Financial Markets and Regulation of Financial Systems

Structure of Financial Markets

• Debt and Equity Markets

• Primary and Secondary Markets

Debt and Equity Markets

• Debt Instruments: Bonds or mortgages involving fixed payments at regular intervals until maturity.- Short-term: Maturity less than one year.

  • Intermediate-term: Maturity between one and ten years.

  • Long-term: Maturity of ten years or longer.

• Equities: Common stock representing a share in net income and assets.- Equity holders may receive dividends and benefit from increased profitability or asset value.

  If you own one share of common stock in a company that has issued one million shares, you are entitled to $1/1,000,000$ of the firm’s net income and $1/1,000,000$ of the firm’s assets.

Primary and Secondary Markets

• Primary Market: New financial instruments are issued by borrowers (e.g., investment banks).

• Secondary Market: Previously issued securities are resold (e.g., New York Stock Exchange, NASDAQ).

• Brokers match buyers and sellers; dealers buy and sell securities.

Financial Intermediaries

Functions of Financial Intermediaries

• Lower Transaction Costs: Reduces time and money spent on financial transactions.

Example: Instead of an individual incurring $500$ in legal fees for a loan contract, a bank can create a standardized contract for $5,000$ and use it for $2,000$ loans at just $2.50$ per loan.

• Risk Sharing: Reduces investor's exposure to risk through asset transformation and diversification.- Asset Transformation: Risky assets are turned into safer assets for investors.

  • Diversification: Investing in a portfolio of assets to reduce risk.