Chapter 2
An Overview of the Financial System
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2.1 Function of Financial Markets
• Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds
2-11
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Shanghai Stock Exchange
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-8
– Investment Banks underwrite securities in primary market. It guarantees an price for a corporation’s securities and then sells them to the public. – Brokers and dealers work in secondary markets funds. The New York and American stock exchanges and NASDAQ are the best-known examples of secondary markets.
short-term: less than a year.
long-term: ten years of longer intermediate-term: between one and ten years
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-5
– Equities – Claims to share in the net income and the assets of a business.
• Equities often make periodic payments (dividends) to their holders and have no maturity date. • Owing stock means you own a portion of the firm and thus have the right to vote on issues important to the firm and to elect its directors.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-10
2.2.3 Exchanges and Over-theCounter (OTC) Markets
– Exchanges: buyers and sellers of securities meet in one central location to conduct trades. NYSE, Chicago Board of Trade – OTC Markets: dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices. A majority of the largest corporations have their shares traded at organized stock exchanges in the U.S. The U.S. government bond market , foreign exchange market are OTC markets.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-6
• The main disadvantage of owning a corporation’s equities rather than its debt is that an equity holder is a residual claimant; that is ,the corporation must pay all its debt holders before it pays its equity holders • The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset value. • In US, the size of the debt market is often larger than the size of the equities market.
2-2
FIGURE 1 Flows of Funds Through the Financial System
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-3
Function of Financial Markets
2-12
Chicago Board of Trade
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-13
• 2.2.4 Money and Capital Markets
– Money markets deal in short-term debt instruments – Capital markets deal in longer-term debt and equity instruments.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-14
2.3 Financial Market Instruments
• 2.3.1 Money Market Instruments • Least price fluctuations and the least risky.
• Promotes economic efficiency by producing an efficient allocation of capital, which increases producove the well-being of consumers by allowing them to time purchases better
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-4
2.2 Structure of Financial Markets
• 2.2.1 Debt and Equity Markets
– Debt instruments A bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date (maturity date). Maturity: number of years (term) until that instrument’s expiration date.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-16
• (2) Negotiable Bank Certificates of Deposit • CD is a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price. • Negotiable CDs are CDs sold in secondary markets. • An extremely important source of funds for commercial banks.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
2-9
• Two important functions of secondary markets: • They make the financial instruments more liquid. • They determine the price of the security that issuing firm sells in the primary market.
• Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities.