This document is a summary of the course Financial Markets & Institutions. The summary contains lectures notes and reading from both Mishkin's book and the academic papers.
Financial markets are markets in which funds are transferred from people who have an
excess of available funds to people who have a shortage. In direct finance, lenders transfer
funds directly to the borrowers by buying securities. Securities are assets for the person who
buys them, but liabilities for the person/firm that sells them.
Indirect finance involves a financial intermediary that transfers funds from the
lender-savers to the borrower-spenders. Financial intermediaries can substantially reduce
transaction costs because of economies of scale and expertise. Other benefits of financial
intermediaries are liquidity services, customization of needs, risk sharing (selling assets with
low risk and using the funds to purchase assets with more risk) and diversification.
Classifications of markets according to different parameters:
- Type of security: debt markets, equity markets
- Nature of securities traded: primary / secondary markets
- Form of organisation: exchanges / OTC (secondary)
- Maturity of instruments: money market (<1y debt), capital markets(>1y)
- Place where instruments issued: Domestic / International markets
Debt and equity markets
A firm or individual can obtain funds in two ways:
- Issue debt: a contractual agreement by the borrower the pay the holder of the
instrument fixed amounts of money (interest and principal payments) at regular
intervals until the maturity date.
- Issue equity: securities that represent a share of ownership in a corporation. Equities
often pay dividends to their holders and are considered long-term securities because
they have no maturity date.
The disadvantage of equity is that equity holders are a residual claimant; the corporation
must pay all its debt holders before it pays its equity holders. On the other hand, equity
holders benefit directly from any increases in the corporation’s profitability or asset value.
Primary and secondary markets
The primary market is the market in which new issues of a security are sold to investors by
the corporation borrowing the funds. Investment banks assist these initial sales by
underwriting the securities; it guarantees a price for a security and then sells it to the public.
An initial public offering (IPO) refers to the process of offering shares of a private
corporation to the public in a new stock issuance for the first time. An IPO allows a company
to raise equity capital from public investors.
In the secondary market, investors exchange with other investors rather than the issuing
entity. The secondary market serves two important functions:
- They make it easier and quicker to sell securities to raise cash (liquidity)
- They determine the price of the security in the primary market.
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,Exchange and over-the-counter markets
Secondary markets can be organised in two ways:
- In organised exchanges buyers and sellers meet in one central location to conduct
trades, for instance the New York Stock Exchange.
- In an OTC market, securities are not listed on an exchange, but trade through a
broker-dealer network. Securities trade OTC is because of low costs, or because they
don't meet the financial or listing requirements to list on an exchange.
Money and capital markets
Money market is a financial market in which only short-term (<1 year) debt instruments are
traded OTC. Because of the short maturity, the securities traded in the money market
undergo the least volatility and thus are the least risky investments.
Money markets instruments (MMI’s)
- Treasury Bills are highly liquid because they are easy to trade. Also the safest of all
MMI’s because of low risk of default.
- Certificates of Deposit is a debt instrument sold by banks to depositors. CDs pay
higher interest rates in exchange for leaving the funds on deposit for a while.
- Commerical Paper is a short-term debt instrument issued by large banks and
well-known corporations.
- Repurchase Agreements are a short-term agreements to sell securities in order to
buy them back at a slightly higher price, mostly for dealers in government securities.
Capital market is the financial market in which longer-term (>1 year) debt and equity
instruments are traded. Capital markets instruments undergo more volatility and are thus
more risky investments:
- Stocks are a securities that represents a share of ownership in a corporation, and
thus are claims on the net income and assets of the corporation.
- Mortgages
- Corporate bonds are long-term bonds, issued by corporations with strong credit
credit ratings.
- Government bonds are long-term bonds, issued by the government.
Internationalisation of financial markets
A foreign bond is issued by an international company in a country different from their own,
and using that country's currency to denominate those bonds.
A Eurobond is a denominated in a currency other than the home currency of the country or
market in which it is issued.
Eurocurrency refers to currency deposits held at banks outside of their country of origin, for
instance U.S. Dollars outside the U.S (Eurodollars).
Information asymmetry
Information asymmetry occurs when one party has more or better information than the
other. The two forms of information asymmetry are adverse selection and moral hazard.
Financial intermediaries make it less likely these problems occur.
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, Adverse selection is a problem created before transaction/contract. Because adverse
selection makes it more likely that loans might be made to bad credit risks, lenders may
decide not to make any loans even though there are good credit risks in the market place.
Moral hazard is a problem created after transaction. Moral hazard can exist when a party to
a contract can take risks without having to suffer consequences. This will make it less likely
that the loan will be paid back.
Government regulation can reduce information asymmetry and increase the efficiency of
financial markets, by increasing the amount of information publicly available. Another reason
for the regulation of financial markets, is to ensure the integrity of financial intermediaries.
Types of financial intermediaries
1. Depository institutions are financial intermediaries that accept deposits (liabilities) and
make loans or mortgages (assets).
- Commercial banks raise funds by issuing sight deposits (cheques), savings
deposits (payable on demand) and time deposits (fixed term to maturity).
- Building Societies have the status of a mutual fund. The are owned by the
depositors and obtain funds through savings deposits.
- Credit unions are very small cooperative lending institutions organised around a
particular group (employees of a firm for example).
2. Contractual savings institutions acquire funds (premiums) at periodic intervals on a
contractual basis. Primary assets are stocks and bonds.
- Life and general insurance
- Pension funds
3. Investment intermediaries
- Finance companies raise funds by selling commercial paper and issuing stocks and
bonds. Primary assets are consumers and business loans.
- Mutual funds sell shares to individuals and then invests the proceeds in bonds and/or
stocks. Lower transaction costs, diversification and closed-end.
- Money market institutions look like mutual funds, but also function as a depository
institution.
Measuring interest rates
The concept of present value is based on the idea that a euro paid to you one year from now
is less valuable to you than a euro paid to you today.
The process of calculating today’s value of euros received in the future is called discounting
the future, where the present value of the cash flow is noted as:
𝐶𝐹
𝑃𝑉 = 𝑛
(1+𝑖)
The process of calculating the future value of euros received today is called capitalizing,
where the future value of the cash flow is noted as:
𝑛
𝐹𝑉 = 𝐶𝐹(1 + 𝑖)
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