Hubbard _ O'Brien Chapter 1 Notes

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					                     Overview of the Financial System

                                      Chapter 1
                                     Finance 327

                         Definition of a Financial System
• Financial System

   – Network of financial markets and financial institutions

   – Brings savers and investors together

• Key financial services of the system

   – Risk Sharing

   – Provision of liquidity

   – Information services

                         Purpose of the Financial System

• Transfer funds from savers to borrowers

   – Savers are suppliers of funds

   – Borrowers are investors, demanders of funds

• Financial markets issue claims on borrowers

• Financial intermediaries act as go-betweens

                 Key Services Provided by the Financial System
• Risk Sharing
   – Savers can hold many assets (diversification)

• Liquidity
   – Ease of converting assets to cash (without slashing price)

• Information
   – Provide information to investors

   – Help solve information asymmetry problems (more on this in Chapter 9)

                                  Financial Markets
• Primary Markets
   – Newly issued claims (e.g., bonds, loans or stock)
   – Sold to initial buyers
   – Province of investment bankers

• Secondary Markets
   – Previously issued claims are resold (traded)
   – Province of Brokers and Exchanges (e.g., NYSE)

• Secondary Markets provide risk sharing, liquidity, and information services

                           Types of Secondary Markets
• Maturity
    • Money Markets < 1 year

Major Components of the Money Market

   – Capital Markets > 1 year

            Market for debt and equity securities with maturities over 1 year

Relative new addition to the capital markets: Mortgage Backed Securities

   •   Developed in the 1970s to help liquidity of financial institutions

   •   Proportional ownership of a pool or a specified obligation secured by a pool
       (“MBS pass through)

   •   Market has experienced very high rates of growth

Mortgage-backed Securities Outstanding, 1979-2007

  Trading places

   – Auction markets like NYSE
   – OTC markets - dealers trade via computerized networks

   – Cash markets - immediate settlement of trades
   – Derivative markets - settlement is made later

                               Financial Intermediaries
• Intermediaries provide risk sharing at lower cost
   – Control large amounts of funds
   – Access to wide variety of investments
   – Hold a diversified portfolio

• Claims against intermediaries are liquid (e.g., bank deposits)

• Intermediaries have economies of scale in collecting information about borrowers

       Financial Regulation, The Federal Reserve, and Monetary Policy

                                 Goals of Regulation

• Provision of information
   – Requires issuers to disclose relevant information
   – E.g., SEC, FASB, Rating Agencies

• Maintenance of financial stability
  – Financial soundness of intermediaries
  – E.g., FDIC, SIPC

• Monetary policy

• Encourages particular activities
   – e.g., encourage home ownership

                    Summary of ways to view capital markets:
1. From an institutional perspective (i.e., what are the characteristics of markets and

2. Alternative approach is from a functional perspective (i.e. what functions do markets
    and intermediaries perform?)

Bottom line: Think of the financial function and not the institutions performing that

    Why? Institutions used to perform the functions will change over time, and will be
    different in different areas as well.

•    Features that we can expect to change:


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