Survey of Financial Markets & Institutions Department of Banking & Finance Semester II - 2003 About Me Professor Shane Khartabil Masters in Business Administration – Monash University – Australia Graduate Diploma Accounting & Economic Studies – Latrobe University – Australia Bachelor Business Administration – American University Economic & Financial Consultant – Australian Bureau of Statistics – Australia Lecturer – Creative Teaching Institute – Australia Room 2 – 101 B , Consultation Times to be advised. About You Tell me something about yourself (Name and Email) your strengths and your plans. Name Email Other Course Outline Textbook: Financial Markets And Institutions, Saunders-Cornett, 2001, McGraw-Hill Companies. Evaluation: Attendance & Hand-ins (20%) Mid Term (20%) Mid Term II (20%) Final Exam (40%) Lecture Handouts: Emailed after each Lecture Topics 1. Overview of Financial Markets 2. Determination of Interest Rates 3. Interest Rates and Security Valuation 4. The Federal Reserve System, Monetary Policy, and Interest Rates 5. MIDTERM I EXAMINATION 6. Securities Markets : Money & Bond Markets 7. Securities Markets : Mortgage & Stock Markets 8. Securities Markets : Foreign Exchange & Derivative Securities Markets 9. Depository Institutions : Commercial Banks & Thrift Institutions 10. Depository Institutions Financial Statement Analysis and Regulation 11. MIDTERM II EXAMINATION 12. Other Financial Institutions: Insurance Companies 13. Other Financial Institutions: : Securities Firms, Investment Banks & Finance Companies 14. Other Financial Institutions: Mutual Funds & Pension Funds 15. Types & Management of Risks Incurred by Financial Institutions 16. FINAL EXAMINATION Financial Markets & Institutions Financial Markets allow for the exchange of financial assets such as stocks and bonds Financial Institutions serve as financial intermediaries in financial markets by facilitating the flow of funds from individuals, corporations, or governments with excess funds to those with deficient funds. Overview of Financial Markets The main participants in financial market transactions are households, businesses (including financial institutions), & governments that purchase or sell financial assets. Participants that provide funds are called surplus units; such as households and businesses, Foreign investors, and Federal Reserve System Participants that enter financial markets to obtain funds are called deficit units; such as the federal government (Treasury) who finances the budget deficit by issuing Treasury securities Many participants simultaneously act as surplus and deficit units. For example, a business may sell new stocks and use some of the proceeds to establish a checking account. Thus, funds are obtained from one type of financial market and used in another. Primary vs Secondary Markets New securities are issued in primary markets. Existing securities are resold in secondary markets. The issuance of new corporate stock or new Treasury securities represents a primary market transaction. The sale of existing corporate stock or Treasury security holdings by any businesses or individuals represents a secondary market transaction. Money Vs Capital Markets Financial markets that facilitate the flow of short-term funds are money markets. Financial Markets that facilitate the flow of long-term funds are capital markets. Securities with a maturity of one year or less are called money market securities Securities with a maturity of more than one year are called capital market securities Common stocks are classified as capital market securities, since they have no defined maturity. Money market securities have a higher degree of liquidity without a loss of value. Capital market securities are typically expected. to generate a higher annual return to investors. Organized Vs Over-the-Counter Markets Some secondary stock market transactions occur at an organized exchange, which is a visible marketplace for secondary market transactions such as Bahrain Stock Exchange. financial market transactions occur in the over-the-counter (OTC) market, which is a telecommunications network. Equity Vs Debt Securities Equity securities (common stock and preferred stock) represent ownership in a business. Debt securities represent IOUs (I- Owe-You); investors who purchase these securities are creditors. Equity securities typically have no maturity. Debt securities have maturities ranging from one day to twenty years or longer. Role of Financial Institutions Markets are imperfect, securities buyers and sellers do not have full access to information and cannot always break down securities to the precise size they desire. Financial intermediaries are needed to resolve the problems caused by market imperfections. They receive requests from surplus and deficit units on what securities are to be purchased or sold, and they use this information to match up buyers and sellers of securities. Because the amount of a specific security to be sold will not always equal the amount desired by investors, financial intermediaries sometimes unbundle the securities by spreading them across several investors until the entire amount is sold. Without financial intermediaries, the information and transaction costs of financial market transactions would be excessive. Flow of Funds Exhibit 1.1 Surplus units are shown at left side , while three types of deficit units are shown at the right side. Some flows of funds shown in the exhibit are directly from the surplus units to deficit units. Securities firms act as Financial intermediaries that serve as brokers by executing the purchases of corporate or government securities desired by surplus units. The remaining flows of funds involve a financial intermediary, which obtains funds from surplus units and provides funds to deficit units. In such situations, the flow of funds from surplus units to deficit units is indirect Types of Financial Intermediaries Depository Institutions Accepts deposits from surplus units and provides credit to deficit units through loans and purchases of securities Non-Depository Institutions Generate funds from sources other than deposits Functions of Depository Institutions They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units. They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units. They accept the risk on loans provided. They have more expertise than individual surplus units to evaluate the credit- worthiness of deficit units. They diversify their loans among numerous deficit units and can absorb defaulted loans better than individual surplus units could. Exposure to Risk Bonds and mortgages are subject to interest rate risk, whereby prices of existing bonds or mortgages decline in response to an increase in interest rates. Stocks are subject to market risk, whereby the stock market experiences lower prices in response to adverse economic conditions or pessimistic expectations of investors. All types of securities denominated in foreign currencies are subject to ex- change rate risk, in which the currencies denominating the securities depreciate against the investor's home currency. Reducing the Risk A derivative instrument is created (or derived) from a previously existing security. Markets have been established for these instruments to hedge/reduce risk. For example, financial futures contracts, derived from securities such as Treasury bonds and Treasury bills, are used by investors holding bonds or mortgages to reduce interest rate risk. Interest rate swaps are also used to reduce their interest rate risk. Stock options, derived from stocks, enable investors who invest in stocks to reduce their exposure to market risk. Foreign exchange instruments, such as currency futures, currency options, and currency swaps, enable investors who invest in foreign securities to reduce their exposure to exchange rate risk. Types of Depository Institutions Commercial Banks Savings Institutions Credit Unions Hand-in 1.1 : Research these types of Depository institutions and explain their role in financial markets in one page presentation. Types of Non-Depository Institutions Finance Companies Mutual Funds Securities Firms Pension Funds Insurance Companies Hand-in 1.2 : Research these types of Non-Depository institutions and explain their role in financial markets in one page presentation. Summary Financial institutions allow funds to flow efficiently between surplus and deficit units. Depository institutions are especially valuable for this service. The flow of funds from surplus units to deficit units commonly involves the purchase of securities. The investment in securities by financial institutions and other investors can cause exposure to various types of risk. Derivative instruments have been created to reduce the risk.
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