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CAPITAL MARKETSOVERVIEW OF MARKET PARTICIPANTS

AND FINANCIAL INNOVATION

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GROUP MEMBERS

KEZBAN ŞAHİN 060207013

ZEYNEP ŞAHİNER 060207028

ÖZNUR UZLAŞAN 060207048

GİZEM VERGİLİ 070207041

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CONTENTS

ISSUERS AND INVESTORS

ROLE OF FINANCIAL INDERMEDIARIES

OVERVIEW OF ASSET/LIABILITY

MANAGEMENT FOR FINANCIALINSTITUTIONS

REGULATION OF FINANCIAL MARKETS

FINANCIAL INNOVATION

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ISSUER AND INVESTORS

We focus on one particular group of market

players,called financial intermediaries, because

of the key economic functions they perform in

financial markets.

Regulators

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CONT’D

Various entities issue financial assets,both debt

instruments and equity instruments and various

investors purchase these financial assets

But these two groups are not mutually exclusive.

It is common for an entity to both issue afinancial asset and at the same time invest in a

different financial asset.5



CLASSIFICATION OF ENTITIES

Central Governments

Agencies of Central Governments

Municipal Governments

Supranationals

Nonfinancial Businesses

Financial Enterprises

Households

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Central governments borrow funds for a wide

variety of reasons.Debt obligations issued bycentral governments carry the full faith and

credit of the borrowing government.

Funds are raised by the issuance of debt

obligations called Treasury Securities. Two type of government agencies in the USA are

Federally Related Institutions and

Government Sponsored Enterprises.

In most countries municipalities raise funds in

the capital market.

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Supranational I nstitution: is an organization

formed by two or more central governmentthrough international treaties.

Two example of supranational institution are

International Bank for Reconstruction and

Development popularly referred to as WorldBank and American Development Bank

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Businesses are classified into;

Nonfinancial

Financial Businesses

These entities borrow funds in the debt market

and raise funds in the equity market.

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Nonfinancial businesses are the form of three category;

Corporations

Farms

Nonfarms/Noncorporate Business

In the last category businesses produce same productsor provide the same services as corporations,but are

not incorporated.Financial businesses more popularly

referred to as f inancial institutions provide one or

more of the following services.

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Transform financial assets acquired through the marketconstitute them into a different and more widely

preferable ,type of asset,which becomes theirliability.This function is performed by financial

intermediaries .(most important type of financialinstitution)

Exchange financial assets on behalf of consumers.

Exchange financial assets on their own account.

Assist in the creation of financial assets for theircustomers and then sell those financial assets to othermarket participants.

Provide investment advice to other market participants.

Manage the portfolios of other market participants.11



CONT’D

Financial intermediaries include depository

institutions(commercial banks,savings and loan

associations) who acquire bulk of their funds by

offering their liabilities to the public mostly inform of deposit.Others are discussed another

chapters.

Some subsidiaries of nonfinancial business

provide financial services.These financialinstitutions called captive f inance companies.

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Examples of captive finance companies;

o General Motor Acceptance Corporations(a

subsidiary of General Motors)

o General Electric Credit(a subsidiary of GeneralElectric)

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R OLE OF FINANCIAL I NTERMEDIARIES

Financial intermediaries play the basic role of the basic

role of transforming financial assets that are less

desirable for a large part of the public into other financial

assets-their own liabilities-which are more widely

preferred by the public.This transformation involves atleast one of the four economic functions;

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CONT’D

I. Providing maturity intermediation

II. Risk reduction via diversification

III. Reducing costs of contracting and information

processing

IV. Providing a payments mechanism

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I. Maturity intermediation:by issuing its own

financial claims the commercial commercial

bank in essence transforms a longer-term asset

into a shorter – term one by giving the borrower a loan for length of time sought and

the investors/depositor a financial asset for the

desired investment horizon.This is called

matur ity intermediation.

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II. This economic function of financial intermediaries-

transforming more risky assets into less risky ones-iscalled diversification.Even though individual investors

can do it on their own,they may not be able to to it as

cost effectively as a financial intermediary,depending

on the amount of funds they want to invest.Attaining

cost effective diversification in order to reduce risk by

purchasing the financial assets of a financial

intermediary is an important economic benefit for

financial markets.

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In addition to the opportunity cost of time to process

the information about the financial asset, the cost of thisinformation must also be considered. All these costs are

information processing costs.

The costs of writing loan contracts are referred to ascontracting costs. Another dimension to contracting costs is

the cost of enforcing terms of loan agreement.



We have two examples of financial intermediaries as

commercial bank and investment company.

So that, economies of scale can be realized in

contracting and processing information because of amount of

funds managed by financial intermediaries.

The lower costs increase to the benefit of investor who

purchases asset and the issuer of financial assets.



PROVIDING A PAYMENTS MECHAISM

The previous three economic functions may not beimmediately obvious. This last one should be. Most

transactions made today are not with cash. Payments are made

using checks, credit cards, debit cards and electronic transfers

of funds. Financial intermediaries provide these methods for

making payments.

At one time, noncash payments were restricted to

checks. Payment by credit card was also at one time the

exclusive domain of commercial banks, but now other

depository institutions offer this service. Debit cards are offered

by various financial intermediaries.



A debit card differs from a credit card in that a bill

sent to credit cardholder periodically (usually once a month)

requests payment for transactions made in the past. With a

debit card, funds are immediately withdrawn from the

purchaser’s account at time transaction takes place.

The ability to make payments without cash is critical

for financial market. In short, depository institutions transform

assets that cannot be used to make payments into other assets.



OVERVIEW OF ASSET/LIABILITY MANAGEMENT

FOR FINANCIAL INSTITUTIONS

To understand why managers of financial

institutions invest in particular types of financial assets and

types of investment strategies employed. It is necessary to

have a general information of asset/liability problem.

For example, depository institutions seek to

generate income by difference between return that they earn

on assets and cost of their funds. This difference is referred

to as spread.



THE NATURE OF LIABILITIES

Liability Type Amount of Cash

Outlay

Timing of Cash

Outlay

Type I Known Known

Type II Known Uncertain

Type III Uncertain Known

Type IV Uncertain Uncertain



TYPE I LIABILITY

Both amount and timing are known. For example,

depository institutions know amount that they are

committed to pay on maturity date of a fixed rate deposit,

the depositor does not withdraw funds prior to the maturity

date.

TYPE II LIABILITY

The amount of cash outlay is known, but timing of

cash outlay is uncertain. Life insurance policy can be an

example for this liability. The most of basic many types of

life insurance policy provides that, for annual premium,

this company agrees to make a specified payment to

beneficiaries upon the death of insured.



TYPE III LIABILITY

Timing is known, but amount is uncertain, such as

when a financial institution has issued an obligation in

which the interest rate adjust based on some interest rate

benchmark.

Depository institutions, for example, issue

liabilities called certificates of deposit with a stated

maturity. The interest rate paid need not to be fixed over

life of deposit but may fluctuate.

.



TYPE IV LIABILITY

Both amount and timing are uncertain. Home

insurance policy is an example. Whenever damage is

done to an insured asset, the amount of payment thatmust be made is uncertain.



L IQUIDITY NEEDS Because of uncertainty about the timing and the amount of the

cash outlays, a financial institution must be prepared withsufficent cash to satisfy its obligations.

Also keep in mind that our discussion of liabilities assumes thatthe entity that holds the obligation against the financialinstitution may exercise its right to change the nature of

deposit, perhaps incurring some penalty.

For example;

In the case of a certificate of deposit,

the depositor may request the withdrawalof funds prior to the maturity date.



The deposit-accepting institution will grant this

request, but assess an early withdrawal penalty.Certain types of investment companies give

shareholders the right to redeem their shares at

any time.

Some life insurance products provide a cash-

surrender value that allows the policyholder to

exchange the policy for a lump sum payment at

specified dates.Some life insurance products also offer a loan

value.



In addition to uncertaintyabout the timing andamount of the cash

outlays, and the potentialfor the depositor or

policyholder to withdrawcash early or borrow

against a policy, afinancial institution isconcerned with possiblereduction in cash inflows.



In the case of a depository institution, it means the

inability to obtain deposits.

For insurance companies, it means reduced premiums

because of the cancellation of policies.

For certain types of investment companies, it means not

being able to find new buyers for shares.



REGULATION OF FINANCIAL

MARKETS

In their regulatory capacities,governments greatly

influence the development and evolution of financial

markets and institutions.

It is important to realize that governments, issuers, and

investors tend to behave interactively and to affect one

another’s actions in certain ways.



JUSTIFICATION FOR

REGULATION

The standard explanation or justification for

govermental regulation of a market is that the

market, will not produce its particular goods or

services in an efficient manner and at the lowest possible cost.

Efficiency and low-cost production are

hallmarks of a perfectly competitive at the time

and that will not gain that status by itself in theforeseeable future.



Of course, it is possible that governments may regulate

markets that are viewed as competitive currently, but

unable to sustain competition, and low-cost production,over the long run.

A version of this justification for regulation is that the

government controls a feature of the economy that themarket mechanisms of competition and pricing could

not manage without help.

A short hand expression used by economists to

describe the reasons for regulation is market failure.



The regulatory structure

in the United States islargely the result offinancial crises thathave occurred atvarious times.Most

regulatory mechanismsare the products of thestock market crash of1929 and the GreatDepression in the1930s.



FORMS OF FEDERAL GOVERNMENT

REGULATION OF FINANCIAL MARKETS

1. Financial Activity Regulation

2. Disclosure Regulation

3. Regulation of Financial

Institutions4. Regulation of Foreign

Participants



1. DISCLOSURE REGULATION: It requires issuers of

securities to make public a large amount of financial

information to actual and potential investors.Thestandard justification for disclosure rules is that the

managers of the issuing firm have more information

about the financial health and future of the firm. The

cause of market failure here, if indeed it occurs, is

commonly described as “asymmetric information,” it

means investors and managers are subject to uneven

access to or uneven possession of information.Also,

the problem is said to be one of “agency .”



The United States is firmly committed to

disclosure regulation.The Securities Act of

1933 and the Securities Exchange Act of1934 led to the creation of the Securities and

Exchange Commission (SEC).

None of the SEC’s requirements or actionsconstitutes a guarantee, a certification, or an

approval of the securities being issued.

Moreover, the government’s rules do not

represent an attempt to prevent the issuance

of risky assets.



2.F INANCIAL ACTIVITY REGULATION: It consists of

rules about traders of securities and trading on financialmarkets. A prime example of this form of regulation is the

set of rules against trading by insiders who are corporate

officers and others in positions to know more about a firm’s prospects than the general investing public. A secondexample of this type of regulation would be rules regarding

the structure and operations of exchanges where securities

are traded.



3. REGULATION OF FINANCIAL INSTITUTIONS: Financial

institutions help households and firms to save; as depository institutions.They also facilitate the complex payments among many elements of the

economy and they serve as conduits for the government’s monetary policy. The U.S. Government imposed an extensive array of regulations

on financial institutions.

I n recent years, expanded regulations restrict how financial institutions

manage their assets and liabilities, in the form of minimum capital

requirements for certain regulated institutions. These capital requirements

are based on the various types of risk faced by regulated financial

institutions and are referred to as r isk-based capital requi rements.

4 REGULATION OF FOREIGN



4. REGULATION OF FOREIGN

PARTICIPANTS:

Government regulation of foreign participants limits the roles foreign firmscan play in domestic markets and theirownership or control of financialinstitutions. Many countries regulate

participation by foreign firms in domesticfinancial securities markets. Like mostcountries, the United States reviews andchanges it policies regarding foreign

firms’ activities in the U.S. financialmarkets on a regular basis.



FINANCIAL

Regulations that impede the free flow of capitaland competition among financial institutions

(particularly interest rates ceilings) motivate the

development of financial products and trading

strategies to get around these restirictions.

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Through technological advances and thereduction in trade and capital bariers, surplus

funds in one country can be shifted more easily

to those who need funds in another country. As a

result…

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CATEGORIZATIONS OF FINANCIAL

INNOVATION

Market-broadening instruments, which

increase the liquidity of markets and the

availability of funds by attracting new investorsand offering new opportunities for borrowers

Risk management instruments, which

reallocate financial risks to those who are less

averse to them or who have offsetting exposure,and who are presumably better able to shoulder

them 44



Artbitraging instruments and processes

,which enable investors and borrowers to take

advantage of differences in the perception of

risks,as well as in information, taxation, andregulations

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MOTIVATION FOR FINANCIAL

INNOVATION

Two extreme views seek to explain financial

innovation.At one extreme are those who believe

that the major impetus for innovation comes outof the endeavor to circumvent (or “arbitrage”) regulations and find loopholes in tax rules.At the

other extreme are those who hold that the

essence of innovation is the introduction of moreefficient financial instruments for redistributing

risk among market participants.46



MOTIVATION FOR FINANCIAL

INNOVATION

If we consider the ultimate causes of financial

innovation, the following emerge as the most

important:

1. Increased volatility of interestrates,inflation,equity prices and exchange rates

2. Advances in computer and telecommunication

technologies

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3. Greater sophistication and educational training

among professional market participants

4. Financial intermediary competition

5. Incentives to get around existing regulations andtax laws

6. Changing global patterns of financial wealth

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ASSET SECURITIZATION AS A

FINANCIAL INNOVATION

Asset securitization means that more than one

institution may be involved in lending capital.

Consider loans for the purchase of

automobiles.A lending scenario can look likethis:

1. A commercial bank originates automobile loans

2. The commercial bank issues securities backed

by these loans.

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3. The commercial bank obtains credit risk

insurance for the pool of loans from a private

insurance company

4. The commercial bank sells the right to servicethe loans to another company that specializes in

the servicing of loans

5. The commercial bank uses the services of

securities firm to distribute the securities toindividuals and institutional investors.

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AS A SUMMARY;

Financial innovation increased dramatically

since the 1960s, particularly in the

late1970s.Although financial innovation can be

result of arbitrary regulations and tax rules,innovations that persist after changes in

regulations or tax rules, designed to prevent

exploitation, are frequently those that offer a

more efficient means for redistributing risk.

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THANKS FOR

YOUR ATTENTIONS…

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