Why Study Financial Markets

Copyright © 2019 Pearson Education Ltd.Chapter 1 Why Study Financial Markets and Institutions?Why Study Financial Markets?Debt Markets and Interest Rates The Stock Market The Foreign Exchange Market Why Study Financial Institutions?Structure of the Financial System Financial Crises Central Banks and the Conduct of Monetary Policy The International Financial System Banks and Other Financial Institutions Financial Innovation Managing Risk in Financial Institutions Applied Managerial Perspective How We Will Study Financial Markets and Institutions Exploring the Web Collecting and Graphing Data Web Exercise Concluding Remarks ◼ Overview and Teaching Tips Before embarking on a study of financial markets and institutions, the student must be convinced that this subject is worth studying. Chapter 1 pursues this goal by showing the student that financial markets and institutions is an exciting field because it focuses on phenomena that affect everyday life. An additional purpose of Chapter 1 is to provide an overview for the entire book, previewing the topics that will be covered in later chapters. The chapter also provides the students with a guide as to how they will be studying financial markets and institutions with a unifying, analytic framework and an applied managerial perspective.In teaching this chapter, the most important goal should be to get the student excited about the material. I have found that talking about the data presented in the figures helps achieve this goal by showing the students that the subject matter of financial markets and institutions has real-world implications that they should care about.In addition, it is important to emphasize to the students that the course will have an applied managerial

PART 1 (INTRODUCTION)

(Financial Markets and Institutions, (Global Edition), 9e Frederic Mishkin, Stanley Eakins) (Solution Manual all Chapters) 1 / 4

Chapter 1: Why Study Financial Markets and Institutions? 3

Copyright © 2019 Pearson Education Ltd.perspective, which they will find useful latter in their careers. Going through the web exercise is also a way of encouraging the students to use the web to further their understanding of financial markets and institutions.◼ Answers to End-of-Chapter Questions

• Well performing financial markets tend to allocate funds to its more efficient use, thereby allowing

the best investment opportunities to be undertaken. The improvement in the allocation of funds results in a more efficient economy, which stimulates economic growth (and thereby poverty reduction).

• In a market economy, resources tend to flow to activities that provide the greatest returns for the risks

the lender bears. When economic activity weakens, monetary policymakers can push interest rate target (adjusted for inflation) temporarily below the economy’s natural rate, which lowers the real cost of borrowing. This improves bank balance sheets and the banks’ capacity to lend. During a financial crisis, many banks may have too little capital, which limits their ability to make loans during the initial stages of an economic recovery. By keeping short-term interest rates low, a central bank helps recapitalize the banking system by helping to raise the industry’s net interest margin (NIM), which boosts banks’ retained earnings, and thus, its capital. However, if interest rates are already at near zero, other solutions maybe necessary. For example, increased government spending through fiscal policy may be an alternative solution.

• If the value of the pound sterling declines in comparison to the euro, it makes British goods less

expensive. German consumers can consume more British goods in the Eurozone as British-made goods will be relatively cheaper than similar goods made in Germany or other countries in the Eurozone.

• Eurozone businesses will benefit from an increase in the value of the U.S. dollar as they will be able

to price products more competitively against American goods. U.S. importers of foreign-made goods like French wine and German appliances can expect a windfall as their products become cheaper.

• The lower price for a firm’s shares means that it can raise a smaller amount of funds, and so investment

in plant and equipment will fall.

• A bond is a debt instrument, which entitles the owner to receive periodic amounts of money

(predetermined by the characteristics of the bond) until its maturity date. A common stock, however, represents a share of ownership in the institution that has issued the stock. In addition to its definition, it is not the same to hold bonds or stock of a given corporation, since regulations state that stockholders are residual claimants (i.e. the corporation has to pay all bondholders before paying stockholders).

• People around the world follow stock markets. Due to fluctuating market conditions, people who

trade on the stock markets can make a lot of money in a day or lose much of it. Apart from this, people often speculate where the market is heading, which is often determined by changes in prices.This is why stock market conditions are usually newsworthy.

• Banks play a key role as the most important financial intermediary in fuelling the economic growth

process by allowing the expansion of physical and human capital and promoting financial innovation (the three key factors of economic growth). Infrastructure projects like roads, dams, and ports can be built because banks channel funds from saving accounts into these projects.

• / 4

• Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition, Global Edition

Copyright © 2019 Pearson Education Ltd.

• Fluctuations in the foreign exchange rate have a direct influence on consumers because when the

domestic currency weakens, imported goods will become more expensive and the consumption of foreign goods will decline. A weakening domestic currency is, however, good for exports.Conversely, a strong domestic currency means that imported goods will become relatively cheaper and their consumption will increase, but exported goods will become more expensive for foreign consumers. Figure 1.3 shows the value of the U.S. dollar in relation to other currencies from 1973–

• From this figure, we can see that the U.S. dollar reached a low point in the 1978–1980 period

and then appreciated dramatically until early 1985; these fluctuations in the exchange rate influenced the cost of imports and exports for American consumers accordingly.

• Financial institutions are what make financial markets work. Without them, financial markets would

not be able to move money from people who save to people or companies who need to borrow.Financial institutions thus play a crucial role in improving the efficiency of the economy.

• A robust financial market creates conditions for economic growth and financial sustainability for the

future by ensuring a constant (uninterrupted) flow of funds between savers and borrowers based on credible information on the best possible uses of these funds. However, when the information flow is not credible (i.e., lacks transparency), the system becomes susceptible to crises, and proper channeling of funds is interrupted, thus stalling economic growth and financial sustainability for the future.

• Monetary policy involves the management of interest rates and money supply. Hence, a monetary

policy affects interest rates, inflation levels, and business cycles. All of these individually and cumulatively have a huge influence on financial markets and financial institutions.

• The latest financial crisis in the US and Europe occurred in 2007 – 2009. At the beginning it hit

mostly the US financial system, but it then quickly moved to Europe, since financial markets are highly interconnected. One specific way in which these markets were related, is that some financial intermediaries in Europe held securities backed by mortgages originated in the US, and when these securities lost their a considerable part of their value, the balance sheet of European financial intermediaries were adversely affected.

• A debt market, or a bond market, is crucial to any economic activity as it enables corporations and

governments to borrow in order to finance their activities; it is also where interest rates are determined. Other than borrowing funds from banks, a company can also issue bonds to the public in order to raise money to finance their activities. A company issues bonds for the general public to buy.The buyer pays cash in return for the bonds, and the issuer pays an annual interest to the buyer. This transaction is operated within a debt market, which is different from the trading of shares of companies in the equity market by the general public.

• The latest financial crisis in Europe and the United States occurred in the 2007–09 period due to

which we have witnessed a riskier economic environment, fluctuating interest rates, crumbling stock markets, and speculative crises in foreign exchange markets. All these developments affect the functioning of financial institutions negatively; thus, institutions must learn to manage risks. 3 / 4

Chapter 1: Why Study Financial Markets and Institutions? 5

Copyright © 2019 Pearson Education Ltd.◼ Quantitative Problems

• The following table lists the foreign exchange rates between the U.S. dollar and the euro (EUR) during

February, 2014:

Date U.S. Dollars per EUR Date U.S. Dollars per EUR

2/1 1.348781 2/16 1.369300

2/2 1.328781 2/17 1.370679

2/3 1.352399 2/18 1.375730

2/4 1.350628 2/19 1.376089

2/5 1.351799 2/20 1.368862

2/6 1.360180 2/21 1.372465

2/7 1.361194 2/22 1.373730

2/8 1.363577 2/23 1.373741

2/9 1.363577 2/24 1.374172

2/10 1.364353 2/25 1.374726

2/11 1.365278 2/26 1.367002

2/12 1.359235 2/27 1.371264

2/13 1.366882 2/28 1.380712

2/14 1.369081

2/15 1.369300

Which day would have been the best day to convert $300 to euros? Which day would have been the worst? What would the difference be in euro?Solution: The best day is 2/2. At a rate of 1.328781/euro, you would have €225.77.The worst day is 2/28. At a rate of 1.380712/euro, you would have €217.28.The difference would be €225.77 – €217.28 = €8.49

• / 4