Download Financial Markets and Intermediaries: Functions, Types, and Regulation and more Study notes Economics in PDF only on Docsity! 1 Material for Lecture 2 & 3 Lecture 2 & 3 will use the following transparencies, plus Figure 1 and Tables 1 – 5 of Chapter 2 of the textbook. Overview of the Financial System 1. The Functions of the Financial System 2. Financial Markets 3. Financial Intermediaries 4. Regulation © 20 06 P ea rs on A dd is on -W es le y. A ll rig ht s re se rv ed 2- 2 Fu nc tio n of F in an ci al M ar ke ts 3 Bonds • Security: any claim on issuer’s future income or wealth • Bond: security that promises to make payments periodically for a specified period of time (up to maturity) • Sold at a per unit price Bonds • ‘Interest rate’ on bond is what can be earned by investing one dollar in bond; can be calculated from bond price • Failure to make promised payment may trigger bankruptcy • Many types of bond exist -> many interest rates - maturity (-> term structure) - bankruptcy risk -> bond ratings, “junk bonds” 4 Stocks • Share: security that represents a claim on the earnings and assets of a corporation • Sold at a per unit price • Often makes periodic payments (dividends); no maturity date Stocks • Equity holders are ‘residual claimants’ • Equity holders often have voting rights • Stock prices fluctuate substantially over time 5 The Money Market • Much more private money market instruments than public ones • Many money market instruments issued and held by intermediaries; households almost never directly participate in the money market • “Globalization” The Capital Market • Government is largest borrower in long term debt market • Households and intermediaries (pension funds, mutual funds) hold capital market instruments • Banks’ importance as lenders has declined, especially for lending to businesses 2- 8 Fi na nc ia l I nt er m ed ia rie s © 20 06 P ea rs on A dd is on -W es le y. A ll rig ht s re se rv ed 2- 9 Si ze o f F in an ci al In te rm ed ia rie s 8 Transactions Costs • Financial intermediaries make profits by reducing transactions costs • Reduce transactions costs by developing expertise and taking advantage of economies of scale Adverse Selection Example 1: The Used Car Market • Quality of car unknown before it is bought • Price will reflect average quality in pool • Sellers of bad cars get a good deal • Sellers of good cars get a bad deal • Some sellers of good cars might withdraw • ‘Adverse selection’ of cars remaining in the pool Solution: car dealer 11 Moral Hazard: The Stock Market • Firm ends up not getting funded, useful projects not undertaken One Solution: Bank • Owns many shares or provides loan • Therefore has power over manager, can prevent misuse So who should borrow from intermediaries ? • Borrowers about whom there is a lot of asymmetric information • Small, young firms, households © 20 06 P ea rs on A dd is on -W es le y. A ll rig ht s re se rv ed 2- 12 R eg ul at io n of F in an ci al M ar ke ts Tw o M ai n R ea so ns fo r R eg ul at io n 1. In cr ea se in fo rm at io n to in ve st or s A . D ec re as es a dv er se s el ec tio n an d m or al h az ar d pr ob le m s B . S E C fo rc es c or po ra tio ns to d is cl os e in fo rm at io n 2. En su rin g th e so un dn es s of fi na nc ia l in te rm ed ia rie s A . P re ve nt s fin an ci al p an ic s B . C ha rte rin g, re po rti ng re qu ire m en ts , r es tri ct io ns o n as se ts an d ac tiv iti es , d ep os it in su ra nc e, a nd a nt i-c om pe tit iv e m ea su re s 2- 10 R eg ul at or y A ge nc ie s
