Chapter 1
Role of Financial Markets and Institutions
Outline
Role of Financial Markets
Accommodating Corporate Finance Needs
Accommodating Investment Needs
Securities Traded in Financial Markets
Money Market Securities
Capital Market Securities
Derivative Securities
Valuation of Securities
Securities Regulations on Financial Disclosure
International Securities Transactions
Government Intervention in Financial Markets
Role of Financial Institutions
Role of Depository Institutions
Role of Nondepository Financial Institutions
Comparison of Roles among Financial Institutions
Relative Importance of Financial Institutions
Consolidation of Financial Institutions
Credit Crisis for Financial Institutions
Systemic Risk During the Credit Crisis
Government Response to the Credit Crisis
Chapter 1: Role of Financial Markets and Institutions ❖ 2
Key Concepts
1. Explain the role of financial intermediaries in transferring funds from surplus units to deficit units.
2. Introduce the types of financial markets available and their functions.
3. Introduce the various financial institutions that facilitate the flow of funds.
4. Provide a preview of the course outline. Emphasize the linkages between the various sections of the
course.
POINT/COUNTER-POINT:
Will Computer Technology Cause Financial Intermediaries to Become
Extinct?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. Surplus and Deficit Units. Explain the meaning of surplus units and deficit units. Provide an
example of each. Which types of financial institutions do you deal with? Explain whether you are
acting as a surplus unit or a deficit unit in your relationship with each financial institution.
2. Types of Markets. Distinguish between primary and secondary markets. Distinguish between money
and capital markets.
3. Imperfect Markets. Distinguish between perfect and imperfect security markets. Explain why the
existence of imperfect markets creates a need for financial intermediaries.
4. Efficient Markets. Explain the meaning of efficient markets. Why might we expect markets to be
efficient most of the time? In recent years, several securities firms have been guilty of using inside
information when purchasing securities, thereby achieving returns well above the norm (even when
accounting for risk). Does this suggest that the security markets are not efficient? Explain.
5. Securities Laws. What was the purpose of the Securities Act of 1933? What was the purpose of the
Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment
decisions? Explain.
6. International Barriers. If barriers to international securities markets are reduced, will a country’s
interest rate be more or less susceptible to foreign lending and borrowing activities? Explain.
7. International Flow of Funds. In what way could the international flow of funds cause a decline in
interest rates?
8. Securities Firms. What are the functions of securities firms? Many securities firms employ brokers
and dealers. Distinguish between the functions of a broker and those of a dealer, and explain how
each is compensated.
9. Standardized Securities. Why do you think securities are commonly standardized? Explain why
some financial flows of funds cannot occur through the sale of standardized securities. If securities
were not standardized, how would this affect the volume of financial transactions conducted by
brokers?
10. Marketability. Commercial banks use some funds to purchase securities and other funds to make
loans. Why are the securities more marketable than loans in the secondary market?
11. Depository Institutions. Explain the primary use of funds for commercial banks versus savings
institutions.
12. Credit Unions. With regard to the profit motive, how are credit unions different from other financial
institutions?
13. Nondepository Institutions. Compare the main sources and uses of funds for finance companies,
insurance companies, and pension funds.
14. Mutual Funds. What is the function of a mutual fund? Why are mutual funds popular among
investors? How does a money market mutual fund differ from a stock or bond mutual fund?
15. Impact of Privatization on Financial Markets. Explain how the privatization of companies in
Europe can lead to the development of new securities markets.
Advanced Questions
16. Comparing Financial Institutions. Classify the types of financial institutions mentioned in this
chapter as either depository or nondepository. Explain the general difference between depository and
nondepository institution sources of funds. It is often stated that all types of financial institutions have
begun to offer services that were previously offered only by certain types. Consequently, many
financial institutions are becoming more similar. Nevertheless, performance levels still differ
significantly among types of financial institutions. Why?
17. Financial Intermediation. Look in a recent business periodical for news about a recent financial
transaction that involves two financial institutions. For this transaction, determine the following:
a. How will each institution’s balance sheet be affected?
b. Will either institution receive immediate income from the transaction?
c. Who is the ultimate user of funds?
d. Who is the ultimate source of funds?
Chapter 1: Role of Financial Markets and Institutions ❖ 6
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ANSWER: This exercise will force students to understand how the balance sheet and income
statement of a financial institution are affected by various transactions. When a financial institution
simply acts as an intermediary, income (fees or commissions) is earned, but the institution’s asset
portfolio is not significantly affected.
18. Role of Accounting in Financial Markets. Integrate the roles of accounting, regulations, and
financial market participation. That is, explain how financial market participants rely on accounting,
and why regulatory oversight of the accounting process is necessary.
19. Impact of Credit Crisis on Liquidity. Explain why the credit crisis caused a lack of liquidity in the
secondary markets for many types of debt securities. Explain how such a lack of liquidity would
affect the prices of the debt securities in the secondary markets.
20. Impact of Credit Crisis on Institutions. Explain why mortgage defaults during the credit crisis
adversely affected financial institutions that did not originate the mortgages. What role did these
institutions play in financing the mortgages?
21. Regulation of Financial Institutions. Financial institutions are subject to regulations to ensure that
they do not take excessive risk and they can safely facilitate the flow of funds through financial
markets. Nevertheless, during the credit crisis, individuals were concerned about using financial
institutions to facilitate their financial transactions. Why do you think the existing regulations were
ineffective at ensuring a safe financial system?
22. Impact of the Greek Debt Crisis. European debt markets have become integrated over time, so that
institutional investors (such as commercial banks) commonly purchase debt issued in other European
countries. When the government of Greece experienced problems in meeting its debt obligations in
2015, some investors became concerned that the crisis would spread to other European countries.
Chapter 1: Role of Financial Markets and Institutions ❖ 7
Explain why integrated European financial markets might allow a debt crisis in one European country
to spread to other countries in Europe.
23. Global Financial Market Regulations. Assume that countries A and B are of similar size, that they
have similar economies, and that the government debt levels of both countries are within reasonable
limits. Assume that the regulations in country A require complete disclosure of financial reporting by
issuers of debt in that country, but that regulations in country B do not require much disclosure of
financial reporting. Explain why the government of country A is able to issue debt at a lower cost
than the government of country B.
24. Influence of Financial Markets Some countries do not have well established markets for debt
securities or equity securities. Why do you think this can limit the development of the country,
business expansion, and growth in national income in these countries?
25. Impact of Systemic Risk Different types of financial institutions commonly interact. They provide
loans to each other, and take opposite positions on many different types of financial agreements,
whereby one will owe the other based on a specific financial outcome. Explain why their
relationships cause concerns about systemic risk.
26. Uncertainty Surrounding Stock Price Assume that your publicly traded company attempts to be
completely transparent about its financial condition, and provides thorough information about its
debt, sales, and earnings every quarter. Explain why there still may be much uncertainty surrounding
your company’s stock price.
Chapter 1: Role of Financial Markets and Institutions ❖ 8
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ANSWER: The value of a company is based on the present value its future cash flows. Investors may
attempt to use financial statements to predict future cash flows. But even when investors are
presented with information value your company’s stock, they may interpret the information in
different ways. They commonly derive different interpretations of the same information, which leads
to different valuations of the firm, reflects uncertainty surrounding the firm’s stock price.
27. Impact of Fraudulent Financial Reporting on Market Liquidity Explain why financial markets
may be less liquid if companies are not forced to provide accurate financial reports.
28. Impact of a Country’s Laws on Its Market Liquidity Describe how a country’s laws can
influence the degree of its financial market liquidity.
ANSWER: The financial markets are much more developed in some countries than in others, and
CRITICAL THINKING QUESTION
The Role of Liquidity during a Credit Crisis. In some periods such as the credit crisis, liquidity in
financial markets declines dramatically, and many surplus units no longer participate in financial markets.
Yet, if the markets are efficient, prices should adjust to existing economic conditions, and one might
argue that investors should always be willing to participate. Write a short essay that explains the logic
behind why participants may temporarily disappear, causing illiquidity. Do you think the credit crisis in
the 2008-2009 period caused illiquidity in the financial markets, or did illiquidity in the financial markets
cause the credit crisis?
ANSWER
Even if the market prices reflect existing conditions, a crisis can cause fear that prices will decline
Chapter 1: Role of Financial Markets and Institutions ❖ 9
Interpreting Financial News
“Interpreting Financial News” tests your ability to comprehend common statements made by Wall Street
analysts and portfolio managers who participate in the financial markets. Interpret the following :
a. “The price of IBM stock will not be affected by the announcement that its earnings have
increased as expected.”
b. “The lending operations at Bank of America should benefit from strong economic growth.”
c. “The brokerage and underwriting performance at Goldman Sachs should benefit from strong
economic growth.”
Managing in Financial Markets
As a financial manager of a large firm, you plan to borrow $70 million over the next year.
a. What are the more likely alternatives for you to borrow $70 million?
b. Assuming that you decide to issue debt securities, describe the types of financial institutions that
may purchase these securities.
c. How do individuals indirectly provide the financing for your firm when they maintain deposits at
depository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions?
Chapter 1: Role of Financial Markets and Institutions ❖ 10
Flow of Funds Exercise
Roles of Financial Markets and Institutions
This continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) in
the financial markets. It illustrates how financial markets and institutions are integrated and facilitate the
flow of funds in the business and financial environment. At the end of every chapter, this exercise
provides a list of questions about Carson Company that require the application of concepts learned
within the chapter, as related to the flow of funds.
Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson
family. It was initially financed with an equity investment by the Carson family and ten other individuals.
Over time, Carson Company has obtained substantial loans from finance companies and commercial
banks. The interest rate on the loans is tied to market interest rates, and is adjusted every six months.
Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a
bank in case it suddenly needs to obtain funds for a temporary period. It has purchased Treasury securities
that it could sell if it experiences any liquidity problems.
Carson Company has assets valued at about $50 million and generates sales of about $100 million per
year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a
strong U.S. economy, Carson plans to grow in the future by expanding its business and through
acquisitions. It expects that it will need substantial long-term financing, and plans to borrow additional
funds either through loans or by issuing bonds. It is also considering the issuance of stock to raise funds
in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows
and cash outflows and thereby affect its value.
a. In what way is Carson a surplus unit?
b. In what way is Carson a deficit unit?
Carson has borrowed funds from financial institutions.
Finance companies can provide loans to Carson so that Carson can expand its operations.
d. How might commercial banks facilitate Carson’s expansion?
Commercial banks can provide loans to Carson so that Carson can expand its operations.
e. Why might Carson have limited access to additional debt financing during its growth phase?
Carson may have already borrowed up to its capacity. Financial institutions may be unwilling to
Chapter 1: Role of Financial Markets and Institutions ❖ 11
f. How might securities firms facilitate Carson’s expansion?
g. How might Carson use the primary market to facilitate its expansion?
It could issue new stock or bonds to obtain funds.
h. How might it use the secondary market?
i. If financial markets were perfect, how might this have allowed Carson to avoid financial
institutions?
It would have been able to obtain loans directly from surplus units. It would have been able to
j. The loans that Carson has obtained from commercial banks stipulate that Carson must receive the
banks’ approval before pursuing any large projects. What is the purpose of this condition? Does
this condition benefit the owners of the company?
The purpose is to prevent Carson from using the funds in a manner that would be very risky, as