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

Power Point Slides for:

Financial Institutions, Markets, & Money, 10th EditionAuthors: Kidwell, Blackwell, Whidbee &

Peterson

Prepared by: Vladimir Kotomin,

University of Wisconsin—Eau Claireand

Lanny R. Martindale, Texas A&M University

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

5

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.

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 forfunds 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 scaleTransaction cost controlRisk management expertise

Competition pulls interest rates down

Financing less costlyProjects have higher NPVsInvestment 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 InstitutionsSavings & Loan AssociationsSavings 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 SSUscan 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

COMMERCIAL

BANKS

FEDERAL

RESERVE

SYSTEM

TREASURY

DEPARTMENT

INVESTMENT

BANKS,DEALERS,

AND BROKERS CORPORATIONS

INSTRUMENT A L A L A L A L A LTreasury 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 ofMajor 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 fundsDSUs 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.