Foundations of Financial Markets and Institutions

1. Financial Markets & Institutions Bridge Savers and Borrowers, Managing Risk.

Financial assets have two principal economic functions.

Connecting capital. Financial markets and institutions serve as vital conduits, transferring funds from those with surplus capital (savers) to those who need it for investment in tangible assets (borrowers). This flow is essential for economic growth and resource allocation.

Risk redistribution. Beyond simple fund transfer, financial assets and intermediaries also redistribute the inherent risks associated with tangible asset cash flows among market participants. Intermediaries like banks and investment companies transform less desirable direct claims into more preferred indirect claims, offering benefits like:

• Maturity intermediation (matching short-term savings with long-term loans)
• Risk reduction through diversification
• Lower costs for information processing and contracting
• Providing payment mechanisms

Diverse players. The financial system involves a wide array of participants, including households, businesses, governments, and specialized financial institutions. These entities interact in markets to issue, buy, sell, and manage financial assets, facilitating the complex web of economic activity.

2. Depository Institutions and Central Banks Anchor the Monetary System.

A strong financial system is vitally important—not for Wall Street, not for bankers, but for working Americans.

Banking's core role. Depository institutions like commercial banks, savings and loans, and credit unions are central to the financial system, primarily by accepting deposits and making loans. They operate as "spread businesses," aiming to profit from the difference between the return on their assets (loans, securities) and the cost of their liabilities (deposits).

The Fed's influence. The U.S. Federal Reserve System acts as the central bank, managing the money supply and banking system. It influences the economy through monetary policy tools, including:

• Setting reserve requirements for banks
• Conducting open market operations (buying/selling government securities)
• Setting the discount rate for bank borrowing

Money creation. The fractional reserve banking system allows banks to create money through lending. The money multiplier effect means that changes in bank reserves, influenced by the Fed, can lead to larger changes in the overall money supply (M1, M2, etc.). The federal funds rate, the rate banks charge each other for overnight reserves, is a key operating target for the Fed.

3. Insurance and Investment Companies Pool Capital and Transform Risk.

Insurance companies provide (sell and service) insurance policies, which are legally binding contracts for which the policyholder (or owner) pays insurance premiums.

Risk bearing. Insurance companies specialize in bearing risk for a fee (the premium), promising to pay specified sums upon contingent future events (death, accident, etc.). They generate income from both underwriting (premiums) and investing the collected funds. Key types include:

• Life insurance (term, whole life, universal, variable)
• Property and casualty (auto, home)
• Health insurance (indemnity, managed care)
• Specialized lines (liability, disability, long-term care, monoline)

Fund management. Investment companies, commonly known as mutual funds, pool investor funds to buy diversified security portfolios. They offer investors:

• Diversification benefits at lower cost
• Professional portfolio management
• Liquidity (for open-end funds)
• Access to various investment objectives (stock, bond, money market, hybrid)

Evolving landscape. Both insurance and investment management industries are undergoing significant changes, driven by deregulation (like the Gramm-Leach-Bliley Act), globalization, and technological advancements. This includes the rise of asset management firms, hedge funds, exchange-traded funds (ETFs), and separately managed accounts (SMAs), blurring traditional lines between financial institutions and products.

4. Financial Assets Possess Distinct Properties Driving Their Value and Risk.

A basic economic principle is that the price of any financial asset is equal to the present value of its expected cash flow, even if the cash flow is not known with certainty.

Value from cash flow. The fundamental principle of financial asset pricing is that value equals the present value of all expected future cash flows, discounted at an appropriate rate. This rate reflects the required return, compensating investors for various risks.

Key properties. Financial assets differ based on properties influencing their appeal and value:

• Moneyness (usability as medium of exchange)
• Divisibility and denomination (minimum trading size)
• Reversibility (cost of buying and selling)
• Cash flow (timing and amount of payments)
• Term to maturity (life of the asset)
• Convertibility (right to exchange for another asset)
• Currency (denomination)
• Liquidity (ease of trading without price impact)
• Return predictability (risk/volatility)
• Complexity (presence of embedded options)
• Tax status (tax treatment of income/gains)

Risk components. The discount rate incorporates premiums for risks like inflation, default, maturity, liquidity, and exchange rate fluctuations. An asset's price sensitivity to interest rate changes is influenced by its maturity, coupon rate, and the prevailing yield level, often summarized by a measure called duration.

5. Interest Rates Reflect Time, Risk, and Inflation, Shaping the Term Structure.

In the presence of inflation, however, the nominal rate is different from, and must exceed, the real rate.

Price of money. Interest rates are the price paid for borrowing funds, reflecting the time value of money, risk, and expected inflation. Fisher's Law posits that the nominal rate equals the real rate plus expected inflation.

Rate determination theories. Different theories explain the level and structure of interest rates:

• Fisher's Theory: Interaction of savers' time preference and borrowers' capital productivity.
• Loanable Funds Theory: Supply and demand for funds by all economic agents.
• Liquidity Preference Theory (Keynes): Supply and demand for money balances.

Yield curve. The term structure of interest rates describes the relationship between yield and maturity for bonds of similar credit quality, typically depicted by the yield curve. Common shapes include upward-sloping (normal), downward-sloping (inverted), and flat.

Spot and forward rates. The theoretical spot rate curve represents yields on zero-coupon bonds, derived from coupon bond prices. Forward rates, extrapolated from the spot curve, represent the market's consensus or hedgeable rates for future interest rates, influencing investment and borrowing decisions. Theories like the Expectations Theory and Preferred Habitat Theory attempt to explain the yield curve's shape based on these factors and risk premiums.

6. Securities Trade in Primary Issuance and Liquid Secondary Markets.

The primary market involves the distribution to investors of newly issued securities by central governments, their agencies, municipal governments, and corporations.

New vs. old. Financial markets are divided into primary markets, where new securities are first sold by the issuer, and secondary markets, where existing securities are traded among investors. The issuer receives funds only in the primary market.

Underwriting process. In the primary market, investment bankers assist issuers by advising, buying (underwriting), and distributing securities. Underwriting involves risk for the investment bank, compensated by a gross spread. Arrangements include:

• Firm commitment (underwriter buys the issue)
• Best efforts (underwriter acts as agent)
• Variations like bought deals, auctions, and rights offerings

Secondary market function. Secondary markets are crucial for providing liquidity to investors and price discovery for issuers. They reduce search and transaction costs, encouraging participation in financial markets. Trading occurs in various locations:

• Organized exchanges (NYSE, Nasdaq)
• Over-the-counter (OTC) markets
• Alternative electronic markets

Market efficiency. Secondary markets strive for efficiency. Operational efficiency means low transaction costs. Pricing efficiency means prices fully reflect available information. Different forms (weak, semistrong, strong) describe the type of information impounded in prices, influencing investment strategy choices (active vs. passive).

7. Government and Municipal Bonds Offer Varying Credit and Tax Profiles.

Treasury securities are issued by the U.S. Department of the Treasury and are backed by the full faith and credit of the U.S. government.

Sovereign safety. U.S. Treasury securities are considered free of credit risk due to the government's backing, making them benchmark rates globally. They are issued via auction (bills, notes, bonds, TIPS) and trade in highly liquid primary and secondary markets.

Agency debt. Federal agency securities are issued by government-chartered entities (government-owned corporations like TVA, or GSEs like Fannie Mae, Freddie Mac, FHLBanks) to support specific sectors. Their debt is generally not fully government-guaranteed and trades at a yield spread over Treasuries due to credit and liquidity differences.

Municipal bonds. Municipal securities are issued by state and local governments and their authorities. Their key feature is often exemption from federal income tax, making them attractive to certain investors. Types include:

• Tax-backed debt (General Obligation bonds)
• Revenue bonds (backed by project revenue)
• Hybrid structures (insured, prerefunded, asset-backed)

Muni risks. Unlike Treasuries, municipal bonds carry credit risk, evaluated by rating agencies. They also face tax risk (changes in tax rates or tax status). The municipal market has its own primary (competitive bidding, negotiation) and secondary (OTC) markets.

8. Corporate Finance Utilizes Diverse Senior Instruments and Equity.

Corporate senior instruments are financial obligations of a corporation that have priority over its common stock in the case of bankruptcy.

Capital structure. Corporations raise funds through various instruments, including debt and equity. Senior instruments, like debt and preferred stock, rank higher than common stock in claims on assets and earnings during bankruptcy.

Corporate debt. Corporate bonds are long-term debt obligations with specified coupon payments and principal repayment. Security can be pledged property (mortgage bonds) or general credit (debentures). Bonds may have call or sinking fund provisions. Other debt instruments include:

• Commercial paper (short-term, unsecured)
• Medium-term notes (continuously offered, flexible maturities)
• Bank loans (syndicated, often floating-rate)
• Lease financing (transferring tax benefits)

Credit risk. Corporate debt carries credit risk (default, spread, downgrade), assessed by rating agencies (Moody's, S&P, Fitch) based on business, corporate governance, and financial risk. High-yield (junk) bonds are below investment grade, often with complex structures like deferred coupons.

Preferred stock. Preferred stock is equity but shares debt features (fixed dividends, seniority over common). Its tax treatment makes it attractive to corporate investors. Types
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Last updated: May 10, 2025