Financial Markets

and Institutions
Chapters 1, 2 & 15

Based on slides for

Financial Markets and Institutions
by Mishkin and Eakins
What are Financial Markets?
Fixed Income
Corporate Bonds
Government Bonds
Municipal Bonds
High Yield Debt

Securitizations
Stock
Hybrid Securities Bond Preferred Stock
Credit Derivatives Market Common Stock
Derivatives Stock
Markets Market
Financial

Markets Foreign
OTC Exchange
Spot Markets
Forwards Other Exchange Rate
Swaps Markets Currency
Options
Money Market
Commodity Market
Real Estate Market
Why Study Financial Markets
and Institutions?
 October inflation figures released are reported to be 5.0%

 Market liquidity stands at negative Rs. 45.02 Billion

 2017 second budget reading jut concluded

 Trump elected president of USA

 What does all this mean?

 Will this impact interest rates?

 Do I care about interest rates?

 Will this impact your firm’s ability to get a bank loan?

 Why Study Financial Markets?
Debt Markets & Interest Rates
 Debt markets, or bond markets, allow governments, corporations, and
individuals to borrow to finance activities

 In this market, borrowers issue a security (i.e. bonds), that promises

timely payment of interest and principal over some specific time horizon

 The interest rate is the cost of borrowing

 interest rates include mortgage rates, car loan rates, credit card rates, etc

Interest Rates on Selected Bonds in US (1950-2014)

 Why Study Financial Markets?
The Stock Market
 The stock market is the market where common stock representing ownership in
a company, are traded
 Companies initially sell stock (in primary market) to raise money
 But after that, the stock is traded among investors (secondary market)
 Of all active markets, the stock market receives most attention from the media
 probably because it is the place where people get rich (and poor) quickly
 Companies, not just individuals, also watch the market
 Corporations often seek additional funding in equity markets after going public and the
success of these seasoned-equity offerings (SEOs) is dependent on the current price of
the company’s stock
Why Study Financial Markets?
The Foreign Exchange Market
 The foreign exchange market is where
international currencies trade and
exchange rates are set

 Although most people know little about

this market, it has an estimated daily
volume around USD 3.98 trillion

 These fluctuations matter

 If US Dollar is weakening relative to the
Euro, U.S. consumers will find that
vacationing in Europe is expensive

 When the dollar strengthens, foreign

purchase of domestic goods falls, and
US manufacturers experience a
decreased demand for their goods
Why Study Financial Markets?
Financial markets, such as bond and stock markets,
are crucial in our economy

 These markets channel funds from savers to investors,

thereby promoting economic efficiency

 Market activity affects personal wealth, the behavior of

business firms, and economy as a whole

 Well functioning financial markets, such as the bond

market, stock market, and foreign exchange market, are
key factors in producing high economic growth
Function of Financial Markets
 Channels funds from person or business without investment
opportunities (“Lender-Savers”) to one who has them
(“Borrower-Spenders”)

Lender-Savers Borrower-Spenders
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners
 Improves economic efficiency
 Financial markets are critical for producing an efficient allocation
of capital, allowing funds to move from people who lack
productive investment opportunities to people who have them
 Financial markets also improve the well-being of consumers,
allowing them to time their purchases better
Segments of Financial Markets
1. Direct Finance
• Borrowers borrow directly from lenders in financial
markets by selling financial instruments which are
claims on the borrower’s future income or assets

2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial
intermediaries (established to source both loanable
funds and loan opportunities) by issuing financial
instruments which are claims on the borrower’s future
income or assets
Function of Financial Markets
Structure of Financial Markets
1. Debt Markets
 Short-Term (maturity < 1 year): Money Markets
 Long-Term (maturity > 10 year)
 Intermediate term (maturity between 1-10 years)
 Local G-Sec Market Represented Rs. 4.6 Trillion as at
November 2016
 Total Debt outstanding Rs. 9.0 Trillion as at June 2016

2. Equity Markets
 Pay dividends, in theory forever
 Represents an ownership claim in the firm
 Colombo Stock Exchange Market capitalization Rs.
2.67 Trillion in November 2016
 Classifications of Financial Markets
1. Primary Market
 New security issues sold to initial buyers
 Typically involves an investment bank who underwrites the
offering

2. Secondary Market
 Securities previously issued are bought and sold
 Examples: CSE, NYSE, NASDAQ (Involves both brokers and dealers)
 Even though firms don’t get any money, per se, from the
secondary market, it serves two important functions:
 Provide liquidity, making it easy to buy and sell the securities of the
companies
 Establish a price for the securities
 We can further classify secondary markets as follows:
 Exchanges
 Trades conducted in central locations (e.g., CSE, NYSE, CBT)
 Over-the-Counter Markets
 Dealers at different locations buy and sell (Best example is the market for
Treasury securities)
Classifications of Financial Markets
 Financial Markets can also be further
classified by the maturity of the securities:
1. Money Market: Short-Term (maturity < 1 year)
2. Capital Market : Long-Term (maturity > 1 year)
Debt plus equities
Why Study Financial Institutions?
 Financial institutions
 Facilitate the smooth flow of funds in financial markets
 Helps get funds from savers to investors
 Instead of savers lending/investing directly with borrowers, a
financial intermediary (Ex: bank) plays the middleman where it
obtains funds from savers and then makes loans/investments with
borrowers
 This process, called financial intermediation, is the primary means of
moving funds from lenders to borrowers
 Engage in process of Indirect Finance - More important source
of finance than securities markets
 Promote market Efficiency
 Ex: Central Banks and the Conduct of Monetary Policy

 Needed because of transactions costs, risk sharing, and

asymmetric information
Function of Financial Intermediaries:
Indirect Finance & Transaction Costs
 Transactions Costs
1. Financial intermediaries make profits by reducing
transactions costs
2. Reduce transactions costs by developing expertise and
taking advantage of economies of scale

 Low transaction costs mean that it can provide

its customers with liquidity services, services
that make it easier for customers to conduct
transactions
1. Banks provide depositors with checking accounts that
enable them to pay their bills easily
2. Depositors can earn interest on checking and savings
accounts and yet still convert them into goods and
services whenever necessary
 Function of Financial Intermediaries:
Indirect Finance & Transaction Costs
 Another benefit made possible by the FI’s low transaction costs is that
they can help reduce the exposure of investors to risk, through a
process known as risk sharing

 FIs create and sell assets with lesser risk to one party in order to buy assets
with greater risk from another party

 This process is referred to as Asset Transformation, because in a sense

risky assets are turned into safer assets for investors

 Financial intermediaries also help by providing the means for individuals

and businesses to diversify their asset holdings

 Low transaction costs allow them to buy a range of assets, pool them,
and then sell rights to the diversified pool to individuals
Function of Financial Intermediaries:
Indirect Finance & Asymmetric Information
 Another reason FIs exist is to reduce the impact of
asymmetric information
 One party lacks crucial information about another party,
impacting decision-making

 Can result in adverse selection and moral hazard

 Financial intermediaries reduce adverse selection

and moral hazard problems, enabling them to
make profits
Function of Financial Intermediaries:
Indirect Finance & Asymmetric Information
 Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes
are ones most likely to seek a loan
3. Similar problems occur with insurance where unhealthy people
want their known medical problems covered

 Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that won't pay loan
back
3. Again, with insurance, people may engage in risky activities
only after being insured
4. Another view is a conflict of interest
Types of Financial Intermediaries
Depository Institutions (Banks)
 Commercial banks
 Raise funds primarily by issuing checkable, savings and time
deposits which are used to make commercial, consumer and
mortgage loans
 Collectively, comprise the largest financial intermediary and
have the most diversified asset portfolios

 S&Ls, Mutual Savings Banks and Credit Unions

 Raise funds primarily by issuing savings, time, and checkable
deposits which are most often used to make mortgage and
consumer loans, with commercial loans also becoming more
prevalent at S&Ls and Mutual Savings Banks
 Mutual savings banks and credit unions issue deposits as shares
and are owned collectively by their depositors, most of which at
credit unions belong to a particular group, e.g., a company’s
workers
Contractual Savings Institutions (CSIs)
 All CSIs acquire funds from clients at periodic intervals on a
contractual basis and have fairly predictable future payout
requirements
 Life Insurance Companies receive funds from policy premiums,
can invest in less liquid corporate securities and mortgages,
since actual benefit pay outs are close to those predicted by
actuarial analysis
 Fire and Casualty Insurance Companies receive funds from
policy premiums, must invest most in liquid government and
corporate securities, since loss events are harder to predict
 Pension and Government Retirement Funds hosted by
corporations and state and local governments acquire funds
through employee and employer payroll contributions, invest in
corporate securities, and provide retirement income via annuities
Investment Intermediaries

 Finance Companies sell commercial paper (a short-term debt

instrument) and issue bonds and stocks to raise funds to lend to
consumers to buy durable goods, and to small businesses for
operations

 Mutual Funds acquire funds by selling shares/units to individual

investors and use the proceeds to purchase large, diversified portfolios
of stocks and bonds

 Money Market Mutual Funds acquire funds by selling checkable

deposit-like shares/units to individual investors and use the proceeds to
purchase highly liquid and safe short-term money market instruments

 Investment Banks advise companies on securities to issue,

underwriting security offerings, offer M&A assistance, and act as
dealers in security markets
Regulation of Financial Markets
 Main Reasons for Regulation
1. Increase Information to Investors
2. Improve Monetary control
3. Ensure the Soundness of Financial
Intermediaries
 Regulation Reason:
Increase Investor Information
• Asymmetric information in financial markets mean that investors
may be subject to adverse selection and moral hazard problems
• This may hinder the efficient operation of financial markets and may
also keep investors away from financial markets

• The Securities and Exchange Commission (SEC) requires

corporations issuing securities to:
• disclose certain information about their sales, assets, and earnings
to the public
• restrict trading by the largest stockholders (known as insiders) in
the corporation

• Government regulation can reduce adverse selection and

moral hazard problems in financial markets and increase their
efficiency by increasing the amount of information available to
investors
Regulation Reason:
Improve Monetary Control
 Because banks play a very important role in determining the
supply of money much regulation of these financial
intermediaries is intended to improve control over the money
supply

 One such regulation is reserve requirements, which make it

obligatory for all depository institutions to keep a certain
fraction of their deposits in accounts with the Federal Reserve
System (the Fed), the central bank in the United States

 Reserve requirements help the Fed exercise more precise

control over the money supply
 Regulation Reason: Ensure Soundness
of Financial Intermediaries
 Providers of funds to financial intermediaries may not be able to assess
whether the institutions holding their funds are sound or not
 If they have doubts about the overall health of financial intermediaries,
they may want to pull their funds out of both sound and unsound
institutions, with the possible outcome of a financial panic
 Such panics produces large losses for the public and causes serious
damage to the economy
 To protect the public and the economy from financial panics, the
government has implemented six types of regulations:
 Restrictions on Entry
 Disclosure
 Restrictions on Assets and Activities
 Deposit Insurance
 Limits on Competition
 Restrictions on Interest Rates
Regulation: Restriction on Entry
 Restrictions on Entry
 Regulators have created very tight regulations as to who
is allowed to set up a financial intermediary
 Individuals or groups that want to establish a
financial intermediary, such as a bank or an insurance
company, must obtain a charter from the state or the
federal government
 Only if they are upstanding citizens with impeccable
credentials and a large amount of initial funds will they be
given a charter
Regulation: Disclosure
 Disclosure Requirements

 There are stringent reporting requirements for financial

intermediaries
 bookkeeping must follow certain strict principles,

 books are subject to periodic inspection,

 must make certain information available to the public

Regulation: Restriction on Assets and
Activities
 There are restrictions on what financial intermediaries are
allowed to do and what assets they can hold

 Before you put your funds into a bank or some other such
institution, you would want to know that your funds are
safe and that the bank or other financial intermediary will
be able to meet its obligations to you
 One way of doing this is to restrict the financial intermediary
from engaging in certain risky activities
 Another way is to restrict financial intermediaries from holding
certain risky assets, or at least from holding a greater quantity
of these risky assets than is prudent
Regulation: Deposit Insurance
 The government can insure people depositors to a financial
intermediary from any financial loss if the financial
intermediary should fail

 In the US, the Federal Deposit Insurance Corporation (FDIC)

insures each depositor at a commercial bank or mutual savings
bank up to a loss of $100,000 per account ($250,000 for IRAs)

 In Sri Lanka, the CBSL implemented a mandatory deposit

insurance scheme under the provisions of the Monetary Law Act
with effect from 1st October 2010 insures depositors a maximum
of Rs. 200,000 per depositor
Regulation: Past Limits on Competition
 Although the evidence that unbridled competition
among financial intermediaries promotes failures
that will harm the public is extremely weak, it
has not stopped governments from imposing
many restrictive regulations
 In the past, banks in U.S. were not allowed to
open up branches in other states, and in some
states banks were restricted from opening
additional locations
Regulation: Past Restrictions on Interest
Rates
 Competition has also been inhibited by
regulations that impose restrictions on interest
rates that can be paid on deposits
 These regulations were instituted because of the
widespread belief that unrestricted interest-rate
competition helped encourage bank failures
during the Great Depression
 Later evidence does not seem to support this
view, and restrictions on interest rates have
been abolished