8th Edition
Solution Manual For
Financial Markets And Institutions 8th Edition Anthony Saunders
Part I
Introduction and Overview of Financial Markets
Chapter One
Introduction
I. Chapter Outline
1. Why Study Financial Markets and Institutions? Chapter Overview
2. Overview of Financial Markets
a. Primary Markets versus Secondary Markets
b. Money Markets versus Capital Markets
c. Foreign Exchange Markets
d. Derivative Security Markets
e. Financial Market Regulation
3. Overview of Financial Institutions
a. Unique Economic Functions Performed by Financial Institutions
b. Additional Benefits FIs Provide to Suppliers of Funds
c. Economic Functions FIs Provide to the Financial System as a Whole
d. Risks Incurred by Financial Institutions
e. Regulation of Financial Institutions
f. Trends in the United States
4. Globalization of Financial Markets and Institutions
Appendix 1A: The Financial Crisis: The Failure of Financial Institutions‘ Specialness
(available through McGraw Hill‘s Connect. Contact your McGraw Hill representative for
more information on making the appendix available to your students).
II. Learning Goals
1. Differentiate between primary and secondary markets.
2. Differentiate between money and capital markets.
3. Understand what foreign exchange markets are.
4. Understand what derivative securities markets are.
5. Distinguish between the different types of financial institutions.
6. Know the services financial institutions perform.
7. Know the risks financial institutions face.
8. Appreciate why financial institutions are regulated.
9. Recognize that financial markets are becoming increasingly global.
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III. Chapter in Perspective
This chapter has three major sections and one minor section. The text provides a
general overview of the major types of U.S. financial markets, focusing primarily on
terminology and descriptions of the major securities, market structures and regulators.
Market microstructure is not discussed. Foreign exchange transactions are also briefly
introduced. Second, the chapter describes the various types of financial institutions and
explains the risks they face and the services they provide to funds‘ users and funds‘
suppliers. The financial crisis is discussed and the impact of Brexit is considered. The
final section of the chapter provides statistics about the rapid growth of globalization of
both markets and institutions. An appendix covering the details of the financial crisis and
the government intervention programs, including the costs as of late 2009, is available
through McGraw Hill‘s Connect. Contact your McGraw Hill representative for more
information on making the appendix available to your students.
IV. Key Concepts and Definitions to Communicate to Students
Financial markets Primary markets
Initial public offerings (IPO) Secondary markets
Derivative security Liquidity
Money markets Over-the-counter (OTC) markets
Capital markets Derivative security markets
Financial institutions Direct transfer
Price risk Indirect transfer
Delegated monitor Asset transformers
Diversify Economies of scale
Enterprise risk management (ERM)
Appendix terms include:
TARP Federal Reserve Rescue Efforts
Federal Stimulus programs American International Group
FDIC Bank takeovers Other financial initiatives
Other housing initiatives
Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction
or distribution without the prior written consent of McGraw Hill.
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, 8th Edition
V. Teaching Notes
a. Why Study Financial Markets and Institutions?
For an economy to achieve its potential growth rate, mechanisms must exist to
effectively allocate capital (a scarce resource) to the best possible uses while accounting
for the riskiness of the opportunities available. Markets and institutions have been created
to facilitate transfers of funds from economic agents with surplus funds to economic
agents in need of funds. For an economy to maximize its growth potential it must create
methods that attract savers‘ excess funds and then put those funds to the best uses
possible, otherwise idle cash is not used as productively as possible. The funds transfer
should occur at as low a cost as possible to ensure maximum economic growth. Two
competing alternative methods exist: direct and indirect financing. In direct financing the
ultimate funds supplier purchases a claim from the funds demander with or without the
help of an intermediary such as an underwriter. In this case, society relies on primary
markets to initially price the issue and then secondary markets to update the prices and
provide liquidity. Trustees are appointed to monitor contractual obligations of issuers
and instigate enforcement actions for breach of contract terms. In indirect financing, the
funds demander obtains financing from a financial intermediary. The intermediary and
the borrower negotiate the terms and cost. The intermediary obtains funds by offering
different claims to fund suppliers. In this case the intermediary is usually responsible for
monitoring the contractual conditions of the financing agreement and perhaps updating
the cost if appropriate.
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or distribution without the prior written consent of McGraw Hill.
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The financial crisis of 2008-2009 reversed a long-term trend of deregulating
financial institutions. Regulatory risk and costs of regulation increased as a result of the
new laws, higher capital requirements and stricter regulatory oversight. A former Federal
Reserve Chair, Alan Greenspan, believed in only minimal regulation and his philosophy
appeared to prevail at many regulatory agencies including the SEC. As discussion leader,
you may wish to point out that it is not clear whether the existing rules would have been
sufficient to prevent the crisis if they had been enforced. Laws and regulations by
themselves are insufficient to ensure proper behavior in any case. Practitioners and
academics also need to emphasize business ethics and individual accountability.
Nevertheless, the financial crisis led to the massive Dodd-Frank bill (Wall Street Reform
and Consumer Protection Act) designed to limit systemic risk and tighten controls on the
institutions that many blame for causing the financial crisis. The ―Volcker Rule‖
prohibited insured intermediaries from engaging in proprietary trading, owning, or
managing a hedge fund and private equity investments. The Volcker rule was only slowly
implemented because banks correctly maintain that many of their proprietary activities
are actually hedges to reduce risk and these are allowed. It is difficult to separate hedging
from speculative based trades. An unintended consequence of the Volcker rule is the
reduction of liquidity in the bond markets as banks reduce their bond trading activities.
Although details are not clear at this time, it is likely the Trump administration will roll
back many Dodd-Frank requirements, including the Volcker rule and the Consumer
Finance Protection Bureau‘s (CFPB) attempts to increase the fiduciary responsibility of
investment advisors with respect to conflicts of interest with their clients. In 2018, the
Volker Rule was amended to exempt smaller banks from the full scope of the Volcker
Rule as well as eliminated the presumption that positions held for fewer than 60 days
violated the rule unless bankers proved otherwise. The amendments went into effect in
2019 resulting in bank holdings of derivative securities increasing to $201.32 trillion by
2019.
Maintaining profitability with restricted activities in a continuously evolving,
globally competitive market has been a major challenge to the financial industry. The
pace of innovation of new technology, financial products and services has not abated.
Technological advances may change traditional methods of offering financial services at
the wholesale, and perhaps eventually, at the retail level. Job opportunities for finance
students in markets and institutions are likely to continue to improve over the next ten to
twenty years as managing risks at intermediaries in increasingly complex and competitive
businesses will grow in importance. For career information you may wish to refer
students to https://dhigroupinc.com/home/default.aspx. The text provides an introductory
examination of the functions and characteristics of markets and risk and profitability
management at major financial institutions in order to help students understand the
workings of the financial system in today‘s global economy.
Growth began to pick up in 2016 and market optimism increased with the election
of the new president. The unemployment rate has fallen very low and while economic
growth has not progressed as rapidly as expected. Bond market issuance continued at a
strong pace, although overall credit provided by banks experienced a delayed growth.
This implies that larger firms have had little difficulty in obtaining credit, but some
smaller firms that rely more on bank lending continue to have difficulty obtaining credit.
Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction
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China‘s growth experienced a 6.2 percent drop in 2019 due to a prolonged trade war with
the U.S., the lowest level in thirty years.
The United Kingdom‘s (UK) surprise vote to leave the European Union single
market in June 2016 reduced the value of the pound and global stock markets. This is not
surprising as markets dislike uncertainty. In March 2017, UK Prime Minister Theresa
May invoked ―Article 50‖ which started the 2-year process of extricating the UK from
the EU. The reason for the British exit (Brexit) vote was to reduce the amount of
immigration from EU countries. Two weeks before the October 31, 2019 deadline, the
UK was still unable to reach a deal with the EU on how the exit would be structured. The
EU grants more or less equal access to trade and capital flows among member countries,
but EU rules require allowing free immigration. In the U.S. and UK there was a backlash
in 2016 against globalization and immigration. While globalization has added greatly to
economic efficiency, including improved corporate profits and lower costs of consumer
goods and services, it has also led to increased competition for jobs and kept wages from
rising. Poor real median per capita income growth has other causes as well though, such
as low productivity growth, low real interest rates and economic uncertainty. Electorates
want their governments to come up with policies that allow job protection and income
growth. This is no easy task and it may require tradeoffs between cost of consumer goods
and protecting jobs.
The most recent shock to the world‘s financial markets was the Coronavirus
Pandemic in 2020, resulting in a virtual shutdown of the world economies. The shutdown
resulted in a 32.5% drop in the DJIA in just over a month, from an all-time high of
29,388.58 on February 6, 2020 down to 19,830.01 by March 19, 2020.
As economic and competition in the markets change, attention to profits and risk
become increasingly important. Making investment and financial decisions requires
managers and individual investors with an understanding of the flow of funds throughout
the economy as well as the operations and structure of both domestic and international
markets. Financial institutions (FIs) play an important role in the functioning of financial
markets. In particular, FIs often provide the least costly and most efficient way of
channeling funds to and from financial markets.
b. Overview of Financial Markets
a. Primary Markets vs Secondary Markets
b. Money Markets vs Capital Markets
The two alternative mechanisms of fund raising are direct financing, where the
saver directly purchases a claim from the ultimate funds user in the primary market, or
indirect financing where savers place their money in a FI and the FI lends money to the
ultimate borrower. In the cases where savers desire to place their money directly in the
markets, institutions such as investment bankers (asset brokers) have evolved to assist in
this process. The first time a firm issues securities to the public is referred to as its initial
public offering (IPO). Issuing additional stock of a firm that already has stock publicly
traded is referred to as a seasoned offering (or sometimes called a ‗follow on‘ offering).
In some cases, firms offer the issue to one or only a few institutional buyers. The primary
markets are the markets where firms (and other borrowers) create and sell new securities
in order to raise cash to fund positive NPV projects (or to meet some other social goals in
the case of nonprofit fund raisers). The financial crisis drastically reduced primary market
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issues of all types. Bond issuance recovered first followed by the recovery of the IPO
issuance in 2012 and 2013.
The instructor should emphasize that the secondary markets exist to provide
liquidity and price information to investors. These functions make the primary market
more attractive. Investors would be far less likely to invest in risky long-term primary
securities unless they believe they can obtain updates of the current value of their claims
and have the ability to sell these claims quickly at low cost. Hence the efficiency of
operations of the secondary markets affects the growth rate in the overall economy
through their effect on the primary markets. Secondary market trading volume has risen
dramatically in the last several decades, particularly with the creation of wholesale and
retail electronic trading mechanisms that have substantially reduced trading costs.
Mergers can emphasize the economies of scale in the exchange business. The NYSE
merged with Euronext in 2006 and was acquired by the Intercontinental Exchange (ICE)
in 2013, after a failed merger attempt by the Deutsche-Bourse. The CME and the CBOT
have also merged. Ask students to think about the pros and cons of having only one
owner of the largest U.S. stock market versus having foreign ownership of our largest
market. Note that electronic trading is growing so rapidly that existing market structures
such as an exchange floor are having a difficult time maintaining profitability.
Money markets evolved to meet the short term investment needs (1 year or less)
of corporations and institutions desiring to earn a small positive rate of return on cash that
would be needed shortly, hence they have evolved with high denomination safe securities
that have little risk of principle loss. Capital markets are markets where borrowers raise
cash for long term investment needs. These are generally riskier than money markets and
hence, capital market securities must promise to pay a higher rate of return to attract
funds. Savers willing to take the associated risk are attracted to these markets.
Discussion question for students:
You may wish to ask students the following question that illustrates these price
changes. Suppose you start with a $1,000 investment in stocks. You lose 54% of your
investment and then you gain 71%. How much money do you end up with and what was
your net rate of return?
Answer:
Step 1: $1,000 × (1 - 0.54) = $460
Step 2: $460 × 1.71 = $786.60
Step 3: Your net rate of return was ($786.60 - $1,000) / $1,000 = -21.34%
c. Foreign Exchange Markets
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The majority of the world‘s business involves international business transactions.
It is increasingly important for firms to recognize that the best investment opportunity
may be located in continental Europe, the lowest cost source of funds may be found in
Britain instead of the U.S., or the highest potential sales growth rate may be in Asia. As
corporations and institutions have increased their international transactions, foreign
exchange risk has become a major source of risk for many firms today and much hedging
with spot and forward foreign exchange trades occurs.
Historically, when a nation‘s current account deficit surpasses 5% of GDP a
correction occurs in currency value. Before the financial crisis the U.S. was able to
consistently run current account deficits above 5% because foreigners were willing to
supply funds to U.S. markets. Part of the reason for this is the usage of the U.S. dollar as
a global reserve currency. Currency manipulation by foreign central banks also
contributed to the strength of the dollar. For instance, foreign central banks continue to
purchase dollars to keep local currencies down to foster their export sectors. The U.S.
economy and the dollar remain key generators of global growth and these factors help the
dollar maintain its value in the global market. The strength in the dollar since the Great
Recession has reduced profitability of some well-known U.S. multinationals with
significant overseas revenues such as IBM. Coca Cola‘s global sales exposes the
company to nearly 70 different foreign currencies, exposing the company to flat or
decreasing net quarter sales in countries with currencies weak compared to the strong
U.S. dollar. Nevertheless, the excess supply of dollars available in the global economy
could precipitate a drop in the currency. The dollar‘s drop can generate long term
inflation concerns and lead to higher commodity prices because most commodities are
priced in dollars regardless of where they are traded globally.
d. Derivative Security Markets
A derivative security is a contract which derives its value from some underlying
asset or market condition. In general, the main purpose of the derivatives markets is to
transfer risk between market participants. Some participants, called hedgers, enter
derivatives contracts to reduce their risk exposure in the underlying cash market. Other
participants, called speculators, use derivative contracts to bet on price movements.
Derivatives are highly leveraged instruments. Le allows hedgers to reduce risk and
speculators to attempt to earn high rates of return with low capital investments. The two
main types of derivatives markets are the market for exchange traded derivatives and the
over the counter (OTC) derivatives markets. Exchange traded derivatives are generally
liquid and involve no counterparty risk, whereas OTC contracts are custom contracts
negotiated between two counterparties and have default risk.
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Derivatives have been blamed for the financial crisis. Mortgage derivatives did
allow a larger amount of mortgage credit to be created and spread the risk of mortgages
to a broader base of investors. Subprime mortgage losses were large, reaching over $700
billion. The instructor may wish to ask students whether it makes sense to blame the
instrument or the users. Warren Buffett has called derivatives, ‗weapons of mass
destruction.‘ However, used properly they allow market participants to transfer risk to
other parties and allow others lower cost methods to gain exposure to markets. It does
seem reasonable to require greater transparency in OTC derivatives to ensure that players
can cover the promises they make. Derivatives that involve payments of principal, such
as credit default swaps, are now supposed to be traded on an exchange to ensure
performance and reasonable limits to speculation.
e. Financial Market Regulation
Financial markets are regulated by the SEC, the exchanges, the Commodity
Futures Trading Commission (CFTC) and the Financial Industry Regulatory Body
(FINRA) (FINRA resulted from a merger of the NASD and the NYSE regulatory arm in
1996 and supersedes both). FINFRA is a self-regulatory body that is subject to SEC
oversight. The primary purposes of regulations are to prevent fraud, to ensure
performance as promised, and to ensure that the public has enough information to
evaluate the riskiness of an investment. The regulators do not attempt to ensure investors
earn a minimum rate of return.
f. Overview of Financial Institutions
Many savers today are willing to risk some of their funds in the capital markets,
but not all. For at least some of their wealth, savers typically desire a different type of
claim than the ultimate borrower wishes to offer. Asset transformers, such as banks,
have evolved to meet this need by offering low risk claims to savers while granting
higher risk, more illiquid investments (e.g., loans) to the funds demanders. Other types of
institutions have evolved to meet special needs of savers such as life insurance firms to
eliminate certain risks, pension funds to transfer wealth through time, money market
mutual funds to pool investors‘ savings, etc.
Deposit-Type Institutions – Offer liquid, government insured claims to savers, such as
demand deposits, savings deposits, time deposits, and share accounts.
Commercial Banks – Make a variety of consumer and commercial loans (direct
claims) to borrowers.
Thrifts – Perform similar to commercial banks but tend to concentrate their loans in
one segment, such as real estate loans or consumer loans.
Savings and Loan Associations – Make mortgage loans (direct claim) to borrowers.
Mutual Savings Banks – Purchase various securities and make loans – mortgages,
consumer loans, government bonds, etc.
Credit Unions – Receive share account deposits and make consumer loans.
Membership requires a common bond, such as a church or labor union.
Non-depository institutions:
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Life Insurance Companies – Provide life insurance and long-term savings
opportunities for savers.
Casualty Insurance Companies – Provide auto, home insurance, purchase direct
financial securities with paid-in-advance premiums from insurance purchasers.
Pension Funds – issue claims to savers or provide investment plans that allow savers
to transfer wealth through time and to future generations.
Other Types of Financial Intermediaries:
Finance Companies – Borrow (issue liabilities) directly from banks and directly from
savers (commercial paper) and make/purchase riskier consumer and business loans.
Mutual Funds – Offer indirect mutual fund shares to savers and purchase direct
financial assets (e.g., stocks and bonds).
Money Market Mutual Funds – Offer (indirect) shares and purchase direct
(commercial paper) and indirect (bank CDs) money market financial assets.
Investment Bankers – Purchase securities from borrowers and repackage the payment
streams, creating new securities to sell to savers. Assist borrowers in selling direct
claims to savers.
E-brokers – E-brokers provide securities trading services over the Internet. Actually,
E-brokers are following one of four business models. A few, such as Schwab, seek to
be an online financial supermarket providing banking, insurance, portfolio
management and brokerage under one brand. Hybrids provide discount commissions
but provide some investment advice and research, some pure discount firms seek to
compete only on price and a few E-brokers are providing specialized services such as
access to special markets or extended credit.
FinTechs – Institutions that use technology to deliver financial solutions in a manner
that directly compete with traditional financing methods.
a. Unique Economic Functions Performed by Financial Institutions
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Relative to the choices available to many savers who invest directly in the
markets, FIs provide savers with very safe, liquid claims with fairly small denominations.
FIs then in turn lend money to funds demanders. The ultimate borrowers, say
corporations, issue risky claims (loans or bonds) held by FIs. The individual savers need
not investigate the riskiness of the corporate borrowers, the FI will do that. Consequently,
FIs allocate capital in an economy. FIs must then be able to accurately assess, price and
monitor risks of borrowers for an economy to achieve its potential growth rate. FIs must
also carefully manage their own risk since they are borrowing money from savers at low
risk and then investing the money in higher risk loans and securities in order to earn a
profit. By carefully evaluating the riskiness of potential investments and by diversifying
their loan and investment portfolios, lending institutions employ the law of large numbers
to reduce their risk exposure. The text argues that intermediaries failed in evaluating the
riskiness of mortgages and this failure resulted in the financial crisis. Actually, the causes
are more complex. Heavy government involvement in currency, mortgage and other
markets, lax regulation, failure of credit ratings agencies, political pressure to promote
affordable housing, failures of corporate governance and an extended period of very low
interest rates all contributed to the crisis. It is easy to blame it on ‗Wall Street‘ or
capitalism but these simplistic arguments don‘t hold up under scrutiny.
The instructor should note that both markets and institutions assess, price and
monitor risk. In some cases however, institutions can perform these functions better than
the markets. In this sense the institution is serving as a delegated monitor. For instance,
in situations where the borrower is reluctant to make information public or frequent
monitoring is needed or when special additional financing requirements may be
necessary, bank loans may be preferable to a public bond issue.
Financial institutions not only improve the quality and of information, but also act
as asset transforms, making investments more attractive to investors than claims directly
issued by corporations. Claims issued by financial institutions have liquidity attributes
that are superior to primary securities. The ability of the financial institutions to diversity
some of their investment risk allows them to provide liquidity services to fund suppliers.
Diversification enables financial institutions to predict more accurately the return and risk
on an investment portfolio allowing them to provide highly liquid claims with little price
risk.
The federal government insures deposits of certain intermediaries. Because of
deposit insurance, depositors do not require a risk premium to place money in an insured
institution. In effect, government insurance subsidizes risk taking at depository
institutions. The government insurance liability requires that insured depository
institutions be regulated to limit the government‘s liability and to limit imprudent risk
taking at these institutions.
b. Additional Benefits FIs Provide to Suppliers of Funds
Funds suppliers who place their money in a FI generally get the following benefits:
Reduced transaction costs due to economies of scale in information production1
1
Economies of scale (EOS) indicate that a firm‘s unit profits grow as it becomes larger. Fixed costs lead to
EOS.
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or distribution without the prior written consent of McGraw Hill.
1-8
Solution Manual For
Financial Markets And Institutions 8th Edition Anthony Saunders
Part I
Introduction and Overview of Financial Markets
Chapter One
Introduction
I. Chapter Outline
1. Why Study Financial Markets and Institutions? Chapter Overview
2. Overview of Financial Markets
a. Primary Markets versus Secondary Markets
b. Money Markets versus Capital Markets
c. Foreign Exchange Markets
d. Derivative Security Markets
e. Financial Market Regulation
3. Overview of Financial Institutions
a. Unique Economic Functions Performed by Financial Institutions
b. Additional Benefits FIs Provide to Suppliers of Funds
c. Economic Functions FIs Provide to the Financial System as a Whole
d. Risks Incurred by Financial Institutions
e. Regulation of Financial Institutions
f. Trends in the United States
4. Globalization of Financial Markets and Institutions
Appendix 1A: The Financial Crisis: The Failure of Financial Institutions‘ Specialness
(available through McGraw Hill‘s Connect. Contact your McGraw Hill representative for
more information on making the appendix available to your students).
II. Learning Goals
1. Differentiate between primary and secondary markets.
2. Differentiate between money and capital markets.
3. Understand what foreign exchange markets are.
4. Understand what derivative securities markets are.
5. Distinguish between the different types of financial institutions.
6. Know the services financial institutions perform.
7. Know the risks financial institutions face.
8. Appreciate why financial institutions are regulated.
9. Recognize that financial markets are becoming increasingly global.
Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction
or distribution without the prior written consent of McGraw Hill.
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, 8th Edition
III. Chapter in Perspective
This chapter has three major sections and one minor section. The text provides a
general overview of the major types of U.S. financial markets, focusing primarily on
terminology and descriptions of the major securities, market structures and regulators.
Market microstructure is not discussed. Foreign exchange transactions are also briefly
introduced. Second, the chapter describes the various types of financial institutions and
explains the risks they face and the services they provide to funds‘ users and funds‘
suppliers. The financial crisis is discussed and the impact of Brexit is considered. The
final section of the chapter provides statistics about the rapid growth of globalization of
both markets and institutions. An appendix covering the details of the financial crisis and
the government intervention programs, including the costs as of late 2009, is available
through McGraw Hill‘s Connect. Contact your McGraw Hill representative for more
information on making the appendix available to your students.
IV. Key Concepts and Definitions to Communicate to Students
Financial markets Primary markets
Initial public offerings (IPO) Secondary markets
Derivative security Liquidity
Money markets Over-the-counter (OTC) markets
Capital markets Derivative security markets
Financial institutions Direct transfer
Price risk Indirect transfer
Delegated monitor Asset transformers
Diversify Economies of scale
Enterprise risk management (ERM)
Appendix terms include:
TARP Federal Reserve Rescue Efforts
Federal Stimulus programs American International Group
FDIC Bank takeovers Other financial initiatives
Other housing initiatives
Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction
or distribution without the prior written consent of McGraw Hill.
1-1
, 8th Edition
V. Teaching Notes
a. Why Study Financial Markets and Institutions?
For an economy to achieve its potential growth rate, mechanisms must exist to
effectively allocate capital (a scarce resource) to the best possible uses while accounting
for the riskiness of the opportunities available. Markets and institutions have been created
to facilitate transfers of funds from economic agents with surplus funds to economic
agents in need of funds. For an economy to maximize its growth potential it must create
methods that attract savers‘ excess funds and then put those funds to the best uses
possible, otherwise idle cash is not used as productively as possible. The funds transfer
should occur at as low a cost as possible to ensure maximum economic growth. Two
competing alternative methods exist: direct and indirect financing. In direct financing the
ultimate funds supplier purchases a claim from the funds demander with or without the
help of an intermediary such as an underwriter. In this case, society relies on primary
markets to initially price the issue and then secondary markets to update the prices and
provide liquidity. Trustees are appointed to monitor contractual obligations of issuers
and instigate enforcement actions for breach of contract terms. In indirect financing, the
funds demander obtains financing from a financial intermediary. The intermediary and
the borrower negotiate the terms and cost. The intermediary obtains funds by offering
different claims to fund suppliers. In this case the intermediary is usually responsible for
monitoring the contractual conditions of the financing agreement and perhaps updating
the cost if appropriate.
Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction
or distribution without the prior written consent of McGraw Hill.
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, 8th Edition
The financial crisis of 2008-2009 reversed a long-term trend of deregulating
financial institutions. Regulatory risk and costs of regulation increased as a result of the
new laws, higher capital requirements and stricter regulatory oversight. A former Federal
Reserve Chair, Alan Greenspan, believed in only minimal regulation and his philosophy
appeared to prevail at many regulatory agencies including the SEC. As discussion leader,
you may wish to point out that it is not clear whether the existing rules would have been
sufficient to prevent the crisis if they had been enforced. Laws and regulations by
themselves are insufficient to ensure proper behavior in any case. Practitioners and
academics also need to emphasize business ethics and individual accountability.
Nevertheless, the financial crisis led to the massive Dodd-Frank bill (Wall Street Reform
and Consumer Protection Act) designed to limit systemic risk and tighten controls on the
institutions that many blame for causing the financial crisis. The ―Volcker Rule‖
prohibited insured intermediaries from engaging in proprietary trading, owning, or
managing a hedge fund and private equity investments. The Volcker rule was only slowly
implemented because banks correctly maintain that many of their proprietary activities
are actually hedges to reduce risk and these are allowed. It is difficult to separate hedging
from speculative based trades. An unintended consequence of the Volcker rule is the
reduction of liquidity in the bond markets as banks reduce their bond trading activities.
Although details are not clear at this time, it is likely the Trump administration will roll
back many Dodd-Frank requirements, including the Volcker rule and the Consumer
Finance Protection Bureau‘s (CFPB) attempts to increase the fiduciary responsibility of
investment advisors with respect to conflicts of interest with their clients. In 2018, the
Volker Rule was amended to exempt smaller banks from the full scope of the Volcker
Rule as well as eliminated the presumption that positions held for fewer than 60 days
violated the rule unless bankers proved otherwise. The amendments went into effect in
2019 resulting in bank holdings of derivative securities increasing to $201.32 trillion by
2019.
Maintaining profitability with restricted activities in a continuously evolving,
globally competitive market has been a major challenge to the financial industry. The
pace of innovation of new technology, financial products and services has not abated.
Technological advances may change traditional methods of offering financial services at
the wholesale, and perhaps eventually, at the retail level. Job opportunities for finance
students in markets and institutions are likely to continue to improve over the next ten to
twenty years as managing risks at intermediaries in increasingly complex and competitive
businesses will grow in importance. For career information you may wish to refer
students to https://dhigroupinc.com/home/default.aspx. The text provides an introductory
examination of the functions and characteristics of markets and risk and profitability
management at major financial institutions in order to help students understand the
workings of the financial system in today‘s global economy.
Growth began to pick up in 2016 and market optimism increased with the election
of the new president. The unemployment rate has fallen very low and while economic
growth has not progressed as rapidly as expected. Bond market issuance continued at a
strong pace, although overall credit provided by banks experienced a delayed growth.
This implies that larger firms have had little difficulty in obtaining credit, but some
smaller firms that rely more on bank lending continue to have difficulty obtaining credit.
Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction
or distribution without the prior written consent of McGraw Hill.
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, 8th Edition
China‘s growth experienced a 6.2 percent drop in 2019 due to a prolonged trade war with
the U.S., the lowest level in thirty years.
The United Kingdom‘s (UK) surprise vote to leave the European Union single
market in June 2016 reduced the value of the pound and global stock markets. This is not
surprising as markets dislike uncertainty. In March 2017, UK Prime Minister Theresa
May invoked ―Article 50‖ which started the 2-year process of extricating the UK from
the EU. The reason for the British exit (Brexit) vote was to reduce the amount of
immigration from EU countries. Two weeks before the October 31, 2019 deadline, the
UK was still unable to reach a deal with the EU on how the exit would be structured. The
EU grants more or less equal access to trade and capital flows among member countries,
but EU rules require allowing free immigration. In the U.S. and UK there was a backlash
in 2016 against globalization and immigration. While globalization has added greatly to
economic efficiency, including improved corporate profits and lower costs of consumer
goods and services, it has also led to increased competition for jobs and kept wages from
rising. Poor real median per capita income growth has other causes as well though, such
as low productivity growth, low real interest rates and economic uncertainty. Electorates
want their governments to come up with policies that allow job protection and income
growth. This is no easy task and it may require tradeoffs between cost of consumer goods
and protecting jobs.
The most recent shock to the world‘s financial markets was the Coronavirus
Pandemic in 2020, resulting in a virtual shutdown of the world economies. The shutdown
resulted in a 32.5% drop in the DJIA in just over a month, from an all-time high of
29,388.58 on February 6, 2020 down to 19,830.01 by March 19, 2020.
As economic and competition in the markets change, attention to profits and risk
become increasingly important. Making investment and financial decisions requires
managers and individual investors with an understanding of the flow of funds throughout
the economy as well as the operations and structure of both domestic and international
markets. Financial institutions (FIs) play an important role in the functioning of financial
markets. In particular, FIs often provide the least costly and most efficient way of
channeling funds to and from financial markets.
b. Overview of Financial Markets
a. Primary Markets vs Secondary Markets
b. Money Markets vs Capital Markets
The two alternative mechanisms of fund raising are direct financing, where the
saver directly purchases a claim from the ultimate funds user in the primary market, or
indirect financing where savers place their money in a FI and the FI lends money to the
ultimate borrower. In the cases where savers desire to place their money directly in the
markets, institutions such as investment bankers (asset brokers) have evolved to assist in
this process. The first time a firm issues securities to the public is referred to as its initial
public offering (IPO). Issuing additional stock of a firm that already has stock publicly
traded is referred to as a seasoned offering (or sometimes called a ‗follow on‘ offering).
In some cases, firms offer the issue to one or only a few institutional buyers. The primary
markets are the markets where firms (and other borrowers) create and sell new securities
in order to raise cash to fund positive NPV projects (or to meet some other social goals in
the case of nonprofit fund raisers). The financial crisis drastically reduced primary market
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issues of all types. Bond issuance recovered first followed by the recovery of the IPO
issuance in 2012 and 2013.
The instructor should emphasize that the secondary markets exist to provide
liquidity and price information to investors. These functions make the primary market
more attractive. Investors would be far less likely to invest in risky long-term primary
securities unless they believe they can obtain updates of the current value of their claims
and have the ability to sell these claims quickly at low cost. Hence the efficiency of
operations of the secondary markets affects the growth rate in the overall economy
through their effect on the primary markets. Secondary market trading volume has risen
dramatically in the last several decades, particularly with the creation of wholesale and
retail electronic trading mechanisms that have substantially reduced trading costs.
Mergers can emphasize the economies of scale in the exchange business. The NYSE
merged with Euronext in 2006 and was acquired by the Intercontinental Exchange (ICE)
in 2013, after a failed merger attempt by the Deutsche-Bourse. The CME and the CBOT
have also merged. Ask students to think about the pros and cons of having only one
owner of the largest U.S. stock market versus having foreign ownership of our largest
market. Note that electronic trading is growing so rapidly that existing market structures
such as an exchange floor are having a difficult time maintaining profitability.
Money markets evolved to meet the short term investment needs (1 year or less)
of corporations and institutions desiring to earn a small positive rate of return on cash that
would be needed shortly, hence they have evolved with high denomination safe securities
that have little risk of principle loss. Capital markets are markets where borrowers raise
cash for long term investment needs. These are generally riskier than money markets and
hence, capital market securities must promise to pay a higher rate of return to attract
funds. Savers willing to take the associated risk are attracted to these markets.
Discussion question for students:
You may wish to ask students the following question that illustrates these price
changes. Suppose you start with a $1,000 investment in stocks. You lose 54% of your
investment and then you gain 71%. How much money do you end up with and what was
your net rate of return?
Answer:
Step 1: $1,000 × (1 - 0.54) = $460
Step 2: $460 × 1.71 = $786.60
Step 3: Your net rate of return was ($786.60 - $1,000) / $1,000 = -21.34%
c. Foreign Exchange Markets
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The majority of the world‘s business involves international business transactions.
It is increasingly important for firms to recognize that the best investment opportunity
may be located in continental Europe, the lowest cost source of funds may be found in
Britain instead of the U.S., or the highest potential sales growth rate may be in Asia. As
corporations and institutions have increased their international transactions, foreign
exchange risk has become a major source of risk for many firms today and much hedging
with spot and forward foreign exchange trades occurs.
Historically, when a nation‘s current account deficit surpasses 5% of GDP a
correction occurs in currency value. Before the financial crisis the U.S. was able to
consistently run current account deficits above 5% because foreigners were willing to
supply funds to U.S. markets. Part of the reason for this is the usage of the U.S. dollar as
a global reserve currency. Currency manipulation by foreign central banks also
contributed to the strength of the dollar. For instance, foreign central banks continue to
purchase dollars to keep local currencies down to foster their export sectors. The U.S.
economy and the dollar remain key generators of global growth and these factors help the
dollar maintain its value in the global market. The strength in the dollar since the Great
Recession has reduced profitability of some well-known U.S. multinationals with
significant overseas revenues such as IBM. Coca Cola‘s global sales exposes the
company to nearly 70 different foreign currencies, exposing the company to flat or
decreasing net quarter sales in countries with currencies weak compared to the strong
U.S. dollar. Nevertheless, the excess supply of dollars available in the global economy
could precipitate a drop in the currency. The dollar‘s drop can generate long term
inflation concerns and lead to higher commodity prices because most commodities are
priced in dollars regardless of where they are traded globally.
d. Derivative Security Markets
A derivative security is a contract which derives its value from some underlying
asset or market condition. In general, the main purpose of the derivatives markets is to
transfer risk between market participants. Some participants, called hedgers, enter
derivatives contracts to reduce their risk exposure in the underlying cash market. Other
participants, called speculators, use derivative contracts to bet on price movements.
Derivatives are highly leveraged instruments. Le allows hedgers to reduce risk and
speculators to attempt to earn high rates of return with low capital investments. The two
main types of derivatives markets are the market for exchange traded derivatives and the
over the counter (OTC) derivatives markets. Exchange traded derivatives are generally
liquid and involve no counterparty risk, whereas OTC contracts are custom contracts
negotiated between two counterparties and have default risk.
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Derivatives have been blamed for the financial crisis. Mortgage derivatives did
allow a larger amount of mortgage credit to be created and spread the risk of mortgages
to a broader base of investors. Subprime mortgage losses were large, reaching over $700
billion. The instructor may wish to ask students whether it makes sense to blame the
instrument or the users. Warren Buffett has called derivatives, ‗weapons of mass
destruction.‘ However, used properly they allow market participants to transfer risk to
other parties and allow others lower cost methods to gain exposure to markets. It does
seem reasonable to require greater transparency in OTC derivatives to ensure that players
can cover the promises they make. Derivatives that involve payments of principal, such
as credit default swaps, are now supposed to be traded on an exchange to ensure
performance and reasonable limits to speculation.
e. Financial Market Regulation
Financial markets are regulated by the SEC, the exchanges, the Commodity
Futures Trading Commission (CFTC) and the Financial Industry Regulatory Body
(FINRA) (FINRA resulted from a merger of the NASD and the NYSE regulatory arm in
1996 and supersedes both). FINFRA is a self-regulatory body that is subject to SEC
oversight. The primary purposes of regulations are to prevent fraud, to ensure
performance as promised, and to ensure that the public has enough information to
evaluate the riskiness of an investment. The regulators do not attempt to ensure investors
earn a minimum rate of return.
f. Overview of Financial Institutions
Many savers today are willing to risk some of their funds in the capital markets,
but not all. For at least some of their wealth, savers typically desire a different type of
claim than the ultimate borrower wishes to offer. Asset transformers, such as banks,
have evolved to meet this need by offering low risk claims to savers while granting
higher risk, more illiquid investments (e.g., loans) to the funds demanders. Other types of
institutions have evolved to meet special needs of savers such as life insurance firms to
eliminate certain risks, pension funds to transfer wealth through time, money market
mutual funds to pool investors‘ savings, etc.
Deposit-Type Institutions – Offer liquid, government insured claims to savers, such as
demand deposits, savings deposits, time deposits, and share accounts.
Commercial Banks – Make a variety of consumer and commercial loans (direct
claims) to borrowers.
Thrifts – Perform similar to commercial banks but tend to concentrate their loans in
one segment, such as real estate loans or consumer loans.
Savings and Loan Associations – Make mortgage loans (direct claim) to borrowers.
Mutual Savings Banks – Purchase various securities and make loans – mortgages,
consumer loans, government bonds, etc.
Credit Unions – Receive share account deposits and make consumer loans.
Membership requires a common bond, such as a church or labor union.
Non-depository institutions:
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Life Insurance Companies – Provide life insurance and long-term savings
opportunities for savers.
Casualty Insurance Companies – Provide auto, home insurance, purchase direct
financial securities with paid-in-advance premiums from insurance purchasers.
Pension Funds – issue claims to savers or provide investment plans that allow savers
to transfer wealth through time and to future generations.
Other Types of Financial Intermediaries:
Finance Companies – Borrow (issue liabilities) directly from banks and directly from
savers (commercial paper) and make/purchase riskier consumer and business loans.
Mutual Funds – Offer indirect mutual fund shares to savers and purchase direct
financial assets (e.g., stocks and bonds).
Money Market Mutual Funds – Offer (indirect) shares and purchase direct
(commercial paper) and indirect (bank CDs) money market financial assets.
Investment Bankers – Purchase securities from borrowers and repackage the payment
streams, creating new securities to sell to savers. Assist borrowers in selling direct
claims to savers.
E-brokers – E-brokers provide securities trading services over the Internet. Actually,
E-brokers are following one of four business models. A few, such as Schwab, seek to
be an online financial supermarket providing banking, insurance, portfolio
management and brokerage under one brand. Hybrids provide discount commissions
but provide some investment advice and research, some pure discount firms seek to
compete only on price and a few E-brokers are providing specialized services such as
access to special markets or extended credit.
FinTechs – Institutions that use technology to deliver financial solutions in a manner
that directly compete with traditional financing methods.
a. Unique Economic Functions Performed by Financial Institutions
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Relative to the choices available to many savers who invest directly in the
markets, FIs provide savers with very safe, liquid claims with fairly small denominations.
FIs then in turn lend money to funds demanders. The ultimate borrowers, say
corporations, issue risky claims (loans or bonds) held by FIs. The individual savers need
not investigate the riskiness of the corporate borrowers, the FI will do that. Consequently,
FIs allocate capital in an economy. FIs must then be able to accurately assess, price and
monitor risks of borrowers for an economy to achieve its potential growth rate. FIs must
also carefully manage their own risk since they are borrowing money from savers at low
risk and then investing the money in higher risk loans and securities in order to earn a
profit. By carefully evaluating the riskiness of potential investments and by diversifying
their loan and investment portfolios, lending institutions employ the law of large numbers
to reduce their risk exposure. The text argues that intermediaries failed in evaluating the
riskiness of mortgages and this failure resulted in the financial crisis. Actually, the causes
are more complex. Heavy government involvement in currency, mortgage and other
markets, lax regulation, failure of credit ratings agencies, political pressure to promote
affordable housing, failures of corporate governance and an extended period of very low
interest rates all contributed to the crisis. It is easy to blame it on ‗Wall Street‘ or
capitalism but these simplistic arguments don‘t hold up under scrutiny.
The instructor should note that both markets and institutions assess, price and
monitor risk. In some cases however, institutions can perform these functions better than
the markets. In this sense the institution is serving as a delegated monitor. For instance,
in situations where the borrower is reluctant to make information public or frequent
monitoring is needed or when special additional financing requirements may be
necessary, bank loans may be preferable to a public bond issue.
Financial institutions not only improve the quality and of information, but also act
as asset transforms, making investments more attractive to investors than claims directly
issued by corporations. Claims issued by financial institutions have liquidity attributes
that are superior to primary securities. The ability of the financial institutions to diversity
some of their investment risk allows them to provide liquidity services to fund suppliers.
Diversification enables financial institutions to predict more accurately the return and risk
on an investment portfolio allowing them to provide highly liquid claims with little price
risk.
The federal government insures deposits of certain intermediaries. Because of
deposit insurance, depositors do not require a risk premium to place money in an insured
institution. In effect, government insurance subsidizes risk taking at depository
institutions. The government insurance liability requires that insured depository
institutions be regulated to limit the government‘s liability and to limit imprudent risk
taking at these institutions.
b. Additional Benefits FIs Provide to Suppliers of Funds
Funds suppliers who place their money in a FI generally get the following benefits:
Reduced transaction costs due to economies of scale in information production1
1
Economies of scale (EOS) indicate that a firm‘s unit profits grow as it becomes larger. Fixed costs lead to
EOS.
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