Transcript FINANCIAL MARKETS AND INSTITIUTIONS: A Modern Perspective

Chapter One
The Investment Envirenment
The presentation has been amended/updated by Dr. Mounira Ben Arab
1.1 REAL ASSETS VERSUS
FINANCIAL ASSETS
• Real Assets
– the land, buildings, knowledge, and machines
Together, physical and “human” assets generate the entire spectrum
of output produced and consumed by the society
• Financial Assets
– Stocks or bonds
are no more than sheets of paper or more likely, computer entries,
and do not directly contribute to the productive capacity of the
economy. Instead, financial assets contribute to the productive
capacity of the economy indirectly
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• Real Assets and financial Assets are distinguished
- operationally by the balance sheets of individuals and firms in the
economy: Whereas real assets appear only on the asset side of the
balance sheet, financial assets always appear on both sides of
balance sheets.
- financial assets are created and destroyed in the ordinary course of
doing business. For example, when a loan is paid off, both the
creditor’s claim (a financial asset) and the debtor’s obligation (a
financial liability) cease to exist. In contrast, real assets are
destroyed only by accident or by wearing out over time.
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1.2 FINANCIAL MARKETS AND
THE ECONOMY
• Real assets determine the wealth of an economy,
whereas financial assets merely represent claims on
real assets.
Financial assets allow us to make the most of the
economy’s real assets.
• Consumption Timing : How can you shift your purchasing
power from high-earnings periods to low-earnings periods of life?
– In high-earnings periods, you can invest your savings in financial
assets such as stocks and bonds.
– In low-earnings periods, you can sell these assets to provide
funds for your consumption needs.
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• Allocation of Risk
Financial markets and the diverse financial
instruments traded in those markets allow investors
with the greatest taste for risk to bear that risk.
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the more optimistic, or risk-tolerant, investors buy shares of stock
the more conservative individuals can buy bonds, which promise
to provide a fixed payment.
• Separation of Ownership and Management :
– Many businesses are owned and managed by the same individual.
– with global markets and large-scale production, the size and
capital requirements of firms have skyrocketed. General Electric
actually has about one-half million stockholders,. Such a large
group of individuals obviously cannot actively participate in the
day-to-day management of the firm. Instead, they elect a board of
directors, which in turn hires and supervises the management of
the firm.
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1.3 CLIENTS OF THE FINANCIAL
SYSTEM
• The Household Sector: are potentially interested in a
wide array of assets. Assets that are attractive can vary
considerably depending on the household’s economic
situation.
• - Taxes lead to varying asset demands because people in different tax
brackets “transform” before-tax income to after-tax income at
different rates
• - Risk considerations also create demand for a diverse set of
investment alternatives
• The Business Sector: businesses typically need to raise
money to finance their investments in real assets
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• The Government Sector
- Like businesses, governments often need to finance
their expenditures by borrowing.
- Unlike businesses, governments cannot sell equity
shares; they are restricted to borrowing to raise funds
when tax revenues are not sufficient to cover
expenditures.
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1.4 THE ENVIRONMENT RESPONDS
TO CLIENTELE DEMANDS
• Financial Intermediation
Evolve to bring the two sectors together (demanders
and suppliers)
For example, a bank raises funds by borrowing and
lending that money to other borrowers. In this way,
lenders and borrowers do not need to contact each
other directly. Instead,
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• All the intermediaries , banks, insurance, investment
companies, credit unions ,… offer similar advantages
- First, by pooling the resources of many small
investors, they are able to lend considerable sums to
large borrowers.
- Second, by lending to many borrowers, intermediaries
achieve significant diversification,
- Third, intermediaries build expertise through the
volume of business they do.
- Economy of scale related to the expense of collecting
information
• Investment companies and mutual funds arise out the “smallness
problem.”
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• Investment Banking
- Because they are constantly in the market, Investment
bankers can provide more than just expertise to
security issuers
- Exemple, Merrill Lynch, Salomon Smith Barney, or
Goldman, Sachs advise the issuing firm on the prices
it can charge for the securities issued, market
conditions, appropriate interest rates, and so forth.
• Financial Innovation and Derivatives
- The mortgage-backed securities such as :
• mortgage pass-through securities (first introduced by the
Government National Mortgage Association
• the collateralized mortgage obligation, or CMO.
- Derivatives have become an integral part of the investment
environment.
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1.5 MARKETS AND MARKET
STRUCTURE
• Direct search markets,
• Brokered markets,
• Dealer markets
• Auction markets.
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1.6 ONGOING TRENDS
• Globalization,
• Securitization,
• Financial Engineering
• Computer Networks.
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Globalization of Financial Markets and
Institutions
Reasons of Growth in Foreign Financial Market
1. The pool of savings from foreign investors (i.e from EU) is
increasing and investors look to diversify globally now more than
ever before
2. Information on foreign markets and investments is becoming
readily accessible and deregulation across the globe is allowing
even greater access
3. International mutual funds allow diversified foreign investment with
low transactions costs
4. Euro is also having a notable impact on the global financial sytem.
5. Global capital flows are larger than ever mainly due to deregulation
in many foreign countries.
McGraw-Hill/Irwin
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Globalization of Financial Markets and
Institutions
While US financial
markets dominate
world markets, the
growth of US financial
markets depends more
and more on the
growth and
development of other
economies.
The success of other
economies depends to a
significant extent on
their financial market
development
Globalization of Financial Markets and
Institutions
• The Largest Banks in the World
• Competition is also increased due to global markets.
McGraw-Hill/Irwin
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Secondary Mortgage Market
Mortgage Sales
• Mortgage sellers: money center banks, smaller banks,
foreign banks, investment banks
• Mortgage sales allow FIs to manage credit risk, achieve
better asset diversification, and improve their liquidity and
interest rate risk positions
• FIs are encouraged to sell loans for economic and
regulatory reasons
– sold mortgages can still generate fee income for the bank
– sold mortgages reduce the cost of reserve and capital requirements
• Mortgage buyers: foreign and domestic banks, insurance
companies, pension funds, closed-end bank loan mutual
funds, and nonfinancial corporations
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Secondary Mortgage Market
Mortgage Backed Securities
• There are 3 different major types of mortgage backed securities.
Pass through and CMOs are securitized mortgages
• Three agencies are directly involved in the creation of pass-through
securities
• Fanniemae and Freddiemac is a stockholder owned corporation with a
line of credit from the US Treasury. Its bonds are rated AAA.
• Pass-through securities “pass through” promised principal and
interest payments to investors
• Private mortgage pass-through issuers create pass-throughs from
nonconforming mortgages
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Mortgage Backed Securities
• Collateralized mortgage obligations (CMOs) are
multiclass pass-throughs with multiple bond holder classes
or tranches
– Unlike a pass through each bond holder class has a different
guaranteed coupon
– mortgage prepayments retire only one tranche at a time, so all
other trances are sequentially prepayment protected
• Mortgage backed bonds (MBBs)
– MBBs allow FIs to raise long-term low-cost funds without
removing mortgages from their balance sheets
– The cash flow on the mortgages backing the bond are not
necessarily directly connected to interest and principal payments
on the MBB.
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WEBSITES
http://www.financewise.com
This is a finance search engine for other financial sites.
http://www.federalreserve.gov/otherfrb.htm
This site contains a map that allows you to access all of the Federal
Reserve Bank sites.
http://www.cob.ohio-state.edu/fin/journal/jofsites.htm
This site contains a directory of finance journals and associations
related to education in the financial area.
http://finance.yahoo.com
This investment site contains information on financial markets.
Portfolios can be constructed and monitored at no charge. Limited
historical return data is available for actively traded securities.
http://moneycentral.msn.com/home.asp
Similar to Yahoo! finance, this investment site contains very complete
information on financial markets.
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End of Chapter 1
Thanks
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