Week 2 Flashcards
What are primary market?
-New security issues sold to initial buyers (such as IPOs)
- Typically involves underwriting groups (i.e. investment banks)
who underwrites the offering
What are secondary market?
-Securities previously issued are bought and sold
- Examples include the NYSE and Nasdaq
- Involves both brokers and dealers
What is difference primary and secondary markets?
- The key distinction between primary and secondary markets:
the seller or source of the securities. - Stock exchanges can be the site of both a primary and
secondary market - The issuer of the security acquires no new funds in the
secondary market
What are functions of secondary markets?
-Makes 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
- They determine the price of the security that the issuing firm
sells in the primary market, because the investors who buy
securities in the primary market will pay the issuing corporation
no more than the price they think the secondary market will
set for this security.
How can secondary markets be organised?
-Exchanges
- Over-the-counter (OTC) markets
What are exchanges?
-marketplaces for the trade of financial instruments (i.e.
securities, commodities, derivatives), and to raise capital
- Physical places OR electronic trading platform
- Heavily regulated (trading rules, capital requirements, etc. . . )
What are over-the counter (OTC) markets?
-Decentralized market in which market participants directly
trade without a central exchange or broker.
- No physical locations (completely electronic)
- trade can be executed in an OTC market without others being
aware of the price at which the transaction was completed
- less transparent than exchanges, and fewer regulations
What is financial intermediation?
-Instead of savers lending/investing directly with borrowers, a
financial institution (such as a bank) plays as the middleman:
- the intermediary obtains funds from savers
- the intermediary then makes loans/investments with borrowers
- This process, called financial intermediation, is actually the
primary means of moving funds from lenders to borrowers.
Why financial institutions are important?
- Because financial markets are imperfect:
- Transaction costs
- Risk sharing
- Asymmetric information
What are transaction costs?
-Financial intermediaries make profits by reducing transactions
costs such as cost of drafting loan contracts and hiring a lawyer
- Reduce transactions costs by developing expertise and taking
advantage of economies of scale
- For example, the same loan contract can be reused in similar loan transactions so that the cost of drafting the contract is
reduced
What are financial intermediary’s low transaction costs ?
-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.
- Banks provide depositors with current accounts that enable them to pay their bills easily.
- Depositors can earn interest on current and savings accounts
and yet still convert them into goods and services whenever
necessary.
What are asset transformation?
Financial intermediaries create and sell assets with risk characteristics that people are comfortable with, and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk.
- Low transaction costs allow Financial intermediaries to make a profit
What is diversification?
- Financial intermediaries help individuals to diversify and thereby lower the amount of risk to which they are exposed: investing
in a collection (portfolio) of assets whose returns do not
always move together, with the result that overall risk is lower than for individual assets. - Low transaction costs allow Financial intermediaries to pool different assts into new assets and sell them to investors.
What is asymmetric information?
- Another reason FIs exist is to reduce the impact of asymmetric information.
- One party lacks crucial information about another party,
impacting decision-making. - Example: borrowing a loan to invest in a project: the lender
vs the investor - We usually discuss this problem along two fronts: adverse
selection and moral hazard.
What is adverse selection?
- Before transaction occurs
- Potential borrowers most likely to produce adverse outcome
are ones most likely to seek a loan - Similar problems occur with insurance where unhealthy people want their known medical problems covered
What is moral hazard?
- After transaction occurs
-Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that won’t pay loan
back - Again, with insurance, people may engage in risky activities
only after being insured
How can Financial intermediaries deal with Moral Hazard?
- Financial intermediaries can alleviate these problems.
- they are better equipped than individuals to screen out bad
credit risks from good ones, thereby reducing losses due to
adverse selection. - they develop expertise in monitoring the parties they lend to,
thus reducing losses due to moral hazard. - The result is that financial intermediaries can afford to pay
lender-savers interest or provide substantial services and still
earn a profit.
Why financial institutions are important?
- Financial institutions provide liquidity services, promote risk
sharing, and solve information problems, thereby allowing small savers and borrowers to benefit from the existence of
financial markets. - The success of FIs is evidenced by the fact that most people
invest their savings with them and obtain loans from financial
intermediaries. - Financial intermediaries play a key role in improving economic efficiency
- channel funds from lender-savers to people with productive
investment opportunities. - Without a well-functioning set of financial intermediaries, it is
very hard for an economy to reach its full potential.
What is economies of scope?
Financial intermediaries are able to lower the production cost of information by
using the information for multiple services: bank accounts,
loans, auto insurance, retirement savings, etc. This is called
economies of scope.
What are conflicts of interest?
-The potentially competing interests of those services may lead an individual or firm to conceal information or disseminate
misleading information
- substantial reductions in the quality of information in financial
markets increases asymmetric information problems and prevents financial markets from channelling funds into the most productive investment opportunities
What are depository institutions?
- Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrift institutions (i.e. building societies and credit unions).
What are commercial banks?
-Raise funds primarily by issuing checkable, savings, and time
deposits which are used to make commercial, consumer and
mortgage loans.
- Collectively, these banks comprise the largest financial
intermediary and have the most diversified asset portfolios.
What are thrifts?
- Thrifts: Building societies and Credit Unions
- Raise funds primarily by issuing savings, time, and checkable
deposits which are most often used to make mortgage and
consumer and commercial loans - They issue deposits as shares and are owned collectively by
their depositors, most of which at credit unions belong to a
particular group, e.g., a company’s workers
For Depository Institutions?:
1.What are types of intermediary?
2. Primary liabilities (Sources of Funds)?
3. Primary Assets (Use of Funds)?
Types of intermediary?:
- commercial banks
- Building societies
- Credit Unions
Primary Liabilities:
- deposits
-deposits
- deposits
Primary Assets (Uses of Funds):
- Business and consumer loans, mortgages, government securities, and municipal bonds
- Mortgages
- Consumer loans
What are contractual savings institutions (CSIs)?
All CSIs acquire funds from clients at periodic intervals on a
contractual basis and have fairly predictable future payout requirements.
What are Life Insurance Companies?
receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis
What are Fire and Casualty Insurance Companies?
receive funds from
policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict
What are Pension and Government Retirement Funds?
hosted by
corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via
annuities
For Contractual Savings Institutions (CSIs)?:
1.What are types of intermediary?
2. Primary liabilities (Sources of Funds)?
3. Primary Assets (Use of Funds)?
What are types of intermediary?
- life insurance companies
- Fire and casualty insurance companies
- Pension funds, government retirement funds
Primary liabilities (Sources of Funds)?
- Premiums from policies
-Premium from policies
- Employer and Employee Contributions
Primary Assets (Use of Funds)?
- Corporate bonds and mortgages
- Municipal bonds, corporate bonds and stock, and U.S government securities
- Corporate bonds and stock
What are finance companies?
- Finance Companies sell commercial paper (a short-term
debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations.
What are mutual funds?
Mutual Funds acquire funds by selling shares to individual
investors (many of whose shares are held in retirement
accounts) and use the proceeds to purchase large, diversified
portfolios of stocks and bonds.
What are Money Market Mutual Funds ?
-Money Market Mutual Funds acquire funds by selling
checkable deposit-like shares to individual investors and use
the proceeds to purchase highly liquid and safe short-term
money market instruments.
What are hedge funds?
-Hedge Funds are a type of mutual fund requiring large
investments ($100,000 or more), long holding periods, and are subject to few regulations. These funds invest across almost all asset classes
What are investment banks?
-Investment Banks advise companies on securities to issue,
underwriting security offerings, offer M&A assistance, and act
as dealers in security markets.
- Doesn’t take deposits and lend them to others
Investment Intermediaries?:
1.What are types of intermediary?
2. Primary liabilities (Sources of Funds)?
3. Primary Assets (Use of Funds)?
What are types of intermediary?
- Finance Companies
- Mutual Funds
- Money Market mutual funds
- Hedge
Primary liabilities (Sources of Funds)?
- Commercial paper, stocks , bonds
- Shares
-Shares
- Partnership participation
Primary Assets (Use of Funds)?
- Consumer and business loans
-Stocks, bonds
- Money Market instruments
- Stocks, bonds, loans, foreign currencies, and many other assets
