Chapter 1 - Role of Financial Markets and Institutions PDF

Role of Financial Markets and Institutions Equity securities (also called stocks) represent equity or ownership in the firm A financial market is a market in which o Some businesses pr...

Role of Financial Markets and Institutions Equity securities (also called stocks) represent equity or ownership in the firm A financial market is a market in which o Some businesses prefer to issue financial assets (securities) such as stocks equity securities rather than debt and bonds can be purchased or sold. securities when they need funds but Funds are transferred in financial markets might not be financially capable of when one party purchases financial assets making the periodic interest previously held by another party. payments required for debt Financial markets facilitate the flow of funds, securities. thereby allowing for financing and investing by households, firms, and government agencies. Accommodating Corporate Finance Needs Role of Financial Markets A key role of financial markets is to accommodate corporate finance activity. Financial markets transfer funds from those Corporate finance (also called financial parties who have excess funds to those parties management) involves corporate decisions who need funds such as how much funding to obtain and o If funds were not supplied, the which types of securities to issue when financial markets would not be able financing operations. to transfer funds to those who need The financial markets serve as the mechanism them. whereby corporations (acting as deficit units) Those participants who receive more money can obtain funds from investors (acting as than they spend are referred to as surplus surplus units). units (or investors). o They provide their net savings to the financial markets. Those participants who spend more money than they receive are referred to as deficit Accommodating Investment Needs units. Another key role of financial markets is o They access funds from financial accommodating surplus units who want to markets so that they can spend more invest in either debt or equity securities. money than they receive Investment management involves decisions Many deficit units such as firms and by investors regarding how to invest their funds government agencies access funds from Financial institutions (discussed later in this financial markets by issuing securities, which chapter) serve as intermediaries within the represent a claim on the issuer. financial markets. They channel funds from Debt securities represent debt (also called surplus units to deficit units. credit or borrowed funds) incurred by the o as shown in Exhibit 1.1. They also issuer. commonly serve as investors and o Deficit units that issue the debt channel their own funds to securities are borrowers. corporations. The surplus units that purchase debt securities are creditors, and they receive interest on a periodic basis (such as every six months). Debt securities have a maturity date, at which time the surplus units can redeem the securities and receive the principal (face value) from the deficit units that issued them. Primary versus Secondary Markets Capital Market Securities o Capital markets facilitate the sale of Primary markets facilitate the issuance of new long-term securities by deficit units securities. Thus, they allow corporations to to surplus units. The securities obtain new funds and offer a means by which traded in this market are referred to investors can invest funds. as capital market securities. Secondary markets facilitate the trading of ▪ Capital market securities existing securities, which allows investors to are commonly issued to change their investments by selling securities finance the purchase of that they own and buying other securities. capital assets, such as An important characteristic of securities that are traded in secondary buildings, equipment, or markets isliquidity, which is the degree to which machinery securities can easily be liquidated (sold) ▪ Three frequently without a loss of value. encountered types of Some securities have an active secondary capital market securities market meaning that there are many willing are bonds, mortgages, and buyers and sellers of the security at a given stocks. moment in time. o Bonds An active secondary market is especially ▪ Bonds are long-term debt desirable for debt securities that have a long- securities issued by the term maturity, because it allows investors Treasury, government flexibility to sell them at any time prior to agencies, and corporations maturity. to finance their operations They provide a return to investors Securities Traded in Financial Markets in the form of interest income Money Market Securities (coupon o Money markets facilitate the sale of payments) every short-term debt securities by deficit six months. units to surplus units. Because bonds o The securities traded in this market represent debt, are referred to as money market they specify the securities, meaning that they are amount and debt securities that have a maturity timing of interest of one year or less. and principal ▪ These securities generally payments to have a relatively high investors who degree of liquidity because purchase them. of their short-term maturity At maturity, but also because they are investors holding desirable to many investors the debt securities and commonly have an are paid the active secondary market. principal. Bonds o Common types of money market commonly have securities include maturities of ▪ Treasury Bills between 10 and ▪ Commercial Paper 20 years. ▪ Negotiable Certificates of ▪ Treasury bonds are Deposit perceived to be free from  default risk because they up-front fees) to compensate for that are issued by the U.S. factor. Treasury. Commercial mortgages are long-term debt ▪ Bonds issued by obligations created to finance the purchase of corporations are subject to commercial property. default (credit) risk because Real estate developers rely on commercial the issuer could default on mortgages so that they can build shopping its obligation to repay the centers, office buildings, or other facilities debt. These bonds must Mortgage-Backed Securities offer a higher Mortgage-backed securities are debt expected return obligations representing claims on a package than Treasury of mortgages. bonds to In their simplest form, the investors who compensate purchase these securities receive monthly investors for that payments that are made by the homeowners default risk. on the mortgages backing the securities. ▪ Bonds can be sold in the secondary market if investors do not want to Stocks hold them until maturity. Because the prices of debt Stocks (or equity securities) represent partial securities change over ownership in the corporations that issue them. time, they may be worth They are classified as capital market securities less when sold in the because they have no maturity; therefore, they secondary market than serve as a long-term source of funds. when they were purchased. o Investors who purchase stocks (referred to as stockholders or shareholders) issued by a Mortgages corporation in the primary market can sell the stocks to other investors Mortgages are long-term debt obligations at any time in the secondary market. created to finance the purchase of real estate. Some corporate stocks are more liquid than Residential mortgages are obtained by others. individuals and families to purchase homes. Stocks of small corporations are less liquid, o Financial institutions serve as because the secondary market for these lenders by providing residential stocks is not as active. mortgages in their role as a financial o Some corporations provide income intermediary. to their stockholders by distributing a The home serves as collateral in the event that portion of their quarterly earnings in the borrower is not able to make the mortgage the form of dividends. payments. As corporations grow and increase in value, Subprime mortgages are offered to some the value of their stock increases; investors borrowers who do not have sufficient income can then earn a capital gain from selling the to qualify for prime mortgages or who are stock for a higher price than they paid for it. unable to make a down payment. Investors can earn a return from stocks in the o Subprime mortgages carry a higher form of both periodic dividends (if there are risk of default, so the lenders any) and a capital gain when they sell the providing these mortgages charge a stock higher interest rate (and additional However, stocks are subject to risk because their future prices are uncertain. When a firm  performs poorly, its stock price commonly Valuation of Securities declines, resulting in negative returns to investors. The valuation of a security is measured as the present value of its expected cash flows, discounted at a rate that reflects the uncertainty surrounding the cash flows. Derivative Securities Debt securities are easier to value than equity Like money market and capital market securities because they promise to provide securities, derivative securities are traded in investors with specific payments (interest and financial markets. principal) until they mature. Derivative securities are financial contracts Investors often rely on financial statements whose values are derived from the values of issued by firms when assessing how stock underlying assets (such as debt securities or prices might change in the future equity securities). Many derivative securities Firms with publicly traded stock are required enable investors to engage in speculation and to disclose financial information and financial risk management. statements to the public. Impact of Information on Valuation Speculation Investors can attempt to estimate the future Derivative securities allow an investor to cash flows that they will receive by obtaining speculate on movements in the value of the information that may influence a security’s underlying assets without having to purchase future cash flows. The valuation process is those assets. illustrated in Exhibit 1.2. o Some derivative securities allow investors to benefit from an increase in the value of the underlying assets, whereas others allow investors to benefit from a decrease in the assets’ value. Investors who speculate in derivative contracts can achieve higher returns than if they had speculated in the underlying assets, but they are also exposed to higher risk. o Some investors rely mostly on Risk Management economic or industry information to value a security, others rely more on By investing in derivative securities that will financial statements provided by the generate gains if the value of the underlying firm assets declines, financial institutions and When investors receive new information about other firms can use derivative securities to a security that clearly indicates the likelihood reduce their exposure to the risk that the value of higher cash flows or less uncertainty sur- of their existing investments in those assets rounding the cash flows, they revise their may decline. valuations of that security upward, it can take specific positions in derivative consequently increasing the demand for the securities that will generate gains if those security. bonds’ value declines Conversely, when investors receive unfavorable information, they reduce the expected cash flows or increase the discount rate used in valuation o Their valuations of the security are revised downward, which results in a  lower demand and an increased Securities Regulations on Financial Disclosure supply of that security for sale in the secondary market. Many regulations exist that attempt to ensure that businesses disclose accurate financial In an efficient market, securities are rationally information, so that investors participating in priced. If a security is clearly under- valued financial markets can more properly value based on public information, some investors stocks and debt securities issued by firms. will capitalize on the discrepancy by purchasing that security. This strong demand for the security will push the security’s price higher until the Securities Act of 1933 discrepancy disappears. The Securities Act of 1933 was intended to ensure complete disclosure of relevant Impact of Behavioral Finance on Valuation financial information on publicly offered securities and to prevent fraudulent practices A security may be mispriced because of the in selling these securities. psychology involved in the decision making. Behavioral finance is the application of psychology to financial decision making. It can Securities Exchange Act of 1934 offer a reason why markets are not always efficient. The Securities Exchange Act of 1934 extended Behavioral finance can sometimes explain the disclosure requirements to secondary why a security’s price moved abruptly market issues Behavioral finance can even be used to it established the Securities and Exchange explain abrupt stock price movements in the Commission (SEC) to oversee the securities entire stock market markets, and the SEC has implemented o This leads to a stock price bubble, additional regulations over time. which subsequently bursts once investors consider fundamental characteristics that affect a firm’s Sarbanes-Oxley Act of 2002 expected future cash flows rather than hype when valuing stocks. Firms that have issued stock and debt securities are required have their financial statements audited by independent auditors Uncertainty Surrounding Valuation of Securities (not their own employees) to verify that their uncertainty because investors have limited financial information is accurate. information available to value that security. o Some auditors might be motivated to ignore any misleading information so a firm’s managers may possess information that they can receive more business about its financial condition that is not from that firm in the future. available to investors o executives of the company can situation known as asymmetric information. benefit from misleading information o although all investors can access the because their compensation may be same public information about a tied to the company’s reported firm, they may interpret it in different profits or its stock price. ways, which leads to different In response to several well- documented valuations of the firm and uncertainty cases of fraudulent financial reporting by surrounding the firm’s stock price. companies that were not detected by auditors, o The higher the degree of uncertainty the U.S. Congress enacted the Sarbanes- about a security’s proper valuation, Oxley Act of 2002. the higher the risk is from investing in that security.  It imposed restrictions to ensure proper Role of Foreign Exchange Market auditing by auditors and proper oversight of International financial transactions typically the audit by the firm’s board of directors require the exchange of currencies. It also required key executives of the company The foreign exchange market facilitates these to sign off on the financial statements, and kinds of exchanges involving different imposed penalties on them if financial fraud currencies. was later detected. financial institutions serve as intermediaries in By establishing these rules, regulators tried to the foreign exchange market by matching up eliminate or at least reduce the amount of participants who want to exchange one asymmetric information surrounding each currency for another. publicly traded firm. also serve as dealers by taking positions in currencies to accommodate foreign exchange International Financial Markets requests. The exchange rate of a currency can fluctuate Financial markets are continuously being substantially over time, which in turn affects developed throughout the world to improve the return earned by investors who invest in the transfer of securities between surplus and securities in international financial markets. deficit units. The financial markets are much more developed in some countries than in others, and they also vary in terms of their liquidity. Role of Financial Institutions The level of liquidity in each country’s financial Because financial markets are imperfect, markets is influenced by local securities laws securities buyers and sellers do not have full regarding financial disclosure. access to all possible information. o countries that require more financial o In addition, they do not have the disclosure tend to have more liquid expertise to assess the financial markets, as investors are creditworthiness of potential more willing to participate when they borrowers. can obtain more information about o Financial institutions are needed to the firms whose securities they trade. resolve these kinds of limitations Each country has its own laws regarding caused by market imperfections. shareholder rights. o Financial institutions can be The enforcement of securities laws also varies classified as depository and non- from country to country. depository institutions. Role of Depository Institutions International Integration of Financial Markets Depository institutions accept deposits from The international integration of financial surplus units and provide credit to deficit units markets allows governments and corporations through loans and purchases of securities easier access to funding from creditors or o They offer deposit accounts that can investors in other countries to support their accommodate the amount and growth. liquidity characteristics desired by investors and creditors in any country can most surplus units. benefit from the investment opportunities o They repackage funds received from available in other countries. deposits to provide loans of the size under unfavorable economic conditions, the and maturity desired by deficit units. international integration of financial markets o They are willing to accept the risk of allows one country’s financial problems to default on loans that they provide. adversely affect other countries.  o They have more expertise than Some commercial banks receive more funds individual surplus units in evaluating from deposits than they need to make loans or the creditworthiness of prospective invest in securities. deficit units. Other commercial banks need more funds to o They diversify their loans among accommodate customer requests than the numerous deficit units, which means amount of funds that they receive from they can absorb defaulted loans deposits. better than individual surplus units The federal funds market facilitates the flow of could. funds between depository institutions ▪ To appreciate these (including banks). advantages, consider what A bank that has excess funds can lend to a the flow of funds from bank with deficient funds for a short-term surplus units to deficit units period, such as one to five days. would be like if depository o Commercial banks are subject to institutions did not exist. regulations that are intended to limit o Each surplus unit would have to their exposure to the risk of failure. In identify a deficit unit desiring to particular, banks are required to borrow the precise amount of funds maintain a minimum level of capital, available for the precise time period relative to their size, so that they have in which funds would be available. a cushion to absorb possible losses o each surplus unit would have to from defaults on some loans perform the credit evaluation of the provided to households or potential borrower and incur the risk businesses. of default. o many surplus units would likely hold Savings Institutions their funds closely rather than Savings institutions, which are sometimes channel them to deficit units referred to as thrift institutions, are another o When a depository institution offers a type of depository institution. loan, it is acting as a creditor, just as Savings institutions include savings and loan if it had purchased a debt security. associations (S&Ls) and savings banks. o The loan agreement is less o Like commercial banks, savings marketable in the secondary market institutions take deposits from than a debt security, however, surplus units and then channel these because the loan agreement is deposits to deficit units. personalized for the particular Like commercial banks, savings institutions borrower and contains detailed rely on the federal funds market to lend their provisions that can differ significantly excess funds or to borrow funds on a short- among loans. term basis. Commercial Banks commercial banks are the most dominant type Credit Unions of depository institution. Credit unions differ from commercial banks They serve surplus units by offering a wide and savings institutions variety of deposit accounts, and they transfer o nonprofit enterprises deposited funds to deficit units by providing o restrict their business to credit union direct loans or purchasing debt securities. members, who share a common Commercial banks serve both the private and bond (such as a common employer public sectors; their deposit and lending or union) services are utilized by households, ▪ Like savings institutions, businesses, and government agencies they are sometimes  classified as thrift Securities firms also often act as dealers, institutions in an effort to making a market in specific securities by distinguish them from maintaining an inventory of securities. commercial banks. a dealer’s income is influenced by the performance of the security portfolio maintained. Some dealers also provide Role of Non-depository Financial Institutions brokerage services and therefore earn income from both types of activities. Non-depository institutions generate funds In addition to brokerage and dealer services, from sources other than deposits but also play securities firms may provide underwriting and a major role in financial intermediation. advising services The underwriting and advising services are commonly referred to as investment banking, Finance Companies and the securities firms that specialize in Most finance companies obtain funds by these services are sometimes referred to as issuing securities and then lend those funds to investment banks individuals and small businesses When securities firms underwrite newly issued securities, they may either sell the securities for a client at a guaranteed price or simply sell Mutual Funds the securities at the best price they can get for Mutual funds sell shares to surplus units and their client. use the funds received to purchase a portfolio of securities. Insurance Companies Some mutual funds concentrate their investments in capital market securities, such Insurance companies provide individuals and as stocks or bonds. Known as money market firms with insurance policies that reduce the mutual funds, concentrate in money market financial burden associated with death, securities. illness, and damage to property. o By investing in mutual funds and These companies charge fees (called money market funds, small savers premiums) in exchange for the insurance that are able to invest in a diversified they provide. portfolio of securities while Insurance companies commonly invest these committing only a relatively small funds in stocks or bonds issued by amount of money to each security. corporations or in bonds issued by the government. Securities Firms Pension Funds Some securities firms act as a broker, executing securities transactions between two The employees and sometimes their parties for a commission (or markup) employers periodically contribute funds to the o The commission as a percentage of plan, and pension funds manage the money the transaction amount will likely be until the individuals withdraw the funds for higher for less common transactions their retirement. o The commission will also likely be Pension funds are important financial higher for transactions involving intermediaries that finance the needs of deficit relatively small amounts, so that the units. broker will be adequately compensated for the time required to execute the transaction. Comparison of Roles among Financial Institutions Institutional Role as a Monitor of Publicly Traded Firms The role of financial institutions in facilitating In addition to filling the roles described in the flow of funds from individual surplus units Exhibit 1.3, financial institutions serve as (investors) to deficit units is illustrated in monitors of publicly traded firms. Exhibit 1.3. Because insurance companies, pension o One set of flows represents deposits funds, and some mutual funds are major from surplus units that are investors in stocks, they can influence the transformed by depository management of publicly traded firms. institutions into loans for deficit institutional investors not only provide units. financial support to companies, but also o A second set of flows represents exercise some degree of corporate control purchases of securities (commercial over them. By serving as activist shareholders, paper) issued by finance companies they can help ensure that managers of publicly that are transformed into finance held corporations make appropriate decisions company loans for deficit units. that are in the best interests of the o A third set of flows reflects the shareholders. purchases of shares issued by mutual funds, which are used by the mutual funds to purchase debt and Relative Importance of Financial Institutions equity securities of deficit units. The deficit units also receive funding from Exhibit 1.4 summarizes the main sources and insurance companies and pension funds. uses of funds for each type of financial Securities firms are not shown in Exhibit 1.3, institution. but they play an important role in facilitating Households with savings are served by the flow of funds. Many of the transactions depository institutions. Households with between the financial institutions and deficit deficient funds are served by depository units are executed by securities firms. institutions and finance companies. Large corporations and governments that issue securities obtain financing from all types of financial institutions. In recent years, the flow of funds has been facilitated by peer-to-peer lending websites Consolidation of Financial Institutions that enable persons with excess money to In recent years, some financial institutions make loans to persons needing funds have merged in an effort to achieve economies Lenders can then offer loans with the interest of scale. rate based on the borrower’s risk. By increasing the volume of services produced with a given infrastructure, the average cost of  providing the services (such as loans) can be First, many financial institutions that reduced. originated mortgages shortly before the crisis As these regulations were loosened over the sold them to other financial institutions (i.e., last 20 years, firms that had specialized in one commercial banks, savings institutions, service expanded into other financial services. mutual funds, insurance companies, By becoming a financial conglomerate, they securities firms, and pension funds) could capitalize on economies of scope. o even financial institutions that were Exhibit 1.5 depicts the typical organizational not involved in the mortgage structure of a financial conglomerate. origination process experienced large losses because they purchased the mortgages originated by other financial institutions. Second, many other financial institutions that invested in mortgage-backed securities received lower payments as mortgage defaults occurred. Third, some financial institutions (especially securities firms) relied heavily on short-term debt to finance their operations and used their holdings of mortgage-backed securities as Global Consolidation of Financial Institutions collateral. o But when the prices of mortgage- Many financial institutions have expanded backed securities plummeted, they internationally to capitalize on their expertise. could not issue new short-term debt An international merger between financial to pay off the principal on maturing institutions enables the merged company to debt. offer the services of both entities to its entire Fourth, as mortgage defaults increased, there customer base. was an excess of unoccupied housing. There A merger between the two entities allows the was no need to construct new homes, so U.S. bank to provide its services to the construction companies laid off many European customer base (clients of the employees. European securities firm) and allows the o As the economy weakened, the European securities firm to offer its services to prices of many equity securities the U.S. declined by more than 40 percent. Eventually, most financial institutions that invested heavily in equities Systemic Risk among Financial Institutions experienced large losses on their investments during the credit crisis. Given the frequent business transactions The U.S. government intervened in an attempt between the various types of financial to improve the economy and rescued some institutions, financial problems that occur at financial institutions. one or a few financial institutions can quickly spread to others. Systemic risk is defined as the spread of financial problems among financial institutions and across financial markets that could cause a collapse in the financial system. During the credit crisis of 2008 and 2009, mortgage defaults affected financial institutions in several ways