Chapter 1 Introduction to Financial Markets and Institutions PDF

1  Chapter 1 IntroduCtIon to FInanCIal Markets and InstItutIons 2 Chapter objectives: after studying this chapter the student will be able to: 1- understanding the financial system concept 2- determining the functions of the financial system 3- identifying the major players...

1  Chapter 1 IntroduCtIon to FInanCIal Markets and InstItutIons 2 Chapter objectives: after studying this chapter the student will be able to: 1- understanding the financial system concept 2- determining the functions of the financial system 3- identifying the major players in any financial system 4- distinguishing between the different financial markets 5- distinguishing between the different types of financial institutions 6- understanding the different types of risks faced by the financial institutions 3  Financial markets and institutions are the major players in the financial system of any economy. Therefore, before starting to elaborate such concepts, we need to start with understanding the meaning of the financial system. The financial system: it is regarded as an intermediary that facilitates the flow of funds from the parties having surplus to the parties having deficit. From the previous definition we can conclude that it is the scarcity of the economic resources in any country that is the main deriver for the development of economic systems. What are the functions of financial systems? 1-the efficient and effective distribution of economic resources to achieve economic growth. 2- to achieve higher (ROI) for the investors. Note that : The financial system in any economy is governed by a set of rules and regulations to protect the participants in the financial system and to enable the financial system to carry out its functions 4  The basic players in the financial system Any financial system consists of five basic players: 1. Individuals 2. Corporations 3. Government 4. The central bank 5. Financial markets and financial institutions (they represent the cornerstone of the financial system) Individuals:  They act as suppliers or borrowers of funds Corporations:  They act as suppliers or borrowers of funds 5 Government:  It can act as supplier or borrower of funds  It sets the rules and regulations that govern the activities of the financial system The central bank:  The central bank represents the regulatory authority of the national monitory policy, as it controls the money supply through being the sole issuer of the currency in circulation.  Stabilizing the value of the domestic currency by controlling inflation.  influencing interest rates that in turn controls the demand and supply of funds.  Acting as the “ lender of the last resort” for commercial banks to cover shortages due to deposits withdrawals. 6 Financial markets: Financial markets are the markets in which financial assets are traded. They represent the environment where buyers and sellers of financial assets interact to trade with each other (buy and sell) The financial assets are intangible assets Financial Assets The future income could be: dividends and capital gains interest payments and in case of stocks principal in case of bonds 7  Examples of financial assets  Bank loans  Foreign bonds  Government bonds  Common stocks  Corporate bonds  Preferred stocks  Municipal bonds  Foreign stocks What are the functions of financial markets? Financial markets perform five basic functions: 1. Determine the price of the financial asset 2. Provide liquidity:- ease of transferring the financial asset into cash 3. Reduce transaction costs associated with finding buyers or sellers of the financial asset. 8 4- facilitating funds mobilization from the parties having surplus to the parties having deficit 5- providing information to the parties involve4d without the requirement od spending money to get it. The classifications of financial markets Financial markets are classified into four basic categories: 1. Debt versus equity markets 2. Primary versus secondary markets 3. Money versus capital markets 4. Foreign exchange markets 9   1- Debt market versus equity market: Debt market:  Is the market in which debt (loan) instruments are traded (bought and sold).  Bonds represent the most common debt instrument that are issued by the government authorities and corporations.  debt instruments usually give the holder the right to receive fixed periodic payments (interest) The equity market:  Often termed as the stock market 10  As preferred stocks and common stocks.  Equity instruments provide variable returns to their holders that depends on the income stream of the corporation. Due to the difference in the risk characteristics of debt and equity instruments: 1- Debt instruments are less risky when compared to equity instruments. Therefore, the expected returns on equity instruments > expected returns on debt instruments. 2- Debt instruments experience less price fluctuations than equity instruments. Primary versus secondary markets: Primary market:  Is the market in which newly issued securities are sold to the initial suppliers of funds.  The primary market allows private firms to go public  The financial institutions involved in the primary market in the U.S are known as Investment bankers 11 In Egypt commercial banks also can play the role of investment bankers as: 1- bank of Alexandria 2- Banque Misr 3- Barclays bank Egypt The secondary market:  Is the market in which the securities that are first bought from the primary market are traded (bought and sold).  The financial institutions involved in the secondary market are “ the Securities Brokers”  Example of secondary markets: 1. NYSE: New york stock exchange. 2. AMEX: American stock exchange 3. EGX: Egyptian stock exchange 12 The functions of the secondary market: 1. Provides liquidity to the investors. 2. 4- stimulating new financing: if investors can trade securities in a liquid secondary market, they will be encouraged to purchase newly issued securities from the primary market which will allow the issuing entity to raise funds 3- The price of the security in the secondary market helps the issuer in: I. Setting the price of any additional issues of an existing security in the primary market. II. Helps the issuer in evaluating his own performance. 4- reducing transaction costs 3- Money market versus Capital market: The financial markets are classified based on the maturity of the traded instrument into :  Money markets  Capital markets 13 The Money Market:  It is the market in which short term debt instruments are traded as:  NCDs: Negotiable certificates of deposits.  T-Bills: Treasury bills.  Money markets are known as: Over the counter market  Over the counter market (OTC):  Is a market that has no physical location.  Trading is conducted directly between the two parties involved ( the buyer and the seller) without any intervention from any central exchange or a broker.  The money market facilitates the constant flow of cash between governments, corporations, banks and financial institutions  When the government or a corporation issues short term debt instrument, it is usually to cover routine operating expenses or supply working capital not for large scale projects. 14 The Capital Market:  Is the market in which long term debt and equity instruments are traded (bonds and stocks) Note that:  The impact of a given change in interest rate is higher on the price of long term debt instruments than on the price of short term debt instruments. Note that: Due to the short term nature of money market instruments, it is regarded as less risky when compared to he capital market instruments Therefore, money market instruments provide lower returns than capital market instruments. 15  4- Foreign Exchange Markets:  The foreign exchange market is known as “FX” or “Forex  they are the markets where one currency is exchanged for another (example: dollars for yen)  The foreign exchange market is an over the counter market that determines the exchange rates for global currencies.  Currencies are always traded in pairs so that the value of one currency in the pair is stated relative to another currency.  The foreign exchange market is the largest financial market in the world in terms of trading volume. 16  The foreign exchange market is made of:  Central banks  Commercial banks  Forex dealers  Investment in foreign currencies is exposed to "foreign exchange rate risk"  The financial risk that exists when the transaction is denominated in a currency rather than the domestic currency of the investor.  The value of the country’s currency depends on whether it is “ Free float” or “ fixed float” 17 Free float currencies:  They are those currencies whose relative value is determined through the interaction between demand and supply.  As: US dollar  Japanese Yen  British Pound Fixed Float currencies:  They are those currencies in which the governing body of the country sets the value of the currency relative to other currencies.  As: Chinese Yuan  Indian Rupee 18  What are the types of foreign exchange market transactions?  There are 2 types of transactions in foreign exchange markets Spot FX transactions forward FX transactions transactions which involve the transactions which involve the immediate exchange of exchange of currencies at a currencies at the current specified future date and at a exchange rate specified exchange rate 19 Financial institutions: they represent the channel through which funds flow from those who have surplus of funds to those who have shortage of funds. They act as mediators between borrowers and investors. What are the different types of financial institutions? There are 7 different types of financial institutions 1. Commercial banks 2. Thrifts 3. Finance companies 4. Insurance companies 20 5- Securities firms 6- Mutual funds 7- Pension funds 1- commercial banks:  They are large depository institutions whose major assets are loans and major liabilities are deposits.  Commercial banks are profit seeking financial institutions.  Commercial banks are publically owned (state-owned) or privately owned. Currently In Egypt, the state owned ( Publically owned) commercial banks are: 1- Banque Misr 2- Banque du Caire 3- the National Bank of Egypt 21 Privately owned commercial banks in Egypt include: 1-Commercial International Bank (CIB) 2- QNB 3- Alex Bank 2. Thrifts Are depository institutions in the form of savings and loans associations and credit unions Compare between commercial banks and thrifts Commercial banks Thrifts Both of them are depository institutions that accept deposits - Large in size - Small in size - Specialize in many types of loans - Specialize in only 1 type of loans as:  Consumer loans  Commercial loans 22  Real estate loans Consumer loans:  They are loans given to consumers to finance specific types of expenditures. What are the types of consumer loans? 1- mortgages: are loans offered to finance the purchase of a house. 2- credit cards: are used to finance daily purchases 3- auto loans: are used to finance the purchase of an vehicle 4- student loans: are loans used to finance education Commercial loans:  Are loans offered to businesses to finance major capital expenditures or to cover operational costs. Commercial real estate loans:  Are loans made to business entities to finance the acquisition\ construction\ development of an income producing property as:  Shopping centers  Office buildings  Hotels 23 Thrifts are organized as: a-credit unions B- savings and loan associations Credit Unions:  They are non-profit making money cooperatives owned by its members.  Credit unions are based on the concept that people help each other.  Members can borrow from pooled deposits at low interest rates.  Members pay lower fees than the fees associated with commercial banks.  Members earn higher returns on their deposits.  An example of credit unions in Egypt: Egyptian – Emirates General Trading Savings and Loan associations:  They are depository institutions that specialize mainly in providing 24 mortgage loans.  3. Finance companies They are financial institutions that provide loans to business and individuals Compare between commercial banks and finance companies Commercial banks Finance companies Both of them provide loans to borrowers (individuals and businesses) Accept deposits from savers Borrow from commercial banks to Lower interest rate on borrowed provide loans to risky borrowers not funds accepted by the commercial banks Higher interest rate on borrowed funds 25 4- Insurance Companies:  They are financial institutions that sell a wide range of insurance policies to protect individuals and businesses against the risk of financial losses.  insurance companies operate by pooling risks among a large number of policyholders to make payments more affordable for the insured. Examples of insurance:  Life insurance  Property insurance  Marine insurance  Fire insurance  Liability insurance  Guarantee insurance Liability insurance: a type of insurance that protects the insured against claims resulting from injuries and damage to people and \or property Guarantee insurance: a type of insurance purchased by a loan company to hedge against the default of one of the borrowers 26 5- Securities firms:  They are financial institutions that help firms to place newly issued securities and to help investors to buy and sell them.  Securities firm serve as financial intermediaries. Example:  Investment banks in the primary market  Securities Brokers in the secondary market. 6- Mutual Funds:  They are financial institutions that pool funds from small investors to invest them in well diversified large portfolios.  an example of mutual funds in Egypt: EFG Hermes 7- Pension Funds:  They are financial institutions that provide saving plans for retirement.  In Egypt, pensions are provided through mandatory social insurance. 27  What are the risks faced by financial institutions?  Financial institutions face 10 types of risk: 1. Interest rate risk 2. Foreign exchange risk 3. Market risk 4. Credit risk 5. Off-balance sheet risk 6. Technology risk 7. Operational risk 8. Country or sovereign risk 9. Insolvency risk 10. Liquidity risk 28 Interest rate risk:  The risk associated with the change in the value and earnings of the assets held by the financial institution due to adverse movements in interest rates.  for commercial banks as an example: When short term interest rate on increases:  the cost of funding will increase ( the interest expense on deposits)  individuals and businesses are discouraged to borrow (resulting in reducing interest revenue from loans)  thus resulting in the reduction in the profit margin and the value of the stock of the commercial bank. Note that:  when interest rate decreases, this will encourage borrowers to acquire loans and consume more. Banks will be able to give more loans which will have positive effect on interest revenues. 29 Foreign Exchange Risk: The risk associated with the fluctuations in the value of assets and liabilities held by the financial institution in foreign currencies due to the fluctuations in foreign exchange rate.  Taking commercial banks as an example: They accept deposits (liabilities) and provide loans (assets) in foreign currencies. The change in the exchange rates results in changing the value of their assets and liabilities. Commercial banks also are engaged in the purchase and sale of foreign currencies to allow customers to participate in international trade transactions. Market Risk:  Occurs to the financial institutions that heavily invest in capital markets.  Market risk occurs due to the unpredictability of equity markets, commodity prices and interest rates.  Fluctuations in commodity prices leads to the change in the value of the company in which the financial institution invests. 30 Credit risk:  Also known as default risk  The risk that the promised cash flows from loans and securities held by the financial institution may not be paid in full  Taking commercial banks as an example: Credit risk is the biggest risk faced by commercial banks It occurs when borrowers fail to meet their contractual obligations. Failure to pay the interest and \or principal as they become due Commercial banks can hedge against credit risk through:  diversification between the different groups of borrowers  Lending money to borrowers with good credit history  Asking for collateral for lending 31 Technology Risk:  The risk that the technological investment undertaken by the financial institution does not generate the expected cost saving. Operational Risk:  Risk of loss due to errors, interruptions, or damages caused by people \ systems  Losses that occur due to human error includes:  Fraud or mistakes during transactions  Security breaching by hackers to steal money or information Country or Sovereign risk:  The risk that payments from foreign borrowers may be affected by the interference from the foreign government. 32 Insolvency risk:  The risk that the financial institution may not have enough capital to cover a sudden decline in the value of its assets. Liquidity risk:  The risk that a sudden increase in liability withdrawals may require the financial institution to liquidate assets in a very short time and at a low price.  The inability to provide cash to customers may result in snow ball effect. As depositors will panic and will all try to withdraw their deposits  Liquidity problems result from :  over reliance on short term sources of funds  Holding too much illiquid assets  Holding too much short term liabilities and not enough short term assets 33 Off balance sheet risk:  Off balance sheet assets and liabilities do not appear in the balance sheet of the financial institution, but are disclosed in notes to the financial institutions.  For example: when loans are securitized and sold out as investments (off balance sheet asset). The secured debt is kept out of the bank books.  Off balance sheet risk refers to the risk associated with contingent assets and liabilities 34