chapter 2 an overview of the financial system. copyright © 2007 pearson addison-wesley. all rights...
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Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-2
Function of Financial Markets
• Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds
• Promotes economic efficiency by producing an efficient allocation of capital, which increases production
• Directly improve the well-being of consumers by allowing them to time purchases better
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Direct finance and Indirect finance
• Direct finance – funds are directly transferred from lenders to borrowers
• Indirect finance – financial intermediaries receive funds from savers and lend them to borrowers Securities are assets for the holder and
liabilities for the issuer
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1.Allows transfers of funds from person or business without investment
opportunities to one who has them
2. Improves economic efficiency
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Structure of Financial Markets
• Debt and Equity Markets Debt instruments – contractual obligation to pay the holder
fixed payments at specified dates (e.g., mortgages, bonds, car loans, student loans)
Short-term debt instruments have a maturity of less than one year
Intermediate-term debt instruments have a maturity between 1 and 10 years
Long-term debt instruments have a maturity of ten or more years
Equity – sale of ownership share (owners are residual claimants).
Owners of stock may receive dividends
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Structure of Financial Markets
• Primary and Secondary Markets Primary market = financial market in which newly
issued securities are sold. Secondary market = financial market in which
previously owned securities are sold. Investment Banks underwrite securities in primary
markets Brokers and dealers work in secondary markets
• Broker – match buyers and sellers
• Dealers – buy and sell securities
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Structure of Financial Markets
• Roles of Secondary Markets Increase liquidity of financial assets Determine security prices that help determine the
price of securities in primary markets
• Exchanges and Over-the-Counter (OTC) Markets Exchange – buyers and sellers meet in one central
location (e.g., NYSE or Chicago Board of Trade) Over-the-counter market – transactions take place
in multiple locations through dealers
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Structure of Financial Markets
• Money and Capital Markets Money markets deal in short-term debt
instruments Capital markets deal in intermediate and
longer-term debt and equity instruments
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Financial Market Instruments
• Money Market Instruments US treasury bills: 1-, 3-, 6-month maturities, discounted; no
default risk Negotiable bank certificates of deposit (NCD): transferable in
the secondary markets, large denominations Commercial paper (CP): issued by large banks or well-known
corporations, growing fast, direct finance; largest instrument Banker’s Acceptances: can be resold in the secondary
markets, use abroad in international trade Repurchase Agreements (repos): treasury bills are used to
serve as collateral, <2 weeks Federal (Fed) funds: overnight loan b/w banks of their deposits
at Fed
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Financial Market Instruments
• Capital Market Instruments Stocks: largest instruments, hold by individuals (1/2),
pensions, mutual funds, and insurance companies Mortgages: 3 government agencies, FNMA (Fannie Mae),
GNMA (Ginnie Mae), FHLMC (Freddie Mac) Corporate bonds: convertible or non-convertible US government securities: issued by US Treasury, most
liquid security US government agency securities: issued by other US gov’t
agencies, e.g., FNMA, GNMA… State and local government bonds: also called municipal
bonds, interest-exemption Consumer and bank commercial loans
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Internationalization of Financial Markets
• Foreign Bonds—sold in a foreign country and denominated in that country’s currency
• Foreign bonds may be used to avoid exchange-rate risk
• Eurobond—bond denominated in a currency other than that of the country in which it is sold
• Eurocurrencies—foreign currencies deposited in banks outside the home country Eurodollars—U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
• World Stock Markets London, Tokyo and other foreign stock exchanges have
grown in importance
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Function of Financial Intermediaries: Indirect Finance• Lower transaction costs
Economies of scale Liquidity services
• Reduce Risk Risk Sharing (Asset Transformation) Diversification
• Asymmetric Information Adverse Selection (before the transaction)—more
likely to select risky borrower Moral Hazard (after the transaction)—less likely
borrower will repay loan
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Function of Financial Intermediaries: Indirect Finance
Adverse Selection: Individuals who are willing to accept a financial (or other) contract are of lower “quality” than a typical individual in the population1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected
Moral Hazard: The existence of a contract causes one party to alter their behavior in a manner detrimental to the other party1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits
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Types of financial intermediaries• Depository institutions
Commercial banks Savings and Loan Associations Mutual savings banks Credit unions
• Contractual savings institutions Life insurance companies Fire and casualty insurance companies Pension funds and government retirement funds
• Investment intermediaries Finance companies Mutual funds Money market mutual funds Investment banks
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Regulation of the Financial System
Two Main Reasons for Regulation (Financial sector is one of the most heavily regulated sectors of the economy)
• To increase the information available to investors: Reduce adverse selection and moral hazard problems SEC forces corporations to disclose information to reduce
insider trading
• To ensure the soundness of financial intermediaries: Restrictions on entry Disclosure Laws (SEC) Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates (no longer in effect)