FNCE 4070FINANCIAL MARKETS AND INSTITUTIONS

Professor Michael PalmerProfessor of FinanceUniversity of Colorado at BoulderSpring Semester 2011Lecture 2: Understanding Financial Markets and Institutions

Financial Markets and Financial Institutions How would you define these?

Perhaps in terms of functions? What roles do financial markets perform?

Perhaps in terms of organizations or institutions? What are the organizations and institutions involved in

financial markets. Commercial organizations Governmental organizations

Working Definitions Financial Markets (Functions):

“Markets through which entities with surplus (“excess”) financial funds transfer those surplus funds to entities who have a shortage (“shortfall”) of available funds.”

Stock markets, bond markets, mortgage markets, money markets…

Other functions to follow (see following slides). Financial Institutions (Organizations):

Commercial entities that facilitate and manage the movement of funds from surplus entities to final borrowers.

Commercial banks, investment banks, asset managers (pension funds, insurance companies), hedge funds, foreign exchange brokers…

Governmental entities that are involved in and/or regulate financial markets

Central banks, regulatory agencies

Functions of Financial Markets

Mechanism for raising funds! Done in primary financial markets (e.g., IPOs)

Mechanism for converting financial assets into cash before maturity. Done in secondary financial markets (e.g., NYSE,

OTC bond markets) Provides the means for entities to protect their

financial/commercial positions. Done in derivatives markets (options, futures,

forwards) Mechanism for generating a return on

surplus funds. Through interest, dividends, capital appreciation

Functions of Financial Markets Allocates financial resources among

competing users. And, we assume, if done so in the most efficient manner (i.e., to

the most productive users): The process will improve economic efficiency and Result in highest possible economic growth!

Provides financial signals to market participants Interest rates, stock prices, exchange rates as measures of

market’s perception of risk and changing risk: Stock prices and interest rates may tell us something about the

market’s assessment of companies, financial institutions, and even overall financial markets: 2008 credit crisis.

Exchange rates and government interest rate spreads may tell us something about the market’s assessment of countries or regions): 2010 – 2011 Crisis in the Euro-zone.

Perhaps we can use financial market signals as a leading indicator of economic activity.

January 21: General Electric (GE, +4.9%) posted better-than-expected earnings and forecasted increasing profits in the coming years.

Exchange Rate Signals

Stock Market as a Leading Indicator (of Future Economic Activity) Signal

Stock Market as a Leading Indicator (of Future Economic Activity) Signal

Stock Market as a Leading Indicator (of Future Economic Activity) Signal

Predicting the End of a Recession Forecasters have

noted that for the U.S. historically investors start discounting a recovering before the end of a recession.

Direct Versus Indirect Finance A financial system offers two different ways for funds to

flow from investors (lenders) to borrowers:  (1) direct flows to borrowers through financial markets, and (2) indirect flows through financial intermediaries, such as

commercial banks, pension funds, and mutual funds. Direct Finance involves the transfer of funds from the

initial investor to the ultimate borrower, generally through a third party.  Direct securities are sold to the public through an underwriter,

i.e., a financial firm that purchases them from the issuer with the intention of reselling them at a profit.

Indirect Finance involves the flow of funds from the initial investor to a financial intermediary who pools the funds of many investors in order to relend at a markup over the cost of the funds.  Ultimate borrowers are normally unknown to the initial investor. 

Illustrating the Flow of Funds Through an Economy

Direct Financial Flows Borrower-spenders obtaining funds directly from

lender-savers through the selling of financial instruments (i.e., liabilities or equity shares): Borrowers issuing bonds in primary markets Borrowers issuing stock in primary markets

Financial institutions play a role in this process: Investment bankers underwriting new publicly offered

issues or arranging for private placements. However, these financial institutions do not manage

the funds of lender-savers, they simply carry out transactions on behalf of lender-savers. These financial institutions act as dealers, in that the

facilitate the transfer of securities from original issuers to lender-savers.

Indirect Financial Flows Borrower-spenders obtaining funds from financial

institutions (i.e., financial intermediaries). Lender-savers place funds with financial institutions

who pool funds and then make decisions about lending or investing:

Commercial banks, saving associations, credit unions Accepting deposits and then making loans.

Insurance companies Accepting policy receipts and then making investments.

Mutual funds (UK: Unit Trusts) Selling shares and making investments.

Hedge funds, private equity, mortgage brokers, finance companies

Raising capital (debt or equity) and making investments This process is called financial intermediation.

Reasons for Financial Intermediation: Transactions Costs Transactions Costs: Refers to the time and

money spent in carrying out financial transactions.

Involves search costs and monitoring costs. It is assumed that financial intermediaries

can reduce transactions costs because they have critical expertise and they can also take advantage of economies of scale.

This encourages lender-savers to place funds in these financial intermediaries and have these intermediaries manage their funds.

Observations on Financial Flows Majority of funds raised by corporations is

through financial intermediaries (i.e., indirect financing): This is true throughout industrial world:

U.S. , U.K., Canada, Germany, France, Japan

With regard to the composition of the direct markets, the picture is mixed in the industrial world: U.S. and Japan: bond markets are larger than

stock market. France and Italy: bond and stock markets about

equal in size.

Internationalization (Globalization) of Financial Markets Before the mid 1980s, most financial markets were segmented

(closed) to the rest of the world. Exception: the U.S. financial markets. Non-US markets were also relative small by U.S. standards.

Over the last three decades, financial markets around the world have been deregulated to allow for freer cross border capital flows.

Additionally, the growth in savings in foreign countries has contributed to the growth in non-U.S. financial markets (Japan and Western Europe).

Important regional development in Europe, i.e., the formation of the euro-zone have also contributed to the growth of non-U.S. financial markets.

Bottom line: financial markets around the world are increasing in importance as sources of funds and potential investment.

Implications of Financial Market Globalization Today foreign markets are potentially attractive

as sources of funds and opportunities for investment. This can be summarized as follows: Major corporations are no longer confined to their

domestic financial markets for sources of funds. Governments are no longer confined to their

domestic markets for sources of funds. Financial institutions and individual investors are

no longer confined to their domestic financial markets for investments.

International Comparison of Household Financial Asset Allocation: Differences in Risk Taking Characteristics

Household financial asset allocation (average 1995-2002) % of GDP

0

20

40

60

80

100

120

140

160

180

Euro area UK US Japan

Banks

Insurance & pension funds

Investment funds

Non-share securities

Shares & other equity

Other

Characteristics of an Efficient Financial Market (1) Transparent:

All participants will have access to reliable and important information at the same time. Importance of trading platforms to transparency.

How quickly is trading information made available? Do all potential traders have access to same trading

information (bid and ask prices publicly displayed). Importance of financial services providers to

transparency in disseminating financial information. Dow Jones, Bloomberg, Reuters.

Central banks and central bankers also play in role in this process by pursuing transparency in terms of their monetary policy processes. Web sites: http://www.bis.org/cbanks.htm

Efficient Financial Market (2) Adequate, but Not Excessive, Regulation:

Financial markets need to have regulation which ensures a level and fair playing field and appropriate behavior. Regulation needs:

To discourage insider trading, price manipulations, unethical behavior

Provide appropriate reporting of financial information to markets. Securities and Exchange Act of 1934 makes it unlawful for any

person "to use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device…”

Issue for regulators: A what point does regulation become a burden (excessive) and/or drive financial service providers to other markets? Cost – Benefit Analysis done by regulators. U.S. Sarbanes Oxley Act (2002) Regulation of hedge funds.

Efficient Financial Market (3) Competition:

Markets need to be structured and regulated so as to offer easy access and exit. Not segmenting financial service providers. Not overly protecting (or rescuing) poorly run firms.

Moral hazard issue Applies to both domestic and foreign entities. Will ensure best prices and services for end users.

(4) Market Structure which Allows for Innovation: To provide needed new services and new product

development. Allow financial service providers to respond to needs of end

users. Development of derivative products in the 1970s through today.

Major Issue Facing Participants in Financial Markets Are the prices of financial instruments

potentially unstable? How volatile are they? Are they subject to? Quick and large short term moves. Substantial longer term trend changes

Quick answer: YES!!! Volatility is one major issue facing

participants in financial markets.

Short and Long Term Interest Rates

Changes in Stock Prices

Changes in Exchange Rates

Impact of Changes in Financial Variables Changes in interest rates:

Affect the cost of borrowing (end users and intermediaries) Influence the returns (and profit margins) to interest sensitive

financial institutions (e.g., banks) and the borrowings/investments of non-financial sectors (household and companies).

Affect asset prices (bonds, stocks, foreign exchange). Impact on the M&A market (leveraging activities) Impact on mortgage markets.

Changes in stock prices: Affect the economy’s perception of wealth:

Influence spending decisions (through the “wealth effect”). Affect the IPO market and M&A market (P/E multiples)

Changes in exchange rates: Affect the competitive position of global firms, exporters and

importers. Affect the returns to global investment funds (mutual funds, pension

funds).

Defining and Classifying Financial Instruments

How would you define a financial instrument?

How would you classify financial instruments and financial markets?

Definition of Financial Instruments Financial Instrument: (1) Instruments which represent a claim on the issuer’s (of

the financial instrument) future income and/or assets. Examples include: Bonds: Debt instruments with a contractual agreement

(indenture specifies interest payment, maturity date, etc.). Common Stocks: Instruments representing an ownership

position in a corporation. (2) Instruments which are neither debt nor equity

based and thus belong in their own category. Foreign Exchange

Classifications of Financial Instruments (1) Financial instruments can also be categorized by form

depending on whether they are cash instruments or derivative instruments:

Cash instruments are financial instruments whose value is determined directly by markets. Stock and bonds

Derivative instruments are financial instruments which derive their value from some other (underlying) financial instrument or variable. Futures, forwards, options (puts and calls) Originated in Chicago in the 1850s (CBOT) for commodities (flour, hay, corn), but

now involves financial assets as well.

(2) Alternatively, financial instruments can be categorized by "asset class" depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If debt, it can be further categorized into short term (less than one year) or long term. Short term: money market instruments Long term: capital market instruments

Classification of Financial Markets Primary Financial Market

Where new securities are sold to initial buyers (e.g., IPOs) Important for raising new capital (involves public and private

placements and investment bankers) Secondary Financial Market

Where securities previously issued (in primary markets) are bought and sold (traded among investors).

Secondary markets provide liquidity for previously issued securities – Allows for conversion of financial assets into cash before asset matures. Done through organized exchanges (central locations; e.g., NYSE,

LSE) or through Over-the-counter arrangements (dealers in different locations; e.g.,

NASDAQ, and U.S. Government bond market) or through US Government Sponsored Enterprises (GSEs): Federal National

Mortgage Association and Federal Home Loan Mortgage Corporation.

Money and capital markets Short term versus long term maturities of traded instruments.

Appendix 1

Useful Websites for Stock Prices and Exchange Rates

Stock Prices

For long term historical views go to: http://moneycentral.msn.com/investor/charts/

chartdl.aspx?Symbol=%24INDU&CP=0&PT=5

For a view of what’s happening now go to: http://bloomberg.com/

Or: http://finance.yahoo.com/marketupdate?u

Exchange Rates

Go to: http://fx.sauder.ubc.ca/ http://www.fxstreet.com/