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Practice of Financial Markets
Week 1
financial intermediaries
 Institutions that reduce the costs of moving funds between savers and borrowers ->
banks, bond markets, stock markets
 Why do we need them?
o Individuals and businesses need to borrow and safe in different periods of
their lives.
o Individuals rely on borrowing to invest in education, housing, retirement etc
o Businesses also rely on credit to operate and grow, to get business ideas
starting.


College 1 overview of financial
markets and institutions
Importance of financial markets
 If there are no financial markets you can earn no return on your savings, could put it
just as easily under your matrass
 However, if a carpenter could use your money to increase productivity, the she’d be
willing to pay some interest.
 Financial markets are critical for producing an efficient allocation of capital, allowing
funds to move from people who lack productive investment opportunities to people
who have them.
 Financial markets also improve the well-being of consumers allowing them to time
their purchases better.

Function of financial markets
 Channels funds from person or business without investment opportunities to one
who has them.

Structure of financial markets
1. Debt markets
a. Short term (maturity < 1 year)
b. Long term (maturity > 10 years)
c. Intermediate term (maturity in between)
2. Equity models
a. Pay dividends in theory forever
b. Represents an ownership claim in firm
1. Primary markets
a. New security issues sold to initial buyers
b. Typically involves an investment bank who underwrites the offering
2. Secondary market

, a. Securities previously issued and bought are sold
b. Examples include NYSE and NASDAQ
c. Includes both brokers and dealers
d. Important for the primary market
1. Exchanges
a. Trades conducted in central locations (NY Stock Exchange, BOT)
2. Over-the-counter markets
a. Dealers at different locations buy and sell
b. Best example is market for treasury securities
 Differences become smaller over time
Classify markets by maturity of securities
1. Money market: short term < 1 year
2. Capital market: long term > 1 year + equities

Internalization of financial markets
The internalization of markets is an important trend. The U.S. does not longer dominate the
world stage.
-international bond markets & Eurobonds
*foreign bonds
-denominated in a foreign market
-targeted at a foreign market
*Eurobonds
-denominated in one currency, but sold in a different market
-now larger than the U.S. corporate bond market
-all the different debts of EU countries in 1 big pile, and over this big
debt is the Eurobond issued.
-Eurocurrency market
-foreign currency deposited outside of home country
-Eurodollars are U.S. dollars deposited in, say, London.
-Gives U.S. borrowers an alternative source of dollars

,Direct vs indirect finance
1. Direct finance
a. Borrowers borrow directly from lenders in financial markets by selling
financial instruments which one claims on the borrower’s future income or
assets.
2. Indirect finance
a. Borrowers borrow indirectly from lenders via Financial intermediars by issued
financial instruments which one claims on the borrowers’ future assets or
income.




Indirect finance
- the intermediary obtains funds from savers
- the intermediary then makes loans/investments with borrowers
- this process (financial intermediation) is the primary means of moving funds from
lenders to borrowers
- more important source of finance than securities markets (such as stocks)
- needed because of transaction costs, risk sharing and asymmetric information




transaction costs

,  a financial intermediary’s’ low transaction costs (because of economies of scale by
for example applying same contract multiple times) means that it can provide its
customers with liquidity services, services that make it easier for customers to
conduct transactions.
o Banks provide depositors with checking accounts that enable them to pay
their bills easily
o Depositors can earn interest on checking and savings account and yet still
convert them into goods and services when necessary
 Another benefit made possible by the low transaction costs is that they can help
reduce the exposure of investors to risk. Through a process known as risk sharing.
o FI’s create and sell assets with lesser risk to one party in order to buy assets
with greater risk from another party (pool assets -> diversification)
o This process is referred to as asset transformation because in a sense, risky
assets are turned into safer assets for investors. Also transforms magnitude &
o maturity.

Asymmetric information: adverse selection & moral hazard
 adverse selection
o before transaction occurs
o potential borrowers most likely to produce adverse outcome are ones most
likely to seek a loan.
o Similar problem occurs with insurance, where unhealthy people want their
known medical problems covered.
 moral hazard
 transaction costs: intermediaries can obtain economies of scale by applying same
contract several times
o after transaction occurs
o hazard that borrower has incentives that engage in undesirable (immoral)
activities, making it more likely that they won’t pay the loan back.
o Again with insurance people may engage in risky activities, only after being
insured.