1 Role of Financial Markets and Institutions Background

Chapter Objectives 1. Describe the types of financial markets 2. Describe the role of financial institutions with financial markets 3. Identify the types of financial institutions that facilitate transactions 2

Overview of Financial Markets Financial Market: a market in which financial assets (securities) such as stocks and bonds can be purchased or sold o o o Financial markets provide for financial intermediation--financial savings (Surplus Units) to investment (Deficit Units) Financial markets provide payments system Financial markets provide means to manage risk 3

Overview of Financial Markets Broad Classifications of Financial Markets Money versus Capital Markets Primary versus Secondary Markets Organized versus Over-the-Counter Markets Public vs. Corporate 4

Primary vs. Secondary Markets o PRIMARY o SECONDARY n New Issue of Securities n Trading Previously Issued Securities n Exchange of Funds for Financial Claim n No New Funds for Issuer n Funds for Borrower; an IOU for Lender n Provides Liquidity for Seller 5

Money vs. Capital Markets o Money o Capital n Short-Term, < 1 Year n Long-Term, >1 Yr n High Quality Issuers n Range of Issuer Quality n Debt Only n Debt and Equity n Primary Market Focus n n Liquidity Market--Low Returns n Secondary Market Focus Financing Investment-6 Higher Returns

Organized vs. Over-the-Counter Markets o Organized n Visible Marketplace n Members Trade n Securities Listed n New York Stock Exchange o OTC n Wired Network of Dealers n No Central, Physical Location n All Securities Traded off the Exchanges 7

Securities Traded in Financial Markets o Money Market Securities n o Capital market securities n o Debt securities Only Debt and equity securities Derivative Securities n n Financial contracts whose value is derived from the values of underlying assets Used for hedging (risk reduction) and speculation (risk seeking) 8

Financial Markets o o Video Clip – Types Financial Markets Vidoe Clip - Derivatives 9

Debt vs. Equity Securities Debt Securities: Contractual obligations (IOU) of Debtor (borrower) to Creditor (lender) o o o Investor receives interest Capital gain/loss when sold Maturity date Equity Securities: Claim with ownership rights and responsibilities n n n Investor receives dividends if declared Capital gain/loss when sold No maturity date—need market to sell 10

Valuation of Securities o Value a function of: n n n o o o Future cash flows When cash flows are received Risk of cash flows Present value of cash flows discounted at the market required rate of return Value determined by market demand/supply Value changes with new information 11

Financial Market Efficiency o Security prices reflect available information o New information is quickly included in security prices o Investors balance liquidity, risk, and return needs 12

Financial Market Regulation Why Government Regulation? n To Promote Efficiency o High level of competition o Efficient payments mechanism o Low cost risk management contracts 13

Financial Market Regulation Why Government Regulation? o To Maintain Financial Market Stability o Prevent market crashes n Circuit breakers n Federal Reserve discount window o Prevent Inflation--Monetary policy o Prevent Excessive Risk Taking by Financial Institutions 14

Financial Market Regulation Why Government Regulation? n To Provide Consumer Protection o Provide adequate disclosure o Set rules for business conduct n To Pursue Social Policies o Transfer income and wealth o Allocate saving to socially desirable areas n n Housing Student loans 15

Financial Market Globalization o Increased international funds flow Increased disclosure of information n Reduced transaction costs n Reduced foreign regulation on capital flows n Increased privatization Results: Increased financial integration--capital flows to highest expected risk-adjusted return n 16

Role of Financial Institutions in Financial Markets o o Information processing Serve special needs of lenders (liabilities) and borrowers (assets) n n o o By denomination and term By risk and return Lower transaction cost Serve to resolve problems of market imperfection 17

Role of Financial Institutions in Financial Markets Types of Depository Financial Institutions Commercial Banks $5 Trillion Total Assets Savings Institutions $1. 3 Trillion Total Assets Credit Unions $. 5 Trillion Total Assets 18

Types of Non-depository Financial Institutions o o o Finance companies Mutual funds Securities companies Insurance companies Pension funds Security pools 19

Role of Non-depository Financial Institutions o o o Focused on capital market Longer-term, higher risk intermediation Less focus on liquidity Less regulation Greater focus on equity investments 20

Trends in Financial Institutions o Increased competition between financial Institutions n n o In the 60’s & 70’s, heavy regulation prevented competition In the late 70’s & 80’s, the development of mutual funds and deregulation led to increased flexibility and competition. This continued through to the 90’s and into today. Increased consolidation of financial institutions via mergers has resulted in the growth of financial conglomerates e. g. Cayman National Corporation 21

Cayman Financial Corporation CNC CNB CNP CNT CNS Caymanx CNIB CGI CNIM 22

Cayman National Corporation Holding Company o CNB – Cayman National Bank – Banking o CNP – Cayman National Property Holding – Property Holding o CNT – Cayman National Trust - Company & Trust Management o CNS – Cayman National Securities - Securities Brokerage o Caymanx – Caymanx Trust Company Limited – Banking, company and trust management o CNI – Cayman National Investments – Investment in a merchant bank o CNIB – Cayman National Insurance Brokers – Insurance brokerage o CGI – Cayman General Insurance – General (property & casualty) and heath insurance o CNIM – Cayman National Insurance Management - General (property & casualty) and heath insurance 23

Global Expansion by Financial Institutions o o International expansion through mergers and emerging markets The single European currency – Euro, €, helped to eliminate concerns about foreign exchange risks 24