Financial Markets and Institutions

13th Edition

by Jeff Madura

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 1 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.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
3 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Markets (1 of 3)

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.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
4 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Markets (2 of 3)

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)

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
5 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 1.1 How Financial Markets Facilitate
Corporate Finance and Investment Management

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
6 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Markets (3 of 3)

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.
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
7 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Securities Traded in Financial Markets (1 of 7)

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.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
8 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Securities Traded in Financial Markets (2 of 7)

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.
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
9 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Securities Traded in Financial Markets (3 of 7)

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.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
10 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Securities Traded in Financial Markets (4 of 7)

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.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
11 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Securities Traded in Financial Markets (5 of 7)

Valuation of Securities (continued)

• 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.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
12 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 1.2 Use of Information to Make
Investment Decisions

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
13 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Securities Traded in Financial Markets (6 of 7)

• Securities Regulations on Financial

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.
• The Sarbanes-Oxley Act of 2002 required that firms
provide more complete and accurate financial
information.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
14 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Securities Traded in Financial Markets (7 of 7)

International Financial Markets

Financial markets vary across the world in terms of:
• Degree of financial market development
• Volume of funds transferred from surplus to deficit units
• International Integration of Financial Markets-Under
favorable economic conditions, the international
integration of financial markets allows governments and
corporations easier access to funding from creditors or
investors in other countries to support their growth.
• Role of Foreign Exchange Market - International
financial transactions normally require the exchange of
currencies. The foreign exchange market facilitates this
exchange.
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
15 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Institutions (1 of 6)

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

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
16 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Institutions (2 of 6)

Role of Depository Institutions (continued)

• 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
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
17 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Institutions (3 of 6)

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

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
18 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Institutions (4 of 6)

Comparison of Roles among Financial Institutions

• Financial institutions facilitate the flow of funds from
individual surplus units (investors) to deficit units. (Exhibit
1.3)
• Institutional Role as a Monitor of Publicly Traded
Firms
• Since insurance companies, pension funds, and some
mutual funds are major investors in stocks, they can
influence the management of publicly traded firms.
• By serving as activist shareholders, they can help ensure
that managers of publicly held corporations make
appropriate decisions that are in the best interests of the
shareholders.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
19 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 1.3 Comparison of Roles
among Financial Institutions

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
20 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Institutions (5 of 6)

Relative Importance of Financial Institutions (Exhibit 1.4)

• Households with savings are served by depository
institutions.
• Households with deficient funds are served by depository
institutions and finance companies.
• Several agencies regulate the various types of financial
institutions, and the various regulations may give some
financial institutions a comparative advantage over others.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
21 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 1.4 Summary of Institutional
Sources and Uses of Funds
FINANCIAL MAIN SOURCES OF FUNDS MAIN USES OF FUNDS
INSTITUTIONS
Commercial banks Deposits from households, businesses, Purchases of government and
and government agencies corporate securities; loans to
businesses and households
Savings institutions Deposits from households, businesses, Purchases of government and
and government agencies corporate securities; mortgages and
other loans to households; some
loans to businesses
Credit unions Deposits from credit union members Loans to credit union members
Finance companies Securities sold to households and Loans to households and businesses
businesses
Mutual funds Shares sold to households, businesses, Purchases of long-term government
and government agencies and corporate securities
Money market funds Shares sold to households, businesses, Purchases of short-term government
and government agencies and corporate securities
Insurance Insurance premiums and earnings from Purchases of long-term government
companies investments and corporate securities
Pension funds Employer/employee contributions Purchases of long-term government
and corporate securities
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
22 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Role of Financial Institutions (6 of 6)

Consolidation of Financial Institutions

• Exhibit 1.5 depicts the typical organizational structure of
a financial conglomerate. The operations of each type of
financial service are commonly managed separately, a
financial conglomerate offers advantages to customers
who prefer to obtain all of their financial services from a
single financial institution.
• Global Consolidation of Financial Institutions - Many
financial institutions have expanded internationally to
capitalize on their expertise.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
23 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 1.5 Organizational Structure of
a Financial Conglomerate

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
24 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Systemic Risk among Financial Institutions

• Systemic risk is defined as the spread of financial problems among

financial institutions and across financial markets that could cause a
collapse in the financial system.
• During the credit crisis of 2008 and 2009, mortgage defaults affected
financial institutions in several ways.
• First, many financial institutions that originated mortgages shortly before
the crisis sold them to other financial institutions.
• Second, many other financial institutions that invested in mortgage-
backed securities received lower payments as mortgage defaults
occurred.
• Third, some financial institutions (especially securities firms) relied
heavily on short-term debt to finance their operations and used their
holdings of mortgage-backed securities as collateral.
• Fourth, as mortgage defaults increased, there was an excess of
unoccupied housing.
• Eventually, most financial institutions that invested heavily in equities
experienced large losses on their investments during the credit crisis.
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
25 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY (1 of 3)

• Financial markets facilitate the transfer of funds from surplus

units to deficit units. Because funding needs vary among
deficit units, various financial markets have been established.
The primary market allows for the issuance of new securities,
and the secondary market allows for the sale of existing
securities.
• Securities can be classified as money market (short-term)
securities or capital market (long-term) securities. Common
capital market securities include bonds, mortgages, mortgage-
backed securities, and stocks. The valuation of a security
represents the present value of future cash flows that it is
expected to generate. New information that indicates a
change in expected cash flows or degree of uncertainty affects
prices of securities in financial markets.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
26 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY (2 of 3)

• Depository and nondepository institutions help to finance the

needs of deficit units. The main depository institutions are
commercial banks, savings institutions, and credit unions. The
main nondepository institutions are finance companies, mutual
funds, pension funds, and insurance companies.
• Many financial institutions have been consolidated (due to
mergers) into financial conglomerates, where they serve as
subsidiaries of the conglomerate while conducting their
specialized services. Thus, some financial conglomerates are
able to provide all types of financial services. Consolidation
allows for economies of scale and scope, which can enhance
cash flows and increase the financial institution’s value. In
addition, consolidation can diversify the institution’s services
and increase its value through the reduction in risk.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
27 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY (3 of 3)

• Financial institutions are subject to systemic risk, because

they commonly invest in the same types of securities and are
similarly exposed to conditions that could cause the prices of
those securities to decline substantially. The credit crisis of
2008 and 2009 illustrates how massive mortgage defaults can
cause a major decline in the prices of mortgagebacked
securities and equity securities, which are investments
commonly held by many types of financial institutions.

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
28 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.