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Financial Markets and Institutions (FMI) Lecture Summary | VU EBE
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Lecture summary for the course Financial Markets and Institutions from Economics and Business Economics at the VU University Amsterdam
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IndexLecture 1: Introduction to FMI 2
Lecture 2: The meaning of interest rates 6
Lecture 3: Stock market, financial structure 14
Lecture 4 + 5: Banking and risk management 20
Lecture 6: The Modern Financial System 29
Lecture 7: Financial Crises 33
Lecture 8: Economic Analysis of Financial Regulation 38
Lecture 9: Central Banks 43
Lecture 10: International Finance and the Foreign Exchange Market 51
Guest lecture: FinTech 55
Green: Additional background information à you do not have to expect specific questions about this in
the exam
,Lecture 1: Introduction to FMI
Main function of the financial system:
• To transfer resources (funds) from lenders/savers to borrowers/spenders
The modern financial system is very complex
• Various types of financial institutions: commercial banks, broker/dealers, insurance companies,
mutual funds, FinTech firms etc.
• They are interconnected
• Shadow bank: financial intermediaries facilitating the creation of credit, but whose members are
not subject to regulatory oversight. Also referred to as unregulated activities by regulated
institutions (e.g. hedge funds, unlisted derivatives)
Financial crisis: major disruptions in financial markets that are characterised by sharp declines in asset
prices and the failures of many financial and nonfinancial firms
Central banks and monetary policy strongly affect the financial system
International finance: global financial markets have become increasingly integrated
Segments of financial system
• 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
• 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
Flows of funds through the financial system
Functions of financial markets
• Perform the essential function of channelling funds from economic players that have saved surplus
funds to those that have a shortage of funds
• Promotes economic efficiency by producing an efficient allocation of capital, which increases
production
• Directly improve the well-being of consumers by allowing them to time purchases better
• Well-functioning financial markets are key factors in producing high economic growth
2
,Classifications of financial markets according to different parameters
• A security (financial instrument) is a claim on the issuer’s future income or assets
• Type of security: debt markets, equity markets
• Nature of securities traded: primary/secondary markets
• Form of organisation: exchanges/OTC (secondary)
• Maturity of instruments: money market, capital markets
• Place where instruments issued: domestic/international markets
Basic financial instruments
• Debt securities: claim on a future cash flow of a person/firm
o Agreement to pay money at a given time
o E.g. bond that promises to make payments periodically for a specified period
o Buyers of debt instruments are suppliers of capital to the firm, not owners of the firm
o Debt instruments have a finite life or maturity date
§ Short term (<1 year) vs. long term (>= 1yeart)
o Advantage: it is a contractual promise to pay with legal rights to enforce repayment
o Disadvantage: return/profit is fixed or limited
o An interest rate is the cost of borrowing or the price paid for the rental of funds
• Equity: residual claim on assets of a firm
o E.g. common stock represents a share of ownership in a firm
o Buyers of common stock are owners of the firm
o Common stock has no finite life or maturity date
o Advantage: potential high income since return is not fixed or limited
o Disadvantage: debt payments must be made before equity payments can be made
Debt and equity markets
• Debt markets: larger in dollars than equity markets, due to greater number of participant classes
(households, businesses, government and foreigners) and size of individual participants (businesses
and government)
• Equity markets: smaller then debt markets largely because the only applicable participants are
businesses
Primary and secondary markets
• Primary markets:
o New security issues sold to initial buyers
o Increases the funds of the firm issuing them
o Not very well known to public as it is done through investment banks
o Investment banks underwrite securities: the IB guarantees a price for a firm’s securities and
sells them to the public
• Secondary market:
o Securities previously issued are bought and sold
o Importance: providing liquidity, setting prices
o Brokers match buyers and sellers
o Dealers link buyers and sellers by buying and selling securities at stated prices
Exchanges and OTC markets
• Exchanges
o Securities (stock, bonds): NYSE, AMEX etc.
o Commodities (metal, grain, oil): CBOT, NYMEX, Euronext
o Physical floor or electronic limit order book where agents meet
3
, o
• Over-the-counter (OTC):
o Network of dealers ready to buy and sell securities
o Used to be significantly less transparent than exchanges
o Nowadays very competitive; linked by computers and prices of different dealers are readily
available
o Example: foreign exchange market, where funds are converted from one currency into
another
Money markets and capital markets
• Money market:
o Maturity of securities traded is less than one year
o Short-term debt
o Examples: bills, notes, commercial paper
o More widely traded à more liquid
o Investors use market to earn interest on surplus funds that are available temporarily
• Capital markets:
o Maturity of securities traded is one year or greater
o Examples: long term bonds, equity
Internationalisation of financial markets
• Foreign bonds: sold in a foreign country and denominated in that country’s currency
o E.g. ABN Amro sells bonds in the US, denominated in the USD
• Eurobond: bond denominated in a currency other than that of the country in which it is sold
o E.g. ABN Amro sells bonds in the Netherlands, denominated in USD
• Eurocurrencies: foreign currencies deposited in banks outside the home country
o Eurodollars: USD deposited in banks outside the US
Financial intermediation
• Not all transactions occur in financial markets
• Indirect finance via financial intermediaries
• Financial intermediaries: institutions that borrow funds from people who saved and in turn make
loans to other people (e.g. banks accept deposits and make loans)
• Benefits:
o Lower transaction costs (time and money spent in carrying out financial transactions)
§ Economies of scale (e.g. loan contract)
§ Liquidity services
• Banks provide depositors with checking accounts that enable them to pay
their bills easily
• Depositors can earn interest on checking and saving accounts and yet still
convert them into goods and services whenever necessary
o Customisation of specific needs, not available in markets
o Reduce the exposure of investors to risk
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