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Financial Markets and Institutions

Leng Ling

Department of Economics & FinanceGeorgia College & State University

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CHAPTER 1

The Role of Financial Markets and Institutions

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CHAPTER 1 OVERVIEW

This Chapter will:

A. describe the 3 types of financial markets that accommodate various transactions,

B. introduce the concept of security valuation within financial markets,

C. describe the role of financial institutions within financial markets,

D. identify the types of financial institutions that facilitate transactions in financial markets.

Questions

Why do people create financial markets?

What are traded in financial markets?

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Overview of Financial Markets

1. Three Types of Financial Marketsa. Money versus Capital Markets

b. Primary versus Secondary Markets

c. Organized versus Over-the-Counter Markets

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Securities

2. Securities Traded in Financial Marketsa. Money Market Securities

Treasury Bill (T-bill); Commercial paper; negotiable CD by banks

b. Capital Market Securities 1) Bonds and Mortgages2) Stocks

c. Derivative Securities1) Speculation2) Risk Management – hedging

Question

How to measure the value of a securities?

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Time Value of Money

1. Receive $100 today

2. Receive $100 one year from now

Would you choose 1 or 2?

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Time Value of Money

Money has time value • People prefer receiving $100 today to receiving

$100 one year from now because they place a LOWER value on cash flow received at a later date. The worth of $100 received one year from now is less than $100 received today.

• You cannot simply add sums of money received at different points in time. the amounts received (or paid) at different time must firstly be converted to a common basis: the same point in time

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Time Value of Money

If you put $100 in a bank deposit account earning 10% annually, how much will be in the account after one year?

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Time Value of Money

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Future Value

Present Value

Number of periods

nrPVFV )1(

Interest rate

Time Value of Money

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Solving for PV, we get

nrPVFV 1

nr

FVPV

)1(

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Valuation of Securities

1. Market Pricing of Securities

a. Impact of Information on Valuations• Economic • Industry• Firm-specific

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Valuation of Securities

b. Impact of Valuations on Pricing• Valuation affects the supply and demand

for a security

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Valuation of Securities

c. Impact of the Internet on the Valuation Process

•More timely pricing•More accurate pricing•More informative pricing

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Market Efficiency

When security prices fully reflect all available information, the market is said to be efficient.

Question

Do financial markets need regulation?

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Financial Market Regulation

a. Disclosuresecurities Act of 1933

Securities Exchange Act of 1934

Securities and Exchange Commission

b. Regulatory Response to Financial ScandalsSarbanes-Oxley Act of 2002

c. Other Regulations

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Role of Financial Institutions

1. How Financial Markets Influence Economic Development

2. Global Integration

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Types of Financial Institutions

1. Depository Institutions a. Commercial Banks

Bank of America, Citigroup, Suntrust

b. Savings Institutions

c. Credit Unions

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Types of Financial Institutions

2. Nondepository Financial Institutions• Finance Companies: American Express, Ford Motor

• Mutual Funds: Fidelity, Vanguard

• Securities Firms: Merrill Lynch, Morgan Stanley

• Insurance Companies: State Farm, Allstate, CNA

• Pension Funds

Exhibit 1.4 Asset Sizes of Financial Institutions (in Billions of Dollars)

Source: Board of Governors, Federal Reserve System, 2007.

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Types of Financial Institutions

1. Competition between Financial Institutions

2. Consolidation of Financial Institutions

Exhibit 1.6 Organizational Structure of a Financial Conglomerate

Question

Is it true that the bigger the better?

What is the tradeoff?

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Summary

1. Financial markets facilitate the transfer of funds from surplus units to deficit units.

2. The valuation of a security represents the present value of future cash flows

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In-class Discussion Assignment

What is the story of Enron, WorldCom? What happened to their stocks?

Tell me some of the regulation in Sarbanes-Oxley Act. What can you infer, tell or predict from the following

statement made by WSJ analyst and investment managers

1. The price of IBM stock will not be affected by the announcement that its earnings have increased as expected.

2. The lending operations at BOA should benefit from strong economic growth.

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