Chapter One

Introduction

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Why study Financial Markets

and Institutions?
Prudent
Prudent investment
investment and
and financing
financing
requires
requires aa thorough
thorough understanding
understanding of
of
the
the structure
structure of
of domestic
domestic and
and international
international
markets
markets
the
the flow
flow of
of funds
funds through
through domestic
domestic and
and
international
international markets
markets
the
the strategies
strategies used
used to
to manage
manage risks
risks faced
faced by
by
investors
investors and
and savers
savers
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Financial Markets
Financial
Financial markets
markets are
are structures
structures
through
through which
which funds
funds flow
flow
Financial
Financial markets
markets can
can be
be distinguished
distinguished
along
along two
two dimensions
dimensions
primary
primary versus
versus secondary
secondary markets
markets
money
money versus
versus capital
capital markets
markets

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Primary versus Secondary Markets

Primary
Primary markets
markets
markets
markets in
in which
which users
users of
offunds
funds (e.g.,
(e.g.,
corporations
corporations and
and governments)
governments) raise
raise funds
funds by
by
issuing
issuing financial
financial instruments
instruments (e.g.,
(e.g., stocks
stocks and
and
bonds)
bonds)

Secondary
Secondary markets
markets
markets
markets where
where financial
financial instruments
instruments are
are traded
traded
among
among investors
investors (e.g.,
(e.g., NYSE
NYSE and
and Nasdaq)
Nasdaq)
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Money versus Capital Markets

Money
Money markets
markets
markets
markets that
that trade
trade debt
debt securities
securities with
with
maturities
maturities of
of one
one year
year or
or less
less (e.g.,
(e.g., CDs
CDs and
and
U.S.
U.S.Treasury
Treasury bills)
bills)

Capital
Capital markets
markets
markets
markets that
that trade
trade debt
debt (bonds)
(bonds) and
and equity
equity
(stock)
(stock) instruments
instruments with
with maturities
maturities of
of more
more
than
than one
one year
year
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Money Market Instruments

Outstanding, ($Bn)

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Capital Market Instruments

Outstanding, ($Bn)

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Foreign Exchange (FX) Markets

FX
FX markets
markets
trading
tradingone
onecurrency
currencyfor
foranother
another(e.g.,
(e.g.,dollar
dollarfor
foryen)
yen)

Spot
Spot FX
FX
the
theimmediate
immediateexchange
exchangeof
ofcurrencies
currenciesatatcurrent
current
exchange
exchangerates
rates

Forward
Forward FX
FX
the
theexchange
exchangeof
ofcurrencies
currenciesin
inthe
thefuture
futureon
onaaspecific
specific
date
dateand
andatataapre-specified
pre-specifiedexchange
exchangerate
rate

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Derivative Security Markets

Derivative
Derivative security
security
aa financial
financial security
security whose
whose payoff
payoffisis linked
linked to
to
(i.e.,
(i.e., derived
derived from)
from) another
another security
security or
or
commodity
commodity
generally
generally an
an agreement
agreement to
to exchange
exchange aa standard
standard
quantity
quantity of
of assets
assets at
at aa set
set price
price on
on aa specific
specific
date
date in
in the
the future
future

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Financial Market Regulation

The
The Securities
Securities Act
Act of
of 1933
1933
full
full and
and fair
fair disclosure
disclosure and
and securities
securities
registration
registration

The
The Securities
Securities Exchange
Exchange Act
Act of
of 1934
1934
Securities
Securities and
and Exchange
Exchange Commission
Commission (SEC)
(SEC) isis
the
the main
main regulator
regulator of
of securities
securities markets
markets

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Financial Institutions (FIs)

Financial
Financial Institutions
Institutions
institutions
institutions through
through which
which suppliers
suppliers channel
channel
money
money to
to users
users of
offunds
funds

Financial
Financial Institutions
Institutions are
are distinguished
distinguished
by
by whether
whether they
they accept
accept deposits
deposits
depository
depository versus
versus non-depository
non-depository financial
financial
institutions
institutions

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Flow of Funds in a World without FIs

Financial Claims
(equity and debt
instruments)
Users of Funds
(corporations)

Suppliers of
Funds
(households)

Cash

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Flow
FlowofofFunds
Fundsinina aWorld
Worldwithout
with FIs
FIs
FIs
(brokers)

Users of Funds

Cash

FIs
(asset
transformers)

Financial Claims
(equity and debt securities)

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Suppliers of Funds

Cash

Financial Claims
(deposits and insurance policies)

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Depository versus Non-Depository FIs

Depository
Depository institutions
institutions
commercial
commercial banks,
banks, savings
savings associations,
associations,
savings
savings banks,
banks, credit
credit unions
unions

Non-depository
Non-depository institutions
institutions
insurance
insurance companies,
companies, securities
securities firms
firms and
and
investment
investment banks,
banks, mutual
mutual funds,
funds, pension
pension funds
funds

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FIs Benefit Suppliers of Funds

Reduce
Reduce monitoring
monitoring costs
costs
Increase
Increase liquidity
liquidity and
and lower
lower price
price risk
risk
Reduce
Reduce transaction
transaction costs
costs
Provide
Provide maturity
maturity intermediation
intermediation
Provide
Provide denomination
denomination intermediation
intermediation

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FIs Benefit the Overall Economy

Conduit
Conduit through
through which
which Federal
Federal Reserve
Reserve
conducts
conducts monetary
monetary policy
policy
Provides
Provides efficient
efficient credit
credit allocation
allocation
Provide
Provide for
for intergenerational
intergenerational wealth
wealth
transfers
transfers
Provide
Provide payment
payment services
services

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Risks Faced by Financial Institutions

Credit
Credit
Foreign
Foreign exchange
exchange
Country
Country or
or
sovereign
sovereign
Interest
Interest rate
rate
Market
Market

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Off-balance-sheet
Off-balance-sheet
Liquidity
Liquidity
Technology
Technology
Operational
Operational
Insolvency
Insolvency

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Regulation of Financial Institutions

FIs
FIs are
areheavily
heavily regulated
regulated to
to protect
protect society
society at
at
large
large from
from market
market failures
failures
Regulations
Regulations impose
impose aa burden
burden on
on FIs
FIs and
and recent
recent
U.S.
U.S. regulatory
regulatory changes
changes have
have been
been
deregulatory
deregulatory in
in nature
nature
Regulators
Regulators attempt
attempt to
to maximize
maximize social
social welfare
welfare
while
while minimizing
minimizing the
the burden
burden imposed
imposed by
by
regulation
regulation
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Globalization of Financial Markets and

Institutions
The
Thepool
poolof
ofsavings
savingsfrom
fromforeign
foreigninvestors
investorsisis
increasing
increasingand
andinvestors
investorslook
lookto
todiversify
diversifyglobally
globally
now
nowmore
morethan
thanever
everbefore
before
Information
Informationon
onforeign
foreignmarkets
marketsand
andinvestments
investmentsisis
becoming
becomingreadily
readilyaccessible
accessibleand
andderegulation
deregulationacross
across
the
theglobe
globeisisallowing
allowingeven
evengreater
greateraccess
access
International
Internationalmutual
mutualfunds
fundsallow
allowdiversified
diversifiedforeign
foreign
investment
investmentwith
withlow
lowtransactions
transactionscosts
costs

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