chapter 2: an overview of the financial system Flashcards
Structure of Financial Markets (which?)
- Debt and Equity Markets
- Primary and Secondary Markets
- Exchanges and Over-the-Counter Markets
- Money and Capital Markets
An Overview of the Financial System
- Function of Financial Markets
- Structure of Financial Markets
- Money Market Instruments
- Internationalization of Financial Markets
- Function of Financial Intermediaries: Indirect Finance
- Types of Financial Intermediaries
- Regulation of the Financial System
what is Function/ def. of Financial Markets?
Channeling funds from agents that have surplus funds (lender – savers) to those that have shortage of funds (borrower – spenders)
of which • Principal lender-savers: households
• Principal borrower-spenders: businesses and
(federal)governments
The function of Financial Markets in the Economy is:
- to allow funds to move from people who lack productive investment opportunities to people who have these opportunities
- Critical for producing an efficient allocation of capital (wealth, that is used to create more wealth), that can help to improve production and efficiency for the overall economy.
- Directly improve the well-being of consumers because financial markets help consumers to time their purchases better, helping the young to buy what they need without forcing them to wait until after having saved for it.
• Indirect Finance:
A financial intermediary borrows funds from lender-savers and uses
these funds to make loans to borrower-spenders
Direct Finance:
Borrowers borrow funds directly from lenders in financial markets by selling the lenders securiDes (or financial instruments) that are claims on
the borrower’s future income or assets
Debt and Equity Markets
Obtains funds in the financial markets in two ways:
- Issuance of a debt instrument: a bond or a mortgage.
* Raising funds through the issuance of equities, such as common stocks.
DEF Issuance of a debt instrument : (you get the funding from)
• A bond or a mortgage, a contractual agreement by the borrower to pay the holder of the instrument a fixed amount (interest and principal payment) at regular intervals until a specified date (maturity date) when the final payment is made.
Maturity:
• the number of years (term) until the instrument’s expiration date
• Short term (< 1 year), intermediate-term (1-10 years), long term (> 10 years)
Common stocks
claims to share in the net income (income after expenses and taxes) and the assets of a business.
what happens in an issuance of equities
- Common stocks
- Equities often make periodic payments (dividends) to the equity holders, since equities are considered long-term securities because they have no maturity date.
- Equities indicate that you own a portion of the firm and have the right to vote in shareholder meetings
Disadvantage of equities with respect to debt:
• Equity holder is a residual claimant, i.e. the firm must pay back all the debt holders BEFORE it can repay its equity holders.
Advantage of equities with respect to debt:
• Equity holders benefit directly from any increase in the firm’s profitability or asset value
Primary Market:
• Financial market where new issues of a security (e.g. bond or stock) are sold to initial buyers by the firm or government borrowing the funds.
(when you have a transfer of fonds from the invester to the company )
Secondary Market:
Secondary Market:
• Financial market where securities that have been issued before can be resold
(the company is no longer part of the transaction)
(is an Important intermediary)
Investment banks function:
- Important financial institution in the primary market
* Underwrites securities: guarantees a price for a firm’s securities and then sells them to the public
investment Banking typically covers 2 key areas:
- M&A: assisting in negotiations and structuring of merger/ acquisition.
- Under-writing: raising capital through selling stocks or bonds to investors.
Secondary Market:
•Important intermediaries:
- Brokers: agents of investors who match buyers and sellers of securities
- Dealers: agents that link buyers and sellers by buying and selling securities at stated prices
Importance of the Secondary Market
advantages
- Generates liquidity: Easy and quick to sell financial instruments to raise cash.
- Increases attractiveness of the primary market: increased liquidity makes financial instruments more attractive and easier for the firm to sell in the primary market
- Prices in secondary market will determine price in primary market
Secondary Markets can be organized in two ways:
- Exchanges
* OTC (Over-the-Counter) markets
Exchanges: (sec. mar.)
Where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades.
E.g. Euronext, NYSE (for stocks since 1792), CBoT (part of the CME-group) (for futures and commodiDes since 1851)
OTC markets:
Dealers at different locations (that have an inventory of securities) are ready to buy and sell securities « over the counter » to anyone who comes to them and is willing to accept their prices
Exchanges versus OTC-Markets:
- OTC Markets are less transparent and operate with fewer rules than exchanges.
- OTCs are not considered exchanges because they are not open to all participants equally.
Money Market
Financial market in which only short-term debt instruments (those with original maturities < 1 year) are traded.
Capital Market:
Financial market where securities with longer term debt instruments (original maturity term > 1 year) and stocks are traded.
Financial Market Instruments
• Money Market Instruments
- US Treasury Bills
- Negotiable Bank Certificates of Deposit
- Commercial Paper
- Repurchase agreement (repo)
- Federal (Fed) funds
• Capital Market Instruments
- Stocks
- Mortgages and Mortgage-Backed-Securities
- Corporate Bonds
- Government Securities
- Consumer and Bank Commercial Loans
- US Treasury Bills:
- Short term government debt (1, 3, 6 month maturity) to finance federal government
- Zero bonds: pay a set amount at maturity and have no interest payments
- Most liquid money market instrument because actively traded
- Safe security, because low probability of default, a situation where the issuer cannot make the interest payment or pay off the amount owed at maturity.
- Held mainly by banks, also households and firms
- Negotiable Bank Certificates of Deposit (CD)
• CD is a debt instrument sold by a bank to depositors that pays
annual interest on a given amount (minimum $ 100 000) and pays back the nominal value at maturity.
- Important source of funds for firms, guaranteed by banks.
- Investors: corporates, insurance companies, pension funds, mutual funds (and wealthy individual investors)
- Negotiable Bank Certificates of Deposit (CD)
• CD is a debt instrument sold by a bank to depositors that pays
annual interest on a given amount (minimum $ 100 000) and pays back the nominal value at maturity.
- Important source of funds for firms, guaranteed by banks.
- Investors: corporates, insurance companies, pension funds, mutual funds (and wealthy individual investors)
- Commercial Paper
- Short-term debt instrument issued by large banks and well-know corporations.
- One of the fastest-growing money market instrument.
• Bought by money market mutual funds that need to hold liquid
high-quality short-term assets
- Repurchase agreement (repo)
• Short-term loans, where a government security (typically a treasury bill) serves as collateral.
• Repos are actual purchases: the dealer sells the government
security to the investor, and buys them back at a higher price at an agreed maturity (term repo) or without specifying a maturity (open repo: in that case interest is paid monthly)
• Usually very short maturity (from overnight up to 2 weeks).
- Federal (Fed) funds
• Typically overnight loans between banks, of their deposits
at the Federal Reserve.
• Federal funds: loans made by banks to other banks
• Federal funds rate: the interest rate charged overnight: the
cost to banks of borrowing funds fro other banks in the US
Capital Market Instruments
Debt and equity instruments with maturities > 1 year. Have far wider price fluctuations than MM instruments and are therefore considered riskier
- Stocks
- Mortgages and Mortgage-Backed-Securities
- Corporate Bonds
- Government Securities
- Consumer and Bank Commercial Loans
- Stocks
• Equity claims on net income and assets of a corporation
materialised stock,you do not have a face value because te price of the stock changes all the time
- Mortgages and Mortgage-Backed-Securities
• Mortgages are loans to household or firms to buy land or
housing, where the housing or the land serves as collateral for
the loan.
• Loans are provided by banks
• These loans have been repackaged into mortgage-backed
securities (MBS): bond-like debt instruments that were backed
by a porkolio of individual mortgages.
- Corporate Bonds
• Long-term bonds that are issued by corporates with strong credit ratings
• Interest payment every six months (US) or every year (Europe),
paying off the face value at maturity
• No high outstanding amounts so less liquid
(convertible/ reverse convertible bond)
Convertible bond:
additional feature: the holder can ask to convert the bond into a specified number of shares at any time up to the maturity
-> reduced interest payments
Reverse convertible bond
the issuer of the bond can ask to convert the bond into a specified number of shares at any time up to the maturity
-> higher interest payments
- Government Securities
US Treasury Bonds: long-term debt instruments by the US Treasury. (here the issuer is safe, the probability that they can pay back is very high )
- Consumer and Bank Commercial Loans
• Loans to consumers and businesses
• Principally made by banks, although consumer loans
also by finance companies
different International Bond Market, Eurobonds and Eurocurrencies:
- Foreign Bonds
- Eurobonds
- Eurocurrencies
Foreign Bonds:
bonds sold in a foreign country and denominated in
that countries currency.
Eurobonds:
a bond denominated in a currency other than that of
the country in which it is sold
Eurocurrencies:
Foreign currencies deposited in banks outside the home country. E.g.: Eurodollars: US dollars deposited in foreign banks outside the US or in foreign branches of US banks.
« Euro »bond:
a bond denominated in euro is called a Eurobond if it is sold outside countries that have adopted the Euro. Most are denominated in US dollars.
Indirect finance:
- funds can move from lenders to borrowers through financial intermediaries that help to transfer the funds.
- The intermediary borrows funds from the savers and uses the funds to make loans to borrower-spenders.
- Financial intermediaries: more important source of financing corporations than the stock market
Different Function of Financial Intermediaries:
- Transaction Costs
- Risk Sharing
- Asymmetric Information
- Economies of Scope and Conflicts of Interest
Transaction Costs :
Time and money spent for financial transactions.
• Financial intermediaries can reduce transaction costs (expertise, economies of scale = reduction in transaction costs per dollar of transaction as the size of the transaction increases)
Risk Sharing:
- Intermediaries create and sell assets with risk characteristics that people are comfortable with and then use the funds acquired to purchase other assets that have more risk (asset transformation)
- Diversification: creating a portfolio of assets, to result the overall risk (« don’t put all of your eggs in one basket »)
Asymmetric Information:
Adverse Selection and Moral Hazard (because different parties do not always have the same information)
Inequality in information:
Often one party does not know enough about the other party to make accurate decisions.
Problem created by asymmetric information before the
transaction = Adverse selection:
• Potential borrowers that are most likely to produce an undesirable outcome (bad credit risk) are the ones that are most
actively looking for loans and are thus the most likely to be selected. This makes it more likely that loans in the market are
made to bad credit risk, so lenders may not want to make any
loans, not even those with good credit risk.
Problem created by asymmetric information after the
transaction = Moral hazard:
• The risk (or hazard) that the borrower might take up activities that are undesirable (immoral) from the lender’s point of view.
Financial intermediaries can reduces the problems of Adverse
Selection and Moral Hazard
• Better equipped to screen out bad from good credit risk , so
reduce losses due to adverse selection.
• Expertise in monitoring the parties they lend to, reducing
losses due to moral hazard.
Economies of Scope:
• lower the cost of information production for each service by
applying one information source to many different services
Conflict of interest:
• A person or institution has multiple objectives (interest), some of which conflict with each other
Types of Financial Intermediaries
• Depository Institutions « banks »:
(Commercial banks + Savings and Loan associations, Mutual Savings banks (« thrift institutions »))
• Contractual Savings Institutions
• Investment Intermediaries
Contractual Savings Institutions:
acquire funds at periodic intervals on a contractual basis
• Life insurance companies
• Fire and casualty insurance companies
• Pension Funds, Government Retirement Funds
• Investment Intermediaries
- Finance Companies
- Mutual Funds
- Money Market Mutual Funds
- Hedge Funds
- Investment Banks
Finance Companies:
sell commercial paper, issue stocks and bonds (eg Ford Motor
Credit Company)
Mutual Funds:
purchase diversified portfolios and sell shares to many individuals
Money Market Mutual Funds:
invest in money market instruments – lower risk, lower
expected return
Hedge Funds:
Mutual fund with special characteristics
• High minimum investment, so subject to weaker regulations
Investment Banks:
Helps a corporate issue securities or in mergers and acquisitions
• Gives advice
• Helps to sell securities (underwrite) by buying them from the corporate at a predetermined price and then reselling them in the market.
Regulation of the Financial System
Increasing Information Available to Investors
Ensuring the Soundness of Financial Intermediaries: • Restrictions on entry • Disclosure • Restrictions on assets and activities • Deposit Insurance • Limits on competition • Restrictions on interest rates
Financial Regulation Abroad
Increasing Information Available to Investors:
- Government regulation to reduce moral hazard and adverse selection and improve efficiency of markets by increasing the information available to investors.
- E.g.: disclosure of trades by insiders
• Ensuring the Soundness of Financial Intermediaries:
To avoid financial panic – the widespread collapse of financial intermediarie:
• Restrictions on entry
• Disclosure: strict reporting requirements
• Restrictions on assets and activities: restrict risky activities, restrict them from holding certain risky assets.
• Deposit Insurance: insures every depositor for savings up to $250 000 per account
• Limits on competition: limits on opening branches
• Restric5ons on interest rates: before: maximum rates that banks can pay on
interest rates
• Ensuring the Soundness of Financial Intermediaries:
To avoid financial panic – the widespread collapse of financial intermediarie:
- Restrictions on entry
- Disclosure: strict reporting requirements
- Restrictions on assets and activities: restrict risky activities, restrict them from holding certain risky assets.
- Deposit Insurance: insures every depositor for savings up to $250 000 per account
- Limits on competition: limits on opening branches
- Restrictions on interest rates: before: maximum rates that banks can pay on interest rates
