Chapter 2: An Overview of the Financial System

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Chapter 2 An Overview of the Financial System

• Function of Financial Markets
• 1. Allows transfers of funds from person or
  business without investment opportunities
• to one who has them
• 2. Improves economic efficiency

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Financial Markets

• Classifications A firm or an individual can
  obtain funds in a financial market in two ways
• 1. Debt Markets
• Short term (maturity lt 1 year), Intermediate
  term (1ltmaturity lt 10 years) Long-term (maturity
  gt 10 year)
• Money Market market for short-term debt
  instruments
• Capital Market market for intermediate- and
  long-term debt instruments
• No ownership for debt holders.
• 2. Equity Markets
• Common stocks
• Confer ownership rights on the equity
  holders.
• The equity holders benefit directly from any
  increases in the corporations profitability or
  asset value.
• The corporation must pay all its debt holders
  before it pays its equity holders.

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Another Classifications of Financial Markets

• 1. Primary Market
• New security issues sold to initial buyers
  (investment banks underwriting securities).
• 2. Secondary Market
• Securities previously issued are bought and sold
  (e.g., NYSE/AMEX, NASDAQ)
• Secondary markets do not help the corporations to
  acquire funds, but do increase the liquidity of
  the securities, which makes the securities in the
  primary markets more attractive.
• Secondary markets also determine the prices of
  the securities issued in the primary market.
• Secondary market can be organized in two ways
• 1) Exchanges
• Trades conducted in central locations (e.g., New
  York Stock Exchange)
• 2) Over-the-Counter Markets
• Dealers at different locations buy and sell
  (e.g., NASDAQ)

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Internationalization of Financial Markets

• International Bond Market
• 1. Foreign bonds (sold in a foreign country,
  denominated in that countrys currency).
• 2. Eurobonds (sold in a country but denominated
  in a currency other than that of the country).
  Now larger than U.S. corporate bond market.
• a variant Eurocurrencies foreign currencies
  deposited in banks outside the home country.
  (e.g., Eurodollars)
• nothing to do with euros.
• World Stock Markets
• U.S. stock markets are no longer always the
  largest Japan sometimes larger

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Indirect Finance Financial Intermediaries

• Financial Intermediaries
• More important source of finance than
  securities markets
• Needed because of transactions costs and
  asymmetric information
• Functions of Financial Intermediaries
• Financial intermediaries make profits by reducing
  transactions costs. Reduce transactions costs by
  developing expertise and taking advantage of
  economies of scale.
• Risk Sharing Create and sell assets with low
  risk characteristics and then use the funds to
  buy assets with more risk (also called asset
  transformation).
• Also lower risk by helping people to diversify
  portfolios
• Financial intermediaries reduce adverse selection
  and moral hazard problems, enabling them to make
  profits.

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Asymmetric Information Adverse Selection and
Moral Hazard

• Adverse Selection
• 1. Before transaction occurs
• 2. Potential borrowers most likely to produce
  adverse outcomes are ones most likely to seek
  loans and be selected
• Moral Hazard
• 1. After transaction occurs
• 2. Hazard that borrower has incentives to engage
  in undesirable (immoral) activities making it
  more likely that wont pay loan back

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Financial Intermediaries
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Regulation of Financial Markets

• Three Main Reasons for Regulation
• 1. Increase information to investors
• A. Decreases adverse selection and moral hazard
  problems
• B. SEC forces corporations to disclose
  information
• 2. Ensuring the soundness of financial
  intermediaries
• A. Prevents financial panics
• B. Chartering, reporting requirements,
  restrictions on assets and activities, deposit
  insurance, and anti-competitive measures
• 3. Improving monetary control
• A. Reserve requirements
• B. Deposit insurance to prevent bank panics