FINANCIAL MARKETS AND

INSTITUTIONS

Lecturer: Truong Thi Thuy Trang

Email: truongthithuytrang.cs2@ftu.edu.vn

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Course content
• Chapter 1: Introduction to Financial Markets and
Institutions
• Chapter 2: Interest Rate
• Chapter 3: Money Market
• Chapter 4: Equity Markets
• Chapter 5: Bond Markets and Valuation
• Chapter 6: Derivative Security Markets
• Chapter 7: Mortgage Markets
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Course materials
• Mishkin & Eakins, Financial Markets and
Institutions
• Madura, Financial Institutions and Markets
• Hull, Options, Futures and other Derivatives
• CFA Curriculum, L1V4 & L1V5

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Course schedule
Lecture Content Materials

Introduction to Financial Mishkin & Eakins, Chap 1,2

1-2
Markets and Institutions Madura, Chap 1

Mishkin & Eakins, Chap 3-5

3-4 Interest rate Madura, Chap 2-3
L1V5R44

Mishkin & Eakins, Chap 11

5 Money markets
Madura. Chap 6

Mishkin & Eakins, Chap 12

6-8 Bond markets Madura, Chap 7-8
L1V5R42,43,44,46

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Course schedule
Lecture Content Materials
Mishkin & Eakins, Chap 13
9 - 11 Equity markets Madura, Chap 10-11
L1V4R37,38,41

12 Mid-term test

Hull, Chap 1
13 - 14 Derivative markets Madura, Chap 13-15
L1V5R48
Mishkin & Eakins, Chap 14
15 Mortgage markets
Madura, Chap 9
Financial institutions
Madura, Part 6 & 7
(Self-study)

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Course assessment

Assessment Contribution
Attendance 10%
Mid-term test (15%)
30%
Research Project (15%)
Final exam (45 MCQs+ 2 tasks) 60%

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Class rules
• Be on time.
• No food and drink in the classroom, except for water.
• Only use laptop and mobile phone if required by the
lecturer.
• Student whose attendance score is less than 7 OR
mid-term test score is less than 4 will be prohibited
from taking the final examination.

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 CHAPTER 1:
INTRODUCTION TO FINANCIAL
MARKETS AND INSTITUTIONS

Lecturer: Truong Thi Thuy Trang

Email: truongthithuytrang.cs2@ftu.edu.vn

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Content
• Overview of financial system and financial markets
• Structure of financial markets
• Financial Intermediaries

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Financial system

Public Finance

Financial
Market
Financial
Institutions

Business Finance Personal Finance

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Financial system
• Public Finance (TCH431)
– Government operations to implement policy.
– Efficient resources allocation, income distribution and
economic stabilization.

• Business Finance (TCH321)

– Business operations to maximize owner’s wealth.
– Investing and financing decisions.

• Personal Finance
– Individual or family activities.
– Maximize utilities. 11
Financial system
• Internal Finance: Reinvest the cash-flows
generated within the families, firms,...
– Some households/firms/governments/sectors are in
budget deficit. Others have a budget surplus.

• External Finance: Ones with budget deficits seek

for outside sources of capital from those with
budget surpluses by the means of direct finance
and indirect finance.

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Flows of Funds Through the Financial System

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Flows of Funds Through the Financial System

• Direct finance: borrowers issue securities to borrow

funds directly from the lenders: bond market, stock
market, money market, foreign exchange market,…
• Indirect finance: financial intermediaries channel
funds from lenders to borrowers: commercial banks,
insurance companies, finance companies, mutual
funds, pension funds,…
• Function: Channels and allocates funds efficiently
from savers to spenders, across economic sectors
and geographical areas.
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Financial Markets
• Financial markets are markets in which funds are
moved from people who have an excess of
available funds (and lack of investment
opportunities) to people who have investment
opportunities (and lack of funds).
• Financial markets (such as bond and stock
markets) are markets in which securities are
traded.

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Financial Markets
• Financial markets facilitate financing and investing
by households, firms, and government agencies.
• A financial market is a market in which financial
assets (securities) can be purchased or sold

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Functions of Financial Markets
• Channel funds from saving to investment.
• Determine prices of financial instruments.
• Reduce information cost, search cost.
• Create liquidity.
• Government implements its economic policy.

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Evaluating Market Quality
• Markets are organized to provide liquidity,
transparency, and assurity of completion, so
they may be judged by the degree to which they
have these qualities in practice.

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Evaluating Market Quality
• In detail, a liquid market is one that has the
following characteristics:
– The market has relatively low bid–ask spreads.
– The market is deep.
– The market is resilient

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Evaluating Market Quality
• Many factors contribute to making a market liquid:
– Many buyers and sellers.
– Diversity of opinion, information, and investment needs
among market participants.
– Convenience.
– Market integrity.

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Trade Cost Measurement
• The implementation shortfall (IS) metric is the
most important ex post trade cost measurement
used in finance.
• The IS metric provides portfolio managers with the
total cost associated with implementing the
investment decision.

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Trade Cost Measurement

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Trade Cost Measurement
• IS formulation decomposes the total cost of the
trade into three categories:
• Fixed fees includes all explicit fees, such as
commissions, exchange fees, and taxes.
• Execution cost corresponds to the shares that
were transacted in the market.
• Opportunity cost corresponds to the unexecuted
shares of the order.

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Trade Cost Measurement
• The IS formulation decomposing costs into these
categories is calculated as follows:

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On Monday, the shares of Impulse Robotics close at £10.00 per share.
On Tuesday, before trading begins, a portfolio manager decides to buy
Impulse

Robotics. An order goes to the trading desk to buy 1,000 shares of

Impulse Robotics at £9.98 per share or better, good for one day. The
benchmark price is Monday’s close at £10.00 per share. No part of the
limit order is filled on Tuesday, and the order expires. The closing price on
Tuesday rises to £10.05.

On Wednesday, the trading desk again tries to buy Impulse Robotics by

entering a new limit order to buy 1,000 shares at £10.07 per share or
better, good for one day. During the day, 700 shares are bought at £10.07
per share. Commissions and fees for this trade are £14. Shares for
Impulse Robotics close at £10.08 per share on Wednesday.

No further attempt to buy Impulse Robotics is made, and the remaining

300 shares of the 1,000 shares the portfolio manager initially specified are
canceled. 25
Trade Cost Measurement
The expanded implementation shortfall can be
broken down as follows:

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Trade Cost Measurement
• Delay cost arises when the order is not submitted
to the market in a timely manner and the asset
experiences adverse price movement, making it
more expensive to transact.

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Structure of Financial Markets
• Debt and Equity Markets
• Primary and Secondary Markets
• Stock Exchanges and Over-the-Counter (OTC)
Markets
• Money and Capital Markets
• Derivatives Markets

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Debt and Equity Markets
• Debt instruments (contractual agreement)

– Treasury, corporate, mortgage-backed, money market,

municipal, etc...

– Maturity: the remaining time until the expiration date

• Equities (claims to net income and assets)

– Stock markets

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Primary and Secondary Markets
• Primary markets are financial markets in which
new issues of a security are sold to initial buyers
by the corporation or government agency
borrowing the funds.
– Underwriting, initial public offering

• Secondary markets are markets in which existing

securities are traded among investors
– Role of secondary market

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Primary and Secondary Markets

• The primary markets are not well known to the

public.
– Investment banks underwrite securities in primary
markets.

• The previously issued securities will be sold in

the secondary market
– Brokers and dealers work in secondary markets.

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Exchanges and Over-the-Counter (OTC) Markets

• Exchanges are markets where buyers and sellers

of securities (or their agents or brokers) meet in
one central location to conduct trades
– Examples: NYSE, Chicago Board of Trade
• Over-the-counter (OTC) markets are markets, in
which 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
– Examples: Foreign exchange, Federal funds
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Money and Capital Markets
• Money markets deal in short-term debt
instruments

– Short terms (one year or less) to maturity, least price

fluctuations and least risky investment

• Capital markets deal in longer-term debt and

equity instruments
– With maturities more than one year

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Derivative markets
• Derivative markets are the markets where
investors trade derivative instruments like futures
and options
• Derivatives (or contingent claims) are securities
whose value depends on the value of some other
underlying security.
• Derivatives include forwards, futures, options and
swaps.

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Types of Stock Market Transactions
1. Secondary market
– trading existing stocks

2. Primary market
– existing firm issues additional shares

3. Initial Public Offering (IPO)

– privately held company offers stock to the public for the
first time
– called “going public”

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The Physical Stock Exchanges
• Physical exchanges
– New York Stock Exchange (NYSE)
– American Stock Exchange (AMEX)
– Chicago Stock Exchange (CHX)
– Philadelphia Stock Exchange (PHLX)
– HOSE
– HNX

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Securities Traded in Financial Markets
• 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

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Securities Traded in Financial Markets
• 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

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Securities Traded in Financial Markets
• 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

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Securities Traded in Financial Markets
• 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

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Securities Traded in Financial Markets
• 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

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 Sources of External Funds for Nonfinancial Businesses:
A Comparison of the United States with Germany, Japan, and Canada

Source: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical Results,” Johann
Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 and are gross flows as
percentage of the total, not including trade and other credit data, which are not available.

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The importance of financial
intermediaries to securities markets
• Obstacles to Matching Savers and Borrowers
• Asymmetric Information

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Obstacles to Matching Savers and Borrowers
• Transactions costs include expenses to
advertise one’s intention to sell or purchase a
financial instrument and the value of time spent in
locating a counterparty - that is, a buyer for a
seller or a seller for a buyer to the transaction.
• Information costs are costs associated with
assessing a financial instrument’s investment
attributes

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Asymmetric Information
• Asymmetric information is a situation that arises
when one party’s insufficient knowledge about the
other party involved in a transaction makes it
impossible for the first party to make accurate
decisions when conducting the transaction.
• Asymmetric information is a serious hindrance to
the operation of financial markets, and solving this
problem is one key to making our financial system
work as well as it does.

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 Asymetric
information

Adverse Moral Hazard

selection

Lemon Principal-
problems Agent Problem

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• Adverse selection: lender’s problem of sorting
good risks from bad risks.
• Moral hazard: (hidden action) is the risk (hazard)
that the borrower will engage in activities that are
undesirable (immoral) for the lender.

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Adverse Selection
• Lemons problem: asymmetric information in a
market leads to adverse selection.
• Lemons problem raises lending costs.
• Lemons problems in the bond market lead to
credit rationing.
• Many countries set information disclosure
requirements if a firm sells securities.
• Small loss from default if invest little

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How to solve the problems arising
from adverse selection?
• Private production and sale of information
– Free-rider problem

• Government regulation to increase information

• Financial intermediation
• Collateral and net worth

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Moral Hazard
• Regulations on reporting by firms reduce the
chance of fraud in equity financing.
• Principal-agent problem: managers have different
goals than the firm’s owners.
• Moral hazard in debt financing is reduced with the
use of restrictive covenants.

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Principal-Agent Problem: Solutions
• Monitoring
• Government regulation to increase information
• Financial Intermediation
• Debt Contracts

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Information Costs and Financial
Intermediaries
• Financial intermediaries reduce adverse selection
by specializing in gathering default risk
information.
• Banks’ information advantage largely accounts for
their role in providing external financing.
• Financial intermediaries deal with moral hazard
through monitoring.

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Financial Intermediaries and Moral Hazard
• Large investors often have more success in reducing the
free-rider problem: they have an incentive to closely
monitor how agents use their funds
– When venture capital firms acquires equity in a new firm, the
shares are not marketable to other investors, and the firm avoids
the free-rider problem and can profit from its monitoring activities

– Private equity or corporate restructuring firms acquire large blocks

of equity in mature firms

• Financial Intermediaries, like banks, earn a profit by acting

as delegated monitors for individual savers

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The Structure of the Financial Industry
Intermediaries can be divided into two broad
categories:
• Depository institutions
– Take deposits and make loans
– What most people think of as banks
• Non-depository institutions.
– Include insurance companies, securities firms, asset
management firms that operate mutual funds and
exchange-traded funds, hedge funds, private equity or
venture capital firms, finance companies, and pension
funds 55