Financial Markets & Institutions
Extensive summary of the lectures & book chapters
Vrije Universiteit Amsterdam, March 2022
This summary contains a summary of the lecture slides and a summary of some of the book chapters from
the book “The economics of money, banking, and financial markets”.
Week 1 (Chapter 2 + lectures week 1)
Financial markets à bond and stock markets.
Financial intermediaries à banks, insurance companies, and pension funds.
Function of financial markets
= 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.
Flows of funds through the financial system
Lender-savers = those who have saved and are lending funds.
Borrower-spenders = those who must borrow funds to finance their spending.
In direct finance, 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.
In indirect finance, a financial intermediary borrows funds from lender-savers and then uses these funds
to make loans to borrower-spenders.
• Securities are assets for the person who buys them but liabilities (IOUs or debts) for the individual
or firm that sells (issues) them.
• For example, if Ford needs to borrow funds, it might borrow the funds from savers by selling them a
bond, a debt security that promises to make periodic payments for a specified period of time, or a
stock, a security that entitles the owner to a share of the company’s profits and assets.
Financial markets allow funds to move from people who lack productive investment opportunities to people
have such opportunities. Financial markets are critical for producing an efficient allocation of capital
(wealth, either financial or physical, that is employed to produce more wealth), which contributes to higher
production and efficiency for the overall economy.
Financial markets that are operating efficiently improve the economic welfare of everyone.
à Improves well-being of consumers by allowing them to time their purchases better. They provide funds to
young people to buy what they need without forcing them to wait until they have saved up the entire
purchase price.
Structure of financial markets
The following descriptions of several categories of financial markets illustrate essential features of these
markets.
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,Debt and equity markets
A firm or an individual can obtain funds in a financial market in two ways:
1. 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, when a final payment is made.
• Maturity = the number of years (term) until that instrument’s expiration date.
• A debt instrument is short-term if its maturity 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. Through the issuance of equities
• Such as common stock, which are claims to share in the net income and the assets of a business.
• Equities often make periodic payments (dividends) to their holders.
• Equities are considered long-term securities because they have no maturity date.
• 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.
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.
Securities brokers and dealers are crucial to a well-functioning secondary market. Brokers are
agents of investors who match buyers with sellers of securities. Dealers link buyers and sellers by
buying and selling securities at stated prices.
When an individual buys a security in the secondary market, the corporation that issued the security
acquires no new funds (only acquires funds in the primary market). Nonetheless, secondary markets serve
2 important functions.
1. They make it easier and quicker to sell these financial instruments to raise cash, 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.
2. Second, secondary markets determine the price of the security that the issuing firm sells in the
primary market. 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.
à Conditions in the secondary market are therefore the most relevant to corporations issuing securities.
Exchanges and over-the-counter markets
Secondary markets can be organized in two ways.
1. Through exchanges, where buyers and sellers of securities (or their agents and brokers) meet in
one central location to conduct trades.
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, 2. The other forum 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.
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 are traded.
The capital market is the market in which longer-term debt instruments (generally those with original
maturity terms of one year or greater) and equity instruments are traded.
Financial market instruments
Next, we will 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
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.
U.S. Treasury Bills
- These short-term debt instruments of the U.S. government are issued in one, three, and six-month
maturities to finance the 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 – that is, at a price lower than the set amount paid at maturity.
- U.S. treasury bills are the most liquid of all of them because they are the most actively traded.
- They are also the safest because there is a low probability of default, a situation in which the party
issuing the debt instrument (fed. gov. in this case) 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 pay annual
interest of a given amount and at maturity pays back the original purchase price.
Commercial Paper
- 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.
- The most important lenders in this market are large corporations.
Federal (Fed) Funds
- 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.
- 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.
Capital market instruments
Capital market instruments are debt and equity instruments with far wider price fluctuations than money
market instruments and are considered to be fairly risky investments.
Stocks
- Stocks are equity claims on the net income and assets of a corporation.
- The amount of new stock issues in any given year is typically quite small.
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, Mortgages and Mortgage-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.
- Mortgages are provided by financial institutions such as savings and loan associations, mutual
savings bank, commercial banks, and insurance companies.
- However, a growing amount of the funds for mortgages have been provided by mortgage-backed
securities, 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.
- The typical corporate bond sends the holder an interest payment twice a year and pays off the face
value when the bond matures.
- 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.
U.S. Government Agency Securities
• These long-term debt instruments are issued by various government agencies, to finance such
items as mortgages, farm loans, or power generating equipment.
State and Local Government 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.
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.
Money market instruments Capital market instruments
U.S. Treasury Bills Stocks
Negotiable Bank Certificates of Deposit Mortgages & Mortgage-Back Securities
Commercial paper Corporate Bonds
Repurchase Agreements U.S. Government Securities
Federal (Fed) Funds U.S. Government Agency Securities
State & Local Government Bonds
Consumer & Bank Commercial Loans
Function of financial intermediaries: Indirect finance
As shown in figure 1, 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. Financial intermediaries are a far more important
source of financing for corporations than securities markets are.
But why are financial intermediaries and indirect finance so important in financial markets?
Transaction costs
• Transaction costs, the time and money spent in carrying out financial transactions, are a major
problem for people who have excess funds to lend.
• Financial intermediaries can substantially reduce transaction costs because they have developed
expertise in lowering them and because their large size allows them to take advantage of
economies of scale.
• In addition, a financial intermediary’s low transaction costs mean that it can provide its customers
with liquidity services, services that make it easier for customers to conduct transactions.
Risk sharing
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