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Chapter 01 – Introduction 6th Edition
1.1.1.1.1Part I
1.1.1.1.1.1.1 Introduction and Overview of Financial Markets
1.1.1.1.2Chapter One
Introduction
I. Chapter Outline
1. Why Study Financial Markets And Institutions? Chapter Overview
2. Overview of Financial Markets
a. Primary Markets versus Secondary Markets
b. Money Markets versus Capital Markets
c. Foreign Exchange Markets
d. Derivative Security Markets
e. Financial Market Regulation
3. Overview of Financial Institutions
a. Unique Economic Functions Performed by Financial Institutions
b. Additional Benefits FIs Provide to Suppliers of Funds
c. Economic Functions FIs Provide to the Financial System as a Whole
d. Risks Incurred by Financial Institutions
e. Regulation of Financial Institutions
f. Trends in the United States
4. Globalization of Financial Markets and Institutions
Appendix 1A: The Financial Crisis: The Failure of Financial Institutions’ Specialness
(available through McGraw-Hill’s Connect. Contact your McGraw-Hill representative for
more information on making the appendix available to your students).
II. Learning Goals
1. Differentiate between primary and secondary markets.
2. Differentiate between money and capital markets.
3. Understand what foreign exchange markets are.
4. Understand what derivative securities markets are.
5. Distinguish between the different types of financial institutions.
6. Know the services financial institutions perform.
7. Know the risks financial institutions face.
8. Appreciate why financial institutions are regulated.
9. Recognize that financial markets are becoming increasingly global.
1.1.1.2 III. Chapter in Perspective
This chapter has three major sections and one minor section. The text provides a general
overview of the major types of U.S. financial markets, focusing primarily on terminology
and descriptions of the major securities, market structures and regulators. Market
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Chapter 01 – Introduction 6th Edition
microstructure is not discussed. Foreign exchange transactions are also briefly
introduced. Second, the chapter describes the various types of financial institutions and
explains the risks they face and the services they provide to funds’ users and funds’
suppliers. The financial crisis is also discussed. The final section of the chapter provides
statistics about the rapid growth of globalization of both markets and institutions. An
appendix covering the details of the financial crisis and the government intervention
programs, including the costs as of late 2009, is available through McGraw-Hill’s
Connect. Contact your McGraw-Hill representative for more information on making the
appendix available to your students.
1.1.1.3
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Intermediation OTC markets vs exchanges
Primary, secondary & derivatives markets Benefits of direct and indirect financing
Money vs capital markets Public and private placements
Asset broker vs asset transformer Economies of scale
Eurobonds Types of financial intermediaries
Global financial markets Risks faced by financial institutions
Securitization Financial crisis
Subprime mortgages
Appendix terms include:
Systemic risk TARP program
TALF programs Stimulus bill
Wall Street Reform and Consumer Protection Act
1.1.1.5
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1.1.1.6 V. Teaching Notes
1. Why Study Financial Markets and Institutions?
For an economy to achieve its potential growth rate, mechanisms must exist to effectively
allocate capital (a scarce resource) to the best possible uses accounting for the riskiness of the
opportunities available. Markets and institutions have been created to facilitate transfers of funds
from economic agents with surplus funds to economic agents in need of funds. For an economy
to maximize its growth potential it must create methods that attract savers’ excess funds and then
put those funds to the best uses possible, otherwise idle cash is not used as productively as
possible. The funds transfer should occur at as low a cost as possible to ensure maximum
economic growth. Two competing alternative methods exist: direct and indirect financing. In
direct financing the ultimate funds supplier purchases a claim from the funds demander with or
without the help of an intermediary such as an underwriter. In this case, we rely on primary
markets to initially price the issue and then secondary markets to update the prices and provide
liquidity. Trustees are appointed to monitor contractual obligations of issuers and instigate
enforcement actions for breach of contract terms. In indirect financing, the funds demander
obtains financing from a financial intermediary. The intermediary and the borrower negotiate the
terms and cost. The intermediary obtains funds by offering different claims to fund suppliers. In
this case the intermediary is usually responsible for monitoring the contractual conditions of the
financing agreement and perhaps updating the cost if appropriate.
The financial crisis of 2008-2009 reversed a long term trend of deregulating financial
institutions. Regulatory risk and costs of regulation have increased as a result of new laws,
higher capital requirements and stricter regulatory oversight. A former Federal Reserve Chair,
Alan Greenspan, believed in only minimal regulation and his philosophy appeared to prevail at
many regulatory agencies including the SEC. As discussion leader, you may wish to point out
that it is not clear whether the existing rules would have been sufficient to prevent the crisis if
they had been enforced. Laws and regulations by themselves are insufficient to ensure proper
behavior in any case. Practitioners and academics also need to emphasize business ethics and
individual accountability. Nevertheless, the financial crisis led to the massive Dodd-Frank bill
(Wall Street Reform and Consumer Protection Act) designed to limit systemic risk and tighten
controls on the institutions that many blame for causing the financial crisis. The new “Volcker
Rule” prohibits insured intermediaries from engaging in proprietary trading, owning or managing
a hedge fund and private equity investments. The Volcker rule has not yet been implemented as
of June 2014 because banks correctly maintain that many of their proprietary activities are
actually hedges to reduce risk and these are allowed. It is difficult to separate hedging from
speculative based trades. An unintended consequence of the Volcker rule is the reduction of
liquidity in the bond markets as banks reduce their bond trading activities.
Maintaining profitability with restricted activities in a continuously evolving, globally
competitive market is a major challenge to the industry. The pace of innovation of new
technology, financial products and services has not abated. Technological advances may change
traditional methods of offering financial services at the wholesale, and perhaps eventually, at the
retail level. Job opportunities for finance students in markets and institutions are likely to be
improving during the next twenty years as managing risks at intermediaries in increasingly
complex and competitive businesses will grow in importance. For career information you may
wish to refer students to the Wall Street Journal (WSJ) data link
http://news.efinancialcareers.com/us-en/page/welcome-to-efinancialcareers. Bank hiring has
been muted in recent years, particularly at smaller banks that are struggling to keep up with the
increased regulatory burden and strict lending standards. The text provides an introductory
examination of the functions and characteristics of markets and risk and profitability
management at major financial institutions in order to help students understand the workings of
the financial system in today’s global economy.
Fallout from the financial crisis continues. As of spring 2014, the pace of economic growth is
slowly increasing, but the unemployment rate remains around 6.0% and the pace of recovery still
faces headwinds from a slow home construction market and uncertainty about taxes and benefits
costs. Bond market issuance continues at a strong pace, although overall credit provided by
banks only recently improved. This implies that larger firms have little difficulty in obtaining
credit, but some smaller firms that rely more on bank lending continue to have difficulty
obtaining credit.
2. Overview of Financial Markets
a. Primary Markets vs Secondary Markets
b. Money Markets vs Capital Markets
The two alternative mechanisms of fund raising are direct financing, where the saver directly
purchases a claim from the ultimate funds user in the primary market, or indirect financing
where savers place their money in a FI and the FI lends money to the ultimate borrower. In the
cases where savers desire to place their money directly in the markets, institutions such as
investment bankers (asset brokers) have evolved to assist in this process. The first time a firm
issues securities to the public is referred to as its initial public offering (IPO). Issuing
additional stock of a firm that already has stock publicly traded is referred to as a seasoned
offering (or sometimes called a ‘follow on’ offering). In some cases firms offer the issue to one
or only a few institutional buyers. The primary markets are the markets where firms (and other
borrowers) create and sell new securities in order to raise cash to fund positive NPV projects (or
to meet some other social goals in the case of non profit fund raisers). The financial crisis
drastically reduced primary market issues of all types. Bond issuance recovered first and more
recently in 2012 and 2013 IPO issuance rebounded sharply as well.
The instructor should emphasize that the secondary markets exist to provide liquidity and price
information to investors. These functions make the primary market more attractive. Investors
would be far less likely to invest in risky long term primary securities unless they believe they
can obtain updates of the current value of their claims and have the ability to sell these claims
quickly at low cost. Hence the efficiency of operations of the secondary markets affects the
growth rate in the overall economy through their effect on the primary markets. Secondary
market trading volume has risen dramatically in the last several decades, particularly with the
creation of wholesale and retail electronic trading mechanisms that have substantially reduced
trading costs. Recent mergers also emphasize the economies of scale in the exchange business.
The NYSE merged with Euronext in 2006 and was acquired by the Intercontinental Exchange
(ICE) in 2013, after a failed merger attempt by the Deutsche-Bourse. The CME and the CBOT
have also merged. Ask students to think about the pros and cons of having only one owner of the
largest U.S. stock market versus having foreign ownership of our largest market. Note that
electronic trading is growing so rapidly that existing market structures such as an exchange floor
are having a difficult time maintaining profitability.
Money markets evolved to meet the short term investment needs (1 year or less) of corporations
and institutions desiring to earn a small positive rate of return on cash that would be needed
shortly, hence they have evolved with high denomination safe securities that have little risk of
principle loss. Capital markets are markets where borrowers raise cash for long term
investment needs. These are generally riskier than money markets and hence, capital market
securities must promise to pay a higher rate of return to attract funds. Savers willing to take the
associated risk are attracted to these markets.
Discussion question for students:
You may wish to ask students the following question that illustrates these price changes. Suppose
you start with a $1,000 investment in stocks. You lose 54% of your investment and then you
gain 71%. How much money do you end up with and what was your net rate of return?
Answer: Step 1:$1,000 * (1-0.54) = $460; Step 2: $460 *1.71 = $786.60; Step 3: Your net rate of
return was ($786.60 - $1,000) / $1,000 = -21.34%
c. Foreign Exchange Markets
The majority of the world’s business involves international business transactions. It is
increasingly important for firms to recognize that the best investment opportunity may be located
in continental Europe, the lowest cost source of funds may be found in Britain instead of the
U.S., or the highest potential sales growth rate may be in Asia.
As corporations and institutions have increased their international transactions, foreign exchange
risk has become a major source of risk for many firms today and much hedging with spot and
forward foreign exchange trades occurs.
Historically, when a nation’s current account deficit surpasses 5% of GDP a correction occurs in
currency value. Before the financial crisis the U.S. was able to consistently run current account
deficits above 5% because foreigners were willing to supply funds to U.S. markets. Part of the
reason for this is the usage of the U.S. dollar as a global reserve currency. Currency
manipulation by foreign central banks also contributed to the strength of the dollar. For instance,
foreign central banks continue to purchase dollars to keep local currencies down to foster their
export sectors. The U.S. economy and the dollar remain key generators of global growth and
these factors help the dollar maintain its value in the global market. The recent strength in the
dollar has reduced profitability of some well-known U.S. multinationals with significant
overseas revenues such as IBM. Nevertheless, over the longer term the dollar continues on a
declining trend. The dollar’s drop can generate long term inflation concerns and lead to higher
commodity prices because most commodities are priced in dollars regardless of where they are
traded globally.
d. Derivative Security Markets
A derivative security is a contract which derives its value from some underlying asset or market
condition. In general, the main purpose of the derivatives markets is to transfer risk between
market participants. Some participants, called hedgers, enter derivatives contracts to reduce
their risk exposure in the underlying cash market. Other participants, called speculators, use
derivative contracts to bet on price movements. Derivatives are highly leveraged instruments.
Leverage allows hedgers to reduce risk and speculators to attempt to earn high rates of return
with low capital investments. The two main types of derivatives markets are the market for
exchange traded derivatives and the over the counter (OTC) derivatives markets. Exchange
traded derivatives are generally liquid and involve no counterparty risk, whereas OTC contracts
are custom contracts negotiated between two counterparties and have default risk.
Derivatives have been blamed for the financial crisis. Mortgage derivatives did allow a larger
amount of mortgage credit to be created, and spread the risk of mortgages to a broader base of
investors. Subprime mortgage losses were large, reaching over $700 billion. The instructor may
wish to ask students whether it makes sense to blame the instrument or the users. Warren Buffett
has called derivatives, ‘weapons of mass destruction.’ However, used properly they allow
market participants to transfer risk to other parties and allow others lower cost methods to gain
exposure to markets. It does seem reasonable to require greater transparency in OTC derivatives
to ensure that players can cover the promises they make. Derivatives that involve payments of
principal, such as credit default swaps, are now supposed to be traded on an exchange to ensure
performance and reasonable limits to speculation.
e. Financial Market Regulation
Financial markets are regulated by the SEC, the exchanges, the Commodity Futures Trading
Commission (CFTC) and the Financial Industry Regulatory Body (FINRA) (FINRA resulted
from a merger of the NASD and the NYSE regulatory arm in 1996 and supersedes both).
FINFRA is a self-regulatory body that is subject to SEC oversight. The primary purposes of
regulations are to prevent fraud, to ensure performance as promised, and to ensure that the public
has enough information to evaluate the riskiness of an investment. The regulators do not attempt
to ensure investors earn a minimum rate of return.
