1 Chapter 4 FINANCIAL INTERMEDIATION ©Thomson/South-Western 2006.
1 1 Role of Financial Markets and Institutions © 2003 South-Western/Thomson Learning Background:...
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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