Role of Financial Markets and Institutions

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Role of Financial Markets and Institutions

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 Financial markets provide for financial intermediation--financial savings (Surplus Units) to investment (Deficit Units) n Financial markets provide payments system

n Financial markets provide means to manage risk

Broad Classifications of Financial Markets

Money versus Capital Markets
Primary versus Secondary Markets
Organized versus Over-the-Counter Markets

Primary vs. Secondary Markets


New Issue of SecuritiesTrading Previously Issued Securities

Exchange of Funds for Financial ClaimNo New Funds for Issuer

Funds for Borrower; an IOU for LenderProvides Liquidity for Seller

Money vs. Capital Markets


Short-Term, < 1 YearLong-Term, >1Yr

High Quality IssuersRange of Issuer Quality

Debt OnlyDebt and Equity

Primary Market FocusSecondary Market Focus

Liquidity Market--Low ReturnsFinancing Investment--Higher Returns

Organized vs. Over-the-Counter Markets


Visible MarketplaceWired Network of Dealers

Members TradeNo Central, Physical Location

Securities ListedAll Securities Traded off the Exchanges

New York Stock Exchange

Securities Traded in Financial Markets

n Money Market Securities
l Debt securities Only

n Capital market securities
l Debt and equity securities

n Derivative Securities
l Financial contracts whose value is derived from the values of underlying assets l 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 Investor receives interest
u Capital gain/loss when sold
u Maturity date
Equity Securities: Claim with ownership rights and responsibilities u Investor receives dividends if declared
u Capital gain/loss when sold
u No maturity date—need market to sell

Valuation of Securities

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

Investor Assessment of New Information


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

2. To Maintain Financial Market Stability
u Prevent market crashes
n Circuit breakers
n Federal Reserve discount window
u Prevent Inflation--Monetary policy
u Prevent Excessive Risk Taking by Financial Institutions

3. To Provide Consumer Protection
Provide adequate disclosure
Set rules for business conduct

4. To Pursue Social...
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