Power Point Slides for Financial Markets and Institutions

Power. Point Slides for: Financial Markets and Institutions 6 th Edition By Jeff Madura Prepared by David R. Durst The University of Akron

CHAPTER 1 Role of Financial Markets and Institutions © 2003 South-Western/Thomson Learning

Chapter Objectives n Describe the types of financial markets n Describe the role of financial institutions with financial markets n Identify the types of financial institutions that facilitate transactions

Overview of Financial Markets Financial Market: a market in which financial assets (securities) such as stocks and bonds can be purchased or sold n n n 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

Overview of Financial Markets n Broad Classifications of Financial Markets Money versus Capital Markets Primary versus Secondary Markets Organized versus Over-the-Counter Markets

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

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

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

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

Debt vs. Equity Securities Debt Securities: Contractual obligations (IOU) of Debtor (borrower) to Creditor (lender) u u u Investor receives interest Capital gain/loss when sold Maturity date

Debt vs. Equity Securities: Claim with ownership rights and responsibilities u u u Investor receives dividends if declared Capital gain/loss when sold No maturity date—need market to sell

Valuation of Securities n Value a function of: l l l n n n 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

Investor Assessment of New Information Economic Conditions Industry Conditions Firm Specific Information Impact of Future Cash Flows Evaluation of Security Pricing Investor Decision to Trade Exhibit 1. 3

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

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

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

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

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

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

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

Types of Nondepository Financial Institutions n n n Insurance companies Mutual funds Pension funds Securities companies Finance companies Security pools

Role of Nondepository Financial Institutions n n n Focused on capital market Longer-term, higher risk intermediation Less focus on liquidity Less regulation Greater focus on equity investments

Trends in Financial Institutions n n Rapid growth of mutual funds and pension funds Increased consolidation of financial institutions via mergers Increased competition between financial Institutions Growth of financial conglomerates

Global Expansion by Financial Institutions n n International expansion International mergers Impact of the single European currency Emerging markets