Power Point Slides for:

Financial Institutions, Markets, and Money, 9th Edition

Authors: Kidwell, Blackwell, Whidbee & Peterson
Prepared by: Babu G. Baradwaj, Towson University And Lanny R. Martindale, Texas A&M University

Copyright 2006 John Wiley & Sons, Inc.

CHAPTER 1

An Overview of Financial Markets and Institutions

The Financial System

Provides for efficient flow of funds from saving to investment by bringing savers and borrowers together via financial markets and financial institutions.

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Exhibit 1.1 Transfer of Funds

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Basic components of the financial system: Markets and institutions.

Financial markets are markets for financial instruments, also called financial claims or securities.

Financial institutions (also called financial intermediaries) facilitate flows of funds from savers to borrowers.

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Economic units with financial needs: Households, Businesses, Governments.

Households supply labor, demand products, and save for the future. Businesses demand labor, supply products, and invest in productive assets. Governments collect taxes and provide public goods (e.g. education, defense).

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Budget positions creating financial needs of economic units: Surplus or deficit.

Surplus spending units ( SSUs) have income for the period that exceeds spending, resulting in savings.
Other words for SSU are saver, lender, or investor. Most SSUs are households.

Deficit spending units (DSUs) have spending for the period that exceeds income.
Another word for DSU is borrower. Most DSUs are businesses or governments.
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Financial claims arise as SSUs lend to DSUs.

SSUs claim against DSU is liability to DSU and asset to SSU. Ones liability is anothers asset: What is payable by one is receivable by another. Assets arising this way are financial assets. The financial system balancestotal financial assets equal total liabilities.
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Marketability: Ease with which a financial asset may be sold to another SSU.

Ability to resell financial claims makes them more liquid by giving SSUs choices:

Match maturity of claim to planned investment period; Buy claim with longer maturity, but sell at end of period; or Buy claim with shorter maturity, then reinvest.

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Direct Financing: The simplest way for funds to flow.

DSU and SSU find each other and bargain SSU transfers funds directly to DSU DSU issues claim directly to SSU Preferences of both must match as to-Amount -Maturity -Risk -Liquidity

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Direct Financing: efficient for large transactions if preferences match.

DSUs and SSUs seize the day DSUs fund desired projects immediately. SSUs earn timely returns on savings. Direct markets are wholesale markets. Transactions typically $1 million or more. Institutional arrangements common.

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Institutional arrangements common in direct finance.

Private placements are simplest.

Investment bankers underwrite new issues of securities. Brokers and dealers bring buyers and sellers of direct claims together.

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Private placements are simplest.

DSU sells whole security issue to one investor or investor group. Advantages include speed and low transactions costs.

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Investment bankers underwrite new issues of securities.

Buy entire issues of securities from DSUs Find SSUs to buy securities at higher price Profit from difference - underwriting spread

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Brokers and dealers Brokers buy or sell at best possible price for their clients. Dealers make markets by carrying inventories of securities.
buy at bid price; sell at ask price Bid-ask spread is dealers gross profit

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Problem with direct financing: DSUs and SSUs cannot always match preferences.

Not every SSU can afford wholesale denominations of $1 million or more. DSUs and SSUs often prefer different terms to maturity.

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Indirect Financing (Financial Intermediation):

Financial intermediaries transform claims:

raise funds by issuing claims to SSUs; use funds to buy claims issued by DSUs. Claims can have unmatched characteristics: SSU has claim against intermediary; Intermediary has claim against DSU.

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Financial intermediaries transform claims

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Familiar forms of financial intermediation

Commercial Banking Insurance

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Commercial Banks

Take deposits and make loans Depositors are SSUs Borrowers are DSUs.

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Insurance Companies

Issue policies, collect premiums, and invest in stocks and bonds.

Policyholders are SSUs; Businesses or governments are DSUs.

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Benefits of financial intermediation are a primary rationale for the financial system.

Financial intermediaries lower the cost of financial services as they pursue profit. Financial intermediaries perform 5 basic services as they transform claims.

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Intermediaries lower the cost of financial services as they pursue profit.

3 sources of comparative advantage: Economies of scale Transaction cost control Risk management expertise

Competition pulls interest rates down

Financing less costly Projects have higher NPVs Investment in real assets boosts economy
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Intermediaries perform 5 basic services as they transform claims.

Denomination Divisibility pool savings of many small SSUs into large investments.

Currency Transformation buy and sell financial claims denominated in various currencies. Maturity Flexibility Offer different ranges of maturities to both DSUs and SSUs.

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Intermediation Services, cont.

Credit Risk Diversification Assume credit risks of DSUs; spread risk over many different types of DSUs. Liquidity Give SSUs and DSUs different choices about when, to what extent, and for how long to commit to financial relationships.

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4 Major types of financial intermediaries transform claims to meet various needs.

Deposit-type or Depository Institutions Contractual Savings Institutions Investment Funds Other Institutions

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Depository Institutions take deposits and make loans.

Commercial Banks Thrift Institutions

Savings & Loan Associations Savings Banks

Credit Unions

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Commercial Banks Largest single class of financial institution

Issue wide variety of deposit products checking, savings, time deposits

Carry widely diversified portfolios of loans, leases, government securities

May offer trust or underwriting services

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Thrift Institutions
Closely resemble commercial banks Focus more on real estate loans, savings deposits, and time deposits

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Credit Unions: Unique Characteristics Mutual ownership -owned by depositors or members Common bond - members must share some meaningful common association Not-for-profit and tax - exempt

Restricted mostly to small consumer loans

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Contractual Institutions bring long-term savers and borrowers together.

Life Insurance Companies Casualty Insurance Companies Pension Funds

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Life Insurance Companies insure against lost income at death.

Policyholders pay premiums, which are pooled and invested in stocks, bonds, and mortgages Investment earnings cover the costs and reward the risks of the insurance company Investments are liquidated to pay benefits.

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Casualty Insurance Companies cover property against loss or damage.

Sources and uses of funds resemble those of life insurers, but Casualty claims are not as predictable as death claims; so More assets are in short-term, easily marketable investments

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Pension Funds help workers plan for retirement.

Workers and/or employers make contributions, which are pooled and invested in stocks, bonds, and mortgages Net of administrative costs, investment earnings are reinvested and compounded Retirement benefits replace paychecks (at least partly)

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Investment Funds help small investors share the benefits of large investments.

Mutual Funds provide intermediated access to various capital markets shareholders money is pooled and invested in stocks, bonds, or other securities according to some objective Money Market Mutual Funds (MMMFs) are uninsured substitutes for deposit accounts MMMFs buy money market instruments wholesale, pay investors interest, and allow limited check-writing

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Other Financial Institutions

Finance Companies Make loans but do not take deposits; raise loanable funds in commercial paper market and from shareholders Federal Agencies Issue agency securities backed by government and lend at sub-market rates for favored social purposes

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Financial Markets are classified in several ways.

Primary and Secondary Organized and Over-the-Counter Spot and Futures Options Foreign Exchange International and Domestic Money and Capital

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Primary and Secondary Markets

Primary markets are where financial claims are born: DSUs receive funds, claims are first issued Secondary markets are where financial claims liveare resold and repriced Claims become more liquid because SSUs can set their own holding periods Trading sets prices and yields of widely held securities

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Organized and Over-the-Counter Markets

Organized Exchanges: physical, relatively exclusive.
Physical trading floor and facilities available to members of exchange, for securities listed on exchange. New York Stock Exchange Chicago Board of Trade (futures) OTC Markets: virtual, relatively inclusive. Decentralized network available to any licensed dealer willing to buy access and obey rules, for wide range of securities. The NASDAQ is a famous OTC market.

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Spot and Futures Markets

Spot Markets: immediate payment for immediate delivery

Futures or Forward Markets: immediate payment for promise of future delivery

Futures contracts: standardized as to amounts, forms, and dates; trade on organized exchanges Forward contracts: individualized between parties with particular needs

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Option Markets Rights in underlying securities or commodities writer grants owner some exclusive right for some certain time Main types of options: Puts (options to sell) Calls (options to buy) Options on listed securities and widely held commodities trade actively on organized exchanges

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Foreign Exchange Markets

Any currency is convertible to any other at some exchange rate Forex involves spot, future, forward, and option markets

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International and Domestic Markets

Help participants diversify both sources and uses of funds Examples of major international markets:
EurodollarsUS dollars deposited outside U.S. Eurobondsbonds issued outside US but denominated in $US

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Money and Capital Markets

Money markets: wholesale markets for short-term debt instruments resembling money itself Capital markets: where capital goods are permanently financed through long-term financial instruments
(Capital goodsreal assets held long-term to produce wealthland, buildings, equipment, etc.)

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Money Markets Help participants adjust liquidity

DSUs borrow short-term to fund current operations SSUs lend short-term to avoid holding idle cash

Common characteristics of money market instruments

Short maturities (usually 90 days or less) High liquidity (active secondary markets) Low risk (and consequently low yield) Dealer/OTC more than organized exchange
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Examples of Major Money Market Instruments

Treasury Bills Negotiable Certificates of Deposit Commercial Paper Federal Funds (Fed Funds)

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Money Market Balance Sheet Position of Major Participants

INSTRUMENT Treasury bills Agency securities Negotiable CDs Commercial paper Bankers acceptances Federal Funds Repurchase agreements

COMMERCIAL BANKS A L

FEDERAL RESERVE SYSTEM A L

TREASURY DEPARTMENT A L

INVESTMENT BANKS, DEALERS, AND BROKERS A L

CORPORATIONS A L

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Capital Markets

Help participants build wealth

DSUs seek long-term financing for capital projects SSUs seek highest possible return for given risk

Differences from money markets

Long maturities (5 to 30 years) Less liquidity
(secondary markets active but more volatile)

Higher risk in most cases

(with higher potential yield)

Traded wholesale and retail on organized exchanges and in OTC markets

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Examples of Major Capital Market Instruments

Common stock Corporate bonds Municipal bonds Mortgages

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Efficiency in financial markets

Allocational Efficiency: highest/best use of funds DSUs try to fund projects with best cost/benefit ratios SSUs try to invest for best possible return for given maturity and risk Informational Efficiency: prices reflect relevant information Informationally efficient markets reprice quickly on new information; informationally inefficient markets offer opportunities to buy underpriced assets or sell overpriced assets Operational Efficiency: transactions costs minimized
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Risks of Financial Institutions

Credit or default risk: risk that a DSU may not pay as agreed Interest rate risk: fluctuations in a security's price or reinvestment income caused by changes in market interest rates Liquidity risk: risk that a financial institution may be unable to disburse required cash outflows, even if essentially profitable

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Risks of Financial Institutions, cont.

Foreign exchange risk: effect of exchange rate fluctuations on profit of financial institution Political risk: risk of government or regulatory action harmful to interests of financial institution.

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