Financial Institutions and Markets - FIN 137

Financial Institutions and Markets - Chapter 1: Role of Financial Markets and Institutions

Chapter Objectives

  • Describe the types of financial markets that facilitate the flow of funds

    • Understanding different markets is crucial for the functioning of the financial system.

  • Describe the types of securities traded within financial markets

    • Recognizing various securities is key to investing and managing financial products.

  • Describe the role of financial institutions within financial markets

    • Institutions bridge the gap between savers and borrowers, facilitating economic activity.

  • Explain how financial institutions were exposed to the credit crisis

    • Awareness of the challenges faced by financial institutions is critical for financial literacy.

What is Financial Market?

  • A financial market is a marketplace where financial assets known as securities are exchanged.

    • Financial Assets/Securities include:

    • Stocks

    • Bonds

    • Other instruments that represent a claim on an asset or cash flow.

  • The market enables the flow of funds among various participants:

    • Surplus Units (those with excess funds)

    • Deficit Units (those lacking funds)

  • Most market activities occur in the Secondary Market, which includes:

    • Capital Market

    • Where long-term securities are traded.

    • Money Market

    • Where short-term securities are traded, usually with maturities of one year or less.

Role of Financial Markets

  • The primary functions of financial markets can be summarized as follows:

    • Transfer of Funds

    • Facilitates the movement of funds from surplus units to deficit units.

    • Medium of Transfer:

    • Financial Securities include:

      • Debt Securities: Represents borrowed funds, including bonds.

      • Equity Securities: Represents ownership in a firm, primarily stocks.

  • Financial institutions act as intermediaries in these transfer activities, ensuring efficiency and security in financial transactions.

Type of Markets

  • Primary Market:

    • Involves the issuance of new securities to raise funds for issuers.

  • Secondary Market:

    • Involves the trading of existing securities, allowing for the transfer of ownership among investors.

  • Liquidity:

    • A critical condition for a healthy and efficient secondary market.

    • Definition of Liquidity: The degree to which securities can easily be liquidated (sold) without a loss of value.

  • Consequences of Illiquidity:

    • Higher transaction costs.

    • Potential loss of value in securities due to difficulty in selling them.

Type of Securities

  • Money Market Securities:

    • Designed to meet short-term liquidity needs.

    • Characteristics:

    • Short-term debt securities.

    • Typically have a maturity of one year or less.

  • Capital Market Securities:

    • Designed to meet long-term liquidity needs.

    • Characteristics:

    • Long-term commitment of funds, including both debt and equity.

    • Maturities of more than one year.

Common Capital Market Securities

  • Bonds:

    • Debt securities issued by Treasury, government agencies, and corporations for financing operations.

  • Stocks:

    • Represent partial ownership in the corporations that issued them.

  • Mortgages:

    • Debt obligations created to finance real estate purchases.

  • Mortgage-Backed Securities:

    • Debt obligations representing claims on a bundle of mortgages.

  • Derivative Securities:

    • Financial contracts whose values are derived from the values of underlying assets.

    • Applications of Derivative Securities:

    • Speculation: Allows investors to speculate on movements in value without purchasing the underlying assets.

    • Risk Management: Financial institutions and other firms can use derivatives to adjust the risk of their existing investments in securities.

Basic concepts below that can help me understand the above information

Overview of Financial Markets

Think of a financial market like a giant marketplace, but instead of buying groceries or clothes, people buy and sell legal contracts called securities. These markets help move money from people who have extra cash to people or businesses that need it.

The Main Players

  • Surplus Units (Savers): These are individuals or businesses that have more money than they currently need to spend. They want to invest their "surplus" to earn more money later.

  • Deficit Units (Borrowers): These are individuals, companies, or governments that need more money than they currently have (a "deficit"). They borrow or sell ownership to get the cash they need for things like buying a house, starting a business, or building a road.

How Money Moves

  1. Primary Markets: This is where "brand new" securities are born. When a company decides to sell stock for the very first time to raise money, it happens here. The company gets the money directly from the buyers.

  2. Secondary Markets: This is like a resale shop or eBay for investments. Once a stock or bond is already owned by someone, they can sell it to another investor here. The original company doesn't get any new money; the cash just moves between the two investors.

Key Concept: Liquidity

  • Liquidity is simply how fast you can turn an investment back into cash without losing money.

  • A "liquid" investment (like a common stock on a major exchange) is easy to sell quickly.

  • An "illiquid" investment is hard to sell fast, which might force you to lower the price just to get rid of it.

Types of Markets by Timeframe

  • Money Markets: These deal with "short-term" loans (usually for one year or less). They are used when companies or governments just need a quick bridge of cash for a few months.

  • Capital Markets: These are for "long-term" needs (more than one year). This includes buying pieces of companies (stocks) or lending money for decades (bonds).

Common Types of Investments (Securities)

1. Bonds (Loans)

  • When you buy a bond, you are essentially acting as the bank. You lend money to a government or a company for a set period, and in return, they promise to pay you back your original money plus interest.

2. Stocks (Ownership)

  • When you buy a stock, you are buying a tiny slice of a company. If the company does well, your slice becomes more valuable. Unlike a bond, you aren't "lending" money; you are becoming a part-owner.

3. Mortgages and Mortgage-Backed Securities

  • Mortgages are loans specifically for buying real estate (like a house).

  • Mortgage-Backed Securities are when a bunch of these house loans are bundled together into one big package that investors can buy a piece of.

4. Derivative Securities

  • These are advanced contracts whose value comes from (or "derives" from) something else, like the price of gold or the price of a specific stock.

    • Speculation: Using them to "bet" on whether a price will go up or down.

    • Risk Management: Using them like an insurance policy to protect against big price changes.