Financial Markets and InstitutionsBy Jeff Madura

Prepared byNazmul H. Palash

Lecturer-Finance & Banking, DIU.

CHAPTER

11 Role of Financial Markets and Institutions

Chapter ObjectivesChapter Objectives

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 MarketsOverview of Financial Markets

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

Financial Market: a market in which financial assets (securities) such as stocks and bonds

can be purchased or sold

Broad Classifications of Financial Markets

Money versus Capital Markets

Primary versus Secondary Markets

Organized versus Over-the-Counter Markets

Overview of Financial MarketsOverview of Financial Markets

Primary vs. Secondary MarketsPrimary vs. Secondary Markets

PRIMARYPRIMARY New Issue of Securities

Exchange of Funds for Financial Claim

Funds for Borrower; an IOU for Lender

SECONDARYSECONDARY Trading Previously Issued

Securities

No New Funds for Issuer

Provides Liquidity for Seller

Money vs. Capital MarketsMoney vs. Capital Markets

MoneyMoney Short-Term, < 1 Year

High Quality Issuers

Debt Only

Primary Market Focus

Liquidity Market--Low Returns

CapitalCapital Long-Term, >1Yr

Range of Issuer Quality

Debt and Equity

Secondary Market Focus

Financing Investment--Higher Returns

Organized vs. Over-the-Counter Organized vs. Over-the-Counter MarketsMarkets

OrganizedOrganized Visible Marketplace

Members Trade

Securities Listed

New York Stock Exchange

OTCOTC Wired Network of

Dealers

No Central, Physical Location

All Securities Traded off the Exchanges

Money Market Securities Debt securities Only

Capital market securities Debt and equity securities

Derivative Securities Financial contracts whose value is derived from the values of

underlying assets Used for hedging (risk reduction) and speculation (risk seeking)

Securities Traded in Financial MarketsSecurities Traded in Financial Markets

Debt vs. Equity SecuritiesDebt vs. Equity Securities

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

Debt vs. Equity SecuritiesDebt vs. Equity Securities

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

Valuation of SecuritiesValuation of Securities

Value a function of: Future cash flows When cash flows are received Risk of cash flows

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 InformationInvestor Assessment of New Information

Exhibit 1.3

Economic Conditions

Industry Conditions

Firm Specific Information

Impact of Future Cash Flows

Evaluation of Security

Pricing

Investor Decision to Trade

Security prices reflect available information

New information is quickly included in security prices

Investors balance liquidity, risk, and return needs

Financial Market EfficiencyFinancial Market Efficiency

Financial Market RegulationFinancial Market Regulation

To Promote Efficiency

High level of competition

Efficient payments mechanism

Low cost risk management contracts

Why Government Regulation?

To Maintain Financial Market Stability Prevent market crashes

Circuit breakers Federal Reserve discount window

Prevent Inflation--Monetary policy

Prevent Excessive Risk Taking by Financial Institutions

Financial Market RegulationFinancial Market Regulation

Why Government Regulation?

To Provide Consumer Protection Provide adequate disclosure Set rules for business conduct

To Pursue Social Policies Transfer income and wealth Allocate saving to socially desirable areas

Housing Student loans

Financial Market RegulationFinancial Market Regulation

Why Government Regulation?

Financial Market GlobalizationFinancial Market Globalization

Increased international funds flow Increased disclosure of information Reduced transaction costs Reduced foreign regulation on capital flows Increased privatizationResults: Increased financial integration--capital

flows to highest expected risk-adjusted return

Role of Financial Institutions in Financial Role of Financial Institutions in Financial MarketsMarkets Information processing Serve special needs of lenders (liabilities) and

borrowers (assets) By denomination and term By risk and return

Lower transaction cost Serve to resolve problems of market

imperfection

Role of Financial Institutions in Role of Financial Institutions in Financial MarketsFinancial Markets

Types of Depository Financial Institutions

CommercialBanks

$5 TrillionTotal Assets

Savings Institutions

$1.3 TrillionTotal Assets

Credit Unions$.5 TrillionTotal Assets

Types of Nondepository Financial Types of Nondepository Financial InstitutionsInstitutions

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

Role of Nondepository Financial Role of Nondepository Financial InstitutionsInstitutions

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

Trends in Financial InstitutionsTrends in Financial Institutions

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 Global Expansion by Financial InstitutionsInstitutions

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