The Economics of Money, Banking, and Financial Markets PDF

The Economics of Money, Banking, and Financial Markets Thirteenth Edition Chapter 2 An Overview of the...

The Economics of Money, Banking, and Financial Markets Thirteenth Edition Chapter 2 An Overview of the Financial System Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved 19-1 © 2016 Pearson Education, Inc. All rights reserved.  Preview This chapter presents an overview of the study of financial markets and institutions. 2-2 © 2016 Pearson Education, Inc. All rights reserved.  Learning Objectives Compare and contrast direct and indirect finance. Identify the structure and components of financial markets. List and describe the different types of financial market instruments. Recognize the international dimensions of financial markets. 2-3 © 2016 Pearson Education, Inc. All rights reserved.  Learning Objectives Summarize the roles of transaction costs, risk sharing, and information costs as they relate to financial intermediaries. List and describe the different types of financial intermediaries. Identify the reasons for and list the types of financial market regulations. 2-4 © 2016 Pearson Education, Inc. All rights reserved.  Function of Financial Markets Performs the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities 2-5 © 2016 Pearson Education, Inc. All rights reserved.  Function of Financial Markets Promotes economic efficiency by producing an efficient allocation of capital, which increases production Well-Functioning of financial markets will improve the well-being of consumers by allowing them to time purchases better and provide young people to buy what they need without forcing them to wait until they have saved up the entire purchase price 2-6 © 2016 Pearson Education, Inc. All rights reserved.  THE ECONOMY AS A CIRCULAR FLOW 2-7 © 2016 Pearson Education, Inc. All rights reserved.  Figure 1 Flows of Funds Through the Financial System 2-8 © 2016 Pearson Education, Inc. All rights reserved.  The arrows shows that funds flow from lenders (Savers) to borrowers (Spenders) via two routes 1. Direct Finance: In which borrowers borrow funds directly from financial markets by selling securities 2. Indirect Finance: In which financial intermediaries borrows finds from lender (Savers) and then uses these funds to make loans to borrowers (Spenders) Securities are assets for the person who buys them but liabilities for the individual or firm that sells them 2-9 © 2016 Pearson Education, Inc. All rights reserved.  Structure of Financial Markets A. Debt and Equity Markets(Product Types) A firm or individual can obtain funds in a financial market in two ways: 1. Debt instruments (maturity) Issuance a dept instruments such as bond or mortgage: - Short Term debt instrument: if the maturity term less than a year - Long Term debt instrument: if the maturity term is ten years or longer. - Intermediate Term instrument: if the maturity between one to ten years. 2-10 © 2016 Pearson Education, Inc. All rights reserved.  Structure of Financial Markets 2. Equities(dividends) Issuance such as common stocks which are claims to share in the net income. Equities often make periodic payment (dividends) to their holders. B. Primary and Secondary Markets (Market Types) 1. Primary Market: is a financial market in which new issues of a securities are sold to initial buyers. Investment banks underwrite securities in primary markets. 2-11 © 2016 Pearson Education, Inc. All rights reserved.  Structure of Financial Markets 2. Secondary Market: is a financial market in which securities that have been issued can be resold. Brokers and dealers work in secondary markets. Brokers: are agents of investors who match buyers with sellers of securities. Dealers: link buyers and sellers by buying and selling securities at stated price. 2-12 © 2016 Pearson Education, Inc. All rights reserved.  Structure of Financial Markets C. Exchanges and Over-the-Counter (OTC) Markets (place to buy): – Exchanges: Secondary Markets can be organized through exchanges where buyers and sellers of securities meet in one central location to conduct trades such as NYSE – OTC markets: in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities over the counter to anyone who comes to them and is willing to accept their prices, so the OTC market is very competitive such as Foreign exchange, Federal funds 2-13 © 2016 Pearson Education, Inc. All rights reserved.  Structure of Financial Markets D. Money and Capital Markets (maturity): – Money markets deal in short-term debt instruments such as deposit certificates – Capital markets deal in longer-term debt and equity instruments such as stocks and long term bonds 2-14 © 2016 Pearson Education, Inc. All rights reserved.  Financial Market Instruments A. Money Market Instruments : The debt instrument traded in the money market undergo the least price fluctuation and so are the least risky investment because of their short term's maturity , such as : 1. Treasury Bills: is a shot term dept instruments of the government are issued in one, three-, and six-months maturities to finance the government. 2. Negotiable bank certificate of deposit (CD):is a Shot term dept instrument sold by bank to depositors that pays annual interest of 2-15 © 2016 Pearson Education, Inc. All rights reserved.  Financial Market Instruments a given amount and at maturity pays back the original purchase price. 3. Commercial paper: is a Shot term dept instrument issued by large banks and well- known corporations such as Microsoft. 4. Repurchase agreements are effectively short-term loans(usually with a maturity term of less than two weeks. 2-16 © 2016 Pearson Education, Inc. All rights reserved.  Financial Market Instruments 2-17 © 2016 Pearson Education, Inc. All rights reserved.  Financial Market Instruments B. Capital Market Instruments : Are debt and equity instruments with maturities of greater than one year. they have wider price fluctuations than money market instruments and are considered to be fairly risky investments. Such as : 1. Stocks: Are equity claims on the net income and assets of a corporation. 2. Mortgage : Mortgages(debt instrument) are loans to house-holders or firms to purchase land, housing or other real structure. 2-18 © 2016 Pearson Education, Inc. All rights reserved.  Financial Market Instruments 3. Corporate Bonds: are(debt instrument)long-term bonds are issued by corporations with very strong credit ratings which send the holder an interest payment twice a year and pays off the face value when the bond matures. 4. Government Securities: are long-term debt instruments are issued by the treasury to finance the deficit of the government. 5. Government Agency Securities: long-term bonds are issued by various government agencies to finance such items as farm loan or power generating equipment. 2-19 © 2016 Pearson Education, Inc. All rights reserved.  Financial Market Instruments 6. State and local Government Bonds: are long- term debt instrument(also called municipal bonds) issued by state and local governments to finance expenditures on schools,roads,and other large programs 7. Consumer and Bank Commercial loans: these loans to consumers and businesses are made principally by banks 2-20 © 2016 Pearson Education, Inc. All rights reserved.  Financial Market Instruments 2-21 © 2016 Pearson Education, Inc. All rights reserved.  Internationalization of Financial Markets 1. International Bond Market, Eurobonds, and Eurocurrencies Foreign Bonds: sold in a foreign country and denominated in that country’s currency Eurobond: 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 – Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks 2. World Stock Markets: – Also help finance government 2-22 © 2016 Pearson Education, Inc. All rights reserved.  Function of Financial Intermediaries: Indirect Finance 1. Transaction Cost Lower transaction costs (time and money spent in carrying out financial transactions) – Economies of scale – Liquidity services 2. Risk Sharing Financial intermediaries can help Reduce the exposure of investors to risk – Risk Sharing (Asset Transformation) – Diversification 2-23 © 2016 Pearson Education, Inc. All rights reserved.  Function of Financial Intermediaries: Indirect Finance 3. Asymmetric Information: Adverse and Moral Hazard : In financial markets one party often doesn`t know enough about the other party to make accurate decisions this inequality called a symmetric information. Deal with asymmetric information problems: – Adverse Selection is the problem created by asymmetric information before the transaction occurs: try to avoid selecting the risky borrower by gathering information about them 2-24 © 2016 Pearson Education, Inc. All rights reserved.  Function of Financial Intermediaries: Indirect Finance – Moral Hazard is the problem created by asymmetric information after the transaction occurs : ensure borrower will not engage in activities that will prevent him/her to repay the loan. 4. Conflict of interest: a type of moral hazard problem, arise when a person or institutions has multiple objectives(interests),some of which conflict with each other Conclusion: – Financial intermediaries allow “small” savers and borrowers to benefit from the existence of financial markets 2-25 © 2016 Pearson Education, Inc. All rights reserved.  Types of Financial Intermediaries 2-26 © 2016 Pearson Education, Inc. All rights reserved.  Types of Financial Intermediaries 2-27 © 2016 Pearson Education, Inc. All rights reserved.  Appendics 1: Summary of Chapter 2 2-28 © 2016 Pearson Education, Inc. All rights reserved.  1. Financial Markets 2. Financial (Direct Finance) Intermediaries (Indirect Finance) Internationalization Function Structure of Financial Markets Function Types Dept and equity Depositary Int`l bond Market markets Institutions Primary and Contractual secondary Eurocurrencies Saving Markets Institutions Exchanges & Investment OTC Markets Intermediaries Money and Money and Capital Markets Capital Markets 2-29 © 2016 Pearson Education, Inc. All rights reserved.