BoaziiUniversity EC344FinancialMarketsandInstitutions L.

Yldran
Section1:Introduction
SmoothingBusinessCycles(Stability) Prices,interestrates,FXrates, FinancialSystem Sustaininggrowth/employment

ExcessFunds (Savings) Households Firms

CentralBank (MonetaryPolicy, MonetaryTheory)

Financial Intermediaries IndirectFinance/Intermediation 95%ofnewcapitalintheUS

Riskaversehouseholds(Consumption smoothingacrosstimeandstates): Decisionmakingunderuncertainty Optimalportfolioselection (TheoryofFinance/Financial Economics) FinancialMarkets(Bonds,stocks,etc.) DirectFinance/Securitization

ShortageofFunds (Investment/consumption opportunities) Firms Governments Households

Profitmaximizingfirms: Whichprojectstoinvestin? Howtofinance(debt/equity)? (CorporateFinance)

WellfunctioningFinancialMarketsandInstitutionsareinstrumentalinimproving MarketEfficiency(Allocational/Informational/Operational):Bestprojectsare financedinthecheapestway,i.e.,maximumnumberofprojects(bestones)are financedwithscarceresources,sothatgrowth(employment)ismaximized. Welfare:Consumptionsmoothingisenabled

FinancialMarkets:
Whydowestudyfinancialmarkets? Interestrates(stockprices)determinedinbond(stock)marketsaffect: o Consumerscons.&savingdecisions o Firmsinvestmentdecisions Whydointerestrates(stockprices)fluctuate?Factorsaffectinginterestrates(stockprices)? Interestratefluctuations:borrowers();lenders(+,?) Stockpricefluctuations:firmsinvestments(+);consumersspending(+)(wealtheffect)

DebtvsEquitymarkets(bonds,mortgage,stocks,preferredstocks,convertibles) Bonds:couponbonds,discountbonds:FV,c,maturity Stocks:residualclaimholder(seniority),sensitivetoprofits,dividends PrimaryvsSecondaryMarkets IPO's(InitialPublicOffering),Investmentbanking,valuation,underwriting Firmsobtainfundsonlyinprimarymarkets Secondarymarketsareimportant,becauseofpricedeterminationandliquidity Brokers(matchbuyers'andsellers'orders)vsDealers(buyandsellsecuritiesatstated prices) Exchanges(e.g.,ISE,NYSE,etc.)vsOvertheCounter(OTC)Markets(e.g.,FXMarket) MoneyvsCapitalMarkets: MoneyMarkets(maturity1year):ShortTermBonds,TreasuryBills(TB), CertificatesofDeposits(CD),CommercialPapers(CP),Banker'sAcceptance(BA), RepurchaseAgreements(repo),interbankloans CapitalMarkets(maturity>1year):LongTermBonds,Stocks,Mortgages,Corporate Bonds(CB) GovernmentSecurities:TB,GovernmentBonds;CorporateSecurities:CP,CB;Bank Securities:CD,BA,Repo
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InternationalBondMarkets: Foreignbonds Eurobonds FinancialIntermediations: Whydowestudyfinancialintermediaries? o 95%ofnewcapitalisraisedthroughintermediariesevenintheUS Whyintermediationwhileitismorecostly? o Smallborrowersandsaversbenefitthemost Functionstheyperform: o Reducetransactioncosts(EconomiesofScale) o Transformations o Size o liquidity(maturity) o risk o Eliminate/reduceasymmetricinformationbetweenfirmsandhouseholds o adverseselection(screening) o moralhazard(monitoring) o costlystateverification(auditing) Riskstheyface;somewaystoreducethem: o o o o Credit risk:Screening,specialization,longtermcustomerrelations,etc. Interestraterisk:Maturitymatching,Derivatives FXraterisk:Currencymatching,Derivatives Portfoliorisk: Diversification

Whytoregulatefinancialinstitutions? Whentoregulateingeneral(marketfailures)? o Marketpower(monopolies,oligopolies) o Asymmetricinformation(betweenbanksandhouseholds)theyhavetobe monitored(provideinformationtopublic),bywhom?Costly(freeridingproblem) o Publicgood o Externalities(bankruns,bankpanics,realsector,paymentsystem)excessive risktaking Lastthreeissuesarerelevant o Increasethesoundnessoffinancialintermediaries
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o Increaseinformationavailabletoinvestors Banksareinclinedtotakeexcessiverisks(duetonegativeexternalities).Investors cannotobservetheriskstakenbybanks.Reducing/eliminatingasymmetric informationisapublicgood. Howtoregulate? o o o o o Entryrestrictions(licensing,chartering) Disclosurerequirements Restrictionsonassets,activities,capital,competition,interestrates Supervision,on/offsiteexaminations Safetynet;Depositinsurance,LenderofLastResort(LLR)

OtherFinancialIntermediaries: o Insurancefirms,pensionfunds(assets:bonds,stocksliabilities:premiums) o Financecompanies(assets:shorttermcreditstoclientsliabilities:longtermbonds) CentralBankingandMonetaryPolicy: o Objectives:stabilityandgrowth(aretheyconflicting?maybeintheshortrunbut notinthelongrun) o Smoothingbusinesscycles(boomsandrecessions) o Tools:MonetaryPolicy(Adjustingtheamountofmoney:M1,M2,M3) o OpenMarketOperations(OMO):Repo,ReverseRepo o Reserverequirements o DiscountLoans o Countercyclicalmonetarypolicy: o Recessionsexpansionarymonetarypolicy(OMpurchase) o Boomscontractionarymonetarypolicy(OMsale) o Moneygrowthrateisrelatedwitheconomicgrowthandinflation(consumption, saving,investment,financingdecisions)