Overview of the Financial Environment Dagmar Linnertová Dagmar.linnertova@mail.muni.cz Office 408 Contents nThe Role of Financial Markets and Institutions nDebt and Equity nMoney Market nCapital Market nCommodities The Role of Financial Markets and Institutions nA financial markets qMarket with assets (securities, financial instruments) qSell and buy … qTransfer of funds… nDeficit subjects nSurplus subjects nFinancial Market: a market in which financial assets (securities) such as stocks and bonds can be purchased or sold qFinancial intermediation – financial savings to investments qPayment system qMeans of manage risk Role of Financial Markets nTransfer funds from those who have excess funds to those who need funds. qStudents – student loan qFamilies – mortgages qBusiness – finance they growth qGovernment – finance their expenditures nOne side supply funds, the other side demand funds nEarn a return but only if fund is available in financial market q Role of Financial Markets nSurplus units – lenders, investors qReceive more money than they spend nDeficit units – borrowers qSpend more money than they receive nThis relation is formally organized by securities qAgreement between lender and borrower qClaim on the issuer Financial cycle of an individual http://www.bellevuecollege.edu/financialeducation/indivi1.gif Main categories of financial instrument nDebt nEquity nDerivative nCurrency nCommodity Debt securities qRepresent debt incurred by issuer – credit, borrowed funds qDeficit units issue the securities to surplus units and… q…pay interest to surplus unit on a periodic basis (such as every six months) – only for coupon bond qCharacteristics: nMaturity date nFace value nInterest rate (fixed or variable) qKinds nCoupon bond nDiscount bond (zero coupon bond) n Equity securities nRepresent equity or ownership in the issuer – stocks qCommon stocks nWhich are claims to share in the net income (income after expenses and taxes) and the assets of a business. nIf 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. qEquities often make periodic payments to their holders nDividends (if the shareholders’ meeting approves) qThey are considered long-term securities because they have no maturity day. qPriority stocks (cummulative priority stocks) Role of Financial Markets nAdvantages and disadvantages qDebt vs. equities qDisadvantages of equities nEquity holder is residual claimant nDividend is not tax deductible, expensive form of the capital qAdvantages of equities nHolders benefit directly from any increases in the corporation’s profitability or asset value n Type of Financial Markets nMoney versus Capital Markets n n n n n qShort-Term, < 1 Year qHigh Quality Issuers qDebt Only qPrimary Market Focus qLiquidity Market--Low Returns n qLong-Term, >1Yr qRange of Issuer Quality qDebt and Equity qSecondary Market Focus qFinancing Investment--Higher Returns n Type of Financial Markets nPrimary versus Secondary Markets n qNew Issue of Securities qExchange of Funds for Financial Claim qFunds for Borrower; an IOU (I owe you) for Lender n qTrading Previously Issued Securities qNo New Funds for Issuer qProvides Liquidity for Seller (market makers, electronic networks, etc.) n Type of Financial Markets nSecurities brokers and dealers are crucial to a well-functioning secondary market qBrokers qDealers n Type of Financial Markets q qBecause over-the-counter dealers are in computer contact and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange. n qStock Exchange qVisible Marketplace qMembers Trade qSecurities Listed qNew York Stock Exchange qNASDAQ (2006) n qOTC qWired Network of Dealers qNo Central, Physical Location qAll Securities Traded off the Exchanges qForex q n How Financial Markets Facilitate Corporate Finance nThree segments of finance qCorporate finance nHow much funding to obtain and how to invest a proceeds to expand their operation qBanks qCapital market qInvestment management nMake a decision about form of financing and investing qDebt vs. Equity financing or investing – investment banks qFinancial markets and institutions nAttract fund from investors and channel the funds to corporation nMoney market – borrow on short term basis qSupport existing operations nCapital market – obtain long term funds qSupport corporate expansion n How Financial Markets Facilitate Corporate Finance n n n n n n n nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Securities Traded in Financial Markets nReturn qExpected return from investment nEx post nEx ante qMean of return nRisk qUncertainty surrounding the expected return qMore uncertainty surrounding the expected return more risk qStandard deviation or variance qCoefficient of variation = expected risk (standard deviation)/ expected return (mean) nAmount of liquidity nTax status nNormally qHigh return with particular preference of low risk and adequate amount of liquidity n Securities Traded in Financial Markets nMoney market securities qOnly debt securities nCapital market securities qBonds qMortgages and Martgage-Backed securities qStocks nDerivative securities qSpeculation nSpeculation on movement in value of underlying assets without having to purchase those assets nLeverage effect qHedging nCommodities nForeign currencies Money market Capital market Stocks Bond Direct and Indirect Financing Role of Financial Institutions nFinancial institutions qDepositary Institutions qNon-depository Financial Institutions Why are financial intermediaries and indirect finance so important? nTransaction Costs qTransaction costs, the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend. qFinancial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them, and because their large size allow them to take advantage of economies of scale. qFor example nA bank knows how to find a good lawyer to produce loan contract, and this contract can be used over and over again in this loan transactions, thus lowering the legal cost per transaction. q q Why are financial intermediaries and indirect finance so important? nRisk Sharing qAnother benefit made possible by the low transaction costs of financial institutions is that they can help reduce the exposure of investors risk. qFinancial intermediaries do this through the process known as risk sharing. qThey create and sell assets with risk characteristics that people are comfortable with. The intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk. qAsset transformation Depository Insitutions nAccept deposit → provide credit → purchase securities nOffer deposit account nRepackage funds to provide loans nAccept risk nExpertise available nDiversification Commercial Banks $5 Trillion Total Assets Savings Institutions $1.3 Trillion Total Assets Credit Unions $.5 Trillion Total Assets Types of Depository Financial Institutions Nondepository Financial Institutions nFocused on capital market nLonger-term, higher risk intermediation nLess focus on liquidity nLess regulation nGreater focus on equity investments Pension Funds Types of Nondepository Financial Institutions Securities Firms Mutual Funds Financial Companies Insurance Companies Comparison of Role among Financial Institutions nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Summary of Institutional Sources and Uses of Funds n nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Relative Importance of Financial Institutions nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Thank you for your attention Sum up: http://www.youtube.com/watch?v=GnJCOof2HJk