Role of Financial Markets and Institutions Study Notes

Role of Financial Markets and Institutions

1. Introduction to Financial Markets

  • Definition: A financial market is defined as a market where financial assets (securities) such as stocks and bonds can be bought or sold. Funds are transferred in financial markets when one party purchases financial assets previously held by another party.

  • Functionality: Financial markets facilitate the flow of funds and enable financing and investing by households, firms, and government agencies.

1-1 Role of Financial Markets

  • Transfer of Funds: Financial markets enable the transfer of funds from surplus units (those with excess funds) to deficit units (those needing funds).

    • Surplus Units: These are participants who have more money than they spend and are referred to as investors. They provide their net savings to the financial markets.

    • Deficit Units: These individuals or organizations spend more than they receive and access funds from financial markets to finance their spending.

    • Example: College students often start as deficit units borrowing funds for education and transition to surplus units post-graduation when they earn and invest.

  • Importance of Funds Supply: If surplus units were unwilling to supply funds, the financial markets would not function effectively.

  • Securities as Claims: Deficit units access funds through the issuance of securities, which are claims on the issuer's assets.

    • Debt Securities: These represent borrowed funds and incur interest obligations for the issuer.

    • Equity Securities (Stocks): These represent ownership in firms, preferred by companies not financially capable of periodic interest payments on debt securities.

1-1a Accommodating Corporate Finance Needs

  • Corporate Finance: Focus on funding acquisition and types of securities issued. Financial markets enable corporations (deficit units) to source funds from investors (surplus units).

1-1b Accommodating Investment Needs

  • Investment Management: Refers to how surplus units decide to invest in debt or equity securities. Financial markets offer access to multiple investment opportunities, including securities issued by government and corporations.

  • Role of Financial Institutions: Serve as intermediaries that channel funds from surplus units to deficit units, thus linking investment management with corporate finance activities.

1-1c Primary vs. Secondary Markets

  • Primary Markets: Facilitate the issuance of new securities, providing needed funds to initial issuers.

  • Secondary Markets: Allow trading of existing securities, thus facilitating ownership transitions without providing new funding to the issuers.

    • Example: Riverto Co. sells Treasury securities in the secondary market to raise funds for expansion.

  • Liquidity: Defined as the ease of selling securities without loss in value. Securities with active secondary markets are typically more liquid.

1-2 Securities Traded in Financial Markets

  • Categories of Securities: Classified as money market securities, capital market securities, or derivative securities.

1-2a Money Market Securities

  • Definition: Short-term debt securities with maturities of one year or less, characterized by high liquidity.

  • Common Types:

    • Treasury Bills: Issued by the U.S. Treasury.

    • Commercial Paper: Issued by corporations.

    • Negotiable Certificates of Deposit: Issued by depository institutions.

1-2b Capital Market Securities

  • Definition: Long-term securities often used to finance the purchase of capital assets.

  • Types:

    • Bonds: Long-term debt securities that pay interest (coupon payments) biannually, maturing generally between 10-20 years. Perceived credit risk differences exist between government and corporate bonds.

    • Mortgages: Long-term obligations for real estate purchase, serving as collateral for the lender.

    • Types:

      • Residential Mortgages: For home buyers.

      • Commercial Mortgages: For real estate developers.

    • Mortgage-Backed Securities: Represent claims on a package of mortgages, generating monthly payments from homeowners to investors.

    • Example: If Mountain Savings Bank sells mortgage-backed securities, it enables funding of homeowners while mitigating its risk.

    • Stocks: Represent ownership in corporations, traded without maturity and generating returns via dividends and capital gains.

1-2c Derivative Securities

  • Definition: Financial contracts whose values derive from underlying assets.

  • Speculation: Allows investors to bet on asset value movements without ownership.

  • Risk Management: Enables firms to hedge investments by making financial positions in derivatives corresponding to their security portfolios.

1-2d Valuation of Securities

  • Definition: Valuation is the present value of a security's expected cash flows, adjusted for credit risk.

    • Debt Securities: Easier to value since they promise specific interest and principal payments.

    • Stocks: More complex due to variable dividends and different selling times by various investors. Environmental factors, firm-specific information, and market sentiment can all influence cash flow expectations and valuations.

1-2f International Securities Transactions

  • Global Development: Financial markets improving internationally due to the need for funding across borders.

  • Foreign Exchange Market: Facilitates currency exchanges needed for international transactions.

1-2g Government Intervention in Financial Markets

  • Examples:

    1. Federal Reserve's purchasing of debt securities to enhance liquidity during the credit crisis.

    2. New regulations to assess bond credit risks more effectively.

    3. Enhanced monitoring of stock trading to prevent insider trading and ensure market fairness.

1-3 Role of Financial Institutions

  • Need for Financial Institutions: Address market imperfections by channeling funds and providing better credit evaluations than individual surplus units could achieve.

1-3a Role of Depository Institutions

  • Definition: Accept deposits and provide credit through loans and securities purchases.

  • Benefits:

    • Offer tailored deposit accounts for liquidity needs.

    • Repackage deposits into loans of varied sizes and maturities.

    • Evaluate borrower creditworthiness with expertise.

    • Diversification of loans minimizes risk exposure.

  • Commercial Banks: Dominant depository institutions, providing a range of deposit accounts and loans.

    • Federal Funds Market: Allows banks to lend excess funds to others with deficits for short terms.

1-3b Role of Nondepository Financial Institutions

  • Functions: Generate funds from sources other than deposits, focusing on specific market segments.

  • Finance Companies: Obtain funds by issuing securities, lending to individuals and small businesses.

  • Mutual Funds: Sell shares to investors and use funds to purchase diversified portfolios of securities.

  • Securities Firms: Act as brokers, executing transactions, and dealers maintaining an inventory of securities.

  • Insurance Companies: Provide risk management products, investing premiums received into securities until claims arise.

  • Pension Funds: Manage retirement contributions, investing heavily in a range of securities to finance deficits for corporations and agencies.

1-3c Comparison of Roles among Financial Institutions

  • Flow of Funds: Highlights the transformation of deposits into loans and the purchasing of securities.

  • Financial Conglomerates: Merged institutions allow for an array of financial services, enhancing convenience for consumers.

    • Example: Wells Fargo’s evolution into a diversified financial services company demonstrates this trend.

Conclusion: The interconnectedness of financial markets, institutions, and investors underpins the functionality and stability of the overall financial system, influenced by regulations and global dynamics.