Chapter 2 Overview of the Financial System I Function of financial Markets a Direct finance borrowers borrow funds directly from lenders in financial markets by selling them securities which are claims on the borrowers future income or assets b See FIGURE 1 II Structure of Financial Markets a Debt and Equity Markets i Debt Market issue an instrument such as a mortgage or a bond which is a contractrual agreement by the borrower to pay the holder of the instrument fixed dollar maounts at regular intervals until a specified date 1 Maturity date number of years until the instruments wxpiration Intermediate Term issue an equity which are claims to shares in the ii Equity markets a Short Term b Long Term c Less than a year Greater than 10 years between 1 and 10 years net income and the assets of a business 1 Dividends periodic payments made to owners iii Debt Market is substationally larger than the equity market 1 20 Trillion compared to 35 Trillion b Primary and Secondary Markets i Primary Market Financial Market in which new issues of a security such as a bond or a stock are sold to initial buyers Place where securuties that have been previously issued can be sold ii Secondary Markets 1 Investment Banks buys securities in the primary market and sells them in the secondary market a Underwritting guaranteeing a price for a corporation securities and then sells them to the public agents who match buyers and sellers link buyers and sellers take ownership 2 Brokers 3 Dealers iii Advantafges 1 c Exchanges nad OTC Marketrs Increased Liquidity i Exchanges central location 1 NYSE 2 Chicago Board of Trade where buyers and sellers of securities meet in one ii Over The Counter Market OTC have an inventory of securities ready to sell are ready to sell at a set price This is done through computers so the prices are competitive deales in different locations who d Money and Capital Markets i Money Markets financial markets in which only short term debt is ii Capital Markets where longer term debt and equity instruments are III Financial Markets Instruments a Money Market Instruments traded traded no interest i US T Bills Less than a Year maturity sold at a discount and have ii CDs iii Commercial Paper short term debt instruments issued by large banks and well known corporations iv Repurchase Agreements Repos short term loans maturity less than 2 weeks for which US Treasuries serve as collateral 1 see page 31 v Federal Fed Funds Overnight Loans to banks from other banks trasfereed through the fed via wire b Capital Markst Instruments i Stocks ii Mortgages iii Corporate Bonds iv US Government Securities v US Government Agency Securities vi State and Local Government Bonds 1 Interest Payment is exempt from federal income tax and state tax in issuing state vii Consumer and Bank Commercial Loans IV Internationalizaiton of Financial Markets a Foreign Bonds that it is sold in in which it is sold b Eurobond bonds sold in a foreign dentoed in the countrys currency a bond denominated in a currency other than that of the country i Bond in US dollars sold in England US dollars deposited in foreign banks c Eurodollars d World Stock Markets V Functions of Financial Intermediaries a Indirect Financing lender saver and the borrow spender involves an intermediary that stands between the i Transaction Costs Costs associated with setting up a loan legal fees etc 1 Financial Intermeidiaries lower them based on economies ofscale and buy b Risk Sharing creating and selling assets with risk characteristics that people are comfortable with and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk i By also allowing customers to diversify c Asymetrical Information other party to make an accurate decision when one party does not know wnough about the i Adverse Selection before the transaction occurs problem created by Asymetrical Informaiton 1 typically companies with bad credit seek this out in order to get financing the problem created by asymmetrical information ii Moral Hazard after the transaction occurs 1 risk hazard that the borrowers miht engage in activities that are undesirable immoral from the lenders point of view VI Types of Financial Intermediaries See TABLE 3 on pg 43 a Depository Institutions i Commercial Banks ii Savings and Loans and Mutual Savings Bank 1 similar to banks now days iii Credit Unions b Contractual Savings Institutions acquire funds at periodic intervals on a contractural basis Liquidity is not an issue so they invest in longer term assets i Life Insurance Companies ii Fire and Casuality Insurance Companies iii Pension Funds and Government Retirement Funds c Investment Intermediaries i Finance Companies ii Mutual Funds iii Money Market Mutual Funds iv Investment Banks