1 Chapter 1 Role of Financial Markets and Institutions Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline  Overview of financial markets  Types of financial markets  Securities traded in financial markets  Valuation of securities in financial markets  Market efficiency  Financial market regulation  Global financial markets  Role of financial institutions in financial markets  Comparison of roles among financial institutions  Overview of financial institutions  Global expansion by financial institutions 3 Overview of Financial Markets  A financial market is a market in which financial assets (securities) can be purchased or sold  Financial markets facilitate financing and investing by households, firms, and government agencies  Participants that provide funds are called surplus units  e.g., households  Participants that enter markets to obtain funds are deficit units  e.g., the government  A major participant in financial markets is the Fed, because it controls the money supply 4 Types of Financial Markets  Financial markets can be distinguished by the maturity structure and trading structure of its securities  Money versus capital markets  The flow of short-term funds is facilitated by money markets  The flow of long-term funds is facilitated by capital markets  Primary versus secondary markets  Primary markets facilitate the issuance of new securities  e.g., the sale of new corporate stock or new Treasury securities  Secondary markets facilitate the trading of existing securities  e.g., the sale of existing stock  Securities traded in secondary markets should be liquid 5 Types of Financial Markets (cont’d)  Organized versus over-the-counter markets  A visible marketplace for secondary market transactions is an organized exchange  Some transactions occur in the over-the-counter (OTC) market (a telecommunications network)  Knowledge of financial markets is power  Decide which markets to use to achieve our investment goals or financing needs  Decide which markets to use as part of your job  Avoid common mistakes in investing and borrowing 6 Securities Traded in Financial Markets  Money market securities  Money market securities are debt securities with a maturity of one year or less  Characteristics:  Liquid  Low expected return  Low degree of risk 7 Securities Traded in Financial Markets (cont’d)  Capital market securities  Capital market securities are those with a maturity of more than one year  Bonds and mortgages  Stocks  Capital market securities have a higher expected return and more risk than money market securities 8 Securities Traded in Financial Markets (cont’d)  Bonds and mortgages  Bonds are long-term debt obligations issued by corporations and government agencies  Mortgages are long-term debt obligations created to finance the purchase of real estate  Bonds and mortgages specify the amount and timing of interest and principal payments 9 Securities Traded in Financial Markets (cont’d)  Stocks  Stocks (equity) are certificates representing partial ownership in corporations  Investors may earn a return by receiving dividends and capital gains  Stocks have a higher expected return and higher risk than long-term debt securities 10 Securities Traded in Financial Markets (cont’d)  Derivative securities  Derivative securities are financial contracts whose values are derived from the values of underlying assets  Speculating with derivatives allow investors to benefit from increases or decreases in the underlying asset  Risk management with derivatives generates gains if the value of the underlying security declines [...]... increased regulation 14 Financial Market Regulation   Many regulations attempt to ensure that businesses disclose accurate information Disclosure  The Securities Act of 19 33 intended to ensure complete disclosure of relevant financial information on publicly offered securities  The Securities Exchange Act of 19 34 extended the disclosure requirements to secondary market issues 15 Financial Market... available 11 Valuation of Securities in Financial Markets (cont’d)  Impact of the Internet on the valuation process  The valuation of securities is improved as a result of the internet because of     Online price quotations The availability of the actual sequence of transactions for some securities Increased information about firms issuing securities Online orders to buy or sell securities 12 Market...   Existing regulations were not completely preventing fraud 16 Financial Market Regulation (cont’d)  Increased regulation is existing or emerging in these areas:  Provision of more complete and accurate financial information  More restrictions to ensure proper auditing by auditors  Proper oversight by the firm’s board of directors 17 Global Financial Markets  Financial markets vary among countries... fully reflect all available information  In an efficient market, different investors may still prefer different securities because of differences in:   Risk preference  Desired liquidity  Tax status 13 Market Efficiency (cont’d)  Impact of asymmetric information    Asymmetric information is information a firm’s managers have that is not available to investors The valuation process is influenced... Eastern European countries allowed for privatization, the sale of government-owned firms to individuals  Financial markets in these countries ensure that businesses can obtain funding from surplus units 18 Global Financial Markets (cont’d)  Global integration  Many    financial markets are globally integrated Participants move funds out of one country’s market and into another Foreign investors serve... purchasing securities U.S investors serve as key surplus units for foreign countries by purchasing foreign securities  Market movements and interest rates have become more correlated between markets 19 Global Financial Markets (cont’d)  Global integration (cont’d)  Barriers    to global integration Lack of information about foreign companies Different accounting regulation Excessive cost of executing... serve as brokers and/or dealers in foreign exchange markets  Foreign exchange market  The exchange rate is the market-determined price of a currency  Price changes in response to supply and demand 21 Role of Financial Institutions in Financial Markets  In a perfect market:  All information about any securities for sale in primary and secondary markets would be continuously and freely available... Units Securities Purchase Shares Policyholders Employers Employees Premiums Employee Contributions Depository Institutions Finance Companies Mutual Funds Deficit Units Insurance Companies Pension Funds 31 Overview of Financial Institutions  Competition between financial institutions  Financial institutions should operate to maximize the value of their owners  Present value of future cash flows  Depends . 1 Chapter 1 Role of Financial Markets and Institutions Financial Markets and Institutions,. derivatives generates gains if the value of the underlying security declines 11 Valuation of Securities in Financial Markets  Securities are valued as