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2. Overview of the financial system - Financial Institutions and MarketsFunction of Financial Markets
Channels funds from person or business without investment opportunities (i.e., “Lender-Savers”) to
one who has them (i.e., “Borrower-Spenders”). It improves economic efficiency.
Segments of Financial Markets
Direct Finance: Borrowers (spenders) borrow directly from lenders (savers) in financial markets by
selling financial instruments which are claims on the borrower’s future income or assets. Securities
are assets for the lender, but liabilities for who is receiving the funds as he has to pay off the debt to
the lender. Example: Corporations selling bonds: have the possibility to use direct finance thanks to
selling bonds or issuing stocks to the public.
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
Functions and Importance of Financial Markets
They are important because if, for example, you save $1,000, but there are no financial markets,
then you can earn no return on this - might as well put the money under your mattress.
However, if a carpenter could use that money to buy a new saw (increasing his productivity), then he
is willing to pay you some interest for the use of the funds.
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.
1. Flows of Funds Through the Financial System
, Structure of Financial Markets
Debt Markets: by issuing a debt instrument such as a bond or mortgage, which represent a
contractual agreement between holder and borrower. The borrower will pay an X amount to the
holder of the instrument at regular intervals, until a specified date (maturity), when the final
payment is made.
- Short-Term (maturity < 1 year)
- Long-Term (10 years or longer)
- Represented $258 trillion globally in Q1 2020
Equity Markets: issued equities ex. common stock, shares. Equities make periodic payments
(dividends) to the holder and are considered long-term as they do not have a predefined maturity.
- Advantage: holders benefit directly from any increase in the corporation profitability/asset
value
- Disadvantage: the equity holder is a residual claimant, meaning that a corporation has to pay
all its debts before it pays its equity to the holders.
- Pay dividends, in theory forever
- Represent an ownership claim in the firm
- Total value of all U.S. equity was $35.5 trillion on June 30th 2020
Primary Market: is the market where new securities such stock and bonds are sold to buyers. It
often takes place behind doors for the presence of an investment bank (kind of financial
intermediary) that assists the initial sale (IPO), by underwriting a price for a corporation's securities
and then sells them to the public. Important difference between an investment and commercial
bank, that are not allowed to do it. Investment banks are involved with companies that ask IB to find
investors willing to buy the security.
- New security issues sold to initial buyers
- Typically involves an investment bank who underwrites (or ‘buys’) the offering
Secondary Market: In which securities previously issued are bought and sold. Investor doesn’t buy
directly from a company but from someone else that is willing to sell. It involves brokers ( an
intermediary that cannot hold shares or having a position. He/she has just to execute) and dealers (a
trader that can hold shares and position: A dealer previously bought what is selling; it is more risky)
- Securities previously issued are bought and sold
- Examples include the NYSE and Nasdaq
- Involves both brokers and dealers (do you know the difference?)
- Even though firms don’t get any money, per se, from the secondary market, it serves
important functions:
- Provides liquidity, making it easy to buy and sell the securities of the companies
- Establishes a price for the securities (useful for company valuation)
- Gives an idea at what price a company can realize a capital increase
- We can further classify secondary markets as follows:
- Exchanges: Trades conducted in central locations (e.g., New York Stock Exchange,
CBT)
- Over-the-Counter (OTC) Markets: Dealers at different locations buy and sell. The
best example is the market for Treasury Securities
,We can also classify markets by the maturity of the securities
- Money Market: Short-Term (maturity < 1 year) plus forex
- Capital Market: Long-Term (maturity > 1 year) plus equities (no maturity)
Internationalization of Financial Markets
The internationalization of markets is an important trend. The U.S. no longer dominates the world
stage. International Bond Market & Eurobonds:
- Foreign bonds: are sold in foreign countries and adopted the country’s currency.
- Denominated in a foreign currency
- Targeted at a foreign market
- Eurobonds
- Denominated in one currency, but sold in a different market
- Now larger than U.S. corporate bond market
- Over 80% of new bonds are Eurobonds
- Eurocurrency Market
- Foreign currency deposited outside of home country
- Eurodollars are U.S. dollars deposited, say, London.
- Gives U.S. borrows an alternative source for dollars.
- World Stock Markets
- U.S. stock markets are no longer always the largest—at one point, Japan’s was larger
The number of international stock market indexes is quite large. For many of us, the level of the Dow
or the S&P 500 is known. How about the Nikkei 225? Or the FTSE 100? Do you know what countries
these represent?
Global Perspective: Relative Decline of U.S. Capital Markets
- The U.S. has lost its dominance in many industries: automobiles and consumer electronics,
to name a few. A similar trend appears at work for U.S. financial markets, as London and
Hong Kong compete. Indeed, many U.S. firms use these markets over the U.S.
Why?
1. New technology in foreign exchanges
2. 9-11 made U.S. regulations tighter
3. Greater risk of lawsuit in the U.S.
4. Sarbanes-Oxley has increased the cost of being a U.S.-listed public company
, Function of Financial Intermediaries: Indirect Finance
Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank)
plays as the middleman:
○ the intermediary obtains funds from savers
○ the intermediary then makes loans/investments with borrowers
● This process, called financial intermediation, is actually the primary means of moving funds
from lenders to borrowers.
● More important source of finance than securities markets (such as stocks)
● Needed because of transactions costs, risk sharing, and asymmetric information
● Transaction Costs
○ Financial intermediaries make profits by reducing transaction costs
○ Reduce transaction costs by developing expertise and taking advantage of
economies of scale
● A financial intermediary’s low transaction costs mean that it can provide its customers with
liquidity services, services that make it easier for customers to conduct transactions
○ Banks provide depositors with checking accounts that enable them to pay their bills
easily
○ Depositors can earn interest on checking and savings accounts and yet still convert
them into goods and services whenever necessary
(parentesis) Global: The Importance of Financial Intermediaries Relative to Securities Markets
● Studies show that firms in the U.S., Canada, the U.K., and other developed nations usually
obtain funds from financial intermediaries, not directly from capital markets.
● In Germany and Japan, financing from financial intermediaries exceeds capital market
financing 10-fold.
● However, the relative use of bonds versus equity does differ by country.
Function of Financial Intermediaries: Indirect Finance continued
● 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
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