Role of Financial Markets and Institutions
Overview of Financial Markets
n Financial markets provide for financial intermediation–financial savings to investment
n Financial markets provide payments system
n Financial markets provide means to manage risk
Primary vs. Secondary Markets
n PRIMARY
l New Issue of Securities
l Exchange of Funds for Financial Claim
l Funds for Borrower; an IOU for Lender
Money vs. Capital Markets
n Money
l Short-Term, < 1 Year
l High creditworthiness of Issuers
l Debt Only
l Liquidity Market–Low Returns
Organized vs. Over-the-Counter Markets
n Organized
l Visible Marketplace
l Members Trade
l Securities Listed
Securities Traded in Financial Markets
n Money Market Securities
l Debt securities Only
n Capital market securities
l Debt and equity securities
n Derivative Securities
l Financial contracts whose value is derived from the values of underlying assets
l Used for hedging (risk reduction) and speculation (risk seeking)
Debt vs. Equity Securities
Debt Securities: Contractual obligations (IOU) of Debtor (borrower) to Creditor (lender)
u Investor receives interest
u Capital gain/loss when sold
u Maturity date
Valuation of Securities
n Value a function of:
l Future cash flows
l When cash flows are received
l Risk of cash flows
n PV of cash flows discounted at the market required rate of return
n Value determined by market demand/supply
n Value changes with new information
Investor Assessment of New Information
Financial Market Efficiency
n In efficient markets
l Security prices reflect available information
l New information is quickly included in security prices
l Investors balance liquidity, risk, and return needs
Financial Market Regulation
l To Promote Efficiency through high level of competition
l To Maintain Financial Market Stability
u Prevent market crashes
u Prevent Inflation–Monetary policy
u Prevent Excessive Risk Taking by Financial Institutions
l To Provide Investor and Consumer Protection
Financial Market Globalization
n Increased international funds flow
l Increased availability and disclosure of information
l Reduced foreign regulation on capital flows
l Increased privatization
Results: Increased financial integration–capital flows to highest expected risk-adjusted return
Role of Financial Institutions in Financial Markets
n Information processing
n Serve special needs of lenders (liabilities) and borrowers (assets)
l By denomination and term
l By risk and return
n Lower transaction cost
Role of Financial Institutions in Financial Markets
Types of Nondepository Financial Institutions
n Insurance companies
n Mutual funds
n Pension funds
n Securities companies
l Brokers, dealers, advisors and underwriters
n Finance companies
Trends in Financial Institutions
n Rapid growth of mutual funds and pension funds
n Increased consolidation of financial institutions via mergers
n Increased competition between financial Institutions
n Growth of financial conglomerates
l E.g. keiretsu in Japan