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1 Role of Financial Markets and Institutions

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the types of financial markets that facilitate the flow of funds,

· ▪ describe the types of securities traded within financial markets,

· ▪ describe the role of financial institutions within financial markets, and

· ▪ explain how financial institutions were exposed to the credit crisis.

A financial market is a market in which financial assets (securities) such as stocks and bonds can be purchased or sold. Funds are transferred in financial markets when one party purchases financial assets previously held by another party. Financial markets facilitate the flow of funds and thereby allow financing and investing by households, firms, and government agencies. This chapter provides some background on financial markets and on the financial institutions that participate in them.

1-1 ROLE OF FINANCIAL MARKETS

Financial markets transfer funds from those who have excess funds to those who need funds. They enable college students to obtain student loans, families to obtain mortgages, businesses to finance their growth, and governments to finance many of their expenditures. Many households and businesses with excess funds are willing to supply funds to financial markets because they earn a return on their investment. If funds were not supplied, the financial markets would not be able to transfer funds to those who need them.

   Those participants who receive more money than they spend are referred to as surplus units (or investors). They provide their net savings to the financial markets. Those participants who spend more money than they receive are referred to as deficit units . They access funds from financial markets so that they can spend more money than they receive. Many individuals provide funds to financial markets in some periods and access funds in other periods.

EXAMPLE

College students are typically deficit units, as they often borrow from financial markets to support their education. After they obtain their degree, they earn more income than they spend and thus become surplus units by investing their excess funds. A few years later, they may become deficit units again by purchasing a home. At this stage, they may provide funds to and access funds from financial markets simultaneously. That is, they may periodically deposit savings in a financial institution while also borrowing a large amount of money from a financial institution to buy a home.

   Many deficit units such as firms and government agencies access funds from financial markets by issuing securities , which represent a claim on the issuer. Debt securities represent debt (also called credit, or borrowed funds) incurred by the issuer. Deficit units that issue the debt securities are borrowers. The surplus units that purchase debt securities are creditors, and they receive interest on a periodic basis (such as every six months). Debt securities have a maturity date, at which time the surplus units can redeem the securities in order to receive the principal (face value) from the deficit units that issued them.

    Equity securities (also called stocks) represent equity or ownership in the firm. Some large businesses prefer to issue equity securities rather than debt securities when they need funds but might not be financially capable of making the periodic interest payments required for debt securities.

1-1a Accommodating Corporate Finance Needs

A key role of financial markets is to accommodate corporate finance activity. Corporate finance (also called financial management) involves corporate decisions such as how much funding to obtain and what types of securities to issue when financing operations. The financial markets serve as the mechanism whereby corporations (acting as deficit units) can obtain funds from investors (acting as surplus units).

1-1b Accommodating Investment Needs

Another key role of financial markets is accommodating surplus units who want to invest in either debt or equity securities. Investment management involves decisions by investors regarding how to invest their funds. The financial markets offer investors access to a wide variety of investment opportunities, including securities issued by the U.S. Treasury and government agencies as well as securities issued by corporations.

   Financial institutions (discussed later in this chapter) serve as intermediaries within the financial markets. They channel funds from surplus units to deficit units. For example, they channel funds received from individuals to corporations. Thus they connect the investment management activity with the corporate finance activity, as shown in Exhibit 1.1 . They also commonly serve as investors and channel their own funds to corporations.

WEB

www.nyse.com

New York Stock Exchange market summary, quotes, financial statistics, and more.

www.nasdaq.com

Comprehensive historic and current data on all Nasdaq transactions.

1-1c Primary versus Secondary Markets

Primary markets facilitate the issuance of new securities. Secondary markets facilitate the trading of existing securities, which allows for a change in the ownership of the securities. Many types of debt securities have a secondary market, so that investors who initially purchased them in the primary market do not have to hold them until maturity. Primary market transactions provide funds to the initial issuer of securities; secondary market transactions do not.

EXAMPLE

Last year, Riverto Co. had excess funds and invested in newly issued Treasury debt securities with a 10-year maturity. This year, it will need $15 million to expand its operations. The company decided to sell its holdings of Treasury debt securities in the secondary market even though those securities will not mature for nine more years. It received $5 million from the sale. In also issued its own debt securities in the primary market today in order to obtain an additional $10 million. Riverto's debt securities have a 10-year maturity, so investors that purchase them can redeem them at maturity (in 10 years) or sell them before that time to other investors in the secondary market.

Exhibit 1.1 How Financial Markets Facilitate Corporate Finance and Investment Management

   An important characteristic of securities that are traded in secondary markets is liquidity , which is the degree to which securities can easily be liquidated (sold) without a loss of value. Some securities have an active secondary market, meaning that there are many willing buyers and sellers of the security at a given moment in time. Investors prefer liquid securities so that they can easily sell the securities whenever they want (without a loss in value). If a security is illiquid, investors may not be able to find a willing buyer for it in the secondary market and may have to sell the security at a large discount just to attract a buyer.

   Treasury securities are liquid because they are frequently issued by the Treasury, and there are many investors at any point in time who want to invest in them. Conversely, debt securities issued by a small firm may be illiquid, as there are not many investors who may want to invest in them. Thus investors who purchase these securities in the primary market may not be able to easily sell them in the secondary market.

1-2 SECURITIES TRADED IN FINANCIAL MARKETS

Securities can be classified as money market securities, capital market securities, or derivative securities.

1-2a Money Market Securities

Money markets facilitate the sale of short-term debt securities by deficit units to surplus units. The securities traded in this market are referred to as money market securities , which are debt securities that have a maturity of one year or less. These generally have a relatively high degree of liquidity, not only because of their short-term maturity but also because they are desirable to many investors and therefore commonly have an active secondary market. Money market securities tend to have a low expected return but also a low degree of credit (default) risk. Common types of money market securities include Treasury bills (issued by the U.S. Treasury), commercial paper (issued by corporations), and negotiable certificates of deposit (issued by depository institutions).

1-2b Capital Market Securities

Capital markets facilitate the sale of long-term securities by deficit units to surplus units. The securities traded in this market are referred to as capital market securities . Capital market securities are commonly issued to finance the purchase of capital assets, such as buildings, equipment, or machinery. Three common types of capital market securities are bonds, mortgages, and stocks, which are described in turn.

WEB

www.investinginbonds.com

Data and other information about bonds.

Bonds Bonds are long-term debt securities issued by the Treasury, government agencies, and corporations to finance their operations. They provide a return to investors in the form of interest income (coupon payments) every six months. Since bonds represent debt, they specify the amount and timing of interest and principal payments to investors who purchase them. At maturity, investors holding the debt securities are paid the principal. Bonds commonly have maturities of between 10 and 20 years.

   Treasury bonds are perceived to be free from default risk because they are issued by the U.S. Treasury. In contrast, bonds issued by corporations are subject to default risk because the issuer could default on its obligation to repay the debt. These bonds must offer a higher expected return than Treasury bonds in order to compensate investors for that default risk.

   Bonds can be sold in the secondary market if investors do not want to hold them until maturity. Because the prices of debt securities change over time, they may be worthless when sold in the secondary market than when they were purchased.

Mortgages Mortgages are long-term debt obligations created to finance the purchase of real estate. Residential mortgages are obtained by individuals and families to purchase homes. Financial institutions serve as lenders by providing residential mortgages in their role as a financial intermediary. They can pool deposits received from surplus units, and lend those funds to an individual who wants to purchase a home. Before granting mortgages, they assess the likelihood that the borrower will repay the loan based on certain criteria such as the borrower's income level relative to the value of the home. They offer prime mortgages to borrowers who qualify based on these criteria. The home serves as collateral in the event that the borrower is not able to make the mortgage payments.

   Subprime mortgages are offered to some borrowers who do not have sufficient income to qualify for prime mortgages or who are unable to make a down payment. Subprime mortgages exhibit a higher risk of default, thus the lenders providing these mortgages charge a higher interest rate (and additional up-front fees) to compensate. Subprime mortgages received much attention in 2008 because of their high default rates, which led to the credit crisis. Many lenders are no longer willing to provide subprime mortgages, and recent regulations (described later in this chapter) raise the minimum qualifications necessary to obtain a mortgage.

   Commercial mortgages are long-term debt obligations created to finance the purchase of commercial property. Real estate developers rely on commercial mortgages so they can build shopping centers, office buildings, or other facilities. Financial institutions serve as lenders by providing commercial mortgages. By channeling funds from surplus units (depositors) to real estate developers, they serve as a financial intermediary and facilitate the development of commercial real estate.

Mortgage-Backed Securities Mortgage-backed securities are debt obligations representing claims on a package of mortgages. There are many forms of mortgage-backed securities. In their simplest form, the investors who purchase these securities receive monthly payments that are made by the homeowners on the mortgages backing the securities.

EXAMPLE

Mountain Savings Bank originates 100 residential mortgages for home buyers and will service the mortgages by processing the monthly payments. However, the bank does not want to use its own funds to finance the mortgages. It issues mortgage-backed securities that represent this package of mortgages to eight financial institutions that are willing to purchase all of these securities. Each month, when Mountain Savings Bank receives interest and principal payments on the mortgages, it passes those payments on to the eight financial institutions that purchased the mortgage-backed securities and thereby provided the financing to the homeowners. If some of the homeowners default on their payments, the payments, and thus the return on investment earned by the financial institutions that purchased the mortgage-backed securities, will be reduced. The securities they purchased are backed (collateralized) by the mortgages.

   In many cases, the financial institution that originates the mortgage is not accustomed to the process of issuing mortgage-backed securities. If Mountain Savings Bank is unfamiliar with the process, another financial institution may participate by bundling Mountain's 100 mortgages with mortgages originated by other institutions. Then the financial institution issues mortgage-backed securities that represent all the mortgages in the bundle. Thus any investor that purchases these mortgage-backed securities is partially financing the 100 mortgages at Mountain Savings Bank and all the other mortgages in the bundle that are backing these securities.

   As housing prices increased in the 2004–2006 period, many financial institutions used their funds to purchase mortgage-backed securities, some of which represented bundles of subprime mortgages. These financial institutions incorrectly presumed that the homes would serve as sufficient collateral if the mortgages defaulted. In 2008, many subprime mortgages defaulted and home prices plummeted, which meant that the collateral was not adequate to cover the credit provided. Consequently, the values of mortgage-backed securities also plummeted, and the financial institutions holding these securities experienced major losses.

Stocks Stocks (or equity securities) represent partial ownership in the corporations that issue them. They are classified as capital market securities because they have no maturity and therefore serve as a long-term source of funds. Investors who purchase stocks (referred to as stockholders) issued by a corporation in the primary market can sell the stocks to other investors at any time in the secondary market. However, stocks of some corporations are more liquid than stocks of others. More than a million shares of stocks of large corporations are traded in the secondary market on any given day, as there are many investors who are willing to buy them. Stocks of small corporations are less liquid, because the secondary market is not as active.

   Some corporations provide income to their stockholders by distributing a portion of their quarterly earnings in the form of dividends. Other corporations retain and reinvest all of their earnings in their operations, which increase their growth potential.

   As corporations grow and increase in value, the value of their stock increases; investors can then earn a capital gain from selling the stock for a higher price than they paid for it. Thus, investors can earn a return from stocks in the form of periodic dividends (if there are any) and in the form a capital gain when they sell the stock. However, stocks are subject to risk because their future prices are uncertain. Their prices commonly decline when the firm performs poorly, resulting in negative returns to investors.

1-2c Derivative Securities

In addition to money market and capital market securities, derivative securities are also traded in financial markets. Derivative securities are financial contracts whose values are derived from the values of underlying assets (such as debt securities or equity securities). Many derivative securities enable investors to engage in speculation and risk management.

WEB

www.cboe.com

Information about derivative securities.

Speculation Derivative securities allow an investor to speculate on movements in the value of the underlying assets without having to purchase those assets. Some derivative securities allow investors to benefit from an increase in the value of the underlying assets, whereas others allow investors to benefit from a decrease in the assets' value. Investors who speculate in derivative contracts can achieve higher returns than if they had speculated in the underlying assets, but they are also exposed to higher risk.

Risk Management Derivative securities can be used in a manner that will generate gains if the value of the underlying assets declines. Consequently, financial institutions and other firms can use derivative securities to adjust the risk of their existing investments in securities. If a firm maintains investments in bonds, it can take specific positions in derivative securities that will generate gains if bond values decline. In this way, derivative securities can be used to reduce a firm's risk. The loss on the bonds is offset by the gains on these derivative securities.

1-2d Valuation of Securities

Each type of security generates a unique stream of expected cash flows to investors. The valuation of a security is measured as the present value of its expected cash flows, discounted at a rate that reflects the uncertainty surrounding the cash flows.

   Debt securities are easier to value because they promise to investors specific payments (interest and principal) until they mature. The stream of cash flows generated by stocks is more difficult to estimate because some stocks do not pay dividends, and so investors receive cash flow only when they sell the stock. All investors sell the stock at different times. Thus some investors choose to value a stock by valuing the company and then dividing that value by the number of shares of stock.

Impact of Information on Valuation Investors can attempt to estimate the future cash flows that they will receive by obtaining information that may influence a security's future cash flows. The valuation process is illustrated in Exhibit 1.2 .

   Some investors rely mostly on economic or industry information to value a security, whereas others rely more on published opinions about the firm's management. When investors receive new information about a security that clearly indicates the likelihood of higher cash flows or less uncertainty surrounding the cash flows, they revise their valuations of that security upward. As a result, investors increase the demand for the security. In addition, investors that previously purchased that security and were planning to sell the security in the secondary market may decide not to sell. This results in a smaller supply of that security for sale (by investors who had previously purchased it) in the secondary market. Thus the market price of the security rises to a new equilibrium level.