Chapter 1 Introduction PDF

Because learning changes everything.® Chapter 1 Introduction © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Learning Goals Differen...

Because learning changes everything.® Chapter 1 Introduction © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Learning Goals Differentiate between primary and secondary markets. Differentiate between money and capital markets. Understand what foreign exchange markets are. Understand what derivative security markets are. Distinguish between the different types of financial institutions. Know the services financial institutions perform. Know the risks financial institutions face. Appreciate why financial institutions are regulated. Recognize that financial markets are become increasingly global. © McGraw Hill 2  Why Study Financial Markets and Institutions? Markets and institutions are primary channels through which capital is allocated in our society. Investment and financing decisions require managers and individual investors to understand the flow of funds throughout the economy. Managers and individuals must also understand the operation and structure of domestic and international financial markets. © McGraw Hill 3  Financial Markets Financial markets are structures through which funds flow. Financial markets can be distinguished along two major dimensions: Primary versus secondary markets. Money versus capital markets. © McGraw Hill 4  Primary versus Secondary Markets 1 Primary markets Markets in which users of funds (e.g., corporations) raise funds through new issues of financial instruments, such as stocks and bonds. Include issues of equity by firms initially going public, referred to as initial public offerings (IPO’s). Secondary markets Markets that trade financial instruments once they are issued. © McGraw Hill 5  Primary and Secondary Market Transfer of Funds Timeline Access the text alternative for slide images. © McGraw Hill 6  Primary versus Secondary Markets 2 How were primary markets affected by the financial crisis? Secondary markets offer the following: Liquidity, or the ability to turn an asset into cash quickly at its fair market value. Information about the prices or the value of investments. Trading with low transaction costs. © McGraw Hill 7  Money versus Capital Markets Money markets trade debt securities or instruments with maturities of one year or less Most U.S. money markets are over-the-counter (OTC) markets. Capital markets trade debt (bonds) and equity (stocks) instruments with maturities of more than one year Wider price fluctuations than money market instruments. Access the text alternative for slide images. © McGraw Hill 8  Money Market Instruments Outstanding Access the text alternative for slide images. © McGraw Hill 9  Capital Market Instruments Outstanding Access the text alternative for slide images. © McGraw Hill 10  Foreign Exchange Markets Foreign exchange risk is the sensitivity of the value of cash flows on foreign investments to changes in the foreign currency’s price in terms of dollars U.S. dollars received on a foreign investment depends on the exchange rate between the U.S. dollar and the foreign currency when the nondollar cash flow is converted into U.S. dollars. © McGraw Hill 11  Derivative Security Markets 1 A derivative security is a financial security (e.g., future, option, swap, or mortgage-backed security) whose payoff FI's linked to another, previously issued security, such as a security traded in capital or foreign exchange markets Derivatives are traded in derivative security markets. Generally involves agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified future date. Derivative markets are the newest of financial security markets and are also potentially the riskiest security. © McGraw Hill 12  Derivative Security Markets 2 Derivative activity: Tremendous growth between 1992-2013. Large drop from 2013 to 2019, due largely to the 2014 implementation of the Volcker Rule. TABLE 1-4 Derivative Contracts Held by Commercial Banks, by Contract Product (in billion of dollars) 1992 2000 2008 2013 2016 2021 Futures and $ 4,780 $ 9,877 $ 22,512 $ 45,599 $ 31,685 $ 31,180 forwards Swaps 2,417 21,949 131, 706 138, 361 107,393 109,290 Options 1,568 8,292 30, 267 33,760 30,999 33,453 Credit _ 426 15, 897 13,901 6,986 3,540 derivatives Total $ 8,765 $ 40,544 $ 200,382 $ 231,621 $ 180,973 177,464 Note: EM dashes represent value that are too small to register. Sources: Office of the Comptroller of the Currency website, various dates. www.occ.treas.gov © McGraw Hill 13  Financial Market Regulation Financial instruments are subject to regulations imposed by regulatory agencies, such as the Securities and Exchange Commission (SEC) Main emphasis of SEC regulations is on full and fair disclosure of information on securities issues to actual and potential investors. SEC monitors trading on the major exchanges to ensure stockholders and managers do not trade on inside information about their own firms. © McGraw Hill 14  Overview of Financial Institutions (FI's) Financial institutions perform the essential function of channeling funds from those with surplus funds to those with shortages of funds. In a world without FI's, the level of funds flowing between suppliers and users would likely be quite low due to the following reasons: Monitoring costs. Liquidity costs. Price risk. © McGraw Hill 15  Types of Financial Institutions Commercial banks —depository institutions whose major assets are loans and whose major liabilities are deposits. Commercial banks’ loans are broader in range, including consumer, commercial, and real estate loans, than are those of other depository institutions. Commercial banks’ liabilities include more non deposit sources of funds, such as subordinate notes and debentures, than do those of other depository institutions. Thrifts—depository institutions in the form of savings associations, savings banks, and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans. Insurance companies—financial institutions that protect individuals and corporations (policyholders) from adverse events. Life insurance companies provide protection in the event of untimely death, illness, and retirement. Property casualty insurance protects against personal injury and liability due to accidents, theft, fire, and so on. Securities firms and investment banks—financial institutions that help firms issue securities and engage in related activates such as securities brokerage and securities trading. Finance companies—financial intermediaries that make loans to both individuals and businesses. Unlike depository institutions, finance companies do not accept deposits but instead rely on short- and long-term debt for funding. Investment funds—financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of assets. Pension funds—financial institutions that offer savings plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years. Funds originally invested in and accumulated in pension funds are exempt from current taxation. FinTech's—institutions that use technology to deliver financial solutions in a manner that competes with traditional financial methods. © McGraw Hill 16  Flow of Funds Flow of Funds in a Flow of Funds in a World without FI's World with FI's Access the text alternative for slide images. © McGraw Hill 17  Monitoring Costs A supplier of funds who directly invests in a fund user’s financial claims faces a high cost of monitoring the fund user’s actions in a timely and complete fashion A solution is for many small investors to group their funds together by holding the claims issued by a FI (i.e., aggregation of funds). © McGraw Hill 18  Liquidity and Price Risk FI’s act as asset transformers, financial claims issued by an FI that are more attractive to investors than are the claims directly issued by corporations. Often, claims issued by FI’s have liquidity attributes that are superior to those of primary securities. FI’s diversify away some, but not all, of their investment risk. © McGraw Hill 19  Additional Benefits and Functions of F I's Additional benefits FI’s provide to suppliers of funds: Reduced transaction cost. Maturity intermediation. Denomination intermediation. Economic functions FI’s provide to the financial system as a whole: Transmission of monetary policy. Credit allocation. Intergenerational wealth transfers or time intermediation. Payment services. © McGraw Hill 20  Risks Incurred by Financial Institutions FI’s face various types of risks: Default risk (i.e., credit risk). Foreign exchange risk and country (i.e., sovereign) risk. Interest rate risk. Market risk, or asset price risk. Off-balance sheet risk. Liquidity risk. Technology and operational risk. Insolvency risk. © McGraw Hill 21  Regulation of Financial Institutions Failures of FI’s can cause widespread panic and withdrawal runs on institutions The 2008 increase in the deposit cap (to $250,000 per person per bank) was intended to instill confidence in the banking system. FI’s are regulated to prevent market failures, as well as associated costs on the economy and society at large. © McGraw Hill 22  Trends in the United States 1 The following trends are evident in the U.S. between 1948 to 2020: Share of depository institutions declined from 62.7% to 29.7%. Insurance companies also witnessed a decline in their share, from 23.4% to 15.6%. Investment companies increased their share from 1.1% to 31.1%, while pension funds increased from 9.1% to 15.4%. Overall assets increased from $0.27t to $79.08t. © McGraw Hill 23  Trends in the United States 2 Rise of financial services holding companies Savers increasingly prefer investments that closely mimic diversified investments in the direct securities markets over the transformed financial claims offered by traditional FI’s. Shift away from risk measurement and management and the financial crisis Under the traditional originate-and-hold banking model, banks may have been reluctant to so aggressively pursue low-credit-quality borrowers for fear of default. © McGraw Hill 24  Enterprise Risk Management Enterprise risk management Recognizes the importance of managing the combined impact of the full spectrum of risks as an interrelated risk portfolio. Seeks to embed risk management as a component in all critical decisions throughout FI. Popularity rose as a result of the failure of advanced risk measurement and management systems to detect exposures that led to the financial crisis. Stresses importance of building strong risk culture. © McGraw Hill 25  Fintech Financial technology, or fintech, refers to the use of technology to deliver financial solutions in a manner that competes with traditional financial methods. Includes services such as cryptocurrencies (e.g., bitcoin) and blockchain. Fintech risk involves the risk that fintech firms could disrupt business of financial services firms in the form of lost customers and lost revenue. Supports models of peer-to-peer mass collaboration. © McGraw Hill 26  Globalization of Financial Markets and Institutions 1 U.S. markets are the world’s largest, but international markets have seen rapid growth in recent years as a result of various factors: 1. Pool of savings in foreign countries has increased. 2. International investors have turned to U.S. and other markets to expand their investment opportunities. 3. Information on foreign investments and markets is now more accessible and thorough. 4. Some U.S. FI’s offer their customers opportunities to invest in foreign securities and emerging markets at relatively low transaction costs. © McGraw Hill 27  Globalization of Financial Markets and Institutions 2 U.S. markets are the world’s largest, but international markets have seen rapid growth in recent years as a result of various factors: 5. The euro is having a notable impact on the global financial system. 6. Economic growth in Pacific Basin countries, China, and other emerging countries has resulted in significant growth in their stock markets. 7. Deregulation in many foreign countries has allowed international investors greater access and allowed the deregulating countries to expand their investor base. © McGraw Hill 28  Appendix 1A - The Financial Crisis: The Failure of FI’s Specialness 1 Home prices plummeted in late 2006 and early 2007 Defaults by subprime mortgage borrowers began to affect the mortgage lending industry, as well as the rest of the economy. Foreclosure filings jumped 93% in July 2007 over July 2006. FIs that held these mortgages and mortgage-backed securities started announcing huge losses as borrowers defaulted. Losses reached over $400b worldwide through 2007. Bear Stearns failed and was bought by JPMorgan Chase for $2 per share. Deal was assisted by Federal Reserve. © McGraw Hill 29  Appendix 1A - The Financial Crisis: The Failure of FI’s Specialness 2 The Crisis Hits September 8, 2008: U.S. government seized Fannie Mae and Freddie Mac. Recorded approximately $9b in losses in the last half of 2007 related to subprime mortgage-backed securities. Put under a conservatorship and continue to operate under the control of Federal Housing Finance Agency (FHFA). September 15, 2008: Lehman Brothers filed for bankruptcy. Merrill Lynch was bought by Bank of America. AIG met with federal regulators to raise cash. Washington Mutual was looking for a buyer. © McGraw Hill 30  The Dow Jones Industrial Average, October 2007 to January 2010 Access the text alternative for slide images. © McGraw Hill 31  Overnight LIBOR, 2001 to 2010 Access the text alternative for slide images. © McGraw Hill 32  Appendix 1A - The Financial Crisis: The Failure of FI’s Specialness 3 The Rescue Plan September 18, 2008: Federal Reserve and central banks around the world invested $180b in global financial markets to unfreeze credit markets. Treasury Secretary Henry Paulson met with congressional leaders to devise a plan to get bad mortgage loans and mortgage-backed securities off the balance sheet of financial institutions. October 3, 2008: $700b rescue plan was based and signed into law. Established the Troubled Asset Relief Program (TARP) that gave the U.LS. Treasury funds to buy “toxic” mortgages and other securities from FI’s. © McGraw Hill 33  Federal Funds Rate and Discount Window Rate Some positive events occurred between September and December 2008 Oil dropped to below $40 in late 2008, leading to falling gas prices. Many banks restructured delinquent mortgage loans rather than foreclose. Fed announced it would drop its target fed funds rate and lower its discount window rate. Access the text alternative for slide images. © McGraw Hill 34  Major Items in the Stimulus Program $116.1 For tax cuts and credits to low- and middle-income workers $69.8 For middle-income taxpayers to get an exemption from the alternative minimum tax $87.0 In Medicaid provisions $27.0 For jobless benefits extension to a total of 20 weeks in addition to regular unemployment compensation $17.2 For increases in student aid $40.6 For aid to states $30.0 For modernization of electric grid and energy efficiency $19.0 For payments to hospitals and physicians who computerize medical record systems $29.0 For road and bridge infrastructure construction and modernization $18.0 For grants and loans for water infrastructure, flood prevention, and environmental cleanup. © McGraw Hill 35  Because learning changes everything. ® www.mheducation.com © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.