
securities.

Financial institutions (also called financial

intermediaries) facilitate flows of funds from
savers to borrowers.

5
 Economic units with financial needs: Households, Businesses,
Governments.

Households supply labor, demand products, and

save for the future.
Businesses demand labor, supply products, and
invest in productive assets.
Governments collect taxes and provide “public
goods” (e.g. education, defense).
 Budget positions creating financial needs of economic units:
Surplus or deficit.

Surplus spending units ( SSUs) have income

for the period that exceeds spending,
resulting in savings.
Other words for “SSU” are saver, lender, or
investor. Most SSUs are households.
Deficit spending units (DSUs) have
spending for the period that exceeds
income.
Another word for “DSU” is “borrower”. Most
DSUs are businesses or governments.
 Financial claims arise as SSUs lend to DSUs.

SSU’s claim against DSU is liability to

DSU and asset to SSU.

One’s liability is another’s asset: What is

payable by one is receivable by another.

Assets arising this way are “financial

assets.” The financial system “balances”-
total financial assets equal total liabilities.
 Marketability: Ease with which a financial asset may be sold to
another SSU.

Ability to resell financial claims makes them

more liquid by giving SSUs choices:

Match maturity of claim to planned investment

period;
Buy claim with longer maturity, but sell at end of
period; or
Buy claim with shorter maturity, then reinvest.
 Direct Financing: The simplest way for
funds to flow.

DSU and SSU find each other and bargain

SSU transfers funds directly to DSU
DSU issues claim directly to SSU
Preferences of both must match as to-
-Amount
-Maturity
-Risk
-Liquidity
 Direct Financing: efficient for large transactions if preferences
match.

DSUs and SSUs “seize the day”—

DSUs fund desired projects immediately.
SSUs earn timely returns on savings.

Direct markets are “wholesale” markets.

Transactions typically $1 million or more.
Institutional arrangements common.
 Institutional arrangements common in direct finance.

Private placements are simplest.

Investment bankers “underwrite” new issues

of securities.

Brokers and dealers bring buyers and sellers

of direct claims together.
 Private placements are simplest.

DSU sells whole security issue to one

investor or investor group.

Advantages include speed and low

transactions costs.
 Investment bankers “underwrite” new issues of securities.

Buy entire issues of securities from DSUs

Find SSUs to buy securities at higher price

Profit from difference - “underwriting

spread”
 Brokers and dealers

Brokers buy or sell at best possible price for

their clients.

Dealers “make markets” by carrying

inventories of securities.

buy at “bid price;” sell at “ask price”

“Bid-ask spread” is dealer’s gross profit
 Problem with direct financing: DSUs and SSUs cannot always match
preferences.

Not every SSU can afford “wholesale”

denominations of $1 million or more.

DSUs and SSUs often prefer different terms

to maturity.
 Indirect Financing (“Financial Intermediation”):

Financial intermediaries “transform”

claims:
raise funds by issuing claims to SSUs;
use funds to buy claims issued by DSUs.

Claims can have unmatched characteristics:

SSU has claim against intermediary;
Intermediary has claim against DSU.
Financial intermediaries transform claims
 Familiar forms of financial intermediation

Commercial Banking

Insurance
 Commercial Banks

Take deposits and make loans -

Depositors are SSUs
Borrowers are DSUs.
 Insurance Companies

Issue policies, collect premiums, and invest

in stocks and bonds.

Policyholders are SSUs;

Businesses or governments are DSUs.
 Benefits of financial intermediation are a primary rationale for the
financial system.

Financial intermediaries lower the cost of financial

services as they pursue profit.

Financial intermediaries perform 5 basic services

as they transform claims.
 Intermediaries lower the cost of financial services as they pursue
profit.

3 sources of comparative advantage:

Economies of scale
Transaction cost control
Risk management expertise

Competition pulls interest rates down

Financing less costly

Projects have higher NPVs
Investment in real assets boosts economy
 Intermediaries perform 5 basic services as they transform
claims.

Denomination Divisibility – pool savings of many

small SSUs into large investments.

Currency Transformation – buy and sell financial

claims denominated in various currencies.

Maturity Flexibility – Offer different ranges of

maturities to both DSUs and SSUs.
 Intermediation Services, cont.

Credit Risk Diversification – Assume credit risks

of DSUs; spread risk over many different types of
DSUs.

Liquidity – Give SSUs and DSUs different

choices about when, to what extent, and for how
long to commit to financial relationships.
 4 Major types of financial intermediaries transform claims to meet
various needs.

Deposit-type or “Depository” Institutions

Contractual Savings Institutions
Investment Funds
“Other” Institutions
 Depository Institutions take deposits and make loans.

Commercial Banks
Thrift Institutions
Savings & Loan Associations
Savings Banks
Credit Unions
 Commercial Banks

Largest single class of financial institution

Issue wide variety of deposit products -

checking, savings, time deposits

Carry widely diversified portfolios of loans,

leases, government securities

May offer trust or underwriting services

 Thrift Institutions

Closely resemble commercial banks

Focus more on real estate loans, savings deposits,

and time deposits
 Credit Unions: Unique Characteristics
Mutual ownership -“owned” by depositors
or “members”

“Common bond” - members must share

some meaningful common association

Not-for-profit and tax - exempt

Restricted mostly to small consumer loans

 Contractual Institutions bring long-term savers and borrowers
together.

Life Insurance Companies

Casualty Insurance Companies

Pension Funds
 Life Insurance Companies insure against lost income at death.

Policyholders pay premiums, which are

pooled and invested in stocks, bonds, and
mortgages

Investment earnings cover the costs and

reward the risks of the insurance company

Investments are liquidated to pay benefits.

 Casualty Insurance Companies cover property against loss or
damage.

Sources and uses of funds resemble those of

life insurers, but

Casualty claims are not as predictable as

death claims; so

More assets are in short-term, easily

marketable investments
 Pension Funds help workers plan for retirement.

Workers and/or employers make

contributions, which are pooled and
invested in stocks, bonds, and mortgages

Net of administrative costs, investment

earnings are reinvested and compounded

Retirement benefits replace paychecks (at

least partly)
 Investment Funds help small investors share the benefits of large
investments.

Mutual Funds provide intermediated access to

various capital markets
shareholders’ money is pooled and invested in
stocks, bonds, or other securities according to
some objective

Money Market Mutual Funds (“MMMFs”) are

uninsured substitutes for deposit accounts
MMMFs buy money market instruments
wholesale, pay investors interest, and allow
limited check-writing
 “Other” Financial Institutions
Finance Companies—
Make loans but do not take deposits; raise
loanable funds in commercial paper market and
from shareholders

Federal Agencies—
Issue “agency securities” backed by government
and lend at sub-market rates for favored social
purposes
Exhibit 1.2—Major Financial Intermediaries
Exhibit 1.3—
Major Financial Intermediaries: Sources & Uses of Funds
 Financial Markets are classified in several ways.

Primary and Secondary

Organized and Over-the-Counter
Spot and Futures
Options
Foreign Exchange
International and Domestic
Money and Capital
Primary and Secondary Markets

Primary markets are where financial claims are

“born”: DSUs receive funds, claims are first
issued
Secondary markets are where financial claims
“live”—are resold and repriced
Claims become more liquid because SSUs
can set their own holding periods
Trading sets prices and yields of widely held
securities
 Organized and Over-the-Counter Markets
Organized Exchanges: physical, relatively
exclusive.
Physical trading floor and facilities available to
members of exchange, for securities listed on
exchange.
New York Stock Exchange
Chicago Board of Trade (futures)

OTC Markets: virtual, relatively inclusive.

Decentralized network available to any licensed dealer
willing to buy access and obey rules, for wide range of
securities.
The NASDAQ is a famous OTC market.
 Spot and Futures Markets

Spot Markets: immediate pricing, immediate

delivery
Futures or Forward Markets: immediate pricing,
promise of future delivery
“Futures” contracts: standardized as to amounts,
forms, and dates; trade on organized exchanges

“Forward” contracts: individualized between

parties with particular needs
 Option Markets
Rights in underlying securities or commodities—
writer grants owner some exclusive right for some
certain time

Main types of options: Puts (options to sell)

Calls (options to buy)

Options on listed securities and widely held

commodities trade actively on organized
exchanges
 Foreign Exchange Markets
Any currency is convertible to any other at some
exchange rate

“Forex” involves spot, future, forward, and option

markets
 International and Domestic Markets
Help participants diversify both sources and uses
of funds

Examples of major international markets:

Eurodollars—US dollars deposited outside U.S.
Eurobonds—bonds issued outside US but
denominated in $US
 Money and Capital Markets

Money markets: wholesale markets for short-term

debt instruments resembling money itself

Capital markets: where “capital goods” are

permanently financed through long-term financial
instruments
(“Capital goods”—real assets held long-term to
produce wealth—land, buildings, equipment, etc.)
 Money Markets

Help participants adjust liquidity—

DSUs borrow short-term to fund current operations
SSUs lend short-term to avoid holding idle cash

Common characteristics of money market

instruments—
Short maturities (usually 90 days or less)
High liquidity (active secondary markets)
Low risk (and consequently low yield)
Dealer/OTC more than organized exchange
 Examples of Major Money Market Instruments

Treasury Bills
Negotiable Certificates of Deposit
Commercial Paper
Federal Funds (“Fed Funds”)
Exhibit 1.4—Major Money Market Instruments
 Money Market Balance Sheet Position of Major Participants

INVESTMENT
FEDERAL BANKS,
COMMERCIAL RESERVE TREASURY DEALERS,
BANKS SYSTEM DEPARTMENT AND BROKERS CORPORATIONS
INSTRUMENT A L A L A L A L A L
Treasury bills     
Agency securities    
Negotiable CDs   
Commercial paper    
Banker’s acceptances     
Federal Funds  
Repurchase agreements      
 Capital Markets

Help participants build wealth

DSUs seek long-term financing for capital projects
SSUs seek highest possible return for given risk
Differences from money markets—
Long maturities (5 to 30 years)
Less liquidity
(secondary markets active but more volatile)
Higher risk in most cases
(with higher potential yield)
Traded “wholesale” and “retail” on organized
exchanges and in OTC markets
 Examples of
Major Capital Market Instruments

Common stock
Corporate bonds
Municipal bonds
Mortgages
Exhibit 1.5—Major Capital Market Instruments
 Efficiency in financial markets

Allocational Efficiency: highest/best use of funds

DSUs try to fund projects with best cost/benefit ratios
SSUs try to invest for best possible return for given
maturity and risk

Informational Efficiency: prices reflect relevant

information
Informationally efficient markets reprice quickly on
new information;
informationally inefficient markets offer opportunities
to buy “underpriced” assets or sell “overpriced” assets
Operational Efficiency: transactions costs minimized
 Risks of Financial Institutions
Credit or default risk: risk that a DSU may not
pay as agreed
Interest rate risk: fluctuations in a security's price
or reinvestment income caused by changes in
market interest rates
Liquidity risk: risk that a financial institution may
be unable to disburse required cash outflows, even
if essentially profitable
 Risks of Financial Institutions, cont.

Foreign exchange risk: effect of exchange rate

fluctuations on profit of financial institution

Political risk: risk of government or regulatory

action harmful to interests of financial institution.