Chapter One

Introduction

Copyright © 2015 by McGraw-Hill Education. All rights reserved.

Why Study Financial Markets
and Institutions?
 Markets and institutions are primary
Markets and institutions are primary
channels
channels to
to allocate
allocate capital
capital in
in our
our society
society
 Proper
Proper capital
capital allocation
allocation leads
leads to
to growth
growth in:
in:
 Societal wealth
Societal wealth
 Income
Income
 Economic opportunity
Economic opportunity

1-2
Financial Markets

 Financial markets are one type of

Financial markets are one type of
structure
structure through
through which
which funds
funds flow
flow
 Financial markets can be distinguished
Financial markets can be distinguished
along
along two
two dimensions:
dimensions:
 primary
primary versus
versus secondary
secondary markets
markets
 money
money versus
versus capital
capital markets
markets

1-3
Primary versus Secondary
Markets
 Primary markets
Primary markets
 markets
markets in in which
which users
users of
of funds
funds (e.g.,
(e.g.,
corporations
corporations andand governments)
governments) raise
raise funds
funds by
by
issuing
issuing financial
financial instruments
instruments (e.g.,
(e.g., stocks
stocks and
and
bonds)
bonds)
 Secondary markets
Secondary markets
 markets
markets where
where existing
existing financial
financial instruments
instruments are
are
traded
traded among
among investors
investors (e.g.,
(e.g., exchange
exchange traded:
traded:
NYSE
NYSE and
and over-the-counter:
over-the-counter: NASDAQ)
NASDAQ)

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Primary versus Secondary
Markets

1-5
Primary versus Secondary
Markets
 How were primary markets affected by
How were primary markets affected by
the
the financial
financial crisis?
crisis?

 Do secondary markets add value to

Do secondary markets add value to
society
society or
or are
are they
they simply
simply aa legalized
legalized
form
form of
of gambling?
gambling?
 How
How does
does the
the existence
existence of
of secondary
secondary markets
markets
affect
affect primary
primary markets?
markets?

1-6
Answer
Primary market issuance declined sharply during the
crisis although with low interest rates bond issuance
boomed after market uncertainty declined in 2010.
Stock issuance remained weaker longer, recovering in
2012 and 2013.
Secondary markets add liquidity for risky
investments and encourage investment in primary
markets. Secondary markets also aid in price
discovery, providing up to date signals of the ongoing
value of firms. These signals also provide benchmarks
for corporate performance. It is not true that
secondary markets are simply a legalized form of
Money versus Capital Markets

 Money
Money markets
markets
 markets
marketsthatthattrade
tradedebt
debtsecurities
securitieswith
withmaturities
maturitiesof
ofone
one
year
yearor orless
less(e.g.,
(e.g.,CDs
CDsandand U.S.
U.S.Treasury
Treasurybills)
bills)
 little
littleor
orno
norisk
riskofofcapital
capitalloss,
loss,but
butlow
lowreturn
return
 Capital
Capital markets
markets
 markets
marketsthat
thattrade
tradedebt
debt(bonds)
(bonds)and
andequity
equity(stock)
(stock)
instruments
instrumentswith
withmaturities
maturitiesof
ofmore
morethan
thanone
oneyear
year
 substantial
substantialrisk
riskof
ofcapital
capitalloss,
loss,but
buthigher
higherpromised
promisedreturn
return
Figure 1.3

1-8
Money Market Instruments
Outstanding, ($Bn)

1-9
Capital Market Instruments
Outstanding, ($Bn)

1-10
Foreign Exchange (FX) Markets

 FX
FX markets
markets
 trading
tradingone
onecurrency
currencyfor
foranother
another(e.g.,
(e.g.,dollar
dollarfor
foryen)
yen)
 Spot
Spot FX
FX
 the
theimmediate
immediateexchange
exchangeof
ofcurrencies
currenciesat
atcurrent
current
exchange
exchangerates
rates
 Forward
Forward FX
FX
 the
theexchange
exchangeof ofcurrencies
currenciesin
inthe
thefuture
futureon
onaaspecific
specificdate
date
and
andat
ataapre-specified
pre-specifiedexchange
exchangeraterate

1-11
Derivative Security Markets

 Derivative security
Derivative security
 a financial security whose payoff is linked to (i.e., “derived”
a financial security whose payoff is linked to (i.e., “derived”
from)
from)another
anothersecurity
securityor
orcommodity,
commodity,
 generally an agreement to exchange a standard quantity
generally an agreement to exchange a standard quantity
of
ofassets
assetsat
ataaset
setprice
priceon
onaaspecific
specificdate
dateininthe
thefuture,
future,
 the main purpose of the derivatives markets is to transfer
the main purpose of the derivatives markets is to transfer
risk
riskbetween
betweenmarket
marketparticipants.
participants.

1-12
Derivative Security Markets
 Selected
Selected examples
examples of
of derivative
derivative securities
securities
 Exchange
Exchangelisted
listedderivatives
derivatives
 Many
Manyoptions,
options,futures
futurescontracts
contracts
 Over
Over the
thecounter
counter derivatives
derivatives
 Forward
Forwardcontracts
contracts
 Forward
Forwardrate
rateagreements
agreements
 Swaps
Swaps
 Securitized
Securitizedloans
loans

1-13
Derivatives and the Crisis

1.
1. Mortgage
Mortgagederivatives
derivativesallowed
allowedaalarger
largeramount
amountofof
mortgage
mortgagecredit
creditto
tobe
becreated
createdin
inthe
themid-2000s.
mid-2000s.
 Growing importance of ‘shadow banking system’
Growing importance of ‘shadow banking system’

2.
2. Mortgage
Mortgagederivatives
derivativesspread
spreadthe
therisk
riskof
ofmortgages
mortgagesto
toaa
broader
broader base
baseofofinvestors.
investors.

3.
3. Change
Changein inbanking
bankingfrom
from ‘originate
‘originateand
andhold’
hold’loans
loansto
to
‘originate
‘originateand
andsell’
sell’loans.
loans.
 Decline in underwriting standards on loans
Decline in underwriting standards on loans

1-14
Derivatives and the Crisis

1.
1. Subprime
Subprimemortgage
mortgagelosses
losseswere
werelarge,
large,reaching
reachingover
over
$700
$700billion.
billion.

2.
2. The
The“Great
“GreatRecession”
Recession”was wasthe
theworst
worstsince
sincethe
the“Great
“Great
Depression”
Depression”of ofthe
the1930s.
1930s.
 Trillions $ global wealth lost, peak to trough stock prices
Trillions $ global wealth lost, peak to trough stock prices
fell
fellover
over50%
50%ininthe
theU.S.
U.S.
 Lingering high unemployment and below trend growth in
Lingering high unemployment and below trend growth in
the
theU.S.
U.S.
 Sovereign debt levels in developed economies reached
Sovereign debt levels in developed economies reached
post-war
post-warall-time
all-timehighs
highs

1-15
Financial Market Regulation

 The Securities Act of 1933

The Securities Act of 1933
 full
full and
and fair
fair disclosure
disclosure and
and securities
securities registration
registration
 The Securities Exchange Act of 1934
The Securities Exchange Act of 1934
 Securities
Securities and
and Exchange
Exchange Commission
Commission (SEC)
(SEC) isis
the
the main
main regulator
regulator of
of securities
securities markets
markets

1-16
Financial Institutions (FIs)

 Financial
Financial Institutions
Institutions
 institutions
institutionsthrough
throughwhich
whichsuppliers
supplierschannel
channelmoney
moneyto
to
users
usersofof funds
funds
 Financial
Financial Institutions
Institutions are
are distinguished
distinguished by:
by:
 whether
whetherthey theyaccept
accept insured
insureddeposits
deposits
 depository versus non-depository financial
depository versus non-depository financial
institutions
institutions
 whether
whetherthey theyreceive
receivecontractual
contractual payments
payments from
from
customers
customers

1-17
Non-Intermediated (Direct)
Flows of Funds

Flow of Funds in a World without FIs

Direct Financing
Financial Claims
(equity and debt
instruments)
Users of Funds Suppliers of
(corporations) Funds
Cash (households)

1-18
Depository versus Non-Depository FIs

 Depository
Depository institutions:
institutions:
 commercial
commercialbanks,
banks,savings
savingsassociations,
associations,savings
savingsbanks,
banks,
credit
creditunions
unions
 Non-depository
Non-depository institutions
institutions
 Contractual:
Contractual:
 insurance companies, pension funds,
insurance companies, pension funds,
 Non-contractual:
Non-contractual:
 securities firms and investment banks, mutual funds.
securities firms and investment banks, mutual funds.

1-19
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

1-20
FIs Benefit the Overall Economy

 Conduit through which Federal Reserve

Conduit through which Federal Reserve
conducts
conducts monetary
monetary policy
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

1-21
Risks Faced by Financial
Institutions
 Credit  Off-balance-sheet
Credit Off-balance-sheet
 Foreign exchange  Liquidity
Foreign exchange Liquidity
 Country or  Technology
Country or Technology
sovereign
sovereign  Operational
Operational
 Interest rate
Interest rate  Insolvency
Insolvency
 Market
Market
Volcker Rule: Insured
institutions may not
engage in proprietary
trading
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Regulation of Financial
Institutions
 FIs
FIs are
are heavily
heavily regulated
regulated to
to protect
protect society
society at
at
large
large from
from market
market failures
failures
 Regulations impose a burden on FIs; before the
Regulations impose a burden on FIs; before the
financial
financial crisis,
crisis, U.S.
U.S. regulatory
regulatory changes
changes were
were
deregulatory
deregulatory inin nature
nature
 Regulators attempt to maximize social welfare
Regulators attempt to maximize social welfare
while
while minimizing
minimizing the
the burden
burden imposed
imposed by
by
regulation
regulation

1-23
Regulation of Financial
Institutions
 Dodd-Frank
Dodd-Frank Bill
Bill
1.1. Promote
Promoterobust
robust supervision
supervisionofof FIs
FIs
 Financial Service Oversight Council to identify
Financial Service Oversight Council to identify
and
andlimit
limit systemic
systemic risk,
risk,
 Broader authority for Federal Reserve (Fed) to
Broader authority for Federal Reserve (Fed) to
oversee
overseenon-bank
non-bankFIs,
FIs,
 Higher equity capital requirements,
Higher equity capital requirements,
 Registration of hedge funds and private equity
Registration of hedge funds and private equity
funds.
funds.

1-24
Regulation of Financial
Institutions
 Dodd-Frank
Dodd-Frank Bill
Bill
2.2. Comprehensive
Comprehensive supervision
supervision of
of financial
financial markets
markets
 New regulations for securitization and over
New regulations for securitization and over
the
thecounter
counter derivatives
derivatives
 Additional oversight by Fed of payment
Additional oversight by Fed of payment
systems
systems

3.3. Establishes
Establishesaa new
new Consumer
Consumer Financial
Financial
Protection
ProtectionAgency
Agency

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Globalization of Financial Markets
and Institutions
 The
Thepool
poolof
ofsavings
savingsfrom
fromforeign
foreigninvestors
investorsisis
increasing
increasingand
andinvestors
investorslook
looktotodiversify
diversifyglobally
globallynow
now
more
morethan
thanever
everbefore,
before,
 Information
Informationononforeign
foreignmarkets
marketsand andinvestments
investmentsis is
becoming
becomingreadily
readilyaccessible
accessibleand andderegulation
deregulationacross
across
the
theglobe
globeis
isallowing
allowingevenevengreater
greateraccess
accesstotoforeign
foreign
markets,
markets,
 International
Internationalmutual
mutualfunds
fundsallow
allowdiversified
diversifiedforeign
foreign
investment
investmentwith
withlow
lowtransactions
transactionscosts,
costs,
 Global
Globalcapital
capitalflows
flowsare
arelarger
largerthan
thanever.
ever.

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