The Economics of Money, Banking, and Financial Markets, Twelfth Edition

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• This chapter presents an overview of the study of financial

markets and institutions

.

Function of Financial

Markets

(2

of

2)

• Promotes economic efficiency by producing an efficient

allocation of

capital

, which increases production

• Directly improve the well

-being of consumers by allowing

them to time purchases better

Figure 1 Flows of Funds Through the

Financial System

Structure of Financial

Markets

(1 of

2)

• Debt and Equity Markets

– Debt instruments (

maturity

)

–

Equities

(

dividends

)

• Primary and Secondary Markets

–

Investment banks

underwrite

securities in

primary

markets

.

–

Brokers

and

dealers

work in

secondary markets

.

Structure of Financial

Markets

(2

of 2)

• Exchanges and Over

-the-

Counter (OTC) Markets:

–

Exchanges

: NYSE, Chicago Board of Trade

–

OTC markets

: Foreign exchange, Federal funds

• Money and Capital Markets:

–

Money markets

deal in short

-term debt instruments

–

Capital markets

deal in longer

-term debt and

equity

instruments

Financial Market

Instruments

(1 of 2)

Table 1

Principal Money Market Instruments

Amount ($ billions, end of year)

Type of Instrument

1990

2000

2010

2016

U.S. Treasury bills

527

647

1,767

1,816

Negotiable bank certificates of deposit

(large denominations)

547

1,053

1,923

1,727

Commercial paper

558

1,602

1,058

885

Federal funds and security repurchase

agreements

372

1,197

3,598

3,778

Source: Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov

Financial Market

Instruments

(2

of 2)

Table 2

Principal Capital Market Instruments

Amount ($ billions, end of year)

Type of Instrument

1990

2000

2010

2016

Corporate stocks (market value)

3,530

17,628

23,567

38,685

Residential mortgages

2,676

5,205

10,446

10,283

Corporate bonds

1,703

4,991

10,337

12,008

U.S. government securities (marketable

long-term)

2,340

3,171

7,405

12,064

U.S. government agency securities

1,446

4,345

7,598

8,531

State and local government bonds

957

1,139

2,961

3,030

Bank commercial loans

818

1,497

2,001

3,360

Consumer loans

811

1,728

2,647

3,765

Commercial and farm mortgages

838

1,276

2,450

2,850

Source:

Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov

Internationalization of Financial Markets

•

Foreign Bonds

: sold in a foreign country and denominated in

that

country

’

s currency

•

Eurobond

: bond denominated in a currency other than that of

the country in which it is sold

•

Eurocurrencies

: foreign currencies deposited in banks outside

the home country

–

Eurodollars

: U.S. dollars deposited in foreign banks outside

the

United States or in foreign branches of

U.S.

banks

•

World Stock Markets

:

– help finance corporations in the United States and the U.S.

federal

government

Function of Financial Intermediaries:

Indirect

Finance

(1 of

3)

• Lower transaction costs (time and money spent in carrying

out financial transactions)

– Economies of scale

– Liquidity services

• Reduce the exposure of investors to risk

– Risk

sharing (asset transformation)

– Diversification

Function of Financial Intermediaries:

Indirect

Finance

(2

of 3)

• Deal with asymmetric information problems:

–

Adverse Selection

(before the transaction): try to

avoid selecting the risky borrower by gathering

information about them

–

Moral Hazard

(after the transaction): ensure borrower

will not engage in activities that will prevent him/her to

repay the loan.



Sign a contract with restrictive covenants

.