Chapter 2Chapter 2

Overview of Market Participants & Financial innovation

Learning ObjectiveLearning ObjectiveParticipants in Financial MarketsBusiness of Financial institutionsFinancial IntermediaryEconomic functions of Financial

IntermediariesAsset & Liability management of

Financial institutionsGovernment RegulationsPrimary reasons for financial

innovation

Classification of Classification of EntitiesEntitiesCentral governmentsAgencies of central governmentMunicipal governmentsSupranationalNon- financial businessesFinancial enterpriseshouseholds

Classification of Classification of EntitiesEntitiesCentral governments

Debt obligations issued by central Governments carry full faith & credit of the borrowing Government.

Agencies of central governmentFederally related institutions, Government sponsored enterprises

Municipal governmentsSupranational

An organization that is formed by two or more central governments through international treaties.

Classification of Classification of EntitiesEntitiesNon- financial businesses

Corporations & non-corporate business

Financial enterpriseshouseholds

Classification of Classification of EntitiesEntities

Financial intermediariesDepository institutions-

commercial banks, S&L associations and credit unions

Insurance companiesPension funds

Classification of Classification of EntitiesEntities

Financial EnterprisesExchanging financial assets on

behalf of customers. (Brokers)Exchanging financial assets for their

own account. (Dealers)Assisting in creation of financial

assets for their customers and then selling those financial assets to other market participants. (Underwriting)

Providing investment advice to other market participants.

Managing portfolios of other market participants.

Role of Financial Role of Financial IntermediariesIntermediaries

Obtain funds by issuing financial claims against themselves to market participants, then investing those funds.

Direct investments- investments made by the financial intermediaries. (assets can be loans /or securities)

Transform financial assets that are less desirable for a large part of the public into other financial assets(their own liabilities ) which are more widely preferred by the public.

Role of Financial Role of Financial IntermediariesIntermediaries

This transformation involves four basic economic functions:

Maturity intermediationRisk reduction and diversificationReducing the costs of contracting

and information processing Providing a payment mechanism

Nature of LiabilitiesNature of Liabilities

Liability Type Amount of cash outlay

Timing of cash outlay

Type I Known Known

Type II Known Uncertain

Type III Uncertain Known

Type IV Uncertain Uncertain

Nature of Liabilities Nature of Liabilities Type I liabilities: Fixed deposit account Guaranteed investment contract

(GIC) issued by the insurance companies

Type II:Life insurance policy

Nature of LiabilitiesNature of LiabilitiesType III liabilities: Floating rate Certificate of

deposits issued by the depository institutions

Type IV liabilities: Automobile and home insurance

policies

Liquidity NeedsLiquidity Needs

Uncertainty about timing and amount of cash outlays

Potential for the depositor or policy holder to withdraw cash early.

Liquidity NeedsLiquidity NeedsReduction in cash inflows:

Depository institutions- inability to obtain deposits

Insurance companies- reduced premium because of the cancellation of policies

Investment companies- not being able to find new buyers for shares.

Regulation OF Financial Regulation OF Financial MarketsMarketsDisclosure RegulationFinancial Activity RegulationRegulation of Financial

InstitutionsRegulation of Foreign Participants

Financial InnovationFinancial InnovationCategorizations of Financial Innovation

Market-broadening Instruments- Increase liquidity of markets and availability of funds by attracting new investors and offering new opportunities for borrowers

Risk- management instrumentsreallocate risk to those who are less risk averse.

Financial InnovationFinancial InnovationArbitraging instruments and

processes- enable investors and borrowers to take advantage of differences in costs and returns between markets.

Motivation for Financial Motivation for Financial InnovationInnovation

Causes of Financial Innovation

Increased volatility of interest rates , inflation , equity prices and exchange rates

Advances in computer and telecommunication technologies

Greater sophistication and educational training among professional market partcipants

Financial intermediary competition

Incentives to get around existing regulation and tax laws

Changing global patterns of financial wealth..