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Structure and Regulation of Financial Markets Lecture Notes 22/23
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Structure and Regulation of Financial Markets Lecture Notes 22/23
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Structure and Regulation of Financial Markets (Autumn)Lecture 1: Introduction (week 2)
Learning objectives
- Compare and contrast direct and indirect finance
- Identify the structure of financial markets and the different types of financial market
instruments
- Describe the roles and types of financial intermediaries
- Identify the reasons for the different types of financial market regulations
Functions of financial markets
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.
Direct finance is when borrowers borrow funds directly from lenders in financial markets by selling
them securities.
Financial markets promote economic efficiency by producing an efficient allocation of capital, which
increases production. They directly improve the wellbeing of consumers by allowing them to time
purchases better.
Structure of financial markets
Financial market instruments: debt instruments and equities
The maturity of a debt instrument is the number of years (term) until that instrument’s expiration
debt – mainly bonds (corporate or government). These instruments make regular fixed payments
until the maturity and then make one final payment at the maturity.
Equities (common stock) are a claim to a share of the net income and assets of a company and often
make periodic payments (dividends – not fixed, depends on the share of the company) to their
holders.
Investment banks underwrite securities in primary markets meaning that they guarantee a price for
a corporation’s securities and then sell them to the public. Brokers and dealers work in secondary
markets.
Secondary markets can be organised in two ways
1. Exchanges: FTSE 100, Chicago Board of Trade for Commodities
2. OTC (over the counter) markets: foreign exchange, government bonds
Money markets deal in short-term debt instruments whereas capital markets deal in longer-term
debt and equity instruments.
Financial market instruments
,Treasury bills are short-term debt instruments issued by the government. Commercial paper are
short-term debt instruments by large banks and corporations. Repurchase agreements are
overnight loans from one bank to another – short term loans if banks have some liquidity needs to
satisfy.
Functions of financial intermediaries
Funds can also move from lenders to borrowers by indirect finance, which involves a financial
intermediary.
Financial intermediaries can:
1. Lower transaction costs (time and money spent in carrying out financial transactions)
- Economies of scale
2. Reduce the exposure of investors to risk
- Risk sharing (asset transformation)
- Diversification
, 3. Deal with asymmetric informations problems by
- Trying to avoid selecting risky borrowers by gathering information about them
- Ensuring the borrower will not engage in activities that will prevent them from repaying
the loan – restrictive covenants
Asset transformation is when the bank sells the assets on its balance sheet to investors (like a long-
term low risk loan) and uses this money to invest in more risky securities.
Diversification: financial intermediaries will invest in assets that have low correlated returns so the
chance of this portfolio having a negative return is much smaller (some assets have a low return and
others have a high return so the overall portfolio stays relatively stable).
, Regulation of the financial system
Governments regulate financial markets primarily to promote the provision of information, and to
ensure the soundness (stability) of the financial system.
Reasons to increase the information available to investors:
- Reduce problems related to asymmetric information
- Reduce insider trading (SEC)
To ensure the soundness of financial intermediaries:
- Restrictions on entry
- Disclosure of information
- Restrictions on assets and activities (control holding of risky assets)
- Deposit insurance (avoid bank runs)
- Limits on competition (mostly in the past)
References
- Mishkin (2013): chapters 1 and 2
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