Chapter 2 NotesFunction of Financial MarketsFunctions of secondary marketsInternationalization of financial marketsChapter 2 NotesFunction of Financial Markets- Channel funds from savers to borrowers- Improves economic efficiencyFlow of funds- Direct finance – borrowers borrow fundsdirectly from lenders in financial markets by selling them securities.Example – Purchasing a bond issued by Ford Motor CompanySaver Borrower- Indirect finance – using a financial intermediary to channel funds from savers to borrowers.Example – Purchasing shares in a mutual fund.Financial IntermediarySaverBorrowerStructure of Financial MarketsDebt – contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date when a final payment is made.Maturity – number of time periods (term) until that instrument’s expiration date.Short-term debt – debt that matures in less than a year. Example – Treasury billIntermediate-term debt – debt that maturesin one to ten years. Example – car loanLong-term debt – debt with a maturity date of ten years or longer. Example – mortgageEquity – claims to share in the net income and the assets of a business.Dividends – payments to the shareholders.Residual claimant -- the right of the stockholder to whatever remains after all other claims against the firm's assets have been met.Primary Market – financial market in which new issues of a security are sold to initial buyers. The corporation acquires new funds here.What financial institution assists in the initial sale of securities?Secondary Market – financial market in which securities that have been previously issued can be resold. The owner of the security receives funds here.Functions of secondary markets- make financial instruments more liquid- determine the prices for securities sold inthe primary marketOrganization of Secondary MarketsExchange – buyers and sellers of securities meet in one central location to conduct trades. Example – NYSEOver-the-counter – dealers at different locations who have an inventory of securities stand ready to buy and sell securities to anyone who comes to them and is willing to accept their prices. Example – U.S. government bond marketMoney Market – a market in which only short-term debt is traded.Money Market Instruments- U.S. Treasury Bills- Negotiable CDs- Commercial paper- Repurchase agreements- Federal fundsCapital Market – the market in which longer-term debt and equity instruments are traded.Capital Market Instruments- Corporate stock- Mortgages and mortgage-backed securities- Corporate bonds- U.S. Treasury notes and bonds- U.S. Government agency bonds- Municipal bonds- Consumer loans- Bank commercial loansInternationalization of financial marketsForeign bond – a bond sold in a foreign country and denominated in that country’s currency. Example – GM bond sold in London in pounds sterlingEurobond – a bond denominated in a currency other than that of the country in which it is sold. Example – GM bond sold in London in dollarsEurodollar – U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banksFinancial Intermediaries- Reduce transactions costs. Transactions costs are the time and money spent carrying out financial transactions. Financial intermediaries can reduce transactions costs through economies of scale.- Risk sharing. Financial intermediaries help individuals to diversify and reduce risk.- Asymmetric information. One party to a negotiation has more information than the other party to the negotiation. Adverse Selection is the asymmetric information problem created before the transaction occurs. Those individuals most likely to produce an adverse outcome are the individuals most actively seeking the transaction. Moral Hazard isthe asymmetric information problemcreated after the transaction occurs. Individuals change their behavior after the transaction takes place.- Economies of scope -- using one resource to provide many different products and service. Can lead to a conflict of interest problem.Types of Financial IntermediariesDepository Institutions – Financial intermediaries that accept deposits from individuals and institutions and make loans.Examples- Commercial banks- Savings and Loan Associations- Mutual Saving Banks- Credit UnionsContractual Savings Institutions – Financial intermediaries that acquire funds at periodic intervals on a contractual basis.Examples- Life insurance companies- Fire and casualty insurance companies- Pension funds and government retirement fundsInvestment Intermediaries—Other types of financial intermediaries.Examples- Finance companies- Mutual funds- Money market mutual fundsFinancial System Regulation1. To increase the information available2. To ensure the soundness of the financial