FMI (chapter 2)

FUNCTION OF FINANCIAL MARKETS

Financial markets perform the essential economic function of channeling funds from
households firms and governments that have saved a surplus of funds to those that have a
shortage.

Lender-savers - those who have saved and are lending funds.

Mainly households, but business enterprises and the government, particularly

local, and foreigners + their govts have excess funds sometimes and lend them
out.

Borrower-spenders - those who must borrow funds to finance their spending.

Mainly businesses and government (particularly federal), but households and

foreigners sometimes too.

Direct finance - borrowers borrow funds directly from lenders in financial markets by
selling them securities (financial instruments), which are claims on the borrower's
future income/assets.

Securities - asset for lender, liabilities for borrower.

Indirect finance - a financial intermediary borrows from lender-savers and uses them
to make loans to borrower-spenders
 Capital - wealth, either financial or physical, that is employed to produce more wealth.

DEBT AND EQUITY MARKETS

Two main ways for firms/individuals to obtain funds in a financial market:

1. Issue a debt instrument, such as a bond or mortgage (contractual agreement by

borrower to pay the holder of the instrument fixed amounts at regular intervals for
interest and principal payments) until a maturity date is reached.

2. Issuing equities, such as common stock (claims to share in the net income and
assets of a business)

Maturity of a debt - number of years until the instrument's expiration date.

Short-term: maturity less than a year

Intermediate-term: maturity between one and ten years

Long-term: maturity ten years or longer

Disadvantage of owning a corporation's equities rather than its debt is that an equity
holder is a residual claimant (the corporation must pay all its debt holders before
paying equity holders)
 Advantages of owning equities is that holders benefit directly from an increase in
profitability or asset value, because equities confer ownership rights to holders. Debt
holders to not share this benefit because their payments are fixed.

PRIMARY AND SECONDARY MARKETS

Primary market - financial market in which new issues of a security, such as bonds or
stocks, are sold to initial buyers by the corporation or government agency borrowing the
funds.

Not well-known to the public because the first sale to initial buyers occurs behind
closed doors.

Investment bank - assists in the initial sale of the securities in the primary market.

Does this by underwriting securities (guarantees a price for a corporation's

securities then sells them to the public)

Secondary market - financial market in which securities that have been previously issued
can be resold.

Examples: New York Stock Exchange, NASDAQ for stocks. Bond markets have a
larger trading volume but other examples include foreign exchange markets, futures,
and options markets.

Key Participants:
- Brokers: Agents who match buyers with sellers.
- Dealers: Link buyers and sellers by trading securities at stated prices.

Function:
1. Enhances liquidity of financial instruments making them more appealing in the
primary market.
2. Influences the price of the security in the primary market. The expected secondary
market price sets the ceiling for the primary market price.

Secondary market conditions are crucial for corporations issuing securities.

Hence, financial market literature often focuses more on secondary markets.

Types of Secondary Markets:

1. Exchanges: Centralized locations where trading occurs. Examples include the New
York and American Stock Exchanges for stocks and the Chicago Board of Trade for
 commodities.
2. Over-the-Counter (OTC) Market: Decentralized market where dealers across
different locations trade securities. Dealers maintain an inventory and use computers
to stay competitive with prices, making it similar to an organized exchange.

EXCHANGES AND OVER-THE-COUNTER MARKETS

Common stocks of many companies are traded over-the-counter (OTC).

Most large corporations have shares traded at organized stock exchanges.

U.S. government bond market:

Larger trading volume than the New York Stock Exchange.

Functions as an OTC market with around 40 dealers ready to buy/sell U.S.

government bonds.

Other OTC markets trade financial instruments such as negotiable certificates of deposit,
federal funds, banker’s acceptances, and foreign exchange.

MONEY AND CAPITAL MARKETS

Money Market:

Trades short-term debt instruments (usually with original maturity less than one year).

Highly liquid with more frequent trades.

Short-term securities have smaller price fluctuations making them safer.

Used by corporations and banks for earning interest on surplus funds available
temporarily.

Capital Market:

Trades longer-term debt (original maturity of one year or more) and equity
instruments.

Often used by financial intermediaries like insurance companies and pension funds
due to long-term stability.

INTERNATIONALIZATION OF FINANCIAL MARKETS

U.S. financial markets dominated globally before the 1980s.

 Recent shift: U.S. market dominance decreasing due to:

Increase in foreign savings pools, especially in countries like Japan.

Deregulation allowing foreign financial markets to expand.

Current scenario:

U.S. entities increasingly tap into international capital markets for funds and
investments.

Foreign entities access American funds, with foreigners becoming significant investors
in the U.S.

INTERNATIONAL BOND MARKETS

Foreign bonds: Sold in a foreign country and denominated in that country’s currency.

Example: If Porsche (German company) sells a bond in the U.S. in U.S. dollars, it's a
foreign bond.

Historical relevance: U.S. railroads in the 19th century were largely financed by selling
foreign bonds in Britain.

EUROBONDS AND EUROCURRENCIES

Eurobond:

Bond denominated in a currency other than that of the country where it's sold.

Example: U.S. dollar-denominated bond sold in London.

Over 80% of new international bond market issues are Eurobonds.

Eurobond market size now surpasses the U.S. corporate bond market.

Eurocurrencies:

Foreign currencies deposited outside their home country.

Key example: Eurodollars - U.S. dollars deposited in foreign banks or in foreign

branches of U.S. banks.

Are similar to short-term Eurobonds since they earn interest.

Major source of funds for American banks.

 Potential confusion: Terms like Eurobond and Eurodollars are not directly linked to the
European Monetary System's euro currency.

A Eurobond is called so only if sold outside countries using the euro.

Most Eurobonds are in U.S. dollars, not euros.

Eurodollars relate to U.S. dollars deposited outside the U.S., not the euro
currency.

WORLD STOCK MARKETS

U.S. stock market was historically the world's largest.

Foreign stock markets gaining importance, sometimes surpassing the U.S.

Growth in U.S. mutual funds specializing in foreign stock trading.

American investors now track foreign stock indexes, like the Nikkei 300 Average
(Tokyo) and the FTSE 100-Share Index (London).

Internalization of financial markets:

Significant foreign investment, especially from Chinese investors.

Provides crucial funds to U.S. corporations and federal government.

Without foreign funds, U.S. economic growth would've been slower over the past
two decades.

The blending of global financial markets is fostering a more integrated global economy.

Enhances inter-country goods and technology flow.

FUNCTION OF FINANCIAL INTERMEDIARIES

Indirect Finance

Funds can be transferred between lenders and borrowers via indirect finance.

This involves a financial intermediary that acts as a bridge between lender-savers and
borrower-spenders.

How it works: A financial intermediary, like a bank, borrows funds (e.g., through
savings deposits) and then uses these funds to make loans or purchase securities.
 Indirect finance, through financial intermediaries (termed financial intermediation), is
the dominant method for moving funds.

Despite the media's emphasis on securities markets, financial intermediaries play a

larger role in financing corporations.

This prominence is observed not just in the U.S. but also in other industrialized
nations.

The significance of intermediaries and indirect finance stems from their role in
addressing transaction costs, risk sharing, and information asymmetry in financial
markets.

TRANSACTION COSTS

The Problem of Transaction Costs

Transaction costs are expenses in terms of time and money for executing financial
transactions.

Example: Lending $1,000 to Carl for a tool might require a $500 legal contract to
secure the loan, making the deal unprofitable.

Such costs can deter small savers or borrowers from participating in financial markets.

Financial Intermediaries to the Rescue

They can significantly lower transaction costs due to their expertise and economies of
scale.

E.g., A bank can use a reusable, high-quality loan contract, bringing down the cost per
loan to as low as $2.50.

With reduced transaction costs, lending becomes feasible and profitable.

Benefits of Reduced Transaction Costs

Enables indirect provision of funds to individuals with viable investment opportunities.

Intermediaries can offer liquidity services due to their low transaction costs.

Banks, for instance, offer checking accounts, allowing easy bill payments.

Depositors can earn interest while maintaining the flexibility to spend as needed.

RISK SHARING AND DIVERSIFICATION

 Asset Transformation and Risk Sharing

Financial intermediaries create and sell assets with risk profiles that cater to general
comfort levels.

Using the funds from these sales, they buy other, potentially riskier assets.

Their low transaction costs facilitate risk sharing, letting them profit from the difference
between returns on risky assets and their liabilities.

This is termed "asset transformation" as risky assets are essentially converted into
more secure assets for investors.

Diversification Benefits

Financial intermediaries aid in diversifying risks for individuals.

Diversification means investing in a variety of assets, ensuring that returns don't

always move in tandem.

Results in a reduced overall risk compared to individual assets.

Due to their low transaction costs, intermediaries can pool various assets into a new
collective asset and offer it to individuals, further promoting diversification.

ASYMMETRIC INFORMATION: ADVERSE SELECTION AND MORAL HAZARD

Asymmetric Information Defined

One party often lacks adequate knowledge about the other to make informed
decisions in financial markets.

For instance, borrowers often know more about the potential risks and returns of their
investments than lenders.

Adverse Selection

Before the transaction, due to asymmetric information.

Bad credit risks, or those most likely to default, are often the most eager to seek loans.

This makes lenders hesitant, even if good credit risks exist.

Example: Between two aunts, the riskier one (Aunt Sheila) is more likely to seek a
loan for a speculative venture, while the conservative one (Aunt Louise) only borrows
 for sure-shot investments. Without proper knowledge, you might end up lending to the
riskier aunt.

Moral Hazard

Occurs after the transaction.

There's a risk that borrowers might engage in activities that decrease the likelihood of
repaying the loan.

Example: Uncle Melvin borrows money for a business but might use it for gambling. If
he wins, he reaps the benefits, but if he loses, the lender bears the loss.

Financial Intermediaries Alleviate Issues

They can mitigate the problems created by adverse selection and moral hazard.

They're better equipped to discern between good and bad credit risks, reducing
losses.

They also possess the expertise to monitor borrowers, further minimizing risks.

Consequently, they can offer interest to lender-savers and still remain profitable.

Significance of Financial Intermediaries

They enhance economic efficiency by guiding funds from savers to those with
productive investment opportunities.

Their roles in providing liquidity, promoting risk sharing, and addressing information
problems are pivotal.

Their success is evident as many Americans trust them with their savings and for
loans.

A robust set of financial intermediaries is crucial for an economy's optimal

performance.

ECONOMIES OF SCOPE AND CONFLICTS OF INTEREST

Economies of Scope

Financial intermediaries can provide multiple services, leading to economies of scope.

Economies of scope allow them to reduce the cost of information production for
different services by using one information resource.
 Example: An investment bank assessing a corporation's credit risk for a loan can use
that information when deciding to sell the corporation's bonds to the public.

Conflicts of Interest

While economies of scope benefit financial institutions, they can also create conflicts
of interest.

Conflicts of interest emerge as a form of moral hazard when an individual or institution

has several goals or interests that clash with each other.

Particularly prevalent when a financial institution offers several services.

Can lead to concealing or providing misleading information.

Implications

Conflicts of interest can degrade the quality of information in financial markets.

This increase in asymmetric information hampers the efficient channeling of funds to

the most productive investments.

Ultimately, it can decrease the efficiency of both the financial markets and the overall
economy.

TYPES OF FINANCIAL INTERMEDIARIES

Financial intermediaries have a pivotal role in the economy. They can be classified into
three main categories:
1. Depository Institutions (Banks)
2. Contractual Savings Institutions
3. Investment Intermediaries
-Each type of intermediary is characterized by its primary liabilities (how they get funds) and
assets (how they use or invest those funds).
CREDIT UNIONS

Definition:

Credit unions are small cooperative financial institutions.

They are organized around specific groups, such as union members or employees of
a particular company.

Funding Sources:
 They gather funds through deposits, commonly referred to as shares.

Primary Activities:

Their main function is to extend consumer loans.

Presence:

There are approximately 7,000 credit unions in operation in the U.S.

CONTRACTUAL SAVINGS INSTITUTIONS

- Contractual savings institutions, such as insurance companies and pension funds, acquire funds
at periodic intervals on a contractual basis.
- They can reasonably predict their future payouts.
- They are less concerned about liquidity of assets compared to depository institutions.
- Primarily invest in long-term securities like corporate bonds, stocks, and mortgages.
1. LIFE INSURANCE COMPANIES
- Function:
They provide insurance against financial losses following death and also sell annuities.
- Funding Sources:
- They gather funds through premiums paid by policyholders.
- Primary Investments:
- Mainly invest in corporate bonds and mortgages.
- They also buy stocks but are limited in the amount they can hold.
- Size:
- They manage assets worth $6.4 trillion, making them one of the largest contractual savings
institutions.
2. FIRE AND CASUALTY INSURANCE COMPANIES
- Function:
- They insure against losses from theft, fire, and accidents.
- Funding Sources:
- They acquire funds through premiums from their policyholders.
- Primary Investments:
- Primarily invest in more liquid assets due to a higher risk of fund loss from major disasters.
- Their largest holdings are in municipal bonds, followed by corporate bonds, stocks, and U.S.
government securities.
3. PENSION FUNDS AND GOVERNMENT RETIREMENT FUNDS
- Function:
- They provide retirement income via annuities to covered employees.
- Funding Sources:
- Funds are gathered from contributions by both employers and employees.
- Primary Investments:
- Their main asset holdings are corporate bonds and stocks.
- Support:
- The establishment and contributions to pension funds are encouraged by federal government
through legislation and tax incentives.

INVESTMENT INTERMEDIARIES
- Financial intermediaries that specialize in assisting companies and individuals in investing funds,
raising capital, and managing investments.
1. FINANCE COMPANIES
- Function:
- Offer loans to consumers for purchases like furniture, automobiles, and home improvements, as
well as to small businesses.
- Funding Sources:
- Acquire funds by selling commercial paper, stocks, and bonds.
- Examples:
- Ford Motor Credit Company makes loans to consumers who want to purchase Ford
automobiles.
2. MUTUAL FUNDS
- Function:
- Pool resources from many individuals to purchase diversified portfolios of stocks and bonds.
- Benefits:
- Provides shareholders with lower transaction costs and diversified portfolios.
- Value of shares is determined by the fund's holdings and can be redeemed at any time.
- Risk:
- Share values can fluctuate greatly due to market conditions.
3. MONEY MARKET MUTUAL FUNDS
- Function:
- Operate like mutual funds but offer deposit-type accounts.
- Characteristics:
- Sell shares to acquire safe and liquid money market instruments.
- Shareholders can write checks against their shareholdings, similar to checking account deposits.
- Assets reached nearly $2.7 trillion by the end of 2015.
4. HEDGE FUNDS
- Function:
- A specialized type of mutual fund with minimum investments typically ranging from $100,000 to
$1 million or more.
- Characteristics:
- Subjected to weaker regulation than other mutual funds.
- Invest in diverse assets, from stocks and bonds to foreign currencies and exotic assets.
5. INVESTMENT BANKS
- Function:
- Assist corporations in issuing securities, advising on types of securities to issue, and helping in
the underwriting process.
- Characteristics:
- Do not function like traditional banks; they don't accept deposits or lend them out.
- Play a key role in mergers and acquisitions, earning significant fees.
- Activities:
- Advise corporations, help sell securities by underwriting them, and act as intermediaries in
mergers and acquisitions.