II. Financial Markets
Financial markets are the places where financial instruments are bought and sold. They
enable both firms and individuals to find financing for their activities. They promote
economic efficiency by ensuring that resources are placed at the disposal of those who can
put them to best use. When they fail to function properly, resources are no longer channeled
to their best possible use and we all suffer. This section looks at the role of financial markets
and the economic justification for their existence.
A. The Role of Financial Markets
1. Financial markets serve three roles in our economic system: they offer savers and
borrowers liquidity; they pool and communicate information; and they allow risk
sharing.
2. Financial markets need to be designed in a way that keeps transactions costs low.
B. The Structure of Financial Markets
1. There are lots of financial markets and many ways to categorize them.
2. There are three possibilities for grouping financial markets:
a. Primary versus secondary markets: in a primary market a borrower obtains funds
from a lender by selling newly issued securities. Most of the action in primary
markets goes on out of public view. Most companies use an investment bank,
which will determine a price and then purchase the company’s securities in
preparation for resale to clients; this is called underwriting. We hear more about
the secondary markets where people can buy and sell existing securities; these are
the prices reported in the news.
b. Secondary market trading in stocks: Historically, secondary financial markets
were organized on centralized exchanges (like the New York Stock Exchange) or
over-the-counter (or OTC) markets, which are electronic networks of dealers who
trade with one another from wherever they are located (NASDAQ, for example).
Today we can add electronic communications networks (ECNs) to the list. The
pace of change is driven by ongoing technological advances and increasing
globalization. Compared to centralized exchanges, electronic markets have
advantages and disadvantages: customers can see the orders, but the speed of
execution means errors can happen.
c. Debt and Equity versus Derivative Markets: equity markets are the markets for
stocks, which are usually traded in the countries where the companies are based.
Debt instruments can be categorized as money market (maturity of less than one
year) or bond markets (maturity of more than one year).
3. Exchanges are becoming more globalized as exchanges merge. With technologies
improving exchanges want to take advantage of lower cost and speedier transactions
afforded by mergers.
C. Characteristics of a Well-Run Financial Market
1. Well-run financial markets exhibit a few essential characteristics that are related to
the role we ask them to play in our economies.
a. They must be designed in a way that keeps transactions costs low.
b. The information the market pools and communicates must be both accurate and
widely available. If not, the prices will not be correct and those prices are the
link between the financial markets and the real economy.
c. Investors must be protected; a lack of proper safeguards dampens people’s
willingness to invest, and so governments are an essential part of financial
markets.
III. Financial Institutions
1) Financial institutions are the firms that provide access to the financial markets; they
sit between savers and borrowers and so are known as financial intermediaries.
Examples include banks, insurance companies, securities firms and pension funds.
2) A system without financial institutions would not work very well for three reasons:
a. Individual transactions between saver-lenders and borrower-spenders would be
extremely expensive.
b. Lenders need to evaluate the creditworthiness of borrowers and then monitor
them to ensure that they don’t abscond with the funds, and individuals are not
equipped to do this.
c. Most borrowers want to borrow long term, while lenders favor short-term loans.
A. The Role of Financial Institutions
1. Financial institutions reduce transaction costs by specializing in the issuance of
standardized securities.
2. They reduce the information costs of screening and monitoring borrowers to ensure
that they are creditworthy and that they use the proceeds of a loan or security issue
properly.
3. Financial institutions curb information asymmetries and the problems that go along
with them, helping to ensure that resources flow into their most productive uses.
4. Financial institutions make long-term loans but allow savers ready access to their
funds.
5. They provide savers with financial instruments that are both more liquid and less
risky than the individual stocks and bonds that savers would purchase directly in
financial markets.
B. The Structure of the Financial Industry
1. Financial institutions or intermediaries can be divided into two broad categories
called depository and nondepository institutions.
2. Depository institutions (commercial banks, savings banks, and credit unions) take
deposits and make loans.
3. Nondepository institutions include insurance companies, securities firms, mutual
fund companies, hedge funds, finance companies, and pension funds.
a. Insurance companies accept premiums, which they invest in securities and real
estate in return for promising compensation to policyholders should certain
events occur (like death, property losses, etc.).
b. Pension funds invest individual and company contributions into stocks, bonds
and real estate in order to provide payments to retired workers.
c. Securities firms (include brokers, investment banks, and mutual fund
companies): brokers and investment banks issue stocks and bonds to corporate
customers, trade them, and advise clients. Mutual fund companies pool the
resources of individuals and companies and invest them in portfolios of bonds,
stocks, and real estate. Hedge funds do the same for small groups of wealthy
investors.
d. Finance Companies: raise funds directly in the financial markets in order to
make loans to individuals and firms.
e. Government Sponsored Enterprises: federal credit agencies that provide loans
directly for farmers and home mortgages, as well as guarantee programs that
insure the loans made by private lenders. The government also provides
retirement income and medical care to the elderly (and disabled) through Social
Security and Medicare.
4. The monetary aggregates are made up of liabilities of commercial banks, so clearly
the financial structure is tied to the availability of money and credit.
Terms Introduced in Chapter 3
asset
asset-backed security
bond market
broker
centralized exchange
collateral
counterparty
dealer
debt market
derivative instrument
direct finance
electronic communications networks (ECNs)
equity market
financial instrument
financial institutions
financial markets
indirect finance
intermediary
liability
money market
mortgage backed security
over-the-counter (OTC) market
portfolio
primary financial market
secondary financial market
trading algorithm
underlying instrument
Using FRED: Data Series used in This Chapter
Data Series FRED Data Code
U.S. household net worth TNWBSHNO
Household financial assets TFAABSHNO
Household deposits DABSHNO
Market value of equities outstanding (nonfarm nonfinancial
corporate)
MVEONWMVBSNNCB
Credit from U.S. domestic financial sector TCMAHDFS
Credit from U.S. commercial banks LOANINV
Residential mortgages HMLBSHNO
LIBOR: U.S. dollar three‐month interest rate USD3MTD156N
Number of commercial banks USNUM
Dow Jones Industrial Average DJIA
Commercial banks’ equity/assets ratio (inverse of leverage) EQTA
Lessons of Chapter 3
1. Financial instruments are crucial to the operation of the economy.
a. Financial arrangements can be both formal and informal. Industrial economies are
dominated by formal arrangements.
b. A financial instrument is the written legal obligation of one party to transfer something of
value, usually money, to another party at some future date, under certain conditions.
c. Financial instruments are used primarily as stores of value and as a means of trading risk.
They are less likely to be used as means of payment, although many of them can be.
d. Financial instruments are most useful when they are simple and standardized.
e. There are two basic classes of financial instruments: underlying and derivative.
i. Underlying instruments are used to transfer resources directly from one party to
another.
ii. Derivative instruments derive their value from the behavior of an underlying
instrument.
f. The payments promised by a financial instrument are more valuable
i. The larger they are.
ii. The sooner they are made.
iii. The more likely they are to be made.
iv. If they are made when they are needed most.
g. Common examples of financial instruments include
i. Those that serve primarily as stores of value, including bank loans, bonds, mortgages,
stocks, and asset-backed securities.
ii. Those that are used primarily to transfer risk, including futures and options.
2. Financial markets are essential to the operation of our economic system.
a. Financial markets:
i. Offer savers and borrowers liquidity, so that they can buy and sell financial
instruments easily.
ii. Pool and communicate information through prices.
iii. Allow for the sharing of risk.
b. There are several ways to categorize financial markets:
i. Primary markets that issue new securities versus secondary markets where existing
securities are bought and sold.
ii. Physically centralized exchanges versus dealer-based electronic systems
(over-the-counter markets), or electronic networks.
iii. Debt and equity markets (where instruments that are used primarily for financing are
traded) versus derivative markets (where instruments that are used to transfer risk are
traded).
c. A well-functioning financial market is characterized by
i. Low transactions costs and sufficient liquidity.
ii. Accurate and widely available information.
iii. Legal protection of investors against the arbitrary seizure of their property.
3. Financial institutions perform brokerage and asset transformation functions.
a. In their roles as brokers or dealers, they provide access to financial markets.
b. In transforming assets, they provide indirect finance.
c. Indirect finance reduces transaction and information costs.
d. Financial institutions, also known as financial intermediaries, help individuals and firms
to transfer and reduce risk.