Overview of financial

markets
 Financial markets are markets which
enable the flow of funds from savers-
lenders to borrowers-spenders
 Maturity of a debt instrument is the
number of years until that instruments
expiration date
 Debt instrument
 Short-term debt instrument
 Long-term instruments
 Equity holder is a residual claimant
 Equity holder shares in the profits of the
firm
 A primary market is a market in which
new securities are issued
 A secondary market is a financial market
in which securities that have been
previously issued are sold
 Investment banks underwrite securities in
the primary markets
 Sellers sell securities through organized
stock exchanges or over-the counter
 Bonds are mostly sold in over the counter
markets; other instruments commonly
sold include negotiable certificates of
deposits, banker’s acceptance and foreign
exchange
 Money market is one in which short-term
debt instruments are traded
 Secondary markets serve two purposes-
they make financial instruments more
liquid
 Firms which buy securities in the primary
markets
 Secondary markets can be organized in
two ways:
 Organized stock exchanges and over-the
counter markets
 Capital markets include longer-term debt
instruments and equities
 International bond market
Foreign bonds
Eurobond- a bond denominated in a
currency of a country other than that in
which it is sold
A bond denominated in US dollars sold in
London is an example
 Eurocurrencies- are foreign currencies
which are deposited in banks outside the
home country
 Eurodollars-are dollars deposited in banks
outside the USA
 International of financial markets is
leading to greater integration of financial
markets in which flow of funds and
technology between countries is more
common place
 Financial intermediaries play an important
role
 Financial intermediaries have lower
transaction costs because of their lower
size. Because of their large size and low
transaction costs they can provide
customers with liquidity services, services
which make it easier for customers to
conduct transactions
 Risk sharing- Low transactions costs
enable risk-sharing for financial
intermediaries
 They sell assets at a lower risk and invest
in more risky assets
 They earn a profit from the spread
between the returns they earn on assets
and the payments they make to sell new
assets
 Financial intermediaries also promote risk
sharing by helping individuals to diversify
and lower the amount of risk to which
they are exposed
 Diversification entails investing in a
portfolio of stocks whose returns donot
move together
 Asymmetric information refers to the fact
that one contracting party in a contract
has more information than the other party
 Adverse selection refers to asymmetric
information before a transaction occurs
 Moral hazard refers to asymmetric
information after the transaction has
occurred
 Moral hazard can lead to conflict of
interest
 Financial intermediaries provide liquidity
services, promote risk sharing and solve
information problems
 Types of financial intermediaries
Depository institutions (banks)
Commercial Banks: Raise funds through
checkable deposits, savings deposits and time
deposits. Use these funds to make consumer,
commercial and mortgage loans
Savings and Loan associations and Mutual
Savings Bank: Raise funds through savings,
checkable and time deposits. Make mainly
mortgage loans
 Credit Union- is a very small cooperative
lending institution organized around a
particular group: employees or union
members. Acquire funds from deposits called
shares
 Contractual Savings associations
Life insurance companies insure people against
financial hazards following death and sell
annuities. They acquire funds from the
premiums they pay an use them to buy
mortgages and bonds
 Fire and Casualty insurance companies- They
insure their policyholders against loss from
theft, fire and accidents. They earn income
from premiums but have a greater possibility
of loss. So they invest in more liquid assets.
 Private pension funds and state and local
government retirement funds provide
retirement income in the form of annuities.
These funds mainly invest in corporate binds
and stocks.
 Investment intermediaries
Finance Companies: Raise funds by selling
commercial paper and by issuing stocks
and bonds
Mutual funds: obtain funds by selling
shares to the public and investing these
funds to invest in a diversified portfolio of
stocks and bonds shareholders to pool their
resources
 Money market mutual funds: They have
characteristics of a mutual fund but also
function as a depository institution
 Governments can reduce problems of
moral hazard and adverse selection and
increase efficiency of markets
 Government can ensure soundness of
financial markets and prevent financial
panic
 Restrictions on entry
 Disclosure
 Restrictions on Assets and activities
 Deposit Insurance
 Limits on competition
 Restrictions on interest rates