FINC/ECON 3830

Financial Markets and Institutions

Leng Ling Ph.D.

Associate Professor of Finance
Department of Economics and Finance

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Role of Financial Markets and Institutions

Chapter Objectives
describe the types of financial markets that facilitate
the flow of funds
describe the types of securities traded within financial
markets
describe the role of financial institutions within
financial markets
explain how financial institutions were exposed to the
credit crisis
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Financial Market

A market in which financial assets (securities) such as stocks

and bonds can be purchased or sold. Funds are transferred in
financial markets when one party purchases financial assets
previously held by another party.

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Role of Financial Markets

Financial markets transfer funds from those who have excess
funds to those who need funds.
. Surplus units: participants who receive more money than
they spend, such as investors.
. Deficit units: participants who spend more money than they
receive, such as borrowers.
. Securities: represent a claim on the issuers
. Debt securities - debt (also called credit, or borrowed funds)
incurred by the issuer.
. Equity securities - (also called stocks) represent equity or
ownership in the firm.
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Role of Financial Markets

Accommodating Corporate Finance Needs: The financial
markets serves as the mechanism whereby corporations (acting
as deficit units) can obtain funds from investors (acting as
surplus units).
Accommodating Investment Needs: Financial institutions
serve as intermediaries to connect the investment management
activity with the corporate finance activity. (Exhibit 1.1)

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Exhibit 1.1 How Financial Markets Facilitate

Corporate Finance and Investment Management

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Role of Financial Markets

Primary versus Secondary Markets
. Primary markets - facilitate the issuance of new securities
IPO
. Secondary markets - facilitate the trading of existing
securities, which allows for a change in the ownership of the
securities
. Liquidity is the degree to which securities can easily be
liquidated (sold) without a loss of value.
. A liquid securities: traded by many investors.

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Securities Traded in Financial Markets

Securities can be classified as money market securities, capital
market securities, or derivative securities.
Money Market Securities
. Money markets facilitate the sale of short-term debt
securities.
. Debt securities that have a maturity of one year or less.
. Very liquid, low expected return, low default risk.
. Treasury bills (T-bill); Commercial paper (issued by
firms); certificates of deposit (issued by depository
institutions)
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Securities Traded in Financial Markets

Capital Market Securities - facilitate the sale of long-term
securities by deficit units to surplus units.
. Bonds - long-term debt securities issued by the Treasury,
government agencies, and corporations to finance their
operations.
. Mortgages - long-term debt obligations created to finance the
purchase of real estate.
. Mortgage-backed securities - debt obligations representing
claims on a package of mortgages.
. Stocks - represent partial ownership in the corporations that
issued them.

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Securities Traded in Financial Markets

Derivative Securities - financial contracts whose values are
derived from the values of underlying assets
. Speculation - allow an investor to speculate on movements in
the value of the underlying assets without having to purchase
those assets.
. Risk management - financial institutions and other firms can
use derivative securities to adjust the risk of their existing
investments in securities.
. Options, futures, swaps, forward.

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How to measure the value of a financial security?

A financial security generates a unique stream of expected cash

flows to investors. The value is measured as the present value of
its expected cash flows, discounted at a rate that reflects the
risk.

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1. Receive $100 today

2. Receive $100 one year from now
Would you choose 1 or 2?

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Time Value of Money (TVM)

Money has time value
People prefer receiving $100 today to receiving $100 one
year from now because they place a LOWER value on cash
flow received at a later date. The value of $100 received one
year from now is less than $100 received today.

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Time Value of Money (TVM)

1. If you put $100 in a bank deposit account earning 4%

annually, how much will be in the account after one year

and after two years?

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Time Value of Money (TVM)

Future Value

Number of periods

FV PV (1 r )
Present Value

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Interest rate

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Time Value of Money (TVM)

FV PV 1 r

FV
PV
n
(1 r )

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Time Value of Money (TVM)

1. Suppose an investment will bring 100 after 1 year. You will

require a 10% annual rate of return. What is the maximum

price you are willing to pay for it?

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Time Value of Money (TVM)

1. Suppose an investment will bring 100 after 1 year and

another 100 after 2 years. You will require a 15% annual rate
of return. What is the maximum price you are willing to pay
for it?

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Securities Traded in Financial Markets

Valuation of Securities
. Impact of information on valuation
. Use economic, industry, and firm-specific information to value
a security
. Estimate future cash flows by obtaining information that may
influence a stocks future cash flows. (Exhibit 1.2)

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Exhibit 1.2 Use of Information to Make Investment

Decisions

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Securities Traded in Financial Markets

Valuation of Securities (cont.)
. Impact of the internet on valuation
. More timely, accurate and informative pricing

. Impact of Behavioral Finance on Valuation

. Various conditions can affect investor psychology. Behavioral
finance can sometimes explain the movements of a securitys
price.
. Weather ?

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Securities Traded in Financial Markets

Securities Regulations
. Required Disclosure
. The Securities Act of 1933 was intended to ensure complete
disclosure of relevant financial information on publicly offered
securities and to prevent fraudulent practices in selling these
securities.

. The Securities Exchange Act of 1934 extended the disclosure

requirements to secondary market issues; SEC.
. After 2001-2002 financial scandals (Enron and WorldCom),
The Sarbanes-Oxley Act required that firms provide more
complete and accurate financial information, proper auditing
and oversight by board of directors.
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Securities Traded in Financial Markets

International Securities Transactions
. Foreign Exchange Market - International financial
transactions normally require the exchange of currencies. The
foreign exchange market facilitates this exchange.

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Securities Traded in Financial Markets

Government Intervention in Financial Markets
In recent years, government has increased its role in financial
markets.
. During credit crisis
. Federal Reserve purchased various debt securities
. Intent ensure more liquidity in the debt securities and
therefore encourage investors to purchase
. Increased monitoring of stock trading
. Prosecuted insider information trading cases
. Ensure no investor had an unfair advantage

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Role of Financial Institutions

Financial institutions are needed to resolve the limitations
caused by market imperfections such as limited information
regarding the creditworthiness of borrowers.
Role of depository institutions - Depository institutions accept
deposits from surplus units and provide credit to deficit units
through loans and purchases of securities.
.
.
.
.
.
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Offer liquid deposit accounts to surplus units

Provide loans of the size and maturity desired by deficit units
Accept the risk on loans provided
Have more expertise in evaluating creditworthiness
Diversify their loans among numerous deficit units

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Role of Financial Institutions

Role of Depository Institutions (cont.)
.

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Commercial Banks
. The most dominant type of depository institution
. Transfer deposit funds to deficit units through loans or purchase of
debt securities
. Federal Funds Market - facilitates the flow of funds between
depository institutions
. Bank of America, Citigroup, Suntrust.
Savings Institutions
. Also called thrift institutions and include Savings and Loans (S&Ls)
and Savings Banks
. Concentrate on residential mortgage loans
Credit Unions
. Nonprofit organizations
. Restrict business to CU members with a common bond
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Role of Financial Institutions

Role of Non-depository Institutions
. Finance companies - obtain funds by issuing securities and
lend the funds to individuals and small businesses. Ford Motor
. Mutual funds - sell shares to surplus units and use the funds
received to purchase a portfolio of securities. Fidelity
. Securities firms - provide a wide variety of functions in
financial markets. (Broker, Underwriter, Dealer, Advisory)
. Insurance companies - provide insurance policies that reduce
the financial burden associated with death, illness, and damage
to property. Charge premiums and invest in financial markets.
. Pension funds manage funds until they are withdrawn for
retirement
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Role of Financial Institutions

Comparison of Roles among Financial Institutions
. Institutional Role as a Monitor of Publicly Traded Firms
. Financial institutions facilitate the flow of funds from
individual surplus units (investors) to deficit units.
. Financial institutions also serve as monitors of publicly
traded firms.

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Role of Financial Institutions

Internet Facilitates Roles of Financial Institutions
. The Internet has enabled financial institutions to perform their
roles more efficiently.
. Allows for lower costs and fees.
. Makes firm more competitive forcing other firms to price
their services competitively

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Role of Financial Institutions

Relative Importance of Financial Institutions (Exhibit 1.4)
. Households with savings are served by depository institutions.
. Households with deficient funds are served by depository
institutions and finance companies.

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Exhibit 1.4 Summary of Institutional Sources and

Uses of Funds

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Role of Financial Institutions

Consolidation of Financial Institutions
. Typical Structure of a Financial Conglomerate - In recent
years, the barriers to entry have been reduced, allowing firms
that had specialized in one service to expand more easily into
other financial services. (Exhibit 1.5)
. Impact of Consolidation on Competition - provided more
convenience. Individual customers can rely on the financial
conglomerate for convenient access to multiple services.
. Global Consolidation of Financial Institutions - Many
financial institutions have expanded internationally to
capitalize on their expertise.
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Exhibit 1.5 Organizational Structure of a Financial

Conglomerate

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Financial Conglomerate
Is it true that the bigger the better?

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Credit Crisis for Financial Institutions

. Following the abrupt increase in home prices in the 20042006 period, many financial institutions increased their
holdings of mortgages and mortgage-backed securities.
. In 2007-2009 period, mortgage defaults increased and home
values declined substantially.

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Credit Crisis for Financial Institutions

Systemic Risk during the Credit Crisis
. Systemic Risk is the spread of financial problems, among
financial institutions and across financial markets, that could cause
a collapse in the financial system.
. Mortgage defaults affected financial firms in several ways:
. Mortgage originators sold mortgages to other financial
institutions shortly before the crisis.
. Many other financial institutions invested in derivatives and
were exposed to the crisis.
. Some financial institutions relied on short-term funding and
used MBS as collateral.
. Decline in home building activity caused a decrease in the
demand for many related businesses leading to a weak economy.
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Credit Crisis for Financial Institutions

Government Response to the Credit Crisis
. Emergency Economic Stabilization Act - October 2008
. Intended to resolve the liquidity problems of financial institutions
and to restore the confidence of the investors who invest in them.

. Federal Reserve Actions - Fed provided emergency loans to

many securities firms that were not subject to its regulation.
. Financial Reform Act of 2010
. Also referred to as Wall Street Reform Act or Consumer
Protection Act
. Mortgage lenders must verify the income, job status, and credit
history of mortgage applicants before approving mortgage
applications.
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Credit Crisis for Financial Institutions

Conclusion About Government Response to the Credit Crisis
. In general, response was intended to enhance the safety of
financial institutions
. Tougher regulations on financial institutions can stabilize the
financial markets and encourage more participation by surplus
and deficit units.

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SUMMARY
. Financial markets facilitate the transfer of funds from surplus
units to deficit units.
. The valuation of a security represents the present value of
future cash flows

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Homework Assignment 1
Chapter 1 Advanced Questions
19, 20, 24, 25, Managing in Financial Markets

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