Financial Markets and Institutions By Jeff Madura

Prepared by Nazmul H. Palash Lecturer-Finance & Banking, DIU.

CHAPTER

Role of Financial Markets and Institutions

Chapter Objectives
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Describe the types of financial markets

Describe the role of financial institutions with financial markets Identify the types of financial institutions that facilitate transactions

Overview of Financial Markets

Financial Market: a market in which financial assets (securities) such as stocks and bonds can be purchased or sold
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Financial markets provide for financial intermediation--financial savings (Surplus Units) to investment (Deficit Units) Financial markets provide payments system Financial markets provide means to manage risk

Overview of Financial Markets

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Broad Classifications of Financial Markets

Money versus Capital Markets Primary versus Secondary Markets

Organized versus Over-the-Counter Markets

Primary vs. Secondary Markets

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PRIMARY
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SECONDARY
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New Issue of Securities

Trading Previously Issued Securities

Exchange of Funds for Financial Claim

No New Funds for Issuer

Funds for Borrower; an IOU for Lender

Provides Liquidity for Seller

Money vs. Capital Markets

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Money
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Capital
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Short-Term, < 1 Year High Quality Issuers Debt Only

Long-Term, >1Yr Range of Issuer Quality Debt and Equity

Primary Market Focus

Liquidity Market--Low Returns

Secondary Market Focus

Financing Investment-Higher Returns

Organized vs. Over-the-Counter Markets

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Organized
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OTC
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Visible Marketplace

Wired Network of Dealers No Central, Physical Location All Securities Traded off the Exchanges

Members Trade
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Securities Listed New York Stock Exchange

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Securities Traded in Financial Markets

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Money Market Securities

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Debt securities Only

Capital market securities

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Debt and equity securities

Derivative Securities
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Financial contracts whose value is derived from the values of underlying assets Used for hedging (risk reduction) and speculation (risk seeking)

Debt vs. Equity Securities

Debt Securities: Contractual obligations (IOU) of Debtor (borrower) to Creditor (lender)
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Investor receives interest Capital gain/loss when sold Maturity date

Debt vs. Equity Securities

Equity Securities: Claim with ownership rights and responsibilities
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Investor receives dividends if declared Capital gain/loss when sold No maturity dateneed market to sell

Valuation of Securities
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Value a function of:

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Future cash flows When cash flows are received Risk of cash flows

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Present value of cash flows discounted at the market required rate of return Value determined by market demand/supply Value changes with new information

Investor Assessment of New Information

Economic Conditions

Industry Conditions

Impact of Future Cash Flows

Evaluation of Security Pricing

Investor Decision to Trade

Firm Specific Information

Exhibit 1.3

Financial Market Efficiency

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Security prices reflect available information

New information is quickly included in security prices Investors balance liquidity, risk, and return needs

Financial Market Regulation

Why Government Regulation?

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To Promote Efficiency
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High level of competition Efficient payments mechanism

Low cost risk management contracts

Financial Market Regulation

Why Government Regulation?
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To Maintain Financial Market Stability

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Prevent market crashes

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Circuit breakers Federal Reserve discount window

Prevent Inflation--Monetary policy Prevent Excessive Risk Taking by Financial Institutions

Financial Market Regulation

Why Government Regulation?
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To Provide Consumer Protection

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Provide adequate disclosure Set rules for business conduct Transfer income and wealth Allocate saving to socially desirable areas
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To Pursue Social Policies

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Housing Student loans

Financial Market Globalization

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Increased international funds flow

Increased disclosure of information l Reduced transaction costs l Reduced foreign regulation on capital flows l Increased privatization Results: Increased financial integration--capital flows to highest expected risk-adjusted return
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Role of Financial Institutions in Financial Markets

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Information processing Serve special needs of lenders (liabilities) and borrowers (assets)
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By denomination and term By risk and return

Lower transaction cost Serve to resolve problems of market imperfection

Role of Financial Institutions in Financial Markets

Types of Depository Financial Institutions
Savings Institutions $1.3 Trillion Total Assets Credit Unions $.5 Trillion Total Assets

Commercial Banks $5 Trillion Total Assets

Types of Nondepository Financial Institutions

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Insurance companies Mutual funds Pension funds Securities companies Finance companies Security pools

Role of Nondepository Financial Institutions

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Focused on capital market Longer-term, higher risk intermediation Less focus on liquidity Less regulation Greater focus on equity investments

Trends in Financial Institutions

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Rapid growth of mutual funds and pension funds Increased consolidation of financial institutions via mergers Increased competition between financial Institutions Growth of financial conglomerates

Global Expansion by Financial Institutions

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International expansion International mergers Impact of the single European currency Emerging markets