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1Role of Financial Markets and Institutions

© 2003 South-Western/Thomson Learning

Background: FIN301 - Chapter 4 – Financial Environment:

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Chapter Objectives1. Describe the types of financial markets

2. Describe the role of financial institutions with financial markets

3. Identify the types of financial institutions that facilitate transactions

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Overview of Financial Markets

Financial markets provide for financial intermediation--financial savings (Surplus Units) to investment (Deficit Units)

Financial markets provide payments system Financial markets provide means to manage risk

Financial Market: a market in which financial assets (securities) such as stocks and bonds

can be purchased or sold

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Broad Classifications of Financial Markets

Money versus Capital Markets

Primary versus Secondary Markets

Organized versus Over-the-Counter Markets

Overview of Financial Markets

Public vs. Corporate

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Primary vs. Secondary Markets

PRIMARYPRIMARY New Issue of Securities

Exchange of Funds for Financial Claim

Funds for Borrower; an IOU for Lender

SECONDARYSECONDARY Trading Previously

Issued Securities

No New Funds for Issuer

Provides Liquidity for Seller

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Money vs. Capital Markets

MoneyMoney Short-Term, < 1 Year

High Quality Issuers

Debt Only

Primary Market Focus

Liquidity Market--Low Returns

CapitalCapital Long-Term, >1Yr

Range of Issuer Quality

Debt and Equity

Secondary Market Focus Financing Investment--

Higher Returns

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Organized vs. Over-the-Counter Markets OrganizedOrganized

Visible Marketplace

Members Trade

Securities Listed

New York Stock Exchange

OTCOTC Wired Network of

Dealers

No Central, Physical Location

All Securities Traded off the Exchanges

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Money Market Securities Debt securities Only

Capital market securities Debt and equity securities

Derivative Securities Financial contracts whose value is derived from the values of

underlying assets Used for hedging (risk reduction) and speculation (risk

seeking)

Securities Traded in Financial Markets

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Financial Markets Video Clip – Types Financial Markets Vidoe Clip - Derivatives

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Debt vs. Equity Securities

Debt Securities: Contractual obligations (IOU) of Debtor (borrower) to Creditor (lender)

Investor receives interest Capital gain/loss when sold Maturity date

Equity Securities: Claim with ownership rights and responsibilities Investor receives dividends if declared Capital gain/loss when sold No maturity date—need market to sell

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Valuation of Securities Value a function of:

Future cash flows When cash flows are received Risk of cash flows

Present value of cash flows discounted at the market required rate of return

Value determined by market demand/supply Value changes with new information

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Security prices reflect available information

New information is quickly included in security prices

Investors balance liquidity, risk, and return needs

Financial Market Efficiency

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Financial Market Regulation

To Promote Efficiency

High level of competition

Efficient payments mechanism

Low cost risk management contracts

Why Government Regulation?

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To Maintain Financial Market Stability Prevent market crashes

Circuit breakers Federal Reserve discount window

Prevent Inflation--Monetary policy

Prevent Excessive Risk Taking by Financial Institutions

Financial Market Regulation

Why Government Regulation?

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To Provide Consumer Protection Provide adequate disclosure Set rules for business conduct

To Pursue Social Policies Transfer income and wealth Allocate saving to socially desirable areas

Housing Student loans

Financial Market Regulation

Why Government Regulation?

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Financial Market Globalization Increased international funds flow

Increased disclosure of information Reduced transaction costs Reduced foreign regulation on capital flows Increased privatization

Results: Increased financial integration--capital flows to highest expected risk-adjusted return

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Role of Financial Institutions in Financial Markets Information processing Serve special needs of lenders (liabilities) and

borrowers (assets) By denomination and term By risk and return

Lower transaction cost Serve to resolve problems of market

imperfection

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Role of Financial Institutions in Financial Markets

Types of Depository Financial Institutions

CommercialBanks

$5 TrillionTotal Assets

Savings Institutions

$1.3 TrillionTotal Assets

Credit Unions$.5 TrillionTotal Assets

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Types of Non-depository Financial Institutions

Finance companies Mutual funds Securities companies Insurance companies Pension funds Security pools

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Role of Non-depository Financial Institutions

Focused on capital market Longer-term, higher risk intermediation Less focus on liquidity Less regulation Greater focus on equity investments

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Trends in Financial Institutions

Increased competition between financial Institutions In the 60’s & 70’s, heavy regulation prevented

competition In the late 70’s & 80’s, the development of mutual funds

and deregulation led to increased flexibility and competition. This continued through to the 90’s and into today.

Increased consolidation of financial institutions via mergers has resulted in the growth of financial conglomerates e.g. Cayman National Corporation

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Cayman Financial Corporation

CNC

CNB CNT CNS Caymanx CNI CNIB

CNP

CGI

CNIM

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Cayman National Corporation - Holding Company

CNB – Cayman National Bank – Banking

CNP – Cayman National Property Holding – Property Holding

CNT – Cayman National Trust - Company & Trust Management

CNS – Cayman National Securities - Securities Brokerage

Caymanx – Caymanx Trust Company Limited – Banking, company and trust management

CNI – Cayman National Investments – Investment in a merchant bank

CNIB – Cayman National Insurance Brokers – Insurance brokerage

CGI – Cayman General Insurance – General (property & casualty) and heath insurance

CNIM – Cayman National Insurance Management - General (property & casualty) and heath insurance

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Global Expansion by Financial Institutions International expansion through mergers and

emerging markets The single European currency – Euro, €, helped

to eliminate concerns about foreign exchange risks