Samenvatting - Financial Markets and Institutions (E_EBE3_FMI)
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Financial Markets and Institutions (E_EBE3_FMI)
Instelling
Vrije Universiteit Amsterdam (VU)
Complete summary of all the book chapters, studies, and articles of Financial markets and Institutions (FMI) given in year 3 of the Study Economics and Business economics
Week 1:
Chapter 2: An overview of the financial system
https://issuu.com/wilhelminagq92/docs/economics-of-money-banking-and-financial-markets-1
§2.1 Function of financial markets
Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by
spending less than their income to those that have a shortage of
funds because they wish to spend more than their income. This
function is shown schematically in Figure 1. Those who have
saved and are lending funds, the lender-savers, are at the left, and
those who must borrow funds to finance their spending, the
borrower-spenders. The arrows show that funds flow from
lender-savers to borrower-spenders via two routes:
1. In direct finance (the route at the bottom of Figure 1),
borrowers borrow funds directly from lenders in financial
markets by selling the lenders securities (also called
financial instruments), which are claims on the
borrower’s future income or assets. Securities are assets
for the person who buys them but liabilities (IOUs or debts) for the individual or firm that sells
(issues) them.
Why is this channeling of funds from savers to spenders so important to the economy? The answer is
that the people who save are frequently not the same people who have profitable investment
opportunities available to them, the entrepreneurs. Let’s first think about this on a personal level.
Suppose that you have saved $1,000 this year, but no borrowing or lending is possible because no
financial markets are available. If you do not have an investment opportunity that will permit you to
earn income with your savings, you will just hold on to the $1,000 and it will earn no interest. Without
financial markets, it is hard to transfer funds from a person who has no investment opportunities to
one who has them. Financial markets are critical for producing an efficient allocation of capital, which
contributes to higher production and efficiency for the overall economy.
§2.2 Structure of financial markets
The following descriptions of several categories of financial markets illustrate essential features of
these markets.
Debt and equity markets:
A firm or an individual can obtain funds in a financial market in two ways.
1. The most common method is through the issuance of a debt instrument, such as a bond or
a mortgage, which is a contractual agreement by the borrower to pay the holder of the
instrument fixed dollar amounts at regular intervals (interest and principal payments) until a
specified date (the maturity date), when a final payment is made. The maturity of a debt
instrument is the number of years (term) until that instrument’s expiration date. A debt
instrument is short-term if its maturity term is less than a year and long-term if its maturity
term is ten years or longer. Debt instruments with a maturity term between one and ten years
are said to be intermediate-term.
2. The second method of raising funds is through the issuance of equities, such as common
stock, which are claims to share in the net income (income after expenses and taxes) and the
assets of a business. Equities often make periodic payments (dividends) to their holders and
are considered long-term securities because they have no maturity date. In addition, owning
stock means that you own a portion of the firm and thus have the right to vote on issues
important to the firm and to elect its directors.
The main disadvantage of owning a corporation’s equities rather than its debt is that an equity
holder is a residual claimant; that is, the corporation must pay all its debt holders before it
, pays its equity holders. The advantage of holding equities is that equity holders benefit
directly from any increases in the corporation’s profitability or asset value because equities
confer ownership rights on the equity holders. Debt holders do not share in this benefit,
because their dollar payments are fixed.
Primary and secondary markets:
A primary market is a financial market in which new issues of a security, such as a bond or a stock,
are sold to initial buyers by the corporation or government agency borrowing the funds. The primary
markets for securities are not well known to the public because the selling of securities to initial buyers
often takes place behind closed doors. An important financial institution that assists in the initial sale
of securities in the primary market is the investment bank. The investment bank does this by
underwriting securities: It guarantees a price for a corporation’s securities and then sells them to the
public.
A secondary market is a financial market in which securities that have been previously issued can be
resold. When an individual buys a security in the secondary market, the person who has sold the
security receives money in exchange for the security, but the corporation that issued the security
acquires no new funds.
A corporation acquires new funds only when its securities are first sold in the primary market.
Nonetheless, secondary markets serve two important functions.
First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they
make the financial instruments more liquid. The increased liquidity of these instruments then makes
them more desirable and thus easier for the issuing firm to sell in the primary market.
Second, secondary markets determine the price of the security that the issuing firm sells in the
primary market. The investors who buy securities in the primary market will pay the issuing
corporation no more than the price they think the secondary market will set for this security. The
higher the security’s price in the secondary market, the higher the price the issuing firm will receive for
a new security in the primary market, and hence the greater the amount of financial capital it can
raise.
Exchanges and over-the-counter markets:
Secondary markets can be organized in two ways. One method is through exchanges, where buyers
and sellers of securities (or their agents or brokers) meet in one central location to conduct trades.
The New York Stock Exchange for stocks and the Chicago Board of Trade for commodities (wheat,
corn, silver, and other raw materials) are examples of organized exchanges. The other form for a
secondary market is an over-the-counter (OTC) market, in which dealers at different locations who
have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone
who comes to them and is willing to accept their prices. Because over-the-counter dealers are in
contact via computers and know the prices set by one another, the OTC market is very competitive
and not very different from a market with an organized exchange.
Money and capital markets:
Another way of distinguishing between markets is on the basis of the maturity of the securities traded
in each market. The money market is a financial market in which only short-term debt instruments
(generally those with original maturity terms of less than one year) are traded; the capital market is
the market in which long-term debt instruments (generally those with original maturity terms of one
year or greater) and equity instruments are traded. Money market securities are usually more widely
traded than longer-term securities and so tend to be more liquid.
§2.3 Financial market instruments
To complete our understanding of how financial markets perform the important role of channeling
funds from lender-savers to borrower-spenders, we need to examine the securities (instruments)
,traded in financial markets. We first focus on the instruments traded in the money market and then
turn to those traded in the capital market. Money market instruments are only debt instruments.
Money market instruments:
Because of their short terms to maturity, the debt instruments traded in the money market undergo the
least price fluctuations and so are the least risky investments. The principal money market
instruments are: U.S. Treasury bills, Negotiable bank certificates of deposit, Commercial paper,
Repurchase agreements, and Federal funds.
U.S. Treasury bills: are the most liquid of all money market instruments because they are the most
actively traded. They are also the safest money market instrument because there is a low probability
of default, a situation in which the party issuing the debt instrument is unable to make interest
payments or pay off the amount owed when the instrument matures. The federal government can
always meet its debt obligations because it can raise taxes or issue currency (paper money or coins)
to pay off its debts.
Negotiable bank certificates of deposit: A certificate of deposit (CD) is a debt instrument sold by a
bank to depositors that pays annual interest of a given amount and at maturity pays back the original
purchase price. Negotiable CDs are those sold in secondary markets. Negotiable CDs are an
extremely important source of funds for commercial banks.
Commercial paper: is a short-term debt instrument issued by large banks and well-known
corporations.
Repurchase agreements: Repurchase agreements (repos) are effectively short-term loans (usually
with a maturity term of less than two weeks) for which Treasury bills serve as collateral, an asset that
the lender receives if the borrower does not pay back the loan. Repos are made as follows: A large
corporation, such as Microsoft, may have some idle funds in its bank account, say $1 million, which it
would like to lend for a week. Microsoft uses this excess $1 million to buy Treasury bills from a bank,
which agrees to repurchase them the next week at a price slightly above Microsoft’s purchase price.
The net effect of this agreement is that Microsoft makes a loan of $1 million to the bank and holds $1
million of the bank’s Treasury bills until the bank repurchases the bills to pay off the loan.
Federal funds: These instruments are typically overnight loans between banks of their deposits at the
Federal Reserve. The federal funds designation is somewhat confusing because these loans are not
made by the federal government or by the Federal Reserve but rather by banks to other banks. One
reason why a bank might borrow in the federal funds market is that it might find it does not have
enough funds in its deposit accounts at the Fed to meet the amount required by regulators. It can then
borrow these funds from another bank, which transfers them to the borrowing bank using the Fed’s
wire transfer system. This market is very sensitive to the credit needs of the banks, so the interest rate
on these loans, called the federal funds rate, is a closely watched barometer of the tightness of credit
market conditions in the banking system and the stance of monetary policy. When high, the federal
funds rate indicates that banks are strapped for funds; when low, it indicates that banks’ credit needs
are low.
Capital market instruments:
Capital market instruments are debt and equity instruments with maturities of greater than one year.
They have far wider price fluctuations than money market instruments and are considered to be fairly
risky investments. The principal capital market instruments are: Stocks, Mortgages and
mortgages-backed securities, Corporate bonds, U.S. government securities, U.S. government agency
securities, State and local government bonds, and Consumer and bank commercial loans.
Stocks: Stocks are equity claims on the net income and assets of a corporation.
Mortgages and mortgages-backed securities: Mortgages are loans to households or firms to purchase
land, housing, or other real structures, in which the structure or land itself serves as collateral for the
loans. Mortgage-backed securities are bond-like debt instruments backed by a bundle of individual
mortgages, whose interest and principal payments are collectively paid to the holders of the security.
, Corporate bonds: These long-term bonds are issued by corporations with very strong credit ratings.
Some corporate bonds, called convertible bonds, have the additional feature of allowing the holder
to convert them into a specified number of shares of stock at any time up to the maturity date.
U.S. government securities: These long-term debt instruments are issued by the U.S. Treasury to
finance the deficits of the federal government. Because they are the most widely traded bonds in the
United States, they are the most liquid security traded in the capital market.
U.S. government agency securities: These long-term bonds are issued by various government
agencies to finance such items as mortgages, farm loans, or power-generating equipment. They
function much like U.S. government bonds.
State and local government bonds: State and local bonds, also called municipal bonds, are long-term
debt instruments issued by state and local governments to finance expenditures on schools, roads,
and other large programs. An important feature of these bonds is that their interest payments are
exempt from federal income tax and generally from state taxes in the issuing state.
Consumer and bank commercial loans: These loans to consumers and businesses are made
principally by banks but, in the case of consumer loans, also by finance companies.
§2.4 Internationalization of financial markets
The growing internationalization of financial markets has become an important trend. American
corporations and banks are now more likely to tap international capital markets to raise needed funds,
and American investors often seek investment opportunities abroad.
International bond market, eurobonds, and eurocurrencies:
The traditional instruments in the international bond market are known as foreign bonds. Foreign
bonds are sold in a foreign country and are denominated in that country’s currency. For example, if
the German automaker Porsche sells a bond in the United States denominated in U.S. dollars, it is
classified as a foreign bond. A more recent innovation in the international bond market is the
Eurobond, a bond denominated in a currency other than that of the country in which it is sold—for
example, a bond denominated in U.S. dollars sold in London. A variant of the Eurobond is
Eurocurrencies, which are foreign currencies deposited in banks outside the home country. The most
important of the Eurocurrencies are Eurodollars, which are U.S. dollars deposited in foreign banks
outside the United States or in foreign branches of U.S. banks.
Note that the currency, the euro, can create some confusion about the terms Eurobond,
Eurocurrencies, and Eurodollars. A bond denominated in euros is called a Eurobond only if it is sold
outside the countries that have adopted the euro.
World stock markets:
Until recently, the U.S. stock market was by far the largest in the world, but foreign stock markets
have been growing in importance, with the United States not always number one. The increased
interest in foreign stocks has prompted the development in the United States of mutual funds that
specialize in trading in foreign stock markets.
§2.5 Function of financial intermediaries: indirect finance
Funds can move from lenders to borrowers by a second route, called indirect finance because it
involves a financial intermediary that stands between the lender-savers and the borrower-spenders
and helps transfer funds from one to the other. A financial intermediary does this by borrowing funds
from lender-savers and then using these funds to make loans to borrower-spenders. The process of
indirect financing using financial intermediaries, called financial intermediation, is the primary route
for moving funds from lenders to borrowers. Indeed, although the media focus much of their attention
on securities markets, particularly the stock market, financial intermediaries are a far more important
source of financing for corporations than securities markets are.
The benefits that financial intermediaries have on the economy are the following:
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