CAPITAL

MARKETS
FM 133
MARJON A. LIMOT
FGBM, FACULTY
Role of Financial Markets and Institutions
Chapter Objectives
■ Describe the types of financial markets that facilitate the flow of
funds.
■ Describe the types of securities traded within financial markets.
■ Describe the role of financial institutions within financial markets.
■ Explain how financial institutions were exposed to the credit
crisis.
Financial Market
A market in which financial assets (securities)
such as stocks and bonds can be purchased or
sold. Funds are transferred in financial markets
when one party purchases financial assets
previously held by another party.
 Role of Financial Markets
• Financial markets transfer funds from those who have excess funds to those who
need funds.
• Surplus units: participants who receive more money than they spend, such as
investors.
• Deficit units: participants who spend more money than they receive, such as
borrowers.
• Securities: represent a claim on the issuers
• Debt securities - debt (also called credit, or borrowed funds) incurred by the
issuer.
• Equity securities - (also called stocks) represent equity or ownership in the firm.
Role of Financial Markets cont’d
• Accommodating Corporate Finance Needs: The financial markets serves
as the mechanism whereby corporations (acting as deficit units) can
obtain funds from investors (acting as surplus units).
• Accommodating Investment Needs: Financial institutions serve as
intermediaries to connect the investment management activity with the
corporate finance activity. (Exhibit 1.1)
Exhibit 1.1 How Financial Markets Facilitate
Corporate Finance and Investment Management
 Role of Financial Markets cont’d
Primary versus Secondary Markets
• Primary markets - facilitate the issuance of new securities
• Secondary markets - facilitate the trading of existing securities, which
allows for a change in the ownership of the securities
- Liquidity is the degree to which securities can easily be
liquidated (sold) without a loss of value.
- If a security is illiquid, investors may not be able to find a willing
buyer for it in the secondary market and may have to sell the
security at a large discount just to attract a buyer.
Securities Traded in Financial Markets
• Securities can be classified as money market securities, capital market
securities, or derivative securities.
Money Market Securities
• Money markets facilitate the sale of short-term debt securities by deficit
units to surplus units.
• Debt securities that have a maturity of one year or less.
Securities Traded in Financial Markets cont’d
• Capital Market Securities - facilitate the sale of long-term securities by
deficit units to surplus units.
• Bonds - long-term debt securities issued by the Treasury, government
agencies, and corporations to finance their operations.
• Mortgages - long-term debt obligations created to finance the purchase of
real estate.
• Mortgage-backed securities - debt obligations representing claims on a
package of mortgages.
• Stocks - represent partial ownership in the corporations that issued them.
Securities Traded in Financial Markets cont’d
• Derivative Securities - financial contracts whose values are derived
from the values of underlying assets
• Speculation - allow an investor to speculate on movements in the value
of the underlying assets without having to purchase those assets.
• Risk management - financial institutions and other firms can use
derivative securities to adjust the risk of their existing investments in
securities.
Securities Traded in Financial Markets cont’d
Valuation of Securities
Impact of information on valuation
• Estimate future cash flows by obtaining information that may influence a stock’s future cash
flows. (Exhibit 1.2)
• Use economic or industry information to value a security
• Use published opinions about the firm’s management to value a security.
Impact of the internet on valuation
• More timely pricing
• More accurate pricing
• More informative pricing
Valuation of Securities (cont.)
Impact of Behavioral Finance on Valuation
• Various conditions can affect investor psychology. Behavioral
finance can sometimes explain the movements of a security’s
price.
• Behavioral Finance - the application of psychology to make
financial decisions.
Uncertainty Surrounding Valuation of Securities
• Limited information leads to uncertainty in the valuation of
securities.
Exhibit 1.2 Use of Information to Make
Investment Decisions
Securities Traded in Financial Markets cont’d
Securities Regulations
Required Disclosure
• The Securities Act of 1933 was intended to ensure complete disclosure of
relevant financial information on publicly offered securities and to prevent
fraudulent practices in selling these securities.
• The Securities Exchange Act of 1934 extended the disclosure requirements
to secondary market issues.
Regulatory Response to Financial Reporting Scandals
• The Sarbanes-Oxley Act required that firms provide more complete and
accurate financial information.
Securities Traded in Financial Markets cont’d
International Securities Transactions
• Financial markets vary across the world in terms of:
• Degree of financial market development
• Volume of funds transferred from surplus to deficit units
Foreign Exchange Market - International financial transactions normally
require the exchange of currencies. The foreign exchange market
facilitates this exchange.
Securities Traded in Financial Markets cont’d
Government Intervention in Financial Markets
In recent years, government has increased its role in financial markets.
During credit crisis…
• Federal Reserve purchased various debt securities.
• Intent – ensure more liquidity in the debt securities and therefore encourage investors to
purchase.
Government regulations changed the manner by which the credit risks of bonds were
assessed.
Increased monitoring of stock trading
• Prosecuted insider information trading cases.
• Ensure no investor had an unfair advantage.
Role of Financial Institutions
• Financial institutions are needed to resolve the limitations caused by market
imperfections such as limited information regarding the creditworthiness of
borrowers.
• Role of depository institutions - Depository institutions accept deposits from surplus
units and provide credit to deficit units through loans and purchases of securities.
- Offer liquid deposit accounts to surplus units
- Provide loans of the size and maturity desired by deficit units
- Accept the risk on loans provided
- Have more expertise in evaluating creditworthiness
- Diversify their loans among numerous deficit units
Role of Financial Institutions
Role of Depository Institutions (cont.)
Commercial Banks
• The most dominant type of depository institution
• Transfer deposit funds to deficit units through loans or purchase of debt securities
• Federal Funds Market - facilitates the flow of funds between depository institutions
Savings Institutions
• Also called thrift institutions and include Savings and Loans (S&Ls) and Savings Banks
• Concentrate on residential mortgage loans
• Credit Unions
• Nonprofit organizations
• Restrict business to CU members with a common bond
Role of Non-depository Institutions
• Finance companies - obtain funds by issuing securities and lend the funds
to individuals and small businesses.
• Mutual funds - sell shares to surplus units and use the funds received to
purchase a portfolio of securities.
• Securities firms - provide a wide variety of functions in financial markets.
(Broker, Underwriter, Dealer, Advisory)
• Insurance companies - provide insurance policies that reduce the
financial burden associated with death, illness, and damage to property.
Charge premiums and invest in financial markets.
• Pension funds – manage funds until they are withdrawn for retirement