CHAPTER 1
AN OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS
CHAPTER OBJECTIVES
1. This chapter introduces the basic elements of the financial system: financial claims, financial
markets, and financial institutions. These elements integrate in a conceptual model of the financial
system, shown in Exhibit 1-1. This chapter also develops basic vocabulary, which may not be prudently
neglected.
2. The chapter compares and contrasts the two basic kinds of financing relationships—direct
finance and financial intermediation—in the context of why financial needs exist, how financial claims
arise, and what choices for financial activity emerge in different types of institutions and markets.
3. The chapter compares and contrasts major types of financial institutions and financial
markets. These mechanisms—institutions and markets—afford participants more liquidity and
diversification. Thus more funds flow to the most productive uses, competition among financial
institutions lowers costs, and widespread market participation links prices more closely to information, all
of which promote market efficiency. A vigorous financial system promotes economic growth and
prosperity by maximizing rational opportunities for investment.
CHANGES FROM THE LAST EDITION
1. Chapter sections are numbered in this edition.
2. Chapter opener has been revised.
3. Tables, exhibits, and data have been updated. Exhibit 1.6 is new to this edition.
4. The set of learning objectives has been revised.
5. “Do You Understand?” questions: (1) in the first set, old Q.4 has been deleted and remaining
questions revised, (2) two sets of DYU questions have been deleted and three added. There are
now five sets of DYU questions in the chapter.
6. End-of-chapter questions: old Q.8 has been deleted and 11 new questions added (Qs. 8, 11-20).
7. Changes to Section 1.1, “The Financial System”:
, - The subsection “A Preview of the Financial System” has been added;
- The subsection “Economic Units” has been eliminated; economic units are now discussed in the
next subsection, “Budget Positions”, which has been shortened.
- The subsection “Financial Claims” has been shortened.
8. The sections “Moving Funds from SSUs to DSUs” and “Benefits of Financial Intermediation”
have been eliminated. In their place are Section 1.2, “Financial Markets and Direct Financing”,
and Section 1.6, “Financial Institutions and Indirect Financing”, that discuss the same material
and more. E.g., Section 1.6 discusses asymmetric information, which gives rise to adverse
selection and moral hazard issues.
9. The order of sections has been changed: Section 1.2, “Financial Markets and Direct Financing”,
is now followed by the sections related to financial markets (“Types of Financial Markets”,
“Money Markets”, and “Capital Markets”), and Section 1.6, “Financial Institutions and Indirect
Financing”, is followed by the sections discussing types of intermediaries and risks they face.
10. Section 1.3, “Types of Financial Markets”, has a new subsection on public and private markets.
11. Section 1.7, “Types of Financial Intermediaries”, has an expanded discussion of money market
mutual funds (MMMFs).
12. The section “Financial Market Efficiency” has been deleted.
13. Section 1.9, “Regulation of the Financial System”, has been added. It covers regulation related to
both consumer protection and stabilizing the financial system, as well as provides the highlights
of the Restoring American Financial Stability Act of 2010.
14. The feature previously called “Chapter Take-aways” is now called “Summary of Learning
Objectives”. The learning objectives from the beginning of each chapter are copied and followed
by a short summary of the chapter material related to each objective. This has been done for every
chapter.
CHAPTER KEY POINTS
1. The financial system brings savers and borrowers together. Stress these key concepts: SSUs and
DSUs, financial claims, direct finance versus financial intermediation, financial institutions,
transformation of claims, and types of financial markets. Remind students of financial intermediation in
their own lives—checking accounts, insurance, student loans, etc.
2. Direct finance works if preferences of SSUs and DSUs match as to amount, maturity, and risk.
Financial intermediaries transform claims to reduce the recurring problem of unmatched preferences:
Denomination Divisibility. DSUs prefer to borrow the full funding need all at once. SSUs tend
, to save small amounts periodically. Intermediaries pool small savings into large investments.
Currency Transformation. Intermediaries can buy claims denominated in one currency while
issuing claims denominated in another. This would be difficult for most ordinary SSUs.
Maturity Flexibility. DSUs generally prefer longer-term financing. SSUs generally prefer
shorter-term investments. Intermediaries can offer different ranges of maturities to both.
Credit Risk Diversification. Intermediaries manage risk by evaluating and holding many
different securities. SSUs on their own would have to leave “more eggs in one basket.”
Liquidity. Many claims issued by intermediaries are highly liquid because intermediaries
substitute their own liquidity for that of DSUs.
3. Financial institutions are classifiable by their origins, purposes, and major characteristics:
Depository Institutions
Commercial banks
Thrifts (savings and loan associations; mutual savings banks)
Credit unions
Contractual Institutions
Insurance companies (life and casualty)
Private pension funds
State and local government pension funds
Investment Funds
Mutual Funds
Money Market Mutual Funds
, Other Institutions
Finance companies
Federal agencies
4. Financial markets are classifiable in a number of concurrent ways:
Primary or Secondary
Public or Private
Exchanges or OTC
Spot, Futures, or Option
Foreign Exchange
International or Domestic
Money or Capital
The respective contributions of money markets and capital markets to the economy are important themes.
Representative lists of money and capital market instruments foreshadow chapters covered later in the
text.
5. Financial intermediaries are major “information producers” in financial markets. The need for
information arises because of asymmetric information – sellers or borrowers in financial transactions
usually have more information than buyers or lenders. Asymmetric information is expressed in two ways:
adverse selection, which occurs before a financial transaction takes place, and moral hazard, which occurs
after the transaction.
6. Risks faced by financial institutions are:
Credit risk
Interest rate risk
Liquidity risk
Foreign exchange risk
AN OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS
CHAPTER OBJECTIVES
1. This chapter introduces the basic elements of the financial system: financial claims, financial
markets, and financial institutions. These elements integrate in a conceptual model of the financial
system, shown in Exhibit 1-1. This chapter also develops basic vocabulary, which may not be prudently
neglected.
2. The chapter compares and contrasts the two basic kinds of financing relationships—direct
finance and financial intermediation—in the context of why financial needs exist, how financial claims
arise, and what choices for financial activity emerge in different types of institutions and markets.
3. The chapter compares and contrasts major types of financial institutions and financial
markets. These mechanisms—institutions and markets—afford participants more liquidity and
diversification. Thus more funds flow to the most productive uses, competition among financial
institutions lowers costs, and widespread market participation links prices more closely to information, all
of which promote market efficiency. A vigorous financial system promotes economic growth and
prosperity by maximizing rational opportunities for investment.
CHANGES FROM THE LAST EDITION
1. Chapter sections are numbered in this edition.
2. Chapter opener has been revised.
3. Tables, exhibits, and data have been updated. Exhibit 1.6 is new to this edition.
4. The set of learning objectives has been revised.
5. “Do You Understand?” questions: (1) in the first set, old Q.4 has been deleted and remaining
questions revised, (2) two sets of DYU questions have been deleted and three added. There are
now five sets of DYU questions in the chapter.
6. End-of-chapter questions: old Q.8 has been deleted and 11 new questions added (Qs. 8, 11-20).
7. Changes to Section 1.1, “The Financial System”:
, - The subsection “A Preview of the Financial System” has been added;
- The subsection “Economic Units” has been eliminated; economic units are now discussed in the
next subsection, “Budget Positions”, which has been shortened.
- The subsection “Financial Claims” has been shortened.
8. The sections “Moving Funds from SSUs to DSUs” and “Benefits of Financial Intermediation”
have been eliminated. In their place are Section 1.2, “Financial Markets and Direct Financing”,
and Section 1.6, “Financial Institutions and Indirect Financing”, that discuss the same material
and more. E.g., Section 1.6 discusses asymmetric information, which gives rise to adverse
selection and moral hazard issues.
9. The order of sections has been changed: Section 1.2, “Financial Markets and Direct Financing”,
is now followed by the sections related to financial markets (“Types of Financial Markets”,
“Money Markets”, and “Capital Markets”), and Section 1.6, “Financial Institutions and Indirect
Financing”, is followed by the sections discussing types of intermediaries and risks they face.
10. Section 1.3, “Types of Financial Markets”, has a new subsection on public and private markets.
11. Section 1.7, “Types of Financial Intermediaries”, has an expanded discussion of money market
mutual funds (MMMFs).
12. The section “Financial Market Efficiency” has been deleted.
13. Section 1.9, “Regulation of the Financial System”, has been added. It covers regulation related to
both consumer protection and stabilizing the financial system, as well as provides the highlights
of the Restoring American Financial Stability Act of 2010.
14. The feature previously called “Chapter Take-aways” is now called “Summary of Learning
Objectives”. The learning objectives from the beginning of each chapter are copied and followed
by a short summary of the chapter material related to each objective. This has been done for every
chapter.
CHAPTER KEY POINTS
1. The financial system brings savers and borrowers together. Stress these key concepts: SSUs and
DSUs, financial claims, direct finance versus financial intermediation, financial institutions,
transformation of claims, and types of financial markets. Remind students of financial intermediation in
their own lives—checking accounts, insurance, student loans, etc.
2. Direct finance works if preferences of SSUs and DSUs match as to amount, maturity, and risk.
Financial intermediaries transform claims to reduce the recurring problem of unmatched preferences:
Denomination Divisibility. DSUs prefer to borrow the full funding need all at once. SSUs tend
, to save small amounts periodically. Intermediaries pool small savings into large investments.
Currency Transformation. Intermediaries can buy claims denominated in one currency while
issuing claims denominated in another. This would be difficult for most ordinary SSUs.
Maturity Flexibility. DSUs generally prefer longer-term financing. SSUs generally prefer
shorter-term investments. Intermediaries can offer different ranges of maturities to both.
Credit Risk Diversification. Intermediaries manage risk by evaluating and holding many
different securities. SSUs on their own would have to leave “more eggs in one basket.”
Liquidity. Many claims issued by intermediaries are highly liquid because intermediaries
substitute their own liquidity for that of DSUs.
3. Financial institutions are classifiable by their origins, purposes, and major characteristics:
Depository Institutions
Commercial banks
Thrifts (savings and loan associations; mutual savings banks)
Credit unions
Contractual Institutions
Insurance companies (life and casualty)
Private pension funds
State and local government pension funds
Investment Funds
Mutual Funds
Money Market Mutual Funds
, Other Institutions
Finance companies
Federal agencies
4. Financial markets are classifiable in a number of concurrent ways:
Primary or Secondary
Public or Private
Exchanges or OTC
Spot, Futures, or Option
Foreign Exchange
International or Domestic
Money or Capital
The respective contributions of money markets and capital markets to the economy are important themes.
Representative lists of money and capital market instruments foreshadow chapters covered later in the
text.
5. Financial intermediaries are major “information producers” in financial markets. The need for
information arises because of asymmetric information – sellers or borrowers in financial transactions
usually have more information than buyers or lenders. Asymmetric information is expressed in two ways:
adverse selection, which occurs before a financial transaction takes place, and moral hazard, which occurs
after the transaction.
6. Risks faced by financial institutions are:
Credit risk
Interest rate risk
Liquidity risk
Foreign exchange risk
