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Chapter 1: Financial Markets

Terms in this set (37)

Proper capital allocation leads to growth in:
1) Societal wealth; 2) Income; 3) Economic opportunity
Primary Markets
Markets in which users of funds (e.g. corporations and governments) raise funds by issuing financial instruments (e.g. stocks and bonds)
Secondary Markets
Markets where financial instruments are traded among investors (e.g. NYSE and Nasdaq)
Money Markets
- Markets that trade debt securities with maturities of one year or less (e.g. CDs and U.S. Treasury bills)
- Little or no risk of capital loss, but low return
Capital Markets
- Markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year
- Substantial risk of capital loss, but higher promised return
FX Markets
trading one currency for another (e.g. dollar for yen)
Spot FX
the immediate exchange of currencies at current exchange rates
Forward FX
the exchange of currencies in the future on a specific date and at a pre-specified exchange rate
Derivative Security
- a financial security whose payoff is linked to (i.e. "derived" from) another security or commodity
- Generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future
Purpose of the derivatives markets
to transfer risk between market participants
Exchange listed derivatives
Many options and futures contracts
Over the counter derivatives
Forward contracts, forward rate agreements, swaps, securitized loans
Derivatives and the Crisis
1) Mortgage derivatives allowed a larger amount of mortgage credit to be created in the mid-2000s
2) Mortgage derivatives spread the risk of the mortgages to a broader base of investors
3) Change in banking from 'originate and hold' loans to 'originate and sell' loans (decline in underwriting standards)
4) Subprime mortgages losses have been quite large, reaching over $700 billion
The "Great Recession" was the worst since the "Great Depression" of the 1930s, resulting in:
1) Trillions of $ global wealth lost, peak to trough stock prices fell over 50% in the U.S.
2) Lingering high unemployment in the U.S.
Sovereign debt levels in developed economies at all-time highs
The Securities Act of 1933
Full and fair disclosure and securities registration
The Securities Exchange Act of 1934
Securities and Exchange Commission (SEC) is the main regulator of securities markets
Depository Institutions
commercial banks, savings associations, savings banks, credit unions
Non-depository institutions
contractual: insurance companies, pension funds
non- contractual: securities firms and investment banks, mutual funds
Financial Institutions benefit suppliers of funds by:
1) reducing monitoring costs, 2) increase liquidity and lower price risk, 3) reduce transaction costs, 4) provide maturity inter-mediation, 5) provide denomination inter-mediation
Financial Institutions benefit the overall economy by:
1) conduit through which Federal Reserve conducts monetary policy, 2) provides efficient credit allocation, 3) provide for inter generational wealth transfers, 4) provide payment services
Risks faced by Financial Institutions
credit, foreign exchange, country or sovereign, interest rate, market, off-balance sheet, liquidity, technology, operational, insolvency
New Dodd-Frank Bill
1) Promote robust supervision of FIs:
- Financial Service Oversight Council to identify and limit systemic risk
- Broader authority for Federal Reserve to oversee non-bank FIs
- Higher equity capital requirements
- Registration of hedge funds and private equity funds
2) Comprehensive supervision of financial markets
- new regulations for securitization and over the counter derivatives
3) Establishes a new Consumer Financial Protection Agency
4) New methods to resolve non-bank financial crises
- More oversight of Fed bailout decisions
5) Increase international capital standards and increased oversight of international operations of FIs
How does the location of the money market differ from that of the capital market?
The capital markets are more likely to be characterized by actual physical locations such as the New York Stock Exchange or the American Stock Exchange. Money market transactions are more likely to occur via telephone, wire transfers, and computer trading.
Which of the the money market instruments has grown the fastest since 1990?
the money market instrument that has had the largest growth is the Federal funds and repurchase agreements which grew from 18.1% of the total value of money market securities outstanding in 1990 to 25.6% in 2010.
What are the major instruments traded in capital markets?
The major instruments traded in capital markets are corporate stocks, securitized mortgages, corporate bonds, Treasury notes and bonds, state and local government bonds, U.S. government owned and sponsored agencies, and bank and consumer loans.
Which of the capital market instruments has grown the fastest since 1990?
the capital market instrument that has had the largest growth is the corporate stocks which grew from 23.6% of the total value of money market securities outstanding in 1990 to 43.4% in 2000 and was still at 31/3% in 2010. One reason for the sharp increase in the amount of equities outstanding is the bull market in stock prices in the 1990s. Stock values fell in the early 2000s as the U.S. economy experienced a downturn—partly because of 9-11 and partly because interest rates began to rise―and stock prices fell. Stock prices in most sectors subsequently recovered and, by 2007, even surpassed their 1999 levels. Stock prices fell precipitously in during the financial crisis of 2008-2009. As of mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen in value 53.8 percent in less than 1 ½ year's time, larger than the decline during the market crash of 1937-1938 when it fell 49 percent. However, stock prices recovered along with the economy in the last half of 2009, rising 71.1 percent between March 2009 and April 2010.
How would economic transactions between suppliers of funds and users of funds occur in a world without FIs?
If there were no FIs then the users of funds, such as corporations in the economy, would have to approach the savers of funds, such as households, directly in order to fund their investment projects and fill their borrowing needs. This would be extremely costly because of the up-front information costs faced by potential lenders. These include costs associated with identifying potential borrowers, pooling small savings into loans of sufficient size to finance corporate activities, and assessing risk and investment opportunities. Moreover, lenders would have to monitor the activities of borrowers over each loan's life span, which is compounded by the free rider problem. The net result is an imperfect allocation of resources in an economy.
Why would a world limited to the direct transfer of funds from suppliers of funds to users likely result in quite low levels of fund flows?
1) Costly monitoring of the use of funds, 2) Liquidity risks, 3) Price-risk upon the sale of the security
How do FIs reduce monitoring costs associated with the flow of funds from fund suppliers to fund investors?
the FI acts as an agent for the fund suppliers in providing information about the fund users. The FI groups the fund suppliers' funds together and invests them in the direct or primary financial claims issued by fund users. This aggregation of funds resolves a number of problems. First, the large FI now has a much greater incentive to collect information and monitor the fund user's actions because the FI has far more at stake than any small individual fund supplier. This alleviates the problem that exists when small fund suppliers leave it to each other to collect information and monitor a fund user's use of the funds it raises
How do FIs alleviate the problem of liquidity and price risk faced by investors wishing to invest in securities of corporations?
Liquidity risk occurs when savers are not able to sell their securities at demand. Commercial banks, for example, are able to offer deposits that can be withdrawn at any time. Yet they are able to make long-term loans or invest in illiquid assets because of two reasons: 1) they are able to diversify their portfolios; 2) they are able to better monitor the performance of firms that have been given the loans or who have issued securities. The less diversified the assets of the FI, the more likely it will hold illiquid assets.
How do financial institutions help individuals to diversify their portfolio risks? Which financial institution is best able to achieve this goal?
FIs can exploit the law of large numbers in making their investment decisions, whereas due to their smaller wealth size, individual fund suppliers are constrained to holding relatively undiversified portfolios. As a result, diversification allows an FI to predict more accurately its expected return and risk on its investment portfolio so that it can credibly fulfill its promises to the suppliers of funds to provide highly liquid claims with little price risk.
What is meant by maturity intermediation?
If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities. That is, the FI can offer the relatively short-term liabilities desired by households (say, in the form of bank deposits) and also satisfy the demand for long-term loans (say, in the form of home mortgages). By investing in a portfolio of long-and short-term assets and liabilities, the FI can both reduce risk exposure through diversification and manage risk exposure by centralizing its hedging activities.
What is meant by denomination intermediation?
Because they are sold in very large denominations, many assets are either out of reach of individual savers or would result in savers holding highly undiversified asset portfolios. For example, the minimum size of a negotiable CD is $100,000; commercial paper (short term corporate debt) is often sold in minimum packages of $250,000 or more. Individual savers may be unable to purchase such instruments directly. However, by buying shares in a mutual fund with other small investors, household savers overcome the constraints to buying assets imposed by large minimum denomination sizes. Such indirect access to these markets may allow small savers to generate higher returns on their portfolios as well.
What other services do FIs provide to financial system?
1) Money Supply Transmission, 2) Credit Allocation, 3) Inter generational Wealth Transfers, 4) Payment Services
Why are FIs regulated?
Failure to provide these services, or a breakdown in their efficient provision, can be costly to both the ultimate suppliers (households) and users (firms) of funds as well as the overall economy. In addition, individual FI failures may create doubts in savers' minds regarding the stability and solvency of FIs in general and cause panics and even runs on sound institutions. FIs are regulated in an attempt to prevent these types of market failures.
What countries have the most international debt securities outstanding?
Measured as more than $1trillion in international debt outstanding the biggest issuers are France, Germany, Italy, the Netherlands, Spain, the United Kingdom, and the United States.
What countries have the largest commercial banks?
France, Germany, Japan, Switzerland, the United Kingdom, and the United States have the biggest banks (in terms of total assets).
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