CHAPTER ONE

Prepared by Mr. Lavie

©2007, The McGraw-Hill Companies, All Rights Reserved

 WHY STUDY FINANCIAL MARKETS AND
INSTITUTIONS?

 They
They are
are the
the cornerstones
cornerstones of of the
the
overall
overall financial
financial system
system inin which
which
financial
financial managers
managers operate
operate
 Individuals
Individuals use
use both
both for
for investing
investing
 Corporations
Corporations and and governments
governments use use
both
both for
for financing
financing

McGraw-Hill/Irwin 1-2 ©2007, The McGraw-Hill Companies, All Rights Reserved

 OVERVIEW OF FINANCIAL MARKETS

 Debt
Debt Markets
Markets versus
versus Equity
Equity Markets
Markets
 Primary
Primary Markets
Markets versus
versus Secondary
Secondary Markets
Markets
 Money
Money Markets
Markets versus
versus Capital
Capital Markets
Markets
 Foreign
Foreign Exchange
Exchange Markets
Markets

McGraw-Hill/Irwin 1-3 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Debt Markets versus Equity Markets

 Debt Markets
E.g. Treasury bills, Bonds and mortgages (nợ có thế chấp,
có thể giao dịch ); thường là long-term
 Equity Markets
Common stocks

McGraw-Hill/Irwin 1-4 ©2007, The McGraw-Hill Companies, All Rights Reserved

 Primary Markets versus Secondary Markets

 Primary
Primary Markets
Markets
–– markets
markets inin which
which users
users ofof funds
funds (e.g.
(e.g. corporations,
corporations, governments)
governments)
raise
raise funds
funds by
by issuing
issuing financial
financial instruments
instruments (e.g.
(e.g. stocks
stocks and
and bonds)
bonds)
–– New
New security
security issues
issues sold
sold to
to initial
initial buyers
buyers
 Secondary
Secondary Markets
Markets
–– markets
markets where
where financial
financial instruments
instruments are
are traded
traded among
among investors
investors
(e.g.
(e.g. NYSE,
NYSE, NASDAQ)
NASDAQ)
–– Securities
Securities previously
previously issued
issued are
are bought
bought and
and sold
sold

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 Money Markets versus Capital Markets

 Money
Money Markets
Markets
–– markets
markets that
that trade
trade debt
debt securities
securities with
with maturities
maturities of
of one
one year
year or
or
less
less (e.g.
(e.g. CD’s,
CD’s, U.S.
U.S.Treasury
Treasury bills)
bills)
 Capital
Capital Markets
Markets
–– markets
markets that
that trade
trade debt
debt (bonds)
(bonds) and
and equity
equity (stock)
(stock) instruments
instruments
with
with maturities
maturities ofof more
more than
than one
one year
year

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 Exchanges vs Over-The-Counter Markets

 Exchanges
Exchanges
Trades
Trades conducted
conducted inin central
central locations
locations (e.g.
(e.g. HNX,
HNX, HOSE,
HOSE,
Toronto
Toronto Stock
Stock Exchange
Exchange andand New
NewYork
York Stock
Stock Exchange)
Exchange)
 Over-the-Counter
Over-the-Counter Markets
Markets
Dealers
Dealers at
at different
different locations
locations buy
buy and
and sell
sell

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 Foreign Exchange Markets

 “FX”
“FX” markets
markets deal
deal inin trading
trading oneone currency
currency
for
for another
another (E.g.
(E.g. dollar
dollar for
for dong)
dong)
 The
The “spot”
“spot” FX
FX transaction
transaction involves
involves the
the
immediate
immediate exchange
exchange of of currencies
currencies at at the
the
current
current exchange
exchange raterate
 The
The “forward”
“forward” FXFX transaction
transaction involves
involves the
the
exchange
exchange ofof currencies
currencies at at aa specified
specified date
date in
in
the
the future
future and
and at
at aa specified
specified exchange
exchange rate
rate
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 Function of Financial Markets
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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 Money Market Instruments
Outstanding, 1990-2004 ($Bn)
2000
2000

1500
1500

1000
1000

500
500

00
1990
1990 2000
2000 2004
2004
Commercial
Commercialpaper
paper Fed
FedFunds
Fundsand
andRepo
Repo U.S.
U.S.T-bills
T-bills
Negotiable
NegotiableCDs
CDs Banker's
Banker'saccept.
accept.
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 Capital Market Instruments
Outstanding, 1990-2004 ($Bn)
20000
20000
15000
15000
10000
10000
5000
5000
00
1990
1990 2000
2000 2004
2004
Corporate
Corporatestocks
stocks Mortgages
Mortgages
Corporate
Corporatebonds
bonds Treasury
TreasurySecurities
Securities
State
State&&Local
LocalGovt.
Govt.bonds
bonds U.S.
U.S.Govt
Govtagencies
agencies
Bank
Bankand
andconsumer
consumerloans
loans
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 Internationalization of Financial Markets

International Bond Market

1. Foreign bonds
2. Eurobonds
Now larger than U.S. corporate bond market
World Stock Markets
U.S. stock markets are no longer always the largest: Japan
sometimes larger

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 OVERVIEW OF FINANCIAL INSTITUTIONS

 Institutions
Institutions that
that perform
perform thethe essential
essential function
function of
of
channeling
channeling funds
funds from
from those
those with
with surplus
surplus funds
funds
to
to those
those with
with shortages
shortages of of funds
funds
E.g.
E.g. banks,
banks, thrifts,
thrifts, insurance
insurance companies,
companies, securities
securities
firms
firms and
and investment
investment banks,
banks, finance
finance companies,
companies,
mutual
mutual funds,
funds, pension
pension funds
funds

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 Flow of Funds in a World without FIs:
Direct Transfer
Financial Claims
(Equity and debt
instruments)
Users of Funds Suppliers of
(Corporations) Funds
(Households)
Cash

Example: A firm sells shares directly to investors without

going through a financial institution.

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 Flow of Funds in a world with FIs:
Indirect transfer

FI
Users of Funds Suppliers of Funds
(Brokers)

Cash FI
(Asset Cash
transformers)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and insurance policies)

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 FINANCIAL INTERMEDIARIES

Financial Intermediaries
1.Engage in process of indirect finance
2.More important source of finance than securities markets
3.Needed because of transactions costs and asymmetric information

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 Function of Financial Intermediaries

Transactions Costs
1.Financial intermediaries make profits by reducing transactions costs
2.Reduce transactions costs by developing expertise and taking
advantage of economies of scale
Risk Sharing
1.Create and sell assets with low risk characteristics and then use the
funds to buy assets with more risk (also called asset
transformation).
2.Also lower risk by helping people to diversify portfolios
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 Asymmetric Information:
Adverse Selection, and Moral Hazard
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are ones most
likely to seek loans and be selected
Moral Hazard
1. 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
McGraw-Hill/Irwin 1-18 ©2007, The McGraw-Hill Companies, All Rights Reserved
 TYPES OF FIS

 Commercial
Commercial banks banks
–– depository
depository institutions
institutions whose
whose major
major assets
assets are
are loans
loans and
and major
major liabilities
liabilities
are
are deposits
deposits
 Thrifts
Thrifts (in
(in the
the U.S)
U.S)
–– depository
depository institutions
institutions in
in the
the form
formofof savings
savings and
and loans,
loans, credit
credit unions
unions
 Insurance
Insurance companies
companies
–– financial
financial institutions
institutions that
that protect
protect individuals
individuals and
and corporations
corporations from
from
adverse
adverse events
events

(continued)
McGraw-Hill/Irwin 1-19 ©2007, The McGraw-Hill Companies, All Rights Reserved
 TYPES OF FIS
 Pension
Pension Funds
Funds
–– financial
financial institutions
institutions that
that offer
offer savings
savings plans
plans for
for retirement
retirement
 Finance
Finance companies
companies
–– financial
financial institutions
institutions that
that make
make loans
loans to
to individuals
individuals and
and businesses
businesses
 Mutual
Mutual Funds
Funds
–– financial
financial institutions
institutions that
that pool
pool financial
financial resources
resources and
and invest
invest in
in
diversified
diversified portfolios
portfolios
 Securities
Securities firms
firms and
andinvestment
investment banksbanks
–– financial
financial institutions
institutions that
that underwrite
underwrite securities
securities and
and engage
engageinin securities
securities
brokerage
brokerage and
and trading
trading
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 Financial Intermediaries

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 Size of Financial Intermediaries

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 REGULATION OF FINANCIAL MARKETS

Two Main Reasons for Regulation

1.Increase information to investors
A. Decreases adverse selection and moral hazard problems
B. Securities commissions force corporations to disclose information
2.Ensuring the soundness of financial intermediaries
A. Prevents financial panics
B. Chartering, reporting requirements, restrictions on assets and activities,
deposit insurance, and anti-competitive measures

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