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AN OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS CHAPTER OBJECTIVES 1. This chapter introduces the basic elements of the financial system: financial claims, financial markets, and financial institutions. These elements integrate in a conceptual model of the financial system, shown in Exhibit 1-1. This chapter also develops basic vocabulary, which may not be prudently neglected. The Study Guide for this chapter includes a section on meanings and context of certain vocabulary terms. 2. The chapter compares and contrasts the two basic kinds of financing relationships—direct finance and financial intermediation—in the context of why financial needs exist, how financial claims arise, and what choices for financial activity emerge in different types of institutions and markets. 3. The chapter compares and contrasts major types of financial institutions and financial markets. These mechanisms—institutions and markets—afford participants more liquidity and diversification. Thus more funds flow to the most productive uses (allocational efficiency); competition among financial institutions lowers costs (operational efficiency), and widespread market participation links prices more closely to information (informational efficiency). A vigorous financial system promotes economic growth and prosperity by maximizing rational opportunities for investment. CHANGES FROM THE LAST EDITION 1. Anecdotal references have been updated. 2. Tables, exhibits, and data have been updated. CHAPTER KEY POINTS 1. The financial system brings savers and borrowers together. Stress these key concepts: SSUs and DSUs, financial claims, direct finance versus financial intermediation, financial institutions, transformation of claims, and types of financial markets. Remind students of financial intermediation in their own lives—checking accounts, insurance, student loans, etc. 2. Direct finance works if preferences of SSUs and DSUs match as to amount, maturity, and risk. Financial intermediaries transform claims to reduce the recurring problem of umatched preferences: Denomination Divisibility . DSUs prefer to borrow the full funding need all at once. SSUs tend to save small amounts periodically. Intermediaries pool small savings into large investments. Currency Transformation . Intermediaries can buy claims denominated in one currency while issuing claims denominated in another. This would be difficult for most ordinary SSUs. Maturity Flexibility . DSUs generally prefer longer-term financing. SSUs generally prefer shorter-term investments. Intermediaries can offer different ranges of maturities to both. Credit Risk Diversification . Intermediaries manage risk by evaluating and holding many different securities. SSUs on their own would have to leave “more eggs in one basket.” Liquidity . Many claims issued by intermediaries are highly liquid because intermediaries substitute their own liquidity for that of DSUs. 1
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This note was uploaded on 03/24/2011 for the course FINA 409 taught by Professor John during the Spring '11 term at Ohio State.

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