Role of Financial Markets and Institutions

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


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