Chapter 1: Role of Financial Markets and Institutions

Financial Market

A market in which financial assets can be purchased or sold

Surplus Units

participants who receive more money than they spend (investors)

Deficit Units

participants who spend more money than they receive (borrowers)

Securities

represent a claim on the issuers

Debt Securities

debt/credit/borrowed funds incurred by the issuer

Equity Securities

equity or ownership in a firm (stocks)

Accommodating Corporate Finance Needs

financial markets serve as the mechanism by which corporations (deficit units) can obtain funds from investors (surplus units)

Accommodating Investment Needs

financial institutions serve as intermediaries to connect the investment management activity with corporate finance activity

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

the degree to which securities can easily be liquidated (sold) without a loss of value

Money Market Securities

facilitate the sale of short-term (1 year or less) debt securities by deficit units to surplus units

Capital Market Securities

facilitate the sale of long-term securities by deficit units to surplus units

Derivative Securities

financial contracts whose values are derived from the values of underlying assets

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

Speculation

allows an investor to speculate on movements in the value of the underlying assets w/out 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

Valuation of Securities

Influences by information, internet, behavioral finance and uncertainty

Behavioral Science

the application of psychology to make financial decisions

Securities Act of 1933

intended to ensure complete disclosure of relevant financial information on publicly offered securities and to prevent fraudulent practices in selling these securities

Securities Exchange Act of 1934

extended disclosure requirements to secondary market

Sarbanes-Oxley Act

required that firms provide more complete and accurate financial information

Foreign Exchange Market

facilitates the exchange of currencies between international financial transactions

Role of Financial Institutions

to resolve the limitations caused by market imperfections such as limited info regarding creditworthiness of borrowers

Role of Depository Institutions

accept deposits from surplus units and provide credit to deficit units through loans and purchases of securities.

Depository Institutions Include:

commercial banks, savings institutions and credit unions.

Commerical Banks

most dominant depository instution and transfers 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

concentrate on residential mortgage loans

Credit Unions

non-profit organizations that restrict business to only credit union memebers with a certain bond

Non-depository Institutions

finance companies, mutual funds, securities firms, insurance companies, pension funds

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 (brokers, underwriter, dealer, advisory)

Insurance Companies

provide insurance policies that reduce the financial burden associated with death, illness and damage of property

Pension Funds

manage funds until they are withdrawn for retirement

Systematic Risk

the spread of financial problems, among financial institutions and across financial markets, that could cause a collapse in the financial system.

Emergency Economic Stabilization Act

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 (Wall Street Reforms Act or Consumers Protection Act)

Requires mortgage lenders to verify the income, job status, and credit history of mortgage applicants before approving mortgage applications