In this chapter you will learn to:

• Compare and contrast direct and indirect finance.

• Identify the structure and components of financial
markets.
• List and describe the different types of financial
market instruments.
• List and describe the different types of financial
intermediaries.
• Identify the reasons for and list the types of
financial market regulations.
1. Financial Market
2. Financial Market Instruments
3. Financial Intermediaries
4. Regulation of the Financial System
Financial markets perform the essential economic
function of channeling funds from households,
firms, and governments that have saved surplus
funds by spending less than their income to those
that have a shortage of funds because they wish
to spend more than their income.
In direct finance, borrowers borrow funds directly
from lenders in financial markets by selling the
lenders securities (also called financial
instruments), which are claims on the borrower’s
future income or assets.
Securities are assets for the person who buys
them but liabilities (IOUs or debts) for the
individual or firm that sells (issues) them.
 Why is this channeling of funds
from savers to spenders so
important to the economy?

• Suppose that you have saved $1,000 this year,

but no borrowing or lending is possible
because no financial markets are available.

• If you do not have an investment opportunity

that will permit you to earn income with your
savings, you will just hold on to the $1,000 and
it will earn no interest.
• However, Carl the Carpenter has a productive
use for your $1,000: He can use it to purchase
a new tool that will shorten the time it takes
him to build a house, thereby earning an extra
$200 per year.

• If you could get in touch with Carl, you could

lend him the $1,000 at a rental fee (interest) of
$100 per year, and both of you would be better
off.

• You would earn $100 per year on your $1,000,

instead of the zero amount that you would
earn.

• Carl would earn $100 more income per year

(the $200 extra earnings per year minus the
$100 rental fee for the use of the funds).
Financial markets have such an important
function in the economy:
+ They allow funds to move from people
who lack productive investment opportunities to
people who have such opportunities.
+ Well-functioning financial markets also
directly improve the well-being of consumers by
allowing them to time their purchases better.
The most common method is through the
issuance of a debt instrument, such as a bond
or a mortgage, which is a contractual agreement
by the borrower to pay the holder of the
instrument fixed dollar amounts at regular
intervals (interest and principal payments) until
a specified date (the maturity date), when a final
payment is made.
The maturity of a debt instrument is the number
of years (term) until that instrument’s expiration
date.
- A debt instrument is short-term if its maturity
term is less than a year.
- A debt instrument is long-term if its maturity
term is ten years or longer.
- Debt instruments with a maturity term
between one and ten years are said to be
intermediate term.

The second method of raising funds is through

the issuance of equities, such as common stock,
which are claims to share in the net income
(income after expenses and taxes) and the
assets of a business.
If you own one share of common stock in a
company that has issued one million shares,
you are entitled to 1 one-millionth of the firm’s
net income and 1 one-millionth of the firm’s
assets.
Equities often make periodic payments (dividends)
to their holders and are considered long-term
securities because they have no maturity date.
Owning stock means that you own a portion of the
firm and thus have the right to vote on issues
important to the firm and to elect its directors.
Equity holders benefit directly from any increases
in the corporation’s profitability or asset value
because equities confer ownership rights on the
equity holders.

The main disadvantage of owning a corporation’s

equities rather than its debt is that an equity holder
is a residual claimant.
• A primary market is a financial market in which
new issues of a security, such as a bond or a
stock, are sold to initial buyers by the corporation
or government agency borrowing the funds.

• An important financial institution that assists in the

initial sale of securities in the primary market is the
investment bank. The investment bank does this
by underwriting securities: It guarantees a price for
a corporation’s securities and then sells them to
the public.
• The New York Stock Exchange (NYSE) and
National Association of Securities Dealers
Automated Quotation System (NASDAQ) are the
best-known examples of secondary markets.

• Other examples of secondary markets are foreign

exchange markets, futures markets, and options
markets.
• Securities brokers and dealers are crucial to a
well functioning secondary market.
– Brokers are agents of investors who match
buyers with sellers of securities.
– Dealers link buyers and sellers by buying and
selling securities at stated prices.

• When an individual buys a security in the

secondary market, the person who has sold
the security receives money in exchange for
the security, but the corporation that issued the
security acquires no new funds.
• A corporation acquires new funds only when its
securities are first sold in the primary market.
• Secondary markets serve two important functions:
- First, they make it easier and quicker to sell these
financial instruments to raise cash; that is, they
make the financial instruments more liquid.
- Second, secondary markets determine the price
of the security that the issuing firm sells in the
primary market. The investors who buy securities
in the primary market will pay the issuing
corporation no more than the price they think the
secondary market will set for this security.
• Exchanges markets, where buyers and sellers of
securities (or their agents or brokers) meet in one
central location to conduct trades.
• The New York Stock Exchange (NYSE) for stocks
and the Chicago Board of Trade for commodities
(wheat, corn, silver, and other raw materials) are
examples of organized exchanges.
• Over-the-counter (OTC) market, where dealers at
different locations who have an inventory of
securities stand ready to buy and sell securities
“over the counter” to anyone who comes to them
and is willing to accept their prices.
• The OTC market is very competitive and not very
different from a market with an organized
exchange.

• Other OTC markets include those that trade

other types of financial instruments, such as
negotiable certificates of deposit, derivatives,
and foreign exchange instruments.
• The money market is a financial market in
which only short-term debt instruments
(generally those with original maturity terms of
less than one year) are traded.
• Money market securities are usually more
widely traded than longer-term securities and
so tend to be more liquid.
• Treasury Bills:
- Short-term debt instruments issued in one-month,
three-month, and six-month maturities to finance
the government.
- The most liquid of all money market instruments
because they are the most actively traded.
- The safest money market instrument.
- Held mainly by banks, although small amounts
are held by households, corporations, and other
financial intermediaries.

• Commercial Paper:
Is a short-term debt instrument issued by large
banks and well-known corporations, such as
Microsoft and General Motors, and the amount
outstanding is around $1 trillion.
• Negotiable Bank Certificates of Deposit:
A certificate of deposit (CD) is a debt instrument
sold by a bank to depositors that pays annual
interest of a given amount and at maturity pays back
the original purchase price.
• Capital market instruments are debt and equity
instruments with maturities of greater than one
year.
• They have far wider price fluctuations than
money market instruments and are considered
to be fairly risky investments.

Stocks: are equity claims on the net income and

assets of a corporation.
 Mortgages: are loans to households or firms to
purchase land, housing, or other real structures,
in which the structure or land itself serves as
collateral for the loans.

Mortgages are provided by financial institutions

such as savings and loan associations, mutual
savings banks, commercial banks, and insurance
companies.

Mortgage-backed securities: is bond-like debt

instruments backed by a bundle of individual
mortgages, whose interest and principal payments
are collectively paid to the holders of the security.
Three government agencies: the Federal National
Mortgage Association (FNMA, “Fannie Mae”), the
Government National Mortgage Association (GNMA,
“Ginnie Mae”), and the Federal Home Loan
Mortgage Corporation (FHLMC, “Freddie Mac”) that
provide funds to the mortgage market by selling
bonds and using the proceeds to buy mortgages.
Corporate Bonds: These long-term bonds are
issued by corporations with very strong credit
ratings. The typical corporate bond sends the
holder an interest payment twice a year and pays
off the face value when the bond matures.

Some corporate bonds, called convertible bonds,

have the additional feature of allowing the holder
to convert them into a specified number of shares
of stock at any time up to the maturity date.
Government Securities:
Municipal Bonds:
• A financial intermediary that helps transfer funds
from lender-savers and then using these funds to
make loans to borrower-spenders.
• The process of indirect financing using financial
intermediaries, called financial intermediation.

Why are financial intermediaries

and indirect finance so important in
financial markets?
Transaction costs, the time and money spent in
carrying out financial transactions, are a major
problem for people who have excess funds to lend.

Carl the Carpenter needs $1,000 for his new tool,

and you know that it is an excellent investment
opportunity.

You have the cash and would like to lend him the
money, but to protect your investment, you have to
hire a lawyer to write up the loan contract that
specifies how much interest Carl will pay you, when
he will make these interest payments, and when he
will repay you the $1,000.
Obtaining the contract will cost you $500. When you
figure in this transaction cost for making the loan,
you realize that you can’t earn enough from the deal
(you spend $500 to make perhaps $100).

Financial intermediaries can substantially reduce

transaction costs because they have developed
expertise in lowering them and because their large
size allows them to take advantage of economies of
scale, the reduction in transaction costs per dollar of
transactions as the size (scale) of transactions
increases.
 For example, a bank knows how to find a good
lawyer to produce an airtight loan contract, and this
contract can be used over and over again in its loan
transactions, thus lowering the legal cost per
transaction.
Instead of a loan contract (which may not be all that
well written) costing $500, a bank can hire a top-
flight lawyer for $5,000 to draw up an airtight loan
contract that can be used for 2,000 loans at a cost
of $2.50 per loan.

In addition, a financial intermediary’s low transaction

costs mean that it can provide its customers with
liquidity services, services that make it easier for
customers to conduct transactions.

For example, banks provide depositors with checking

accounts that enable them to pay their bills easily. In
addition, depositors can earn interest on checking
and savings accounts and yet still convert them into
goods and services whenever necessary.
 Risk sharing
Financial intermediaries create and sell assets with
risk characteristics that people are comfortable
with, and the intermediaries then use the funds
they acquire by selling these assets to purchase
other assets that may have far more risk (asset
transformation).
Financial intermediaries also promote risk sharing
by helping individuals to diversify and thereby lower
the amount of risk to which they are exposed.
“You shouldn’t put all your eggs in one basket”

A. Depository Institutions:
Financial intermediaries that accept deposits from
individuals and institutions and make loans.
These include commercial banks and thrift institutions
(thrifts): savings and loan associations, mutual savings
banks, and credit unions.
1. Commercial Banks
- Raise funds primarily by issuing checkable deposits,
savings deposits, and time deposits.
- They use these funds to make commercial, consumer,
and mortgage loans and to buy government securities
and municipal bonds.
2. Savings and Loan Associations (S&Ls) and
Mutual Savings Banks
- Obtain funds primarily through savings deposits
and time and checkable deposits. Mostly made
mortgage loans for residential housing.
- Restrictions on these institutions have been
loosened and these intermediaries have become
more like commercial banks and are now more
competitive with each other.

3. Credit Unions
- Very small cooperative lending institutions
organized around a particular group.
- They acquire funds from deposits called
shares.
- Primarily make consumer loans.
B. Contractual Savings Institutions:
1. Life Insurance Companies
2. Fire and Casualty Insurance Companies
3. Pension Funds and Government Retirement
Funds

C. Investment Intermediaries:
1. Finance Companies
2. Mutual Funds
3. Money Market Mutual Funds
4. Hedge Funds
5. Investment Banks
Increasing information available to investor:
- Government regulation can reduce adverse
selection and moral hazard problems in financial
markets and increase their efficiency by
increasing the amount of information available to
investors.
- This requires corporations issuing securities to
disclose certain information about their sales,
assets, and earnings to the public and restricts
trading by the largest stockholders in the
corporation.
Ensuring the soundness of financial
intermediaries:
Six types of regulations:
1. Restrictions on entry: Regulation will govern who
is allowed to set up a financial intermediary.
Owners of financial institutions must obtain a
charter from the government. Charters are
provided only to those who are with impeccable
credentials and a large amount of initial funds.

Ensuring the soundness of financial

intermediaries:
Six types of regulations:
2. Disclosure: Bookkeeping must follow certain
strict principles, their books are subject to periodic
inspection, and they must make certain information
available to the public.
Ensuring the soundness of financial
intermediaries:
Six types of regulations:
3. Restrictions on assets and activities: There are
restrictions on what financial intermediaries are
allowed to do and what assets they can hold, and
also a financial intermediary is forbidden from
engaging in certain risky activities. Another way is
to restrict financial intermediaries from holding
certain risky assets.

Ensuring the soundness of financial

intermediaries:
Six types of regulations:
4. Deposit insurance: The most important
government agency that provides this type of
insurance is the Federal Deposit Insurance
Corporation (FDIC), which insures each depositor
at a commercial bank or mutual saving banks up to
a loss of $100,000 per account.
Ensuring the soundness of financial
intermediaries:
Six types of regulations:
5. Limit on competition: Unbridled competition
promotes failures that will harm the public. First are
the restrictions on the opening of additional
locations (branches).
6. Restrictions on interest rates: Impose restrictions
on interest rate that can be paid on deposits.