copyright © 2000 addison wesley longman slide #2-1 chapter two an overview of the financial system
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Copyright © 2000 Addison Wesley Longman Slide #2-1
Chapter Two
AN OVERVIEW OF THE FINANCIAL SYSTEM
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Copyright © 2000 Addison Wesley Longman Slide #2-2
Function of Financial Markets 1. Allows transfers of funds from person or business without investment opportunities to one
who has them
2. Improves economic efficiency
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Copyright © 2000 Addison Wesley Longman Slide #2-3
Classifications of Financial Markets
1. Debt Markets Short-Term (maturity < 1 year) Money Market
Long-Term (maturity > 1 year) Capital Market
2. Equity Markets Common Stock
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Copyright © 2000 Addison Wesley Longman Slide #2-4
Classifications of Financial Markets
1. Primary MarketNew security issues sold to initial buyers
2. Secondary MarketSecurities previously issued are bought and sold
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Copyright © 2000 Addison Wesley Longman Slide #2-5
Classifications of Financial Markets
1. ExchangesTrades conducted in central locations
(e.g., New York Stock Exchange)
2. Over-the-Counter MarketsDealers at different locations buy and sell
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Copyright © 2000 Addison Wesley Longman Slide #2-6
Internationalization of Financial Markets
International Bond Market1. Foreign bonds
2. Eurobonds—Now larger than U.S. corporate bond market
World Stock MarketsU.S. stock markets are no longer always the largest: at one point, Japan's was larger
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Copyright © 2000 Addison Wesley Longman Slide #2-7
Function of Financial Intermediaries
Financial Intermediaries1. Engage in process of indirect finance
2. More important source of finance than securities markets
3. Needed because of transactions costs and asymmetric information
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Copyright © 2000 Addison Wesley Longman Slide #2-8
Function of Financial Intermediaries
Transactions Costs 1. Financial intermediaries make profits by
reducing transactions costs
2. Reduce transactions costs by developing expertise and taking advantage of economies of scale
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Copyright © 2000 Addison Wesley Longman Slide #2-9
Asymmetric Information: Adverse Selection and Moral
Hazard
Adverse Selection1. Before transaction occurs2. Potential borrowers most likely to produce
adverse outcome are ones most likely to seek loan and be selected
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Copyright © 2000 Addison Wesley Longman Slide #2-10
Asymmetric Information: Adverse Selection and Moral
HazardMoral Hazard
1. After transaction occurs2. Hazard that borrower has incentives to
engage in undesirable (immoral) activities making it more likely that won't pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits
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Copyright © 2000 Addison Wesley Longman Slide #2-11
Financial Intermediaries
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Copyright © 2000 Addison Wesley Longman Slide #2-12
Size of Financial Intermediaries
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Copyright © 2000 Addison Wesley Longman Slide #2-13
Regulatory Agencies
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Copyright © 2000 Addison Wesley Longman Slide #2-14
Regulation of Financial Markets
Three Main Reasons for Regulation1. Increase Information to Investors
A. Decreases adverse selection and moral hazard problems
B. SEC forces corporations to disclose information
2. Ensuring the Soundness of Financial IntermediariesA. Prevents financial panicsB. Chartering, reporting requirements, restrictions on
assets and activities, deposit insurance, and anti-competitive measures
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Copyright © 2000 Addison Wesley Longman Slide #2-15
3. Improving Monetary ControlA. Reserve requirements
B. Deposit insurance to prevent bank panics
Regulation of Financial Markets