Financial Markets and Institutions

11th Edition

by Jeff Madura
 

Chapter 1:
Role of
Financial
Markets &
Institutions
 Role of Financial Markets and Institutions
Chapter Objectives

■ describe the types of financial markets that

facilitate the flow of funds
■ describe the types of securities traded within
financial markets
■ describe the role of financial institutions within
financial markets
■ explain how financial institutions were exposed to
the credit crisis

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 Financial Market

A market in which financial assets (securities)

such as stocks and bonds can be purchased or
sold. Funds are transferred in financial markets
when one party purchases financial assets
previously held by another party

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 Role of Financial Markets

Financial markets transfer funds from those who have

excess funds to those who need funds.
§  Surplus units: participants who receive more money
than they spend, such as investors
§  Deficit units: participants who spend more money
than they receive, such as borrowers
§  Securities: represent a claim on the issuers
§  Debt securities - debt (also called credit, or borrowed
funds) incurred by the issuer
§  Equity securities - (also called stocks) represent equity
or ownership in the firm

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 Role of Financial Markets

Accommodating Corporate Finance Needs: The

financial markets serves as the mechanism whereby
corporations (acting as deficit units) can obtain funds from
investors (acting as surplus units)
Accommodating Investment Needs: Financial
institutions serve as intermediaries to connect the
investment management activity with the corporate
finance activity (Exhibit 1.1)

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Exhibit 1.1 How Financial Markets Facilitate
Corporate Finance & Investment Management

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 Role of Financial Markets

Primary versus Secondary Markets

§ Primary markets - facilitate the issuance of new
securities
§ Secondary markets - facilitate the trading of existing
securities, which allows for a change in the ownership
of the securities
§ Liquidity is the degree to which securities can easily be
liquidated (sold) without a loss of value
§ If a security is illiquid, investors may not be able to find a
willing buyer for it in the secondary market and may
have to sell the security at a large discount just to attract
a buyer

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 Securities Traded in Financial Markets

Securities can be classified as money market securities,

capital market securities, or derivative securities.
Money Market Securities
§ Money markets facilitate the sale of short-term debt
securities by deficit units to surplus units
§ Debt securities that have a maturity of one year or
less

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 Securities Traded in Financial Markets

Capital Market Securities - facilitate the sale of long-term

securities by deficit units to surplus units.
§ Bonds - long-term debt securities issued by the
Treasury, government agencies, and corporations to
finance their operations
§ Mortgages - long-term debt obligations created to
finance the purchase of real estate
§ Mortgage-backed securities - debt obligations
representing claims on a package of mortgages
§ Stocks - represent partial ownership in the corporations
that issued them

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 Securities Traded in Financial Markets

Derivative Securities - financial contracts whose values

are derived from the values of underlying assets
§  Speculation - allow an investor to speculate on
movements in the value of the underlying assets without
having to purchase those assets
§  Risk management - financial institutions and other
firms can use derivative securities to adjust the risk of
their existing investments in securities

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 Securities Traded in Financial Markets

Valuation of Securities
§ Impact of information on valuation
§ Estimate future cash flows by obtaining information that may
influence a stock’s future cash flows. (Exhibit 1.2)
§ Use economic or industry information to value a security
§ Use published opinions about the firm’s management to value a
security.
§ Impact of the internet on valuation
§ More timely pricing
§ More accurate pricing
§ More informative pricing

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 Securities Traded in Financial Markets

Valuation of Securities (cont.)

§ Impact of Behavioral Finance on Valuation
§ Various conditions can affect investor psychology.
Behavioral finance can sometimes explain the movements
of a security’s price
§ Behavioral Finance - the application of psychology to
make financial decisions
§ Uncertainty Surrounding Valuation of Securities
§ Limited information leads to uncertainty in the valuation
of securities

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 Exhibit 1.2 Use of Information to Make
Investment Decisions

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 Securities Traded in Financial Markets

Securities Regulations
§ Required Disclosure
§ The Securities Act of 1933 was intended to ensure
complete disclosure of relevant financial information on
publicly offered securities and to prevent fraudulent practices in
selling these securities
§ The Securities Exchange Act of 1934 extended the
disclosure requirements to secondary market issues
§ Regulatory Response to Financial Reporting Scandals
§ The Sarbanes-Oxley Act (SOX) required that firms
provide more complete and accurate financial information

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 Securities Traded in Financial Markets

International Securities Transactions

§ Financial markets vary across the world in terms of:
§ Degree of financial market development
§ Volume of funds transferred from surplus to deficit
units
short for FX
§ Foreign Exchange Market - International financial
transactions normally require the exchange of
currencies; the foreign exchange market facilitates this
exchange

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 Securities Traded in Financial Markets

Government Intervention in Financial Markets

In recent years, government has increased its role in
financial markets:
§ During credit crisis…
§ Federal Reserve purchased various debt securities
§ Intent – ensure more liquidity in the debt securities
and therefore encourage investors to purchase
§ Government regulations changed the manner by
which the credit risks of bonds were assessed
§ Increased monitoring of stock trading
§ Prosecuted insider information trading cases
§ Ensure no investor had an unfair advantage
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 Role of Financial Institutions

Financial institutions are needed to resolve the limitations

caused by market imperfections such as limited
information regarding the creditworthiness of borrowers.
Role of depository institutions - Depository institutions
accept deposits from surplus units and provide credit to
deficit units through loans and purchases of securities.
§ Offer liquid deposit accounts to surplus units
§ Provide loans of the size and maturity desired by deficit
units
§ Accept the risk on loans provided
§ Have more expertise in evaluating creditworthiness
§ Diversify their loans among numerous deficit units

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 Role of Financial Institutions

Role of Depository Institutions (cont.)

§ Commercial Banks
§ The most dominant type of depository institution
§ Transfer deposit funds to deficit units through loans or
purchase of debt securities
§ Federal Funds Market - facilitates the flow of funds
between depository institutions
§ Savings Institutions
§ Also called thrift institutions and include Savings and
Loans (S&Ls) and Savings Banks
§ Concentrate on residential mortgage loans
§ Credit Unions
§ Nonprofit organizations
§ Restrict business to CU members with a common bond

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 Role of Financial Institutions

Role of Non-depository Institutions

§ Finance companies - obtain funds by issuing securities and
lend the funds to individuals and small businesses
§ Mutual funds - sell shares to surplus units and use the funds
received to purchase a portfolio of securities
§ Securities firms - provide a wide variety of functions in
financial markets (Broker, Underwriter, Dealer, Advisory)
§ Insurance companies - provide insurance policies that reduce
the financial burden associated with death, illness, and
damage to property; charge premiums and invest in financial
markets Life insurance long ;
Accident short

§ Pension funds – manage funds until they are withdrawn for

retirement

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 Role of Financial Institutions

Comparison of Roles among Financial Institutions

§ Institutional Role as a Monitor of Publicly Traded Firms
§ Financial institutions facilitate the flow of funds
from individual surplus units (investors) to deficit
units. (Exhibit 1.3)
§ Financial institutions also serve as monitors of
publicly traded firms
§ By serving as activist shareholders, they can help ensure
that managers of publicly held corporations are making
decisions that are in the best interests of the shareholders

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 Exhibit 1.3 Comparison of Roles among
Financial Institutions

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 Role of Financial Institutions

How the Internet Facilitates Roles of Financial Institutions

§ The Internet has enabled financial institutions to perform
their roles more efficiently
§ Allows for lower costs and fees
§ Makes firm more competitive forcing other firms to price
their services competitively

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 Role of Financial Institutions

Relative Importance of Financial Institutions (Exhibit 1.4)

§  Households with savings are served by depository
institutions
§  Households with deficient funds are served by depository
institutions and finance companies
§  Several agencies regulate the various types of financial
institutions, and the various regulations may give some
financial institutions a comparative advantage over others

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 Exhibit 1.4 Summary of Institutional Sources
and Uses of Funds

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 Role of Financial Institutions

Consolidation of Financial Institutions banks coming together

§ Typical Structure of a Financial Conglomerate - In

recent years, the barriers to entry have been reduced,
allowing firms that had specialized in one service to
expand more easily into other financial services (Exhibit
1.5)
§ Impact of Consolidation on Competition - provided
more convenience. Individual customers can rely on the
financial conglomerate for convenient access to multiple
services
§ Global Consolidation of Financial Institutions -
Many financial institutions have expanded
internationally to capitalize on their expertise
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 Exhibit 1.5 Organizational Structure of a
Financial Conglomerate

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 Credit Crisis for Financial Institutions

§ Following the abrupt increase in home prices in the

2004-2006 period, many financial institutions increased
their holdings of mortgages and mortgage-backed
securities
§ In 2007-2009 period, mortgage defaults increased and
home values declined substantially

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 Credit Crisis for Financial Institutions

Systemic Risk during the Credit Crisis

§  Systemic Risk is the spread of financial problems, among
financial institutions and across financial markets, that could
cause a collapse in the financial system
§  Mortgage defaults affected financial firms in several ways:
§  Mortgage originators sold mortgages to other financial
institutions shortly before the crisis
§  Many other financial institutions invested in derivatives and
were exposed to the crisis
§  Some financial institutions relied on short-term funding and
used MBS as collateral
§  Decline in home building activity caused a decrease in the
demand for many related businesses leading to a weak
economy
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 Credit Crisis for Financial Institutions

Government Response to the Credit Crisis

§ Emergency Economic Stabilization Act - October 2008
§ Intended to resolve the liquidity problems of financial
institutions and to restore the confidence of the investors
who invest in them
§ Federal Reserve Actions - Fed provided emergency loans
to many securities firms that were not subject to its
regulation
§ Financial Reform Act of 2010
§ Also referred to as Wall Street Reform Act or Consumer
Protection Act
§ Mortgage lenders must verify the income, job status, and
credit history of mortgage applicants before approving
mortgage applications
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 Credit Crisis for Financial Institutions

Conclusion About Government Response to the Credit

Crisis
§ In general, response was intended to enhance the safety
of financial institutions
§ Tougher regulations on financial institutions can stabilize
the financial markets and encourage more participation
by surplus and deficit units

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 SUMMARY

§ Financial markets facilitate the transfer of funds from surplus

units to deficit units. Because funding needs vary among
deficit units, various financial markets have been
established. The primary market allows for the issuance of
new securities, and the secondary market allows for the sale
of existing securities
§ Securities can be classified as money market (short-term)
securities or capital market (long-term) securities. Common
capital market securities include bonds, mortgages,
mortgage-backed securities, and stocks. The valuation of a
security represents the present value of future cash flows
that it is expected to generate. New information that
indicates a change in expected cash flows or degree of
uncertainty affects prices of securities in financial markets
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 SUMMARY (Cont.)

§ Depository and non-depository institutions help to finance the

needs of deficit units. The main depository institutions are
commercial banks, savings institutions, and credit unions
§ The main non-depository institutions are finance companies,
mutual funds, pension funds, and insurance companies. Many
financial institutions have been consolidated (due to mergers)
into financial conglomerates, where they serve as subsidiaries
of the conglomerate while conducting their specialized
services. Thus, some financial conglomerates are able to
provide all types of financial services
§ Consolidation allows for economies of scale and scope, which
can enhance cash flows and increase the financial institution’s
value. In addition, consolidation can diversify the institution’s
services and increase its value through the reduction in risk
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 SUMMARY (Cont.)

§  The credit crisis in 2008 and 2009 had a profound effect on
financial institutions. Those institutions that were heavily
involved in originating or investing in mortgages suffered
major losses
§  Many investors were concerned that the institutions might fail
and therefore avoided them, which disrupted the ability of
financial institutions to facilitate the flow of funds. The credit
crisis led to concerns about systemic risk, as financial
problems spread among financial institutions that were
heavily exposed to mortgages

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 Glossary

ask quote (ask

price) Price at which a seller is willing to sell

behavioral The application of psychology to make financial

finance decisions
bid quote (bid
Price a purchaser is willing to pay for a specific security
price)
broker One who executes securities transactions between two
parties
capital market Long-term securities, such as bonds, whose maturities
securities are more than one year
dealers Securities firms that make a market in specific
securities by adjusting their inventories
debt securities Securities that represent credit provided to the initial
34 issuer by the purchaser
 Glossary (cont.)  

derivative Financial contracts whose values are derived from the

securities values of underlying assets
equity Securities, such as common stock and preferred stock,
securities that represent ownership in a business
federal funds
market Market that facilitates the flow of funds from banks that
have excess funds to banks that are in need of funds

financial market Market in which financial assets (or securities) such as

stocks and bonds are traded
foreign
exchange The financial market that facilitates the exchange of
market currencies

imperfect Markets in which buyers and sellers of securities do not

markets have full access to information and cannot always break
down securities to the precise size they desire
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 Glossary (cont.)  

liquidity Ability to sell assets easily without loss of value.

money market
mutual funds Mutual funds that concentrate their investment in money
market securities.

money market
securities Short-term securities, such as Treasury bills or certificates
of deposit, whose maturities are one year or less.

money Financial markets that facilitate the flow of short-term

markets funds.

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