Financial Markets and Institutions
The value of the finance industry
(Households, firms, and financial intermediaries)
Mehran Ebrahimian
Investment Management (BE452)
Spring 2025
Learning Goals...
▶ The big picture:
▶ households/investors, firms, financial intermediaries,
government and regulatory agencies
▶ Flow of funds in the economy
▶ The investment environment
▶ The value of the finance industry
What is the function of the finance industry?
A. Make the rich richer
B. Serve the society
C. Make everyone richer
D. Help households with better investment (decisions)
E. None of above
F. All of above
G. B and C
H. B and C and/or D
Why we need to be clear on this?
1 / 13
The final exam question :))
Discuss: “Financial markets and institutions are there just to
make some rich and some others poor. It’s a zero-sum game, there
is no value for the society as a whole.”
False. Explain...
2 / 13
The Economy
▶ Firms/corporations: raise funds
...to buy machines, hire talent, etc.
▶ Households/investors: supply funds
...to save for retirement, transferring wealth to kids, etc.
▶ Capital needs to be channeled to where it is mostly needed...
▶ sometimes also from households to households, we’ll see
3 / 13
The Economy with Financial Intermediaries
▶ Financial intermediaries: intermediate funds between
households and firms — raising funds from investors,
allocating capital to firms
▶ Commercial banks; Credit unions; Insurance companies; Investment
companies [mutual funds/pension funds/hedge funds]; Investment
bankers; Private equity, venture capital; Fintech, decentralized
finance; Etc.
4 / 13
The Economy with Financial Intermediaries
+ government/regulatory agencies
▶ Financial intermediaries: intermediate funds between
households and firms
+ Government/Regulatory agencies intervene (as borrowers &
lenders, and setting rules)
5 / 13
Real vs. Financial Assets
▶ Real Assets: what sits in the firm. the physical machinery or
intangible talent that produces goods and services...
▶ Financial Assets: stocks/bonds that households hold. claims
to the outcome of real assets...
▶ financial assets of claim holders are liabilities of issuers
numbers: US and EU
6 / 13
Primary vs. Secondary Markets
▶ Primary Markets: where corporations raise funds through
new issues of financial instruments (e.g. stocks and bonds) —
initial public offerings (IPOs), Startups’ fundraisings, etc.
▶ Secondary Markets: where financial instruments are traded
after they are issued
▶ What this course is mostly about...
transfer of funds
7 / 13
Secondary markets offer...
Secondary markets offer...
▶ Liquidity, or the ability to turn an asset into cash quickly
▶ Information about the prices (or the value) of investments
▶ Trading with low transaction costs
▶ Risk sharing among investors
▶ Economies of scale, in various functions
8 / 13
The function of the finance industry
How financial markets generate value in the economy?
1. The Informational Role of Financial Markets
▶ Stock prices are set in financial markets / informative signals...
▶ Capital flows to the most productive fortune
▶ high productivity → higher price → lower return/cost of
capital → capital flow, more investment
▶ Efficient allocation requires that financial markets work well...
9 / 13
The function of the finance industry
How financial markets generate value in the economy?
2. Consumption Timing
▶ “Shift” individuals’ consumption over
the lifecycle — consumption
smoothing
▶ We prefer a balanced consumption
despite volatile earnings...
▶ Buy financial assets when you earn
more, sell when you earn less (Saving
for retirement)
▶ Borrow when you earn less, but expect
to earn more (Mortgage, Student loan)
▶ Contract enforcement...
10 / 13
The function of the finance industry
How financial markets generate value in the economy?
3. Risk Pooling + Allocation of Risk
▶ Eliminate the firm-specific/idiosyncratic/non-systemic risk,
▶ holding a tiny bit of each company: law of large numbers...
▶ Allocate riskier securities to the risk-tolerant households
▶ Separation of ownership and management? agency conflicts...
11 / 13
The function of the finance industry
How financial markets generate value in the economy?
4. Economies of Scale
▶ Avoid duplicated information gathering/monitoring cost
▶ FI does it more efficiently as well
▶ Denomination intermediation, Delegated monitoring
▶ Who monitors the monitor? agency conflicts...
12 / 13
Financial Literacy, Social Norms, Etc.
Not everyone believes in the financial markets, apparently.
13 / 13
Where are we?
“Financial Markets and Institutions”
Today’s Lecture:
▶ The value of the finance industry
▶ Financial Intermediaries, households and firms
Next Lectures:
▶ Lecture 2: Asset Classes —
▶ money market, bonds market, stocks
▶ asset allocation: basics
▶ Lecture 3: Investment Companies —
▶ Mutual Funds
▶ Hedge Funds
▶ ETFs
Key Terms
▶ Financial Intermediaries
▶ Flow of Funds
▶ Capital Allocation
▶ Real Assets, Financial Assets
▶ Primary Markets, Secondary Markets
▶ Diversification
▶ Consumption Smoothing
▶ Economies of Scale
Appendix
Supplementary Numbers and Pictures
The Balance Sheet of Households
U.S., June 2021
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June
2021
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The Balance Sheet of Commercial Banks & Savings Inst.
U.S., FDIC-insured, June 2021
Source: Federal Deposit Insurance Corporation, June 2021
go back
The Balance Sheet of nonfinancial Corporations
U.S., June 2021
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June
2021
go back
The Balance Sheet of Households, % of GDP
EU, 2022
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The Balance Sheet of Households, Composition
EU, 2022
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Primary and Secondary Market: Transfer of Funds
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