Chapter 1: An Overview of Financial Markets and Institutions

There are Three Types of Economic Units:

1. Households : They Receive Income and make expenditures
2. Business Firms: They Sell Goods and Services and Receive Income, Pay for
wages.
3. Government: They Receive Tax and pay for government purchases.
- Budget Position: it can be one of the following:
1. Deficit Position: Income < Expenditure.
2. Balance Position: Income = Expenditure.
3. Surplus Position: Income > Expenditure.
Financial System is transferring purchasing power from SSU to DSU.
Financial Claims (IOU):
Is written promise by DSU to pay sum of money plus interest, it is an assets for SSU
and liability for DSU, if IOU can be resold, it called "marketability".
- If the borrower wants to borrow, he issuing financial claims.
- If the lender wants to lend, he buying financial claims.
Types of financial claims:
There are two types of financial claims:
1. Debt financing: loans and bonds (just lend and borrow), also called fixedincome securities.
- Bonds can be trading (liquid).
- Loans cannot be trading.
2. Equity financing: stocks (ownership stocks).
- There net income is divided into two parts, either dividend (receive money
now), or Retained earnings (invest the existing money now to receive more in the
future).
Types of Investment:
There are two types of investment:
1. Financial Investment: Lend your money to a borrower and receive interest.
2. Economic Investment: Borrowing a money and invest it.
Transferring Funds from SSU to DSU:
It done either by using direct financing or indirect financing.

Direct Financing:
- DSU's is issues financial claims (it will be their liability), SSU's is buying
these financial claims (it will be their asset) directly or through an institutional
arrangements.
- The financial claims issued by direct financing called "Direct Claims" and
their sold in "Direct Credit Market".
SSU's
Assets

DSU's
Liabilities

- Money
+ Direct Claims

Assets
+ Money

Liabilities
+ Direct Claims

Institutional Arrangements:
Private Placement: Simplest method of transferring funds through sells an entire
security issued by DSU to single institutional investor or small group of such
investors. It is faster than IPO and has low transaction cost.
Brokers and Dealers: to aid in the search processes to bringing buyers and sellers
together.
Brokers: execute their clients transactions at best possible price, their profits is the
commission fee charged from their services.
Dealers: primary function to "make a market" for securities, they buying securities
at bid-price and sell it at ask-price for the investors, their profits is called bid-ask
spread.
- Bid-price: higher price by dealers to purchase a given security.
- Ask-price: lowest price at which dealers will sell the security.
- Bid-ask spread: the differences between bid and ask prices, also called
Dealers Gross Profit.
Investment Bankers: they helps DSU's newly to create a market, their important
economic function is the Risk Bearing, also called "Underwriting".
- Underwriting: is the process of purchase an entire issue of stocks or bonds
from the DSU's at a guaranteed fixed price, and resell it individually to
investors either by IPO or Private Placement.

- Underwriting spread: is the difference between the fixed price paid for the
securities, and the price at which they resold, it is the profit of investment
bankers.
Problems with Direct Financing:
1. Large denomination of the securities sold in direct credit market.
2. DSU's must find SSU's that want primary claims with precisely of
characteristics they can and willing to sell (double coincidence of wants).
Indirect Financing: is the financing through financial intermediaries.
Financial Intermediaries: firms that specialize in intermediation.
Intermediation: Purchase direct claims (their asset) with one set of characteristics
from DSU's and transform it into indirect claims (their liability) with different set of
characteristics, which they sell to the SSU. (Look at the following balance sheets)
SSU's
Assets
- Money
+ Indirect Claims

Financial Intermediaries
Liabilities

Assets
+ Direct Claims

Liabilities
+ Indirect
Claims

DSU's
Assets
+ Money

Liabilities
+ Direct Claims

The Benefits of Financial Intermediaries:

- Financial Intermediaries can achieve economies of scale because of their
specialization.
- Financial Intermediaries can reduce transaction cost involved in searching for
credit information.
- Financial Intermediaries can reduce the problem of unreliable information
because of its intimate knowledge about the borrowers.
Intermediation Services:
1. Denomination divisibility: produce wide range of denomination by pooling
funds of many individuals and investing them in direct securities of varying
size (borrow small amount and lend large amount).
2. Currency transformation: buying in one currency and selling in another.
3. Maturity flexibility: borrow short-term and lend long-term.
4. Credit risk diversification: invest in many portfolios.
5. Liquidity: manage our liquidity through maturity flexibility and denomination

divisibility and ability to convert assets into cash without losing value.
6. Information Intermediation: deal with problem of asymmetric information.
Asymmetric information: different information between lenders and
borrowers
Problems with asymmetric information:
1. Before Transaction: Adverse Selection (Lend to wrong person).
2. After Transaction: Moral hazard (Make bad choice which will make
repayment of loan difficult).
Types of Financial Intermediaries:
- Depository Institutions: most commonly recognized intermediaries because
most people use their services on a daily basis. The deposits are devoid of any
risk of loss of principal and ate highly liquid.
Commercial Banks:
1. Largest and most diversified intermediaries based on range of assets.
2. Their liabilities are in the form of checking accounts, saving accounts and
various time deposits.
3. Their assets are loans in different denomination and maturities
4. highly regulated
5. Play a very important role in the economic growth.
6. To manage their liquidity, they keep reserves and invest it in short-term
bond or treasury bills [T-Bills: short-term, safe and very liquid].
Thrift Institutions: they issue saving accounts and use funds for longterm investment to finance mortgage.
Credit Unions: small, non-profit, cooperative, consumer organized
institutions owned entirely by their member-customers.

- Contractual Saving Institutions: obtain funds under long-term contractual

arrangement and invest the funds in the capital market, these institutions have a
steady cash inflow from contractual commitments with their insurance
policyholders and pension fund participation.
Life Insurance: obtain funds by selling insurance policies that protect
against loss of income from premature death or retirement.
1. Predictable inflow of funds.
2. Predictable outflow

3. invest in high yielding long-term assets

Causality Insurance: sell protection against loss of property from fire,
theft, and accident.
1. Predictable inflow.
2. not very predictable outflow
3. Invest in short-term and highly marketable securities.
Pension Funds: obtain funds from employer and employee contributions
during employee's working years and provide monthly payment upon
retirement.
1. Predictable inflow and outflow
2. Invest in highly yielding long-term assets.
Note: In insurance companies, the fund received called Premiums.
Note2: In Causality Insurance, there is More Liquid Problem.
- Investment Funds: sell shares to investors and use these funds to purchase
financial claims. They offer investors the benefits of both denomination
flexibility and default risk intermediation.
Mutual Funds: sell equity shares to investors and use these funds to
purchase stock or bonds.
Advantages of Mutual Funds over direct investment:
1. Provides small investors access to reduced investment risk resulted from
diversification.
2. Economies of scale.
3. Professional Financial Managers.
Money Market Mutual Funds: Are the mutual funds that invest in shortterm with low default risk securities.

- Other Types of Financial Intermediaries:

Finance Companies: make loans to consumers and small businesses,
unlike commercial banks, they do not accept saving deposits from
consumers but they obtain funds from issuing commercial papers(short
term claims).
Federal Agencies: the primary purposes of federal agencies are to reduce
the cost of funds and increase the availability of funds to target sectors in
the economy by selling debt instruments called agency securities, most of

the funds provided by the federal agencies support agriculture and housing
because of these sectors to the nation's well being.
Types of financial Markets:
1. Primary and Secondary Markets: in Primary market, they create claims,
but in secondary market, they trading with the existing claims.
2. Money and Capital Markets:
Money is short-term (maturity 1 year) and it is market for liquidity
with higher efficiency.
Types of Money Market: T-Bills, Commercial Papers, and CD's
(Certificate of Deposits: issued by high banks, you can deposit your
money within one year with large denomination (Time Deposits), with
Interactive Interest rate, and you can negotiate with them on interest).
Note: CD's can be Short-Term or Long-Term.
Characteristics of Money Market Securities:
1. Short-Term.
2. Large Denomination amount, whole sale market (for big
investors/players).
3. Low Default Risk.
4. High marketability "Liquidity".
5. Close Substitute, Short-term interest rate are similar.
6. Sold at a discount (below face value).
Capital is long-term (maturity > 1 year) and it is market for economic
investment, it leads to economic growth.
Types of Capital Market: T-Bonds, Corporate Bonds, Loans
(Mortgages), Stocks.
3. Organized Exchanges and Over-The-Counter Markets: Organized
Security Exchange provide a physical meeting place and communication
facilities for members to conduct their transaction under a specific rules and
regulations. Only members of the exchange may use the facilities (exclusive),
and only securities listed on the exchange can be traded.
Financial Claims also can be traded "over the counter" by visiting of phoning
an "over the counter" dealer or by computer system. "over the counter" is
available for any licensed dealer (inclusive).
4. Debt and Equity Markets:
Equity is Stocks and Debt is Loans and Bonds, for a company bond financing are
riskier, but they dont depend on stocks 100% because if they continuing to issue
a stocks, that leads stock price to go down (financial leverage).
Some Points regarding to this chapter:

Federal Funds is Short-Term loans between banks.

Repurchase Agreement (REPO) sells a security (at low price for
lending) and buys it back (at high price for borrowing).
Bankers Acceptance: Bank Guarantee to . .
Real Investment is Long-Term Investment.
Capital market is finance Long-Term Investment.
Money Market helps lenders and borrowers to manage their liquidity.
Capital Market is finance Economic investment.
Commodities is not a financial claims, it is financial goods.
Risks faced by financial institutions:
1. Credit (Default) Risk: default risk of borrowing because the lender is
accepting the possibility that the borrower will fail to repay the loan plus
interest. We can reduce this risk by diversification, conduct a careful credit
analysis of the borrower to measure default risk exposure, and monitor the
borrower over time of the loan or investment to detect any critical changes
in financial health
2. Interest Rate Risk: risk of fluctuation in a securities price or reinvestment
income. It is applicable only to bonds but also to financial institutions
balance sheet.
Note: There is negative relationship between stock price and interest rate.
3. Liquidity Risk: is the risk that a financial institution will be unable to
generate sufficient inflow to meet cash outflow. We can reduce this risk by
invest in money market securities.
4. Foreign Exchange Risk: is the fluctuation un the value of financial
institution that arises from fluctuation in exchange rates. We can reduce
this risk by diversification and currency hedging.
Currency Hedging: enter into forward contracts with fixed rate now and the
delivery in the future.
5. Political Risk: risk of fluctuation in value of financial institutions because
of government action. We can reduce this risk by diversification.
Chapter Key Points
1. The role of the financial system is to collect funds from lenders and to allocate them to
borrowers for real (economic) investment or for current consumption. The key elements of
the financial system are financial markets, financial institutions (intermediaries) and financial
claims.

2. Financial markets exist to facilitate the transfer of funds from lenders who have a surplus of
funds to borrowers who have a shortage of funds. Financial markets can do this either
through direct finance, in which borrowers borrow funds directly from lenders by selling
them securities, or through indirect finance, which involves a financial intermediary who
stands between the lender and the borrower and helps transfer funds from one to the other.
3. Business firms and government are the major issuers of financial claims (deficit spending
units), and households are the major holders of financial claims (surplus spending units).
4. Financial intermediaries acquire financial claims with funds obtained by issuing their own
liabilities. The type of financial claims that each intermediary acquires depends on its business
objectives, its tax status, and the type of liabilities it has issued to obtain its funds.
5. Financial intermediaries can be classified, based on their sources of funds (liabilities) and uses
of funds (assets), as:
i. Depository Institutions - commercial banks and credit unions
ii. Savings Institutions - life insurance companies, casualty insurance companies, and
pension funds
iii. Investment Institutions - mutual funds and finance companies
6. The benefits of financial intermediaries include (a) reduce transaction costs because of
economies of scale, (b) reduce risk through diversification, and (c) solve the asymmetric of
information problems - adverse selection (before the transaction) and moral hazard (after
the transaction).
7. The key services that financial intermediaries provide to investors are (a) denomination
divisibility, (b) currency transformation, (c) maturity flexibility, (d) risk diversification, and (e)
liquidity.
8. Financial markets can be classified as (a) primary and secondary markets, (b) organized and
over-the-counter markets, (c) money and capital markets, and (d) debt and equity.
9. The secondary market allows investors to adjust their portfolios and change their risk
exposure. An active secondary market enhances the primary market as investors are
encouraged to buy new securities if the secondary market provides liquidity.
10. The economic role of the money market is to provide an efficient means for investors to
adjust their liquidity positions. The economic role of the capital market is to provide
financing for long-term capital investments.
11. The general characteristics of money market securities are (a) short-term maturity, (b) low
default risk, and (c) high marketability (liquidity).
12. The risks faced by financial institutions are credit risk, interest rate risk, liquidity risk, foreign
exchange risk, and political risk.

Basic Options Concepts

An option give you the right to buy (call) or sell(put) the underlying asset at a specified price
(strike price) during a specified period (until the 3rd Friday of the expiration month).

Options are available in several strike prices above and below the current price of the
underlying asset. Stocks priced below $25 per share usually have strike prices at 2 dollar
intervals. Stocks priced above $25 per share usually have strike prices at 5 dollar intervals.

The price of an option (called the option premium) is determined by the current price of the
underlying asset, the strike price of the option, the time remaining until expiration, and
volatility of the underlying asset.

Each stock has a corresponding cycle of months that it offers options in. There are three fixed
expiration cycles available. Each cycle has a 4-month interval:
1. January, April, July, and October
2. February, May, August, and November
3. March, June, September, and December

The option premium is priced on a per share basis. Each option on a stock corresponds to
100 shares. Therefore, if the option premium is priced at $2, the option on the stock (the total
option premium) would be $200 ($2 x 100 = $200).