Chapter 2 – An Overview of the Financial System
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 – See figure 1
Direct finance: borrowers borrow funds directly from lenders in financial
markets by selling them securities, which are claims on the borrower’s
future income or assets.
Securities: assets for the person who buys them but liabilities for the
individual or firm that sells them.
Financial markets are critical for producing an efficient allocation of capital,
which contributes to higher production and efficiency for the overall
economy.
Capital: wealth, either financial or physical, that is employed to produce
more wealth.
STRUCTURE OF FINANCIAL MARKETS
A firm can obtain funds in a financial market in two ways:
1. Issue debt instrument (bond, mortgage): contractual agreement by
the borrower to pay the holder of the instrument fixed dollar
amounts at regular intervals until a specified date, when a final
payment is made. Maturity: the number of years until that
instrument’s expiration date. Short-term: if maturity is less than a
year. Intermediate-term: between 1 and 10 years. Long-term: if
maturity is longer than 10 years.
2. Issue equities: for example, common stock: claims to share in the
net income and the assets of a business. Long term no maturity
date. Right to vote. Dividends: periodic payments. Disadvantage:
being a residual claimant: company pays its debt holders before its
equity holders. Advantage: benefit directly from any increases in the
corporation’s profitability. Debt holders do not benefit this because
their dollar payments are fixed.
Primary market: new issues of a security, such as a bond or stock, are
sold to initial buyers by the corporation or government agency borrowing
the funds. Behind doors, investment banks underwrite securities:
guarantees a price for a corporation’s securities and then sells them to the
public.
Secondary market: (foreign exchange markets, options markets)
securities that have been previously issued can be resold. Brokers:
agents of investors who match buyers with sellers of securities. Dealers:
link buyers and sellers by buying and selling securities at stated prices.
Facilitate to sell financial instruments to raise cash: they make them
more liquid. Makes it more desirable and so easier to sell in the
primary market.
1
, Determine price of these security that the issuing firm sells in the
primary market.
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.
Secondary market organization:
Exchanges: buyers and sellers of securities meet in one central
location to conduct trades (NYSE).
Over-the-counter (OTC) markets: dealers at different locations
stand ready to buy and sell securities over the counter to anyone
who comes to them and is willing to accept their prices. Very
competitive.
Money market: financial market in which only short-term debt
instruments are traded. More liquid because traded more. Smaller
fluctuations in prices safer investments.
Capital market: market in which longer-term debt and equity
instruments are traded.
FINANCIAL MARKER INSTRUMENTS
Money market instruments:
1. U.S. Treasury Bills: one-, three-, and six-month maturities to
finance federal government. They pay a set amount at maturity and
have no interest payments, but they effectively pay interest by
initially selling at a discount. Default: the party issuing the debt
instrument is unable to make interest payments of pay off the
amount owed when the instrument matures. Banks hold treasury
bills.
2. Negotiable Bank Certificates of Deposits (CD): 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. Extremely important to commercial banks.
3. Commercial Paper: issued by large banks and well-known
corporations.
4. Repurchase Agreements (repos): maturity less than two weeks.
Treasury bills serve as collateral: an asset that the lender receives if
the borrower does not pay back the loan.
5. Federal funds: overnight funds between banks of their deposits at
the Federal Reserve. Made by banks to other banks necessary to
meet deposit amounts required by regulators. Federal funds rate:
closely watched barometer of the tightness of credit market
conditions in the banking system and the stance of monetary policy.
High: banks are strapped for funds, low: bank needs are low.
Capital market instruments:
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