EK0008

Financial Institution and

Capital Market
INTRODUCTION

ACCOUNTING PROGRAM
Why study Financial Markets
and Institutions?
• They are the cornerstones of the overall
financial system in which financial managers
and individual investors operate
• The structure and operations of various
financial markets and financial institutions
 Overview of Financial
Markets
• Primary Markets versus Secondary Markets
• Money Markets versus Capital Markets
• Foreign Exchange Markets
• Derivative Markets
 Primary Markets versus
Secondary Markets
• Primary Markets
• markets in which users of funds (e.g. corporations,
governments) raise funds by issuing financial
instruments (e.g. stocks and bonds)
• Secondary Markets
• markets where financial instruments are traded
among investors (e.g. NYSE, NASDAQ)
Money Markets versus Capital
Markets
• Money Markets
• markets that trade debt securities with maturities of
one year or less (e.g. CD’s, U.S. Treasury bills)
• Capital Markets
• markets that trade debt (bonds) and equity (stock)
instruments with maturities of more than one year
 Money Market Instruments
Outstanding, 1990‐2013
100,00%

50,00%

25,70% 33,70%
26,60% 23,30%
18,10% 26,50% 19,30% 28,10%
2,60%
0,00% 27,10% 35,60% 14,40% 0,20% 18,90% 0%
1990 ($2,06 trillion 2000 ($4,51 trillion 2013 ($5,31 trillion
outstanding) outstanding) outstanding)

Commercial paper Fed Funds and Repo U.S. T-bills

Negotiable CDs Banker's accept.
Capital Market Instruments
Outstanding, 1990‐2013
50,00%

43,40%

36,20%

25,00% 23,60%
25,50%
16,80% 16,70% 16,30%
11,40% 12,10%
10,60% 12,90%
10,90% 9,70%
7,70% 4,70%
9,60% 11,10% 3,70% 5,70%
0 3,50%
0,00%
1990 ($14,93 trillion 2000 ($40,6 trillion 2013 ($78,5 trillion
outstanding) outstanding) outstanding)

Corporate stocks Mortgages Corporate bonds Treasury Securities

State & Local Govt. bonds U.S. Govt agencies Bank and consumer loans
 Foreign Exchange Markets
• “FX” markets deal in trading one currency for
another (e.g. dollar for yen)
• The “spot” FX transaction involves the
immediate exchange of currencies at the
current exchange rate
• The “forward” FX transaction involves the
exchange of currencies at a specified date in
the future and at a specified exchange rate
 Derivative Security Markets
• The markets in which derivative securities
trade.
• Derivative Security
• An agreement between two parties to exchange a
standard quantity of an asset at a predetermined
price on a specified date in the future.
 Overview of Financial
Institutions
• Institutions that perform the essential function
of channeling funds from those with surplus
funds to those with shortages of funds (e.g.
banks, thrifts, insurance companies, securities
firms and investment banks, finance companies,
mutual funds, pension funds)
 Flow of Funds in a World without FIs:
Direct Transfer
Financial Claims
(Equity and debt
instruments)
Suppliers of
Users of Funds
Funds
(Corporations)
(Households)
Cash

Example: A firm sells shares directly to investors without

going through a financial institution.
 Flow of Funds in a world with FIs:
Indirect transfer

FI
Users of Funds Suppliers of Funds
(Brokers)

Cash FI
Cash
(Asset
transformers)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and insurance policies)
 Types of FIs
• Commercial banks
• depository institutions whose major assets are loans
and major liabilities are deposits
• Thrifts
• depository institutions in the form of savings and
loans, credit unions
• Insurance companies
• financial institutions that protect individuals and
corporations from adverse events
 Types of FIs
• Securities firms and investment banks
• financial institutions that underwrite securities and
engage in securities brokerage and trading
• Finance companies
• financial institutions that make loans to individuals and
businesses
• Mutual Funds
• financial institutions that pool financial resources and
invest in diversified portfolios
• Pension Funds
• financial institutions that offer savings plans for
retirement
 Services Performed by
Financial Intermediaries
• Monitoring Costs
• Liquidity and Price Risk
• Transaction Cost Services
• Maturity Intermediation
• Denomination Intermediation
 Services Provided by FIs
Benefiting the Overall Economy
• Money Supply Transmission
• Credit Allocation
• Intergenerational Wealth Transfers
• Payment Services
 Risks Faced by Financial
Institutions
• Interest Rate Risk
• Foreign Exchange Risk
• Market Risk
• Credit Risk
• Liquidity Risk
• Off‐Balance‐Sheet Risk
• Technology Risk
• Operational Risk
• Country or Sovereign Risk
• Insolvency Risk
 Regulation of Financial
Institutions
• FIs provide vital financial services to all
sectors of the economy; therefore, their
regulation is in the public interest
• In an attempt to prevent their failure and the
failure of financial markets overall
 Globalization of Financial
Markets and Institutions
• Financial Markets became more global as the
value of stocks traded in foreign markets
soared
• Foreign bond markets have served as a major
source of international capital
• Globalization also evident in the derivative
securities market
Factors Leading to Significant
Growth in Foreign Markets
• The pool of savings from foreign investors has
increased
• International investors have turned to U.S. and other
markets to expand their investment opportunities
• Information on foreign investments and markets is
now more accessible (e.g. internet)
• Some mutual funds allow ability to invest in foreign
securities with low transaction costs
• Deregulation has enhanced globalization of capital
flows