Notes Lectures Financial Markets and
Institutions
Tirza van der Vliet
September 2021
Contents
1 Chapter 1 Why Study Money, Banking, and Financial Mar-
kets? 3
2 Chapter 2: An Overview of the Financial System 3
2.1 Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 Financial intermediaries (institutions) and financial markets . . . 4
2.3 Direct Finance: Financial Markets . . . . . . . . . . . . . . . . . 4
2.3.1 Structure of Financial Markets . . . . . . . . . . . . . . . 4
2.3.2 The Bond Market . . . . . . . . . . . . . . . . . . . . . . 5
2.3.3 The Stock Market . . . . . . . . . . . . . . . . . . . . . . 5
2.3.4 Secondary Markets . . . . . . . . . . . . . . . . . . . . . . 5
2.3.5 Financial Market Instruments . . . . . . . . . . . . . . . . 6
2.3.6 International Financial Markets . . . . . . . . . . . . . . . 6
2.4 Indirect Finance: Financial Intermediaries . . . . . . . . . . . . . 7
2.4.1 Types of Financial Intermediaries . . . . . . . . . . . . . . 8
2.4.2 Regulation of the Financial System . . . . . . . . . . . . . 8
3 Chapter 4: The Meaning of Interest Rates 9
3.1 Measuring Interest Rates . . . . . . . . . . . . . . . . . . . . . . 9
3.2 Four types of Credit Market Instruments . . . . . . . . . . . . . . 10
3.2.1 Yield to Maturity: a Simple Loan . . . . . . . . . . . . . 11
3.2.2 Yield to Maturity: Fixed-Payment Loan . . . . . . . . . . 11
3.2.3 Yield to Maturity: Coupon Bond . . . . . . . . . . . . . . 11
3.2.4 Yield to Maturity: Discount Bond . . . . . . . . . . . . . 12
3.3 Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3.3.1 The Distinction between Interest Rate and Returns . . . 13
3.4 Maturity and the Volatility of Bond Returns: Interest-Rate Risk 13
3.5 The Distinction between Real and Nominal Interest Rates . . . . 14
3.5.1 The Fisher Equation . . . . . . . . . . . . . . . . . . . . . 14
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,4 Chapter 5: The Behavior of Interest Rates 14
4.1 Theory of Portfolio Choice . . . . . . . . . . . . . . . . . . . . . . 15
4.2 Supply and Demand in the Bond Market . . . . . . . . . . . . . . 15
4.2.1 Factors that shift the Demand Curve for Bonds . . . . . . 16
4.2.2 Factors that shift the Supply Curve for Bonds . . . . . . . 17
4.2.3 Response to a Change in Expected Inflation . . . . . . . . 17
4.3 Supply and Demand in the Market for Money: the Liquidity
Preference Framework . . . . . . . . . . . . . . . . . . . . . . . . 18
4.3.1 Equilibrium in the Market for Money . . . . . . . . . . . 18
4.3.2 Changes in Equilibrium Interest Rates in the Liquidity
Preference Framework . . . . . . . . . . . . . . . . . . . . 19
4.4 Does a higher Rate of Growth of the Money Supply Lower Interest
Rates? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
5 Chapter 6: The Risk and Term Structure of Interest Rates 21
5.1 Risk Structure of Interest Rates . . . . . . . . . . . . . . . . . . . 21
5.2 Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . 22
5.2.1 Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . . 23
5.2.2 Theory of the Term Structure . . . . . . . . . . . . . . . . 23
5.3 Expectations Theory . . . . . . . . . . . . . . . . . . . . . . . . . 24
5.4 Segmented Market Theory . . . . . . . . . . . . . . . . . . . . . . 25
5.5 Liquidity Premium Theory . . . . . . . . . . . . . . . . . . . . . 26
6 Chapter 7: The Stock Market, the Theory of Rational Expec-
tations, and the Efficient Market Hypothesis 27
6.1 Computing the Price of Common Stock . . . . . . . . . . . . . . 28
6.2 Theory of Rational Expectations . . . . . . . . . . . . . . . . . . 29
6.2.1 Adaptive Expectations . . . . . . . . . . . . . . . . . . . . 29
6.2.2 Formal Statement of the Theory . . . . . . . . . . . . . . 30
6.2.3 Implications of the Theory . . . . . . . . . . . . . . . . . 30
6.3 The Efficient Market Hypothesis: Rational Expectations in Fi-
nancial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
6.3.1 Rationale behind the Hypothesis . . . . . . . . . . . . . . 31
6.4 Behavioral Finance . . . . . . . . . . . . . . . . . . . . . . . . . . 32
7 Chapter 8: an Economic Analysis of Financial Structure 33
7.1 Financial Intermediaries Benefits . . . . . . . . . . . . . . . . . . 33
7.2 Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . 34
7.3 Information Costs . . . . . . . . . . . . . . . . . . . . . . . . . . 34
7.3.1 Adverse Selection Solution . . . . . . . . . . . . . . . . . . 34
7.3.2 Moral Hazard Solution . . . . . . . . . . . . . . . . . . . . 35
8 Chapter 9: Banking and the Management of Financial Institu-
tions 37
8.1 The Bank Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . 37
8.2 Basic Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
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, 8.2.1 Basic Banking: Making a Profit . . . . . . . . . . . . . . . 39
8.3 General Principles of Bank Management . . . . . . . . . . . . . . 40
8.3.1 Liquidity Management and the Role of Reserves . . . . . 40
8.3.2 Capital Adequacy Management . . . . . . . . . . . . . . . 41
8.3.3 Managing Interest-Rate Risk . . . . . . . . . . . . . . . . 43
9 Chapter 10: Economic Analysis of Financial Regulation 44
9.1 Asymmetric information as a Rationale for Financial Regulation 44
9.2 Drawbacks of the Government Safety Net . . . . . . . . . . . . . 44
9.3 Types of Financial Regulation . . . . . . . . . . . . . . . . . . . . 45
9.3.1 Restrictions on Asset Holdings . . . . . . . . . . . . . . . 46
9.3.2 Capital Requirements . . . . . . . . . . . . . . . . . . . . 46
10 Chapter 11: Banking Industry: Structure and Competition 47
10.1 Decline Traditional Banking . . . . . . . . . . . . . . . . . . . . . 49
10.1.1 Banks’ Responses . . . . . . . . . . . . . . . . . . . . . . . 50
10.2 Bank Consolidation and Nationwide Banking . . . . . . . . . . . 50
10.2.1 Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
10.2.2 Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
10.3 Separation of the Banking and other Financial Service Industries 50
11 Chapter 12: Financial Crises in Advanced Economies, Chapter
13: Financial Crises in Emerging Economies 51
11.1 Advanced Economies . . . . . . . . . . . . . . . . . . . . . . . . . 52
11.2 Emerging Economies . . . . . . . . . . . . . . . . . . . . . . . . . 52
12 Quiz 2 53
13 Quiz 3 55
1 Chapter 1 Why Study Money, Banking, and
Financial Markets?
Financial markets and institutions make the whole financial system.
2 Chapter 2: An Overview of the Financial Sys-
tem
2.1 Financial System
A financial system helps transferring the funds from economic agents like people
and firms who have an excess of available funds (savers) to the economic agents
who have a need of funds (borrowers). Financial markets, such as those for
bonds, stocks or foreign exchange and institutions, such as banks, insurance
companies or mutual funds affect our every day life and the flow of funds through
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,our economy which in turn affect business profits, production of goods and
services and the economic well being of other countries.
2.2 Financial intermediaries (institutions) and financial
markets
There can be made a major distinction in how the funds are channeled from
savers (which are mainly households, but can also be firms and governments)
to the borrowers (which are mainly businesses and governments, but can also
be households or foreigners).
The funds can be channeled either through financial intermediaries or in-
stitutions which is called indirect finance or through financial markets which is
called direct finance. In direct finance, borrowers borrow funds directly from
lenders in financial markets by selling them securities (or financial instruments).
In indirect finance, transferring funds between the counter parties through fi-
nancial intermediaries. The whole financial system promotes economic efficiency
by producing an efficient allocation of capital, which increases production and
directly improves the well being of the consumers by allowing them to time
purchases better.
2.3 Direct Finance: Financial Markets
Well functioning financial markets are a key factor in producing high economic
growth. In advanced countries, bond and stock markets are highly functioning.
Poorly performing financial markets are one reason that many countries remain
poor.
It is already mentioned that in financial markets, securities are traded. Secu-
rities are a claim on the issuer’s future income or assets. Securities are assets for
the person who buys them, or invests in them, but a liability for the individual
or firm that sells or issues them.
2.3.1 Structure of Financial Markets
There are several classifications of financial markets. The first one is by the
nature of claim: if one has to borrow funds for e.g. production, it might borrow
the funds from savers either by issuing a debt instrument (issuing a bond) or
by issuing equities (stocks).
The second classification of financial markets is through the time of issuing
the securities. A primary market is a financial market in which new issues
securities are sold to initial buyers of the corporation. A secondary market
is a financial market in which the security that have been previously issued
can be resold. An important financial institution that assists the initial sale of
securities in the primary market is the investment bank. The investment bank
assists by underwriting securities, which means that it guarantees a price for a
corporation’s securities first, and then sells them to the public. Corporations
acquire new funds only when its securities are first sold in the primary market. It
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,does not receive funds when stocks are traded in the secondary market. Brokers
and dealers work in secondary markets.
The last way to classify financial markets is through maturity of claim.
Money market instruments are securities that have a maturity of less than a
year. These securities are usually wider traded than longer securities, and there-
fore tend to be much more liquid. Securities that have maturity longer than a
year are traded in capital markets. Stock markets are part of capital markets.
Money markets deal in short-term debt instruments. Capital markets deal in
longer-term debt and equity instruments.
2.3.2 The Bond Market
A bond is a debt security (IOU) stating that the issuer is indebted to the
holder. It is a debt security that promises to make payments periodically for
a specified period of time until its maturity. These fixed payments are called
interest payments, which are actually the cost of borrowing for the firm that
issues them. There are multiple types of bonds, one of them is a coupon bond.
A coupon bond is often issued by corporations. On the bond is the interest
(coupon) rate, the maturity and the nominal (face) value. This means that,
until its maturity, the holder of the bond is going to receive periodically the
interest rate of the nominal value of the bond. At maturity, the issuer is going
to pay the nominal value of the bond and the transaction is completed. The
riskier the bond, the higher the interest rate.
2.3.3 The Stock Market
Issuing a stock and selling it to the public is another way for corporations to
raise funds to finance their activities. Stocks are securities that entitles the
owners a share of the ownership of the corporation. Stocks are a privately-held
claim on the residual earning and assets of the corporation. The stocks do not
have a maturity and they pay dividends. Dividends are fractions of the profits
of the company, which are paid to the owner of the stock. Stocks are traded in
the stock markets, which are most the widely followed financial markets in the
world. The stock market is also an important factor in investment decisions,
this is because a higher price for a firm’s shares, means that the firm can raise
a larger amount of funds. This can be used to buy production, facilities or
equipment by the corporation.
2.3.4 Secondary Markets
Secondary markets can be organized in two ways. One method is through
exchanges (like stock exchanges), where buyers and sellers meet in one central
location to conduct trades. The other form of 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 that comes to them and that is willing to accept their prices. Because
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, over-the-counter dealers are in contact by computers and the prices are set
by one another, they are competitive and not very different from a market of
exchange.
2.3.5 Financial Market Instruments
Because money market instruments have short-term maturity, they have the
least price fluctuations and they are considered the least risky investment. US
Treasury bills or the Dutch Treasury certificates 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
since they are issued by the government. Certificates of deposits (CD’s) are
issued by the banks to the public. Commercial paper is issued by large banks
and corporations. Repos are very short term instruments, like shorter than two
weeks. Fed funds are typically overnight loans between banks of their deposits at
the Federal Reserve banks, which is the central bank of the United States. These
loans are made by banks, not by the fed. The interest rate, called the federal
funds rate is closely watched in the credit market as it shows the financing costs
of the banks and it also indicated the stance of the monetary policy. Every
central bank has its own interbank interest rate, e.g. in the Eurozone it is called
the re-financing rate. A higher interbank interest rate means that the banks are
desperate for funds, a low interbank interest rate means that the bank’s credit
needs are low.
Capital market instruments have a wider price fluctuations than money mar-
ket instruments and are considered to be very risky investments. Stocks are part
of the capital market instruments, as well as mortgages. Mortgages are loans
to households or firms to purchase land, housing or other real structures where
the structure or land itself serves as the collateral for the loans. Corporate
bonds are issued by corporations with very strong credit ratings. There are also
government bonds that are longer than one year, like government securities,
government agency securities and state bonds which are also part of capital
market instruments.
2.3.6 International Financial Markets
There is an outstanding international bond market where traditionally foreign
bonds are traded. Foreign bonds are sold in a foreign country and are denomi-
nated in that country’s currency. A more recent innovation in the international
bond market is the Eurobond. Eurobond is denominated in a currency other
than that of a country in which it is sold. For instance, a bond denominated in
US dollars that is sold in London, is a Eurobond. Another major part of the
international financial markets is the World Stock Market. Investors worldwide
are now paying attention to foreign stock markets like Amsterdam Exchange
Index and Hong Kong stock Exchange. The most important issue in investing
in foreign markets is the exchange rate risk which has to be paid attention to
by investors apart from the volatility of stock markets themselves.
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