Chapter 3 — Market Structures This Lecture

Chapter 3 - Market Structures

This Lecture Ü Financial Systems Ü Markets Ü Intermediaries 2

This Lecture Ü options of financial demand supply Ü regional differences in financial structures Ü how people save and invest Ü criteria of financial market classifications Ü the trade-off between risk and return Ü the international dimension Ü the interconnectedness of markets 3

Options Which options has a private household in western Europe • looking to finance the purchase of a new car, a house, or other consumer durables? • looking for an opportunity to save? 4

Options a private household in western Europe looking to finance the purchase of consumer durables can • take a bank loan • look for special finance (mortgage, consumer loan offered by a car producer. . . ) • use a credit card • spend own savings. . . in most cases a financial intermediary is needed 5

Options a private household in western Europe looking for an opportunity to save can • open a savings account • buy bonds or shares • speculate in foreign exchange • invest in derivatives • buy insurance • keep the money under the mattress in most cases a financial intermediary is needed 6

Financial intermediaries • take the money from one party and give it to another in exchange for a small fee or other form of compensation, or • arrange for capital demand supply to meet in organised markets. 7

Providers of financial services include • banks • investment funds • insurance companies • credit card companies • non-bank financial firms (GE Capital, Ford Motor Credit Company). . . 8

Options Which options has a business firm in western Europe looking to • finance an investment or • its daily expenses or • actively manage financial risks? 9

Options A business firm can • take a bank loan • issue securities • buy and sell short-term papers, bonds and shares • engage in money market and foreign exchange transactions • engage in derivatives trading 10

Options Firms’ financial options depend on size: In financial markets, larger customers • get better conditions both as borrower and investor; • face a wider spectrum of financial instruments and • have better market access than smaller ones. 11

Options Discuss: In which way do business firms and households differ with respect to • transparency • creditworthiness • overall economic performance? 12

Business firms Special case: Institutional Investors • mutual funds • life insurance companies • pension funds 13

Business firms Institutional Investors are characterised by • financial strength • professional management of collective portfolios • strict prudential rules for asset allocation • long-term engagements, buy-and-hold strategy • strong preference for stable markets and smooth trading • high risk of reverse price movements, strong focus on traditional debt instruments and equity. 14

Business firms Institutional Investors are: • large and reliable sources of finance; • enhancing market stability; • contributing to financial development • and economic growth. 15

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In Europe, as in the United States and Japan, households are the ultimate providers of funds for non-financial corporations and governments. Financial corporations merely function as intermediaries. 17

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Europeans appear more risk averse than US Americans. They spend more on life insurance and less on securities and mutual funds. 19

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European households • rely on loans for external funding and • invest their money above all in shares and bank accounts. For companies in Europe • the stock markets are the most important source of external finance • followed by bank loans. • Debt securities play a minor role. 21

Other European characteristics are: • the importance of internal funding • the role of private equity Both can be explained in parts by the comparably high share of small and medium-sized firms in Europe. 22

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Financial market diversity reflects the variety of needs and preferences. . . and the inherent dangers and limitations. 24

There is a constant trade-off between risk and return underlying all financial transactions: 25

If overall risk in a market rises from A to A’, investors will invest less in this market and demand a higher return. As a consequence, returns will rise. Higher returns mean higher borrowing costs leading to a decline in borrowing from C to C’. Since at higher risks some investments will not be made at all total investment will decline from D to D’. 26

Discuss: In which way do the positions of shareholders and bond holders differ with respect to • flexibility • overall risk • return of their investment? Distinguish between institutional investors and private households. 27

Products are only one way to classify markets. . . 28

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Financial Market Classification Services • technical • advisory • information and knowledge based • administrative 30

Financial Market Classification Ways of Trading • physical • electronic • virtual 31

Financial Market Classification Actors • professionals • non-professionals • institutions • individuals • officials 32

Financial Market Classification Origin • domestic • cross-border • regional • international 33

Internationalisation and globalisation of financial services have widened the range of opportunities: • borrowing and investing are not restricted to domestic markets; • borrowing and investing are not restricted to the domestic currency; • borrowing and investing are not restricted to domestic suppliers of financial services. 34

Why do financial institutions, borrowers and investors go abroad? • market access: actors may be excluded from sources in one place that are available to them in others; • risk and return considerations: conditions in international markets may be more favourable; risk monitoring and managing simpler and more reliable; diversification opportunities more numerous. • cost and efficiency considerations: financial institutions may realise additional economies of scale. 35

Domestic, foreign and international financial markets offer a wide range of risk and return combinations. Actors usually engage in a variety of borrowing and lending activities. As a consequence, markets are highly interconnected: 36

Example: a decline in shareholders’ trust in a company’s future performance may trigger a chain reaction. . . 37

Links exist • across markets • within industries • between industries 38

Summary • Europe’s financial landscapes are characterised by diversity. • Compared to the US, Europeans appear more risk averse. • Internal funding and private equity play an important role. • The diversity of financial products reflects the variety of needs and preferences. • Financial market participants face a constant trade-off between risks and returns. • As a consequence of internationalisation and globalisation financial opportunities are not restricted to domestic markets. • Financial markets for different products are highly interconnected. 39

Key Words Ä Assets Financial claims or pieces of property that are a store of value; in the balance sheet: items representing what a company owns (in contrast to liabilities which describe what a company owes) Ä Loan The temporary provision of money which is usually repaid with interest Ä Security Claim on a borrowers’ future income that is sold to the lender; already existing securities can be bought and sold on exchanges or over the counter (OTC) Ä Bond A debt security issued by a company, government or other borrower usually paying interest and traded in a market; by some practitioners only used to describe long-term debt instruments Ä Equity Claims to share a corporation’s net income and assets Ä Private Equity securities of companies that have not listed their stock on a public exchange; investors wishing to sell private equity must find a buyer in the absence of a marketplace 40

Key Words Ä Institutional Investor An organisation whose core activity is to invest its own assets or those held in trust by it for others Ä Risk premium The part of the rate of return which compensates the investor for assuming risk Ä Internal finance Finance generated within a firm by retained earnings and depreciation. Ä Tradability Characteristic of a financial asset allowing it to be publicly bought and sold Ä Transferability The ability to change ownership or title Ä Market The place where potential buyers and sellers meet; the total of all the existing and potential buyers of a product or service Ä Exchange An organized market providing a facility for members to trade 41