final project of financial management

2. CONTENTS
CAPITAL ALLOCATION PROCESS
FINANCIAL MARKETS
FINANCIAL INSITUTIONS
FINANCIAL REGULATIONS
 STOCK MARKET

3. Capital allocation process
Direct Transfer
Business Savers
Securities (Stocks/Bonds)
Cash
Investment Bank
Investment Bank
Business Savers
Securities
Cash
Securities
Cash
Financial
Intermediary
Financial Intermediary
Business Savers
Business’s
Securities
Cash Cash
Intermediar
y’s
Securities

4. Segments of Financial Markets
• Direct Financing
– Funds are transferred directly from ultimate savers to ultimate borrowers
• Indirect Financing
– A financial "intermediary" transforms financial claims with one set of characteristics into
financial claims with other characteristics e.g. deposits are used to make loans.

5.  WHAT IS FINANCIAL MARKETS?
 WHY STUDY FINANCIAL MARKETS?
 FUNCTIONS OF FINANCIAL MARKETS
 TYPES OF FINANCIAL MARKETS
 INSTRUMENTS TRADED IN
FINANCIAL MARKETS?
Financial Markets

6. What is Financial Markets?
 Financial markets perform the essential function of channeling funds from
economic players that have saved surplus funds to those that have a shortage of
funds
 At any point in time in an economy, there are individuals or organizations with
excess amounts of funds, and others with a lack of funds they need for
example to consume or to invest.
Exchange between these two groups of agents is settled in financial
markets
The first group is commonly referred to as lenders, the second group is
commonly referred to as the borrowers of funds.

7. What is Financial Markets? (cont’d)
 Financial Market: is market place for selling financial securities: stocks, bonds
and derivatives.
 A security is a piece of paper that represents the investor’s rights to certain
prospects or property and the conditions under which he or she may exercise
those rights.
 Stock or share represents ownership right in the corporation
 Bond is a debt instrument issued by corporations who borrow money.
 Derivative: is a security that derives its value from the value of another
security

8. Why study financial markets?
Financial markets, such as bond and stock
markets, are crucial in our economy.
1. These markets channel funds from savers to investors, thereby promoting
economic efficiency.
2. Market activity affects personal wealth, the behavior of business firms, and
economy as a whole
 Well functioning financial markets, such as the bond market, stock market, and
foreign exchange market, are key factors in producing high economic growth.

9. Functions of financial markets
 A Financial Market is a market in which financial assets (securities) can be
purchased or sold.
 Financial markets facilitate transfers of funds from person or business without
investment opportunities (i.e., “Lender-Savers”, or “Surplus Unit”) to those
who have investment opportunities (i.e., “Borrower-Spenders”, or “Deficit
Unit”).

10. Functions of Financial markets (cont’d)
 Borrowing and Lending
Financial markets channel funds from households, firms, governments
and foreigners that have saved surplus funds to those who encounter a
shortage of funds (for purposes of consumption and investment)
 Price Determination
Financial markets determine the prices of financial assets. The
secondary market herein plays an important role in determining the
prices for newly issued assets

11. Types of financial markets
 Spot vs future market:
Spot market: assets are delivered immediately
Future market: participants agree today to buy or sell an asset at some
future date
 Money vs capital market:
Money assets: short term financial assets are traded
Capital market: long term financial assets are traded
 Primary vs secondary market:
Primary market: market where financial assets are sold for the first time
Secondary market: market for previously sold financial assets

12. Instruments traded in financial market
• Money market securities:
– Money market securities are debt securities with a maturity of one year
or less
– Characteristics:
• Liquid
• Low expected return
• Low degree of risk

13. Securities Traded in Money Markets
 Treasury Bills.
 Certificate of Deposit (CDs).
 Commercial Papers.
 Eurodollar Deposits.
 Banker’s Acceptance.
 Federal Funds.
 Repurchase Agreements.

14. Securities Traded in Financial Markets(cont’d)
• Capital Market Securities:
– Capital market securities are those with a maturity of more than one
year
• Bonds and mortgages
• Stocks
– Capital market securities have a higher expected return and more risk
than money market securities

15. Securities Traded in Capital Markets
• Treasury Notes and Bonds.
• Municipal Bonds.
• Corporate Bonds.
• Mortgages.
• Commons Stocks.
• Preferred Stocks.

16. Securities Traded in Financial Markets (cont’d)
• Bonds and Mortgages:
– Bonds are long-term debt obligations issued by corporations and
government agencies
– Mortgages are long-term debt obligations created to finance the purchase
of real estate
– Bonds and mortgages specify the amount and timing of interest and
principal payments.

17. Securities Traded in Financial Markets (cont’d)
• Stocks:
– Stocks (equity) are certificates representing partial ownership in
corporations
– Investors may earn a return by receiving dividends and capital gains
– Stocks have a higher expected return and higher risk than long-term debt
securities

18. Securities Traded in Financial Markets (cont’d)
• Derivative Securities:
– Derivative securities are financial contracts whose values are derived
from the values of underlying assets
– Speculating with derivatives allow investors to benefit from increases or
decreases in the underlying asset
– Risk management with derivatives generates gains if the value of the
underlying security declines

19. Financial institutions
What are Financial Institutions?
Why study financial institutions?
Function of financial Institutions
Types of Financial Institutions
Role of financial institutions in financial markets

20. What are financial institutions?
Financial institutions are businesses which offer multiple services in
banking and finance. The services customers receive may include
savings and checking accounts, loans, investments and financial
counseling. The benefits consumers gain by using financial institutions
includes convenience, cost savings, safety and security.
Any classification of financial institutions is ultimately somewhat
arbitrary, since financial markets are subject to high dynamics and
frequent innovation. Thus, we roughly use four categories:
 Brokers
 Dealers
 Investment banks
 Financial intermediaries

21. What are financial institutions? (cont’d)
 Brokers are agents who match buyers with sellers for a desired
transaction.
A broker does not take position in the assets she/he trades (i.e.
does not maintain inventories of those assets)
Brokers charge commissions on buyers and/or sellers using their
services
Examples: Real estate brokers, stock brokers
 Like brokers, dealers match sellers and buyers of financial assets.
 Dealers, however, take position in their assets, their trading
 As opposed to charging commission, dealers obtain their

22. What are financial institutions? (cont’d)
 profits from buying assets at low prices and selling them at
high prices
 A dealer’s profit margin, the so-called bid-ask spread is the
difference between the price at which a dealer offers to sell an
asset (the asked price) and the price at which a dealer offers to
buy an asset (the bid price
 Examples: Dealers in U.S. government bonds, Nasdaq stock
dealers
 Investment Banks
Investment banks assist in the initial sale of newly issued
securities (e.g. IPOs)

23. What are financial institutions? (cont’d)
Investment banks are involved in a variety of services for their
customers, such as advice, sales assistance and underwriting of
issuances
Examples: Morgan-Stanley, Goldman Sachs, ...Lehman Brothers
..(Before Crisis 2008)
 Financial Intermediaries
 Financial intermediaries match sellers and buyers indirectly
through the process of financial asset transformation.
 As opposed to three above mentioned institutions. they buy a
specific kind of asset from borrowers –usually a long term loan
contract – and sell a different financial asset to savers –usually
some sort of highly-liquid short-run claim.

24. What are financial institutions? (cont’d)
 Although securities markets receive a lot of media attention, financial
intermediaries are still the primary source of funding for businesses.
 Even in the United States and Canada, enterprises tend to obtain
funds through financial intermediaries rather than through securities
markets.
 Other than historic reasons, this prevalence results from a variety of
factors.

25. Why study financial institutions?
 Financial Institutions are the institutions that make financial markets work
 “Financial Institutions are the intermediaries, that take funds from the people
who save and lend it to people who have productive investment opportunities”.

26. Function of Financial Institutions: Indirect Finance
 Lower transaction costs
 Economies of scale
 Liquidity services
Since transaction costs are reduced, financial intermediaries are able to
provide customers with additional liquidity services, such as checking
accounts which can be used as methods of payment or deposits which
can be liquidated any time while still bearing some interest.
 Reduce Risk
 Risk Sharing (Asset Transformation)
 Diversification

27. Function of Financial Institutions: Indirect Finance (cont’d)
Through the process of asset transformation not only maturities,
but also the risk of an asset can change: A financial intermediary
uses funds it acquires (e.g. through deposits) and often turns them
into a more risky asset (e.g. a larger loan). The risk then is spread
out between various borrowers and the financial intermediary
itself.
The process of risk sharing is further augmented through
diversification of assets (portfolio-choice), which involves
spreading out funds over a portfolio of assets with different
types of risk
 Reduce Asymmetric Information
 Asymmetric Information in financial markets - one party often does
not know enough about the other party to make accurate decisions.

28. Functions of Financial institutions: Indirect Finance (cont’d)
 Adverse Selection (before the transaction)—more likely to select risky borrower
 Moral Hazard (after the transaction)—less likely borrower will repay loan
 => Financial intermediaries are important in the production of information. They help
reduce informational asymmetries about some unobservable quality of the borrower
for example through screening, monitoring or rating of borrowers, Net worth and
collateral.
 Finally, some financial intermediaries specialize on services such as
management of payments for their customers or insurance contracts
against loss of supplied funds.
 Through all of these channels financial intermediaries increase market
efficiency from an economic point of view.

29. Types of financial institutions
 Investment banks
 Commercial banks
 Credit unions
 Pension funds
 Life insurance companies
 Mutual funds
 Hedge funds

30. Types of financial institutions(cont)
• Commercial Banks:
– Are the most dominant depository institution
– Offer a wide variety of deposit accounts
– Transfer deposited funds by providing direct loans or purchasing debt
securities
– Serve both the public and the private sector
– it helps the Federal reserve system to expand or control the money
supply

31. Types of financial institutions(cont’d)
• Investment banks:
 helping how to design security to attract investor
 buy themselves
 sell on behalf company and ensure them in generating capital
 Risk for bank
• Credit Unions:
– Are nonprofit organizations
– Restrict their business to credit union members
– Tend to be much smaller than other depository institutions

32. Types of financial institutions(cont’d)
• Mutual Funds:
– a mutual fund is registered with the SEC, and can be sold to an unlimited number of investors.
– Mutual funds may advertise freely
– Sell shares to surplus units
– Use funds to purchase a portfolio of securities
 Hedge funds:
 Most hedge funds are not registered and can only be sold to carefully defined
sophisticated investors
 Usually a hedge fund will have a maximum of either 100 or 500 investors
 hedge funds may not advertise freely
 Unregulated funds

33. Types of financial institutions(cont’d)
• Insurance Companies:
– Provide insurance policies to individuals and firms for death, illness, and
damage to property
– Charge premiums (annually)
– Invest in stocks or bonds issued by corporations

34. Types of financial institutions(cont’d)
• Pension Funds:
– Offered by most corporations and government agencies
– Manage funds until they are withdrawn from the retirement account
– Invest in stocks or bonds issued by corporations or in bonds issued by
the government

35. Market Efficiency
• When security prices fully reflect all available information, the markets for
those securities are said to be efficient.
• When Markets are inefficient, investors can use available information ignored
by the market to earn abnormally high returns on their investments.

36. Financial Regulations
Why regulate financial markets?
Financial markets are among the most regulated markets in modern
economies.
The first reason for this extensive regulation is to increase the
information available to investors (and, thus, to protect them).
The second reason is to ensure the soundness of the financial system.

37. Financial Regulations (cont’d)
Increasing information available to investors
As mentioned above, asymmetric information can cause severe
problems in financial markets (Risk behavior, insider trades,....)
Certain regulations are supposed to prohibit agents with superior
information from exploiting less informed agents.
In the U.S. the stock-market crash of 1929 led to the establishment of
the Securities and Exchange Commission (SEC), which requires
companies involved in the issuance of securities to disclose certain
information relevant to their stockholders. The SEC further prohibits
insider trades

38. Financial Regulations (cont’d)
Even more devastating consequences from asymmetric information manifest
themselves in collapses of the entire financial system – so called financial
panics.
Financial panics occur if providers of funds on a large scale withdraw their
funds in a brief period of time from the financial system leading to a
collapse of the system. These panics can produce enormous damage to an
economy.
Examples of some recent panics are the crises in the Asian Tiger states,
Argentina or Russia. The United States, while spared for most of the second
half of 20th century, has a long tradition of financial crises throughout the 19th
century up to the Great Depression

39. Financial Regulations (cont’d)
Solutions for ensuring the soundness of financial intermediaries
 Restrictions on entry
 Disclosure
 Restrictions on Assets and Activities
 Deposit Insurance
 Limits on Competition
 Restrictions on Interest Rates

40. The Stock Market
Two types of stock markets:
Organized Exchanges
NYSE
AMEX
Over-the-Counter
NASDAQ

41. Organized Security Exchanges
 Formal organizations with physical locations where
auction markets are conducted in designated
(“listed”) securities.

42.  The New York Stock Exchange (NYSE) is a stock
exchange located at 11 Wall Street in lower
Manhattan, New York City, USA. It is the world's
largest stock exchange.

43. Over-the-Counter (OTC)
A large collection of brokers and dealers, connected electronically to trade
securities not listed on the organized exchanges.
Characteristics of OTC markets:
 The relatively few market makers (dealers) that hold inventories of OTC securities
 The thousands of brokers that who act as agents in bringing dealers together with
investors
 The electronic network that links it all together.

44. Over-the-Counter (OTC)
 Bid Price: price at which dealer is willing to buy the
issue.
 Asked Price: price at which dealer is willing to sell the
issue.
 Prices are continuously updated to reflect changes in
supply and demand.
 Bid/Ask Spread: represents dealers profit