Mastering the Basics of Finance: A Beginner's Guide to Financial Instruments and Portfolio Management

 (Last update on: February 6, 2023)

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(Basics of Finance)

What is finance? 

The word finance is derived from the French language. Finance is very important for any individual, company and government. Finance is as vast as the ocean, just as the ocean is vast in itself, Finance is in a sense a vast ocean when it comes to money. The less said about finance! The resources we need to run any function, product, company and company system we call finance, this resource is directly related to our money. To start any company, organization or any start-up we need money, we also need to pay the salary of any kind of employees we hire, all these things are done only with money. So, in simple terms, finance means managing money. To start any manufacturing or company, we can invest that money ourselves, also if we are short of money, there are many institutions that provide us with loans, we call them finance institutes.

Finance is the disciplinary study of money, currency and capital assets. Finance is related to economics but not the same as economics. The study of the production, distribution and consumption of money, assets, goods and services combines finance and economics. Economic activities take place in financial systems in various sectors. Hence this sector can be roughly divided into personal, corporate and public finance.

In finance, in the financial system, assets are bought, sold or traded as financial instruments such as currency, debt, bonds, shares, stocks, options, futures etc. The property can also be banked, invested and insured. In practice there are always risks in any financial activity and organization.

A wide range of subsectors in finance exists due to its wide scope. The objective of asset, money, risk and investment management is to maximize value and minimize volatility. Financial analysis is an evaluation of the feasibility, sustainability and profitability of an action or entity. In some cases, theories of finance can be tested using the scientific method embodied by experimental finance.

Finance is a multidisciplinary field such as mathematical finance, financial law, financial economics, financial engineering, and financial technology, so finance is the foundational field for business and accounting.

The early history of finance parallels the early prehistory of money. Ancient and medieval civilizations incorporated basic functions of finance such as banking, trade and accounting into their economies. In the late 19th century, the global financial system was created.

In the mid-20th century, finance emerged as a separate academic discipline, distinct from economics. The first academic practice in finance, The Journal of Finance, began publication in 1946. The earliest doctoral programs in finance were then established in the 1960s and 1970s. Finance is widely studied at undergraduate and postgraduate levels.

There are three main types of finance: Personal finance, Corporate finance, Public finance.

The application of economic principles to any decision making that involves the allocation of money under conditions of uncertainty is what we call finance. In other words, in finance we care about money and we care about the future. Investors allocate their funds in financial assets to meet their objectives, and businesses and governments raise funds by issuing claims against themselves and then use those funds for operations.

Finance provides a framework for making decisions about how to obtain funds and what to do with them once they are received. A framework is a financial system that provides a platform through which funds are transferred from organizations that have funds to organizations that need funds.

The foundations of finance are drawn from the field of economics, and for this reason, finance is often referred to as financial economics. Competition is important in company valuation. The ability to keep competitors at bay is valuable because it ensures that the company can continue to make financial profits.

Finance is…

• It is based on economic principles.
• Accounting uses information as input to make decisions.
• Finance is analytical, statistical, probability and mathematical to solve problems.
• Also, the study of how to raise money and invest it productively from a global perspective.

The tools used to make economic decisions are drawn from many fields outside of Economics: Financial accounting, Mathematics, Probability theory, Statistical theory, and Psychology.

One can think of the field of finance as comprising three areas: Capital markets and Capital market theory, Financial management and Investment management. The three areas are interconnected based on a common set of theories and principles.

Financial profit is earnings beyond the cost of capital used to generate revenue. In other words, financial profit is the return expected based on the risk of the investment in excess of the normal profit.

Capital Market and Capital Market Theory

The field of capital markets and capital market theory focuses on the study of financial systems such as the structure of interest rates and the pricing of risky assets. The financial system of an economy consists of three components: Financial markets, Financial intermediaries, Financial regulators. For this reason the sector is often referred to as financial markets and institutions.

Many of the important topics covered in this specialized area of finance are the price efficiency of financial markets, the role and investment behavior of financial market players, the best way to structure and regulate financial markets, the measurement of risk, and the theory of assets. Price The price efficiency of financial markets is important because it relates to whether investors can Beat the market. Capital Markets If a market is highly cost efficient, it is extremely difficult for investors to earn higher than expected returns for the level of investment risk. That means it is difficult for investors to beat the market. An investor following an investment strategy seeking to beat the market must believe that the sector of the financial market to which the strategy is applied is not very price efficient, such a market beating strategy is called an active strategy. Financial theory states that if capital markets are efficient, the optimal strategy is not an active strategy, but rather a passive strategy that tries to match market performance.

Beating the market in finance means outperforming the market by earning the expected return on investment after adjusting for risk and transaction costs. What is expected from the investment after adjusting for risk? To be able to determine this quantitatively, it is necessary to develop and empirically test theories about how an asset is valued, or equally to determine the fair value of an asset.

A basic and important principle of valuation is that the value of any financial asset is the present value of expected cash flows. Thus valuation of financial assets involves estimating expected cash flows. Determining the appropriate interest rate or interest rates that should be used to discount cash flows. It is also necessary to calculate the present value of expected cash flows. For example valuing a stock often involves predicting future dividends and measuring how uncertain these dividends are. Calculating the present value or discounted value of cash flows requires the use of basic finance mathematics. In this calculation process of present value or discounted value, an appropriate interest rate, referred to as the discount rate, should be used. Capital market theory provides guidance to investors in choosing the right interest rate.

Financial Management (what is financial management?)

Financial management, sometimes called business finance or corporate finance, is a specialized area of finance concerned with financial decision-making within a business entity. Although financial management is referred to as corporate finance, the principles of financial management also apply to other types of business and government organizations. Financial managers are primarily concerned with investment decisions and financing decisions in organizations, whether the organization is a sole proprietorship, limited liability company, partnership, corporation, or government agency.

Essential questions for buying or selling all types of property:

• Should the business buy a new machine?
• Should the business introduce a new product line?
• Sell an old manufacturing facility?
• Want another business?
• Build a manufacturing plant?
• Maintain high levels of inventory?

Financing decisions are concerned with the purchase of funds that can be used for long-term investments and day-to-day operations.

• Should financial managers use the increased profits from company revenues or distribute those profits to owners?
• Should financial managers take money from outside the business?

A company's operations and investments can be financed by borrowing from outside the business (such as through bank loans or the sale of bonds or by selling ownership interests). Because each method of financing imposes different constraints on the business, financing decisions are extremely important. Also the financing decision includes the dividend decision. This decision involves how much of the company's profits to retain and how much to distribute to owners.

A company's financial strategic plan is a framework for achieving the company's goal of maximizing shareholder wealth. Long-term and short-term financial planning is necessary to implement the strategic plan. This planning combines the company's sales forecasts with financing and investment decision making. Budgeting is used to manage the information used in this financial planning. Performance measures are used to evaluate progress toward strategic goals.

A company's capital structure is the mix of debt and equity that management chooses to finance the company's assets. There are many economic theories about how to finance a company and whether an optimal capital structure (i.e. one that maximizes the value of the company) exists.

The investment decisions undertaken by the financial manager involve the long-term commitment of the company's scarce resources in long-term investments. These decisions are called capital budgeting decisions. These capital budgeting decisions play a major role in determining the success of a business venture. While there are capital budgeting decisions that are routine so do not change the company's course or risk, there are also strategic capital budgeting decisions that either affect the future market position of the company's current product lines or allow it to expand.

The financial manager needs to make decisions about the company's current assets because current assets are those assets that can be converted into cash in one operating cycle or one year. Current assets include cash, marketable securities, accounts receivable, and inventories and support a company's long-term investment decisions.

Company risk management is another important function in financial management, which involves deciding which risks to accept, as well as which to neutralize and which to transfer in the process of risk management. There are four major processes in risk management which are given below:

1. Identification
2. Assessment
3. Mitigation
4. Transfer

The traditional process of risk management focuses on managing the risks of only parts of the business (products, departments or divisions) without regard to the effects on the value of the company. While some form of enterprise risk management is practiced by large corporations, it is applied to the company as a whole. Enterprise risk management allows aligning risk appetite and strategies across the company, improving the quality of company risk response decisions, as well as identifying and managing risks across the company.

Acknowledging the reality of risk is the first step in the risk management process. Denial is a common tactic that substitutes willful ignorance for thoughtful planning.

Investment Management

Investment management is an important area of finance concerned with the management of individual or institutional funds. Asset management, portfolio management, money management and wealth management are all other terms used to describe the field of finance. In industry terms, an asset manager drives money.

Investment management consists of five primary activities: Setting investment objectives, Establishing an investment policy, Selecting an investment strategy, Selecting specific assets, Measuring and evaluating investment performance. Investment management begins with setting investment goals or a thorough analysis of what the client wants to achieve. Given the investment objectives, the investment manager develops strategic guidelines, taking into account any client-imposed investment limitations, legal/regulatory constraints and tax restrictions. This task begins with a decision on how to allocate the assets in the portfolio. A portfolio is a set of investments that are managed for the benefit of a client or clients. Also the investment manager must choose a portfolio strategy consistent with investment objectives and investment policy guidelines.

Portfolio strategies are generally classified as active or passive, and these portfolios are tasked with selecting specific financial assets, hence referred to as the portfolio selection problem, which is the next step. Harry Markowitz formulated the theory of portfolio selection in 1952. This theory suggests how investors can construct portfolios based on two parameters: the average return and the standard deviation of the returns. Also the latter parameter is a measure of risk. One of the most important tasks is to evaluate the performance of the asset manager. This function allows the client to determine answers to questions such as: How did the asset manager perform after adjusting for the risks associated with the planned active strategy? And how did the asset manager achieve the reported returns?

• It combines economics, psychology, accounting, statistics, mathematics and probability theory to make decisions involving future outcomes.
• Finance is usually comprised of three related areas: capital markets and capital market theory, financial management and investment management.
• Capital markets and capital market theory focus on financial systems that include markets, intermediaries, and regulators.
• Financial management focuses on making business enterprise decisions, including decisions related to investing in long-term assets and financing these investments.
• Investment management manages the investments of individuals and organizations.

Financial system (Financial Instruments, Markets and Intermediaries).

A strong financial system is very important for everyone. When markets work, people throughout the economy benefit. When the financial system is under stress, millions of workers suffer the consequences. Governments have a responsibility to ensure that our financial system is effectively regulated.

A country's financial system consists of institutions that help facilitate the flow of funds from those who have funds to those who need funds to invest. Is it necessary to round up enough people willing to lend to finance the purchase of a home? It will be challenging and a little awkward but it requires careful planning. Likewise, a lot of paperwork to keep track of loan agreements, how much tax and who should be repaid? What about the people you are borrowing from? How should they assess whether they should lend and what interest rate they should charge for the use of their funds?

Dealing directly with other parties or parties in lending and investment situations is not only awkward, but there is also the problem that one party has a different information set than the other. In other words, it is an information asymmetry.

Financial systems enable more efficient transfers of funds by reducing the problem of information asymmetry between those who have funds to invest and those who need funds. Apart from lenders and borrowers, the financial system consists of three major components:

(1) Financial markets where transactions take place.

(2) Financial intermediaries who facilitate transactions.

(3) Regulators of economic activity who try to ensure that everyone is playing fairly.

Financial assets

A financial asset is a resource that is expected to provide future benefits and therefore has a financial value. Financial assets can be classified into two types: tangible assets and intangible assets. The value of a tangible asset is based on its physical properties. Such as buildings, aircraft, land and machinery are some examples of tangible assets, which we often refer to as fixed assets.

An intangible asset represents a legal claim to some future financial gain or benefit. Intangible assets include patents, copyrights and trademarks. The value of the intangible asset has no relation to the form, physical or otherwise, in which the claims are recorded. Stocks and bonds are also intangible asset instruments because future benefits come in the form of a claim to future cash flows. A financial instrument can also use the term for a financial asset. Often certain types of financial instruments are referred to as securities, including stocks and bonds.

Every financial instrument has at least two parties. The party that agrees to make future cash payments is the issuer and the party that owns the financial instrument. Hence the investor is entitled to receive the payments made by the issuer.

Why does everyone need financial assets?

Financial assets serve two major functions:

• It helps to allow the transfer of funds from institutions that have excess funds to those that need funds to invest in tangible assets.

• Financial assets allow the transfer of funds in a way that helps redistribute the inherent risk associated with the cash flows of tangible assets between those seeking and providing funds.

However, the claims of holders of ultimate assets are usually different from the obligations issued by those institutions, because the activities of institutions operating in financial systems transform the ultimate obligations of financial intermediaries into different financial assets preferred by investors.

What is the difference between debt and equity?

A financial instrument may be classified by the investor's claim on the issuer. A financial instrument in which the issuer agrees to pay the investor interest as well as repay the borrowed amount is a debt instrument or simply a loan. Debt can be in the form of a loan, bond or note. The issuer is required to pay interest payments which are fixed as per the agreement. In the case of debt instruments required to make payments, this amount may be a fixed dollar amount or a percentage of the face value of the loan, or may vary depending on some benchmark. An investor who lends funds or expects interest and repayment of the loan is a creditor of the issuer.

The key point is that an investor in a debt instrument cannot borrow more than the contractual amount, so debt instruments are often referred to as fixed income instruments.

Mickey Mouse Loan

The Walt Disney Company bonds issued in July 1993 and maturing in July 2093 bear interest at 7.55%. This means that Disney pays investors who buy bonds $7.55 a year for every $100 of debt they own.

An equity instrument against a debt obligation specifies that if the issuer pays the investor an amount based on earnings, the issuer must pay the obligation owed to the company's creditors. Common stock and partnership shares are examples of equity instruments, a stock is an ownership interest in a corporation, while a partnership share is an ownership interest in a partnership. Hence any distribution of company's earnings is referred to as dividend.

Example of common stock

Procter & Gamble, a US consumer products company, had 3,032,717 shares outstanding at the end of 2008, with financial institutions owning nearly 60% of the stock. Procter & Gamble includes pension funds and mutual funds. The remainder of Procter & Gamble's stock was owned by individual investors. The stock is therefore listed on the New York Stock Exchange with the ticker symbol PG.

Some financial instruments fall into both the categories of common stock and partnership shares depending on their properties. A preferred stock is a hybrid because it resembles debt in that investors in this security are entitled to receive only a fixed contractual amount. Preferred stock is similar to equity as payments to investors are made only after the company's debt obligations are met.

Preferred stock is referred to as a fixed income instrument because preferred stockholders are generally entitled to a fixed contractual amount, so fixed income instruments include debt instruments and preferred stock.

A hybrid instrument is a convertible bond or convertible note. A convertible bond or note is a debt instrument that allows the investor to convert into shares of common stock under certain conditions and at a certain exchange ratio.

Do you want loans or stocks?

Ticker: SIRI- Sirius XM Radio issued convertible notes in October 2004. The notes bear interest at 3.25% and Sirius XM Radio Inc. Exchangeable at the rate of 188.6792 shares of the Company's common stock. Principal amount of $1000 notes.

The notes matured in 2011 giving investors in these convertible notes time to convert their notes into shares, otherwise they would receive the $1000 face value of the notes.

The classification of debt and equity is very important for two legal reasons. The first reason is that investors in debt instruments have priority over equity investors in their claims on the issuer's assets in the event of the issuer's bankruptcy. Second, the tax treatment of payment by the issuer differs depending on the type of class. Interest payments especially on debt instruments are tax deductible to the issuer while dividends are not.

Role of Financial Markets

Investors exchange financial instruments in financial markets. Trade is a more popular term for the exchange of financial instruments. Financial markets provide three major economic functions: price discovery, liquidity, and reduction of transaction costs.

Price discovery is the interaction of buyers and sellers in financial markets that determine the price of traded assets. Equally, financial market participants determine the required return to purchase that financial instrument. Financial markets indicate how available funds are allocated from those who want to lend or invest funds to those who need funds. Because the motive of the fund seekers depends on the required return demanded by the investors.

Second, financial markets provide a platform for investors to sell financial instruments and hence provide liquidity to investors. The presence of buyers and sellers ready to trade is called liquidity. This is an attractive feature when conditions arise that force or induce the investor to sell the financial instrument. Without liquidity the investor will be forced to hold the financial instrument until either 1) conditions arise that permit the disposal of the financial instrument or 2) the issuer is contractually obligated to repay it. For a debt instrument when it matures or for an equity instrument which does not mature but, as long as there is a perpetual security, the company is not liquidated voluntarily or involuntarily. All financial markets provide some form of liquidity so the degree of liquidity is a factor that characterizes different financial markets.

A third economic function of a financial market is that it lowers transaction costs when parties want to trade a financial instrument. Transaction costs can generally be classified into two types: search costs and information costs.

Search costs fall into two categories namely explicit costs and implicit costs. Expenditure on advertising one's intention to sell or buy a financial instrument is included in conspicuous expenditure. Implicit costs include the value of time spent searching for a counterparty, such as for a seller-to-buyer or buyer-to-seller transaction. The presence of some form of organized financial market in implicit costs reduces search costs.

Information costs are the costs associated with evaluating the investment properties of a financial instrument, so in an efficient market, prices reflect the aggregate information gathered by all market participants.

Role of Financial Intermediaries

The important role of financial markets to invest those who have funds and efficiently allocate funds to those who need them may not always work. As a result, financial systems require a specific type of financial entity, financial intermediation, when circumstances make it difficult for borrowers or investors of funds to deal directly with borrowers of funds in financial markets. Financial intermediaries include depository institutions, non-deposit finance companies, insurance, regulated investment companies and investment banking companies.

The role of financial intermediaries is to create more favorable transaction terms through lenders/investors and borrowers than those dealing directly with each other in financial markets. Financial intermediaries complete the following two steps in the process:

1. Obtaining funds from lenders or investors.
2. Financial intermediaries lend or invest funds to those who need funds.

Funding by a financial intermediary depends on the financial claim, either the financial intermediary's debt or the financial intermediary's equity participation. Where a financial intermediary provides funds or invests it becomes an asset of the financial intermediary.

Let's consider two examples using financial intermediaries:

Example 1: A commercial bank

A commercial bank is a type of depository institution, which accepts deposits from individuals, corporations and governments, the depositors are lenders to the commercial bank. The funds received by the merchant bank are the responsibility of the merchant bank. The bank then in turn provides these funds by either lending or buying securities. These loans and bonds become the assets of the merchant bank.

Example 2: Mutual Fund

A mutual fund is a type of regulated investment company, which accepts funds from mutual fund investors and in return issues mutual fund shares to the investors. A mutual fund invests those funds in a portfolio of financial instruments. Mutual fund shares represent an equity interest in a portfolio of financial instruments, and financial instruments are the assets of the mutual fund.

Basically this process allows financial intermediaries to convert financial assets that are less desirable to a large segment of the investing public. Among other financial assets are their own liabilities which are widely preferred by the people. This economic asset transformation provides at least one of three economic functions:

1. Maturity intermediation.
2. Reducing risk through diversification.
3. Cost reduction for contracts and information processing.

Let's have a brief description of each.

Other services that financial intermediaries can provide include:

• The function of facilitating the trading of financial assets for clients of financial intermediaries through a brokerage system.
• The act of facilitating the trading of financial assets by using own capital to take other positions in financial assets to accommodate customer transactions.
• Assisting in the creation of financial assets for its customers and distribution of those financial assets to other market participants.
• Providing investment advice to clients.
• Managing the financial assets of customers.
• Providing payment mechanism.

Now the three financial functions of financial intermediaries are described as follows, when they convert financial assets.

Maturity intermediation

In the example of a commercial bank, two things need to be noted. First, the maturities of deposits are generally short-term. Banks have deposits that are payable on demand or have a specific maturity date and are usually less than three years. Second, the maturity of a loan made by a commercial bank may exceed three years. What would happen if commercial banks did not exist in the financial system? In this scenario, borrowers will either (1) borrow for a shorter period to match the loan term they are willing to lend, or (2) find borrowers who are willing to invest for the requested loan term.

If commercial banks are considered in terms of financial system, by issuing its own financial claims, the commercial bank converts into a long-term asset by lending to the borrower for the requested period and the depositor (borrower) into a financial asset. This function of financial intermediaries is referred to for the desired investment horizon and maturity is arbitrated.

Maturity intermediation has implications for financial systems in two ways. The first implication is that borrowers/investors have more options regarding the maturity of the financial instruments they invest in and borrowers have more options for the length of their debt obligations. Another implication is that investors are reluctant to fund long-term loans, forcing them to pay higher interest rates to long-term borrowers than to short-term loans. However, the financial intermediary is willing to provide long-term loans and at a lower cost to the borrower than the individual investor, because the financial intermediary can rely on continuous funding sources over a long period of time (albeit with some risk). (For example - a depository institution may reasonably expect to hold successive deposits to be able to fund a long-term investment, thus reducing the cost of long-term debt in the economy as a result of intermediation).

Reducing risk through diversification ( What is diversification? )

Suppose a mutual fund invests the funds received from investors in the stocks of a large number of companies, thereby diversifying the mutual fund and reducing its risk, i.e. reducing the risk of investing in assets whose returns do not move in the same direction at the same time is called diversification.

Investors with small amounts of money to invest find it difficult to achieve diversification like mutual funds because they don't have enough funds to buy shares of a large number of companies, but investors can achieve this diversification by investing in mutual funds for the same dollar amount invested, thus reducing risk.

Financial intermediaries perform the financial function of diversification, converting riskier assets into less risky assets. Individual investors with sufficient funds can diversify on their own, although they cannot do so as cost-effectively as financial intermediaries. One of the most important economic benefits for financial systems is to provide cost-effective diversification to reduce risk by purchasing the financial assets of a financial intermediary.

Reducing the Costs of Contracting and Information Processing

Investors buying financial assets must develop the necessary skills to assess their risk, as well as return. After developing the necessary skills, investors can apply them to analyze specific financial assets when considering their purchase or sale. Investors who want to make loans to businesses or customers must have the skills to write legally enforceable contracts to protect their interests. Investors should monitor the financial condition of the borrower after granting this loan, and if necessary take legal action if the borrower violates any of the provisions of the loan agreement. While some investors may enjoy devoting free time to this task if they have the prerequisite skill set, most find free time scarce and want to be compensated for the sacrifice. This compensation may take the form of a higher return on investment.

In addition to the opportunity cost of time to process information about a financial asset and its issuer, the cost of obtaining that information must be considered, such costs are called information processing costs. Costs associated with writing loan agreements are contract costs. Another aspect of contractual costs is the cost of enforcing the terms of the loan agreement.

Keeping these points in mind, it is necessary to consider two examples of financial intermediaries, commercial banks and mutual funds. Two financial intermediaries, commercial banks and mutual funds, are staffed by investment professionals trained to analyze and manage financial assets. In the case of loan agreements either standardized agreements may be drawn up or legal advice may be part of professional staff involving more complex transactions. Investment professionals monitor the borrower's activities to assure compliance with the terms of the loan agreement, taking action to protect the interests of financial intermediaries where there is any violation.

It is obviously costly for financial intermediaries to maintain such staff as investment of funds is their normal business. Financial intermediaries are aware of contracting and processing information about financial assets due to the amount of funds they manage. (1) accumulate for the benefit of investors who purchase financial claims of financial intermediaries; and (2) issuers of financial assets (due to reduced funding costs).

Regulating financial activities

Most governments in all countries regulate various aspects of economic activity because they recognize the important role played by the country's financial system. Although the degree of regulation varies by country, regulation takes one of four forms:

1. Disclosure Regulation.
2. Regulation of Economic Activities.
3. Regulation of Financial Institutions.
4. Regulation of Foreign Participants.

Disclosure regulation requires any publicly traded company to provide timely financial information and non-financial information, thereby affecting the value of its security to actual and potential investors. Governments justify disclosure regulation by pointing out that the issuer can have better information about the financial well-being of the organization than those who own or consider owning the securities.

Economies of scale are the reduction in cost per unit as the number of units sold and produced increases. In this context, this cost benefit comes when the intermediary increases the scale of its operations in the contract and process.

Economists refer to this unequal information or unequal access as asymmetric information. Disclosure regulations are contained in various securities laws, which mandate the Securities and Exchange Commission (SEC) to collect and publish relevant information and to punish issuers who provide fraudulent or misleading data. However disclosure regulation does not seek to prevent the distribution of risky assets. Disclosure is the sole motivation of the SEC to ensure that issuers provide diligent and intelligent investors with the information necessary to properly evaluate securities.

Trading on financial markets includes the regulation of financial activities and the regulation of traders in securities. The best example of this type of regulation is a set of rules restricting the trading of securities by people who, because of their privileged position within the corporation, know more about the issuer's financial prospects than the general investing public. Corporate managers and board members include, but are not limited to. Although it is not illegal for insiders to sell or buy a company's stock, they are considered insiders. Illegal insider trading is based on an individual trading in a company's security. Illegal insider trading is a problem caused by asymmetric information. The SEC is responsible for monitoring the transactions that directors, corporate officers, and major stockholders make in their firm's securities.

Another example of financial activity regulation is the set of rules applied regarding the operations and trading of securities where exchanges are structured by the SEC. The justification for such rules is that they reduce the likelihood that members of an exchange will, under certain circumstances, be able to commit fraud by colluding with the general investing public. Self-regulatory organizations and the SEC, the Financial Industry Regulatory Authority (FINRA), are responsible for the regulation of markets and securities firms in both states.

The SEC and the (CFTC) Commodity Futures Trading Commission, another federal government agency, share responsibility for federal regulation of trading in options, futures, and other derivative instruments. Derivative instruments are securities whose value depends on a specific other security or asset (for example - a call option on a stock is a derivative security, so the value of this stock depends on the value of the underlying stock.)

Regulation of financial institutions is a form of government oversight that restricts activity. Due to the important role of financial institutions in the country's economy, regulation by the government is justified.

Government regulation of participants in another country includes restrictions on the role that foreign companies can play in the country's domestic market and in the ownership or control of financial institutions. Although many different countries have these types of regulations, the trend is to reduce these restrictions.

Lists securities markets and securities laws in major countries. The current regulatory system consists of market and industry focused regulators.

Although the details of the financial regulatory reform have not been finalized, there are several elements of reform that appear in the key proposals:

• An advanced warning system that seeks to identify systemic risks before they affect the general economy.
• Increased transparency in mortgage brokerage, consumer finance, asset backed securities and complex securities.
• Increased transparency of credit-rating firms.
• Enhanced consumer protection.
• Increased regulation of nonbank lenders.

Types of financial markets

Earlier this article provided the general role of financial markets in the financial system. In this article let's look at several ways of classifying financial markets.

We can break down the financial market of a country into internal market and external market from below country perspective. Internal market is also called national market. This market consists of two parts domestic market and foreign market. Domestic markets are those domiciled in the country that issue securities and where investors trade those securities. (For example:- Securities issued by Microsoft Corporation trade in domestic market from United States perspective).

Federal regulation and description of securities markets in the United States

• Securities Act of 1933 - This act regulates new offers of securities to the public. It requires the filing of a registration statement containing specific information about the issuing corporation and prohibits fraudulent and fraudulent practices related to security offerings.
• Securities and Exchange Act of 1934 - Establishes the Securities and Exchange Commission (SEC) to enforce securities regulations and increase regulation for secondary markets.
• Investment Company Act of 1940 - Gives the SEC regulatory authority over publicly held companies engaged in the business of investing in and trading securities.
• Investment Advisers Act of 1940 - required registration of investment advisers and regulation of their activities.
• Federal Securities Act of 1964 - Expands the SEC's regulatory authority to include the over-the-counter securities market.

• Securities Investor Protection Act of 1970 - Creates the Securities Investor Protection Corporation, which is charged with the liquidation of securities firms in financial difficulty and which insures investor accounts with brokerage firms.
• Insider Trading Sanctions Act of 1984 - Provides for treble damages against violators of securities laws.
• Insider Trading and Securities Fraud Enforcement Act of 1988 - Provides preventive measures against insider trading and establishes enforcement procedures and penalties for violations of the securities laws.
• Private Securities Litigation Reform Act of 1995 - Limits shareholder lawsuits against companies, provides a safe-harbor for forward-looking statements by companies, and provides for auditor disclosure of corporate fraud.
• The Securities Litigation Uniform Standards Act of 1998 - amends the Private Securities Litigation Reform Act of 1995, limiting the ability of plaintiffs to bring securities fraud cases through state courts.
• Sarbanes-Oxley Act of 2002 – sweeping changes that provided improvements in corporate accountability and financial disclosures, creation of a public company accounting oversight board, and increased penalties for accounting and corporate fraud.

A foreign market is where securities of issuers not domiciled in the country are sold and traded. (For example:- Seen from a US perspective, securities issued by Toyota Motor Corporation trade in foreign markets). The overseas market in the United States is also referred to as the Yankee market. The security issuing regulatory authority enforces the rules for the issuance of foreign securities. (For example:- Corporations seeking to issue securities in a non-U.S. United States must comply with U.S. securities laws). Non-Japanese corporations that wish to sell securities in Japan must comply with the regulations enacted by the Japanese Ministry of Finance and Japanese securities.

Yankee Market and more...

The foreign market is nicknamed the Samurai Market in Japan, the Bulldog Market in the United Kingdom, the Rembrandt Market in the Netherlands and the Matador Market in Spain.

External market is another sector of financial market of a country. Securities with the following two distinctive features are traded in this market:

• Securities are offered simultaneously to investors in multiple countries during a trade issue.
• These securities are issued outside the jurisdiction of any one country.

External markets are referred to as international markets, offshore markets and Euromarkets (although these markets are not limited to Europe).

Money Market

Money market is a sector of financial market. This sector includes financial instruments with a maturity or maturity date of one year or less at the time of issuance. Generally money market instruments are debt instruments. These debt instruments include treasury bills, commercial paper, negotiable certificates of deposit, repurchase agreements and bankers' acceptances.

Treasury bills (also known as T-bills):- These are short-term securities issued by the US government; Their original maturity is four weeks, three months or six months. T-bills do not carry any stated interest rate. In lieu of this interest rate, the government sells these securities on a discounted basis. That is, the T-bill holder gets a return by buying the securities at a price lower than the maturity value.

Commercial paper:- It is a promissory note. A written promise to pay is issued by a large, creditworthy corporation or municipality. Commercial paper is the original maturity of a financial instrument that typically ranges from one day to 270 days. Most issuers of commercial paper back up the paper with a bank line of credit, which means that the bank is ready to pay the liability if the issuer is unable. These commercial papers can either be interest bearing or sold on a discounted basis.

Certificates of Deposits (CDs):- These are written promises by a bank to pay a depositor. Investors can buy and sell negotiable certificates of deposit consisting of CDs issued by major commercial banks. Negotiable CDs typically have original maturities between one month and one year, and are valued at more than $100,000. Investors pay face value for a negotiable CD, plus receive a fixed interest rate on the CD. On the maturity date of this certificate of deposit, the issuer repays the principal and interest.

Eurodollar CD:- This is a negotiable CD for US dollar deposits in a bank located outside the United States or in international banking facilities. The interest rate on Eurodollar CDs is the London Interbank Offered Rate (LIBOR), the rate at which major international banks are willing to offer each other fixed Eurodollar deposits. A repurchase agreement is also a type of short-term loan. There is another form of taking. Let's further describe why companies use this tool to understand this agreement. There are participants in this financial system who use leverage to implement trading strategies in the bond market. That is, monetary policy involves buying bonds with borrowed funds. In this agreement, instead of borrowing from the bank, the market participant can use the securities borrowed as collateral for the loan. Specifically, a lender can lend a certain amount of funds to an organization in need of funds using bonds as collateral. This common loan agreement is referred to as a repurchase agreement, or repo, because it specifies that the borrower sells the bonds to the borrower in exchange for proceeds, plus the borrower repurchases the bonds from the borrower at a specified price at some specified future date. The specified price, also called the repurchase price, is higher than the price at which the bond is sold because it reflects the interest expense charged to the borrower. Repo rate is the interest rate in repo (Repo interest rate). Thus repo is nothing more than a collateralized loan. A loan backed by a specific asset is classified as a money market instrument as the repo term is generally less than one year.

Bankers' Acceptance:- These are short-term loans, usually granted by banks to importers and exporters, to finance specific transactions. An acceptance is created when a bank customer writes a draft (promise to pay) and the bank accepts it with a promise to pay. A bank's acceptance of a draft is a promise to pay the face amount of the draft to whoever presents that acceptance for payment. So the bank customer then finances the transaction using the draft. These drafts are issued to the supplier in exchange for goods, as the acceptances arise from specific transactions, they are available in various principal amounts. Bankers' acceptances generally have maturities of less than 180 days, so bankers' acceptances are sold at a discount to their face value and paid at maturity. Bankers' acceptances are less likely to default, as both the bank issuing the acceptance and the buyer of the goods are backed.

Capital market

The capital market is a sector of the financial market, in which long-term financial instruments issued by corporations and governments are traded. Long-term here refers to financial instruments with an original maturity of more than one year and permanent securities (those with no maturity). There are two types of capital market securities: those that represent shares of ownership interest, issued by corporations, also called equity, and those that represent indebtedness, issued by corporations and US, state, and local governments.

The difference between equity and debt instruments has been described earlier. Equity includes common stock and preferred stock. Because common stock represents ownership of the corporation and because the corporation has a perpetual life, common stock is a perpetual security, this stock has no maturity. Preferred stock also represents an ownership interest in a corporation, which can either have a redemption date or be perpetual.

A capital market debt obligation is a type of financial instrument. This loan obligation commits the borrower to repay the maturity value within a specified period beyond one year. We can divide these debt obligations into two types: bank loans and debt securities. Bank loans were once not considered capital market instruments, but today there is a huge market for trading these debt obligations. Syndicated bank loan is one such type of bank loan. It is a loan in which a group of banks (or syndicate) provides funds to the borrower. The need for a group of banks arises because the amount demanded by the borrower and the credit risk may be too great for any single bank.

Debt securities include bonds, notes, asset backed securities and medium term notes. The difference between a bond and a note relates to the number of years until the obligation is satisfied after the issuer issues the original security. Historically a first rate note is a debt security with a maturity at issuance of 10 years or less. And bonds are meant to provide debt security with a maturity of more than 10 years.

The difference between a note and a medium term note has nothing to do with maturity, but rather with the manner in which the security is issued. A bond, note or medium-term note is referred to simply as a bond in this article. Investors in any debt obligation are referred to as debt holders, bondholders, borrowers or noteholders.

Derivatives Market

Financial markets can be classified into derivatives market and cash market. Cash market is also called spot market. A cash market is a market for the immediate purchase and sale of a financial instrument. Some financial instruments are contracts that specify that the holder of the contract has an obligation or option to buy or sell something either at or before a future date. It is the underlying asset or simply the underlying that is the subject of the contract. The contract may contain an underlying stock, bond, financial index, interest rate, currency or commodity. These are contracts that derive their value from the underlying value, hence these contracts are referred to as derivative instruments or simply derivatives. Markets in which derivative instruments are traded are known as derivatives markets.

These markets include derivative instruments such as forwards, futures, options, swaps, caps and floors. A discussion of the important financial instruments in this market as well as their applications in corporate finance and portfolio management is covered in later chapters.

The primary role of derivative instruments is to provide a transactionally efficient vehicle to protect issuers and investors from various types of risks. At an early stage it is difficult to see how derivatives are useful for controlling risk in an efficient way because often the popular press focuses on how derivatives are misused by corporate treasurers and portfolio managers.

This distinction between notes and bonds is not strictly true, but is consistent with the common usage of the terms note and bond. Whether notes and bonds contain an indenture agreement is identified by a legal agreement specifying the terms and any restrictions of borrowing and the identification of a trust to look after the interests of the borrowers. A bond has an indenture agreement, while a note does not have an indenture agreement.

Primary market

When an issuer first issues a financial instrument, that instrument is sold in the primary market. Companies raise new capital in the market by selling new issues. Hence the primary market is the market whose sale generates income for the issuer of the financial instrument. Compliance with securities laws is essential when issuing securities. Both the public market and the private placement market comprise the primary market.

Public market offerings of new issues typically involve the use of an investment bank, so investment banks' process for bringing securities to the public market is underwriting. Another method of auction process is to offer new issues. Bonds of certain entities such as some regulated entities and municipal governments are issued in this manner.

To the general investing public, privately held securities have different regulatory requirements. Two major securities laws in the United States - the Securities Act of 1933 and the Securities Exchange Act of 1934 - declare that all securities offered to the general public must be registered with the SEC unless an exemption is granted.

One of the exemptions specified in the 1933 Act is "for transactions not involving any public offer by the issuer". Such an offer is referred to as a private placement offering. Before 1990, buyers of privately held securities were not allowed to sell these securities for up to two years after acquisition.

SEC Rule 144A, adopted by the SEC in 1990, eliminates the two-year holding period if certain conditions are met. As a result the private placement market is now classified into two categories: (1) Rule 144A offerings and (2) Non-Rule 144A offerings. (commonly referred to as a traditional private placement).

Secondary market

Financial instruments are resold to investors in the secondary market. Issuers do not raise new capital in the secondary market so the issuer of the security does not receive money from the sale. Trading takes place between investors in the secondary market. Also, investors buying and selling securities in this market can avail the services of stock brokers, organizations that buy and sell securities for their clients.

The way in which they trade in secondary markets is referred to as market structure. Order driven and quote driven are the two overall main market structures for trading financial instruments.

Market structure is the mechanism by which buyers and sellers interact to determine price as well as quantity. In an order-driven market structure, buyers and sellers submit their bids through their brokers, who send these bids to a centralized location for bid matching and transaction execution. This market is also known as auction market.

In a quote-driven market structure, intermediaries (market makers or dealers) quote prices at which public participants trade. Market makers provide a bid quote (to buy) and an offer quote (to sell) and earn revenue from the spread between these two quotes. Market makers thus profit from the turnover and spread of their security inventory. Hybrid market structures contain elements of both quote-driven and order-driven market structures.

Secondary markets can also be classified in terms of organized exchanges and over-the-counter markets. Exchanges are central trading venues where financial instruments are traded, so financial instruments must be listed by an organized exchange. By listing, we mean that a financial instrument has been accepted for trading on an exchange. To be listed, an issuer must meet the requirements set by the exchange.

In the case of common stocks, the main organized exchange is the New York Stock Exchange (NYSE). For a corporation's common stock to be listed on the NYSE, for example, it must meet minimum requirements for pretax earnings, net tangible assets, market capitalization, and the number and distribution of publicly held shares. In the United States, the Securities and Exchange Commission (SEC) must approve a market to qualify as an exchange.

In contrast, the over-the-counter market (OTC market) is typically the trading of unlisted financial instruments. For common stocks, there are listed and unlisted stocks. Although listed bonds, bonds are generally unlisted and therefore trade over-the-counter. Same is the case with loans. The foreign exchange market is the OTC market. There are listed and unlisted derivative instruments.

Market efficiency

Investors do not like risk. They should be compensated for taking risks, the bigger the risk, the higher the compensation. This has implications for the different strategies that investors can pursue, as well as an important question about financial markets – can investors earn a return on financial assets that is greater than necessary to compensate for the risk? Economists also call this excess compensation abnormal return. In less technical terms, the above article refers to it as "market beating". Can this market beating be done in a particular financial market? This is an empirical question. If there is a strategy that produces extraordinary returns, the properties that motivate the implementation of such a strategy are known as market anomalies.

Market efficiency refers to how efficiently a financial market prices the assets traded in that market. A price efficient market or simply an efficient market is an economic market. Asset prices in this efficient market reflect all available information rapidly. Also, all available information is already captured in the asset price, so investors should expect to earn the return necessary to compensate for their expected risk. Doing so will avoid abnormal returns. But according to Eugene Fame, there are three main levels of market efficiency:

(1) Weak-form efficient

(2) Semi-strong efficient

(3) Strong-form efficient

In the weak form of market efficiency, current asset prices reflect past prices and all price movements. This means that all the useful information about the stock's historical prices is already reflected in today's price. Even if the investor cannot use the same information to predict tomorrow's price, extraordinary profits cannot be made.

Semi-strong form of market efficiency:- Semi-strong-efficient where current asset prices reflect all publicly available information. This means that investors cannot make abnormal profits if they use investment strategies based on the use of publicly available information. This does not mean that prices change immediately to reflect new information, but that asset prices reflect this information rapidly. Empirical evidence supports the idea that the US stock market is for the most part quasi-firmly efficient. That is, careful analysis of companies issuing stocks does not consistently yield abnormal returns.

In strong form of market efficiency:- Strong-form efficiency means that asset prices reflect all public and private information. In other words, the market (which includes all investors) knows everything about all financial assets, including information that has not been made public. The robust nature means that investors cannot make abnormal returns from trading on inside information (discussed earlier), which has not yet been made public. Also this form of market efficiency in stock market is not supported by empirical studies. In fact, we know from recent events that the opposite is true, that trading on inside information leads to profits. Thus the US stock market, as empirical evidence suggests, is essentially semi-strongly efficient but not in robust form.

If the financial markets in which securities are issued are semi-firmly efficient, then the implication of market efficiency for issuers is that issuers should expect investors to pay prices for shares that reflect their value. This means that if new information about the issuer is revealed to the public (for example:- about a new product), the price of the security should change to reflect that new information.

Eugene F. Fama :- Journal of Finance 25 (1970): 383–417, Efficient Capital Markets: A Review of Theory and Empirical Work.

Empirical evidence from the US stock market suggests that this market is weakly efficient. In other words you cannot outperform (beat) the market using information on past stock prices.

Character of financial system

Financial crises are notoriously difficult to predict, and each episode of financial instability seems to have unique aspects, but two scenarios are common in such events. The first is that major crises usually involve financial institutions or markets that are either very large or play some significant role in the financial system. Another thing is that the origins of most financial crises (except, perhaps, those caused by natural disasters, war and other non-economic events) can be traced back to failures of market discipline or due diligence by a significant group of market participants.

In the financial system, the number of players who buy and sell financial instruments is large. The Federal Reserve (Fed), by providing information on the financial markets that it publishes quarterly, categorizes players into sectors. This article reports the most extensive classification. The purpose of this article is to introduce all of these players in the financial system, using the Federal Reserve's classification by sector.

Household and non-profit are self-explanatory, so can focus on other areas.

Another way to look at the economic system is to round up information on how much each sector contributes to gross domestic product (GDP). When considering GDP components for the United States for 2008, non-financial businesses make the largest contribution to GDP.

As discussed in the article above, however, financial sectors facilitate the flow of funds into the economy. As this sector does not generate as much GDP as non-financial businesses, financial sectors are important in the financing and investment activities of non-financial businesses.

Domestic non-financial sectors

Government sector

The government sector includes the federal government, as well as state and local governments.

Also government sector includes government sponsored and government owned enterprises.

Federal Government

The federal government raises funds by issuing securities. The securities, known as Treasury securities, are issued through an auction process by the Department of the Treasury.

Treasury securities show the amount of government debt and who owns the debt. Until the most recent financial crisis, the major owners were the Federal Reserve Banks and foreign investors, the latter including foreign governments.

Government owned corporations

The federal government has agencies that participate in financial markets by buying and selling. Agencies are chartered by the federal government to provide funding for specific US government projects. These organizations are called government owned corporations. A good example is the Tennessee Valley Authority (TVA), which was established by Congress in 1933 primarily to promote flood control, water transportation, and agriculture and the use of electric power in the Tennessee Valley region, and to provide industrial development. Two other examples of government-owned corporations are the United States Postal Service and the National Railroad Passenger Corporation (more popularly known as Amtrak). In fact, among all state-owned corporations, TVA is the only one that is a frequent issuer of securities directly in the financial markets. Other state-owned corporations raise funds through the FFB - Federal Financing Bank. A federal financing bank is authorized to buy or sell obligations issued, sold, or guaranteed by other federal agencies.

Government-sponsored enterprise

Another type of government chartered organization is chartered to provide support to two sectors considered critically important to the economy: agriculture and housing. These institutions are Government Sponsored Enterprises (GSE) and are privately owned institutions. A list of GSEs is provided below.

There are two types of GSEs. The GSE is the first publicly owned shareholder corporation whose stock is publicly traded. Publicly owned Government Sponsored Enterprises (GSEs) include the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the Federal Agricultural Mortgage Corporation. The first two are the most well-known Government Sponsored Enterprises (GSE) as they played an important role in the housing finance market. Both Fannie Mae and Freddie Mac have similar goals, which are to promote home ownership through access to financing. They accomplish this by buying mortgages, bundling them, and selling mortgage-backed securities to investors. As both Fannie Mae and Freddie Mac faced financial difficulties, the US government took over these two GSEs by bailing them out.

Another type of GSE is the funding component of the federally chartered bank lending system, which includes the Federal Home Loan Bank and the Federal Farm Credit Bank.

Government-sponsored corporations are often confused with government-owned corporations. An important difference is that state-owned corporations do not issue stock to the public, whereas GSEs do. Another difference is that state-owned corporations are not run for profit, while GSEs are profit-driven. Another distinction is that the entire board of directors of state-owned corporations is appointed by the U.S. president, while only five of the nine directors for GSEs such as Fannie Mae and Freddie Mac are appointed by the president.

State and local governments

State and local governments are both issuers and investors in financial markets. Additionally, these organizations set up commissions and authorities that issue securities in the financial markets (examples include:- Port Authority of New York/New Jersey).

The Federal Housing Finance Agency (FHFA) is the custodian of both Fannie Mae and Freddie Mac, meaning that FHFA has full authority over the assets and operations of these companies.

That doesn't account for the current conservatorship, of course, which gives the federal government more power than usual over the GSEs.

State and local governments invest when they have a mismatch in tax or other revenue and when they have more cash to spend. However, the funds available to invest through the pension funds they sponsor for their employees is the main reason they participate as investors. More specifically, many state and local governments provide a defined benefit program, a form of pension where they guarantee benefits to employees and their beneficiaries. According to Pensions and Investments, the five largest state and local sponsors of defined benefit pension funds (referred to as public pension funds) and their size in the billions of total assets are:

California Public Employees $213.5

California State Teachers $147.0

New York State Common $138.4

Florida State Board $114.5

New York City Retirement $93.2

Non-financial business

Non-financial businesses are enterprises formed by individuals and other businesses to engage in activities for profit, where these activities are not primarily owned by financial intermediaries such as commercial banks. These businesses issue debt and equity instruments as well as invest in the financial markets.

Businesses participate as investors in the financial markets by investing excess funds in the money market and, like state and local governments, invest the funds of the defined benefit plans they sponsor. The largest defined benefit pension funds of businesses in the US are those of non-financial corporations. Five examples of the largest total assets (in billions), according to pensions and investments:

General Motors $91.0

AT&T $61.9

General Electric $50.0

IBM $49.4

Boeing $42.5

Some non-financial businesses have subsidiaries that engage in the same activities as financial corporations. Financial subsidiaries known as captive finance companies participate in the financial market by providing loans. Example :- Includes Ford Motor Credit (subsidiary of Ford Motor) and General Electric Credit Corporation (subsidiary of General Electric).

Domestic financial sectors

The financial sector includes such initiatives and regulators that provide a framework to facilitate lending and borrowing. The type of transactions they facilitate depends on the classification of their activities into different sectors:

Depository institutions

Depository institutions include commercial banks and thrifts. Thrifts include savings and loan associations, credit unions, and savings banks. As the name suggests, these institutions accept deposits which represent the liabilities (i.e. loans) of the deposit-taking institution. Depository institutions make loans to a variety of entities (businesses, consumers, and state & local governments), including funds raised through depository and non-depository sources by issuing debt obligations in the financial markets.

Commercial banks are the largest type of depository institution and are the focus here. A commercial bank is a financial institution owned by shareholders and engaged in accepting deposits as well as lending for profit. A bank may be owned by a bank holding company (BHC), a company that owns one or more banks.

As of September 30, 2009, the five largest bank holding companies in the United States and the Federal Reserve System, according to the National Information Center, had total assets in the billions:

Bank of America $2,253

JPMorgan Chase & Co. $2,041

Citigroup $1,889

Wells Fargo & Company $1,229

Goldman Sachs Group $883

Bank services

The main services provided by commercial banks are as follows:

• Personal Banking
• Institutional Banking
• Global Banking

Personal banking includes personal-oriented financial investment services such as consumer loans, residential mortgage loans, consumer installment loans, credit card financing, automobile and boat financing, brokerage services, student loans, and personal trust and investment services.

Institutional banking includes lending to both non-financial and financial businesses, governmental entities (state and local governments in the United States and foreign governments), commercial real estate financing, and leasing activities.

In global banking, commercial banks compete head-to-head with investment banking firms, another type of financial institution. In the global arena, banks provide corporate financing in two ways:

(1) Involves the purchase of funds for the bank's customers, which may be advanced. Beyond traditional bank lending it also includes underwriting of securities and providing letters of credit and other forms of guarantees.

(2) Financial advice on matters such as funding strategies, corporate restructuring, divestitures and acquisitions. Where a bank may act as a seller or broker in a service includes transactions in capital markets, foreign exchange products and services.

Bank Funds

Banks are highly leveraged financial institutions, meaning that most of their funding comes from loans. One form of borrowing involves deposits. Following are four main types of deposit accounts issued by banks:

• Demand Deposit
• Saving Deposit
• Time Deposit
• Money market demand accounts.

Demand deposit accounts, more popularly known as checking accounts, can be withdrawn on demand and pay minimal interest. Savings deposits usually pay interest below the market rate of interest, have no specific maturity and are usually withdrawable on demand. Time deposits, more popularly referred to as certificates of deposits or CDs, have a fixed maturity date and offer either a fixed or floating interest rate. The newly known as Money Market Demand Account pays interest based on short-term interest rates.

The sources of deposits other than loans available to banks are as follows.

• Deposits such as money and bonds act as borrowings by issuing instruments in the market.
• Federal funds act to borrow stocks in the deposit market of this nature.
• The Federal Reserve (Fed) borrows from these deposits through the discount window facility.

The first source is self-explanatory. The last two require clarification.

A bank cannot invest $1 for every $1 it raises through deposits because it is required to maintain a certain percentage of deposits in a non-interest-bearing account at one of 12 Federal Reserve banks. These specified percentages are reserve ratios. The dollar amount required to be kept on deposit with the Federal Reserve Bank is called reserve requirement. These reserve ratios are established by the Federal Reserve Board, and represent one of the monetary policy tools employed by the Reserve Fed. Banks meet these reserve requirements each period through actual reserves, calculated as the average amount of reserves held at the Federal Reserve Bank at the close of business. If the actual stock is more than the required reserve then this stock is referred to as excess reserve. Opportunity cost is associated with additional reserves due to holding reserves in non-interest bearing accounts. However, the Fed imposes penalties if reserves are short. Banks are therefore encouraged to manage their reserves to meet reserve requirements as accurately as possible. It is a market where banks temporarily short of their required reserves can borrow reserves from banks with higher reserves. This market is called the Federal Funds Market and the interest rate charged for borrowing funds in this Federal Funds Market is called the Federal Funds Rate.

Let's take a look at how a bank can borrow at the Fed discount window.

Since the Federal Reserve Bank is effectively the banker's bank, lending to banks to meet liquidity needs is charged at the Fed discount window. This means the Federal Reserve Bank is the last bank to be charged. A bank that is temporarily short of funds can borrow from the Fed at its discount window. However, a bank seeking funds to borrow at the discount window must put up collateral to do so, meaning the Fed is willing to make secured or collateralized loans. The Fed establishes (and changes from time to time) the types of collateral eligible for borrowing at the discount window. The interest rate charged by the Fed to borrow funds during the discount window is known as the discount rate. The Fed changes from time to time to implement monetary policy.

Let's then discuss investment banking, which encompasses a wide range of activities including corporate financing and capital markets and foreign exchange products and services.

Some of these activities were prohibited by the Banking Act of 1933, which contained four sections (known as the Glass-Steagall Act) that prohibited commercial banks from certain investment banking activities. The restrictions were effectively repealed in November 1999 with the passage of the Gramm-Leach-Bliley Act, which expanded the permitted activities for banks and bank holding companies.

Bank regulation

Because of their important role in financial markets, depository institutions are highly regulated and supervised by many federal as well as state government agencies. At the federal level it is supervised by the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (FDIC). Banks are insured by the BIF - Bank Insurance Fund, a BIF administered by the Federal Deposit Insurance Corporation. Federal depository insurance began in the 1930s and insurance programs are administered by the FDIC.

The capital structure of banks is highly leveraged. That is, the ratio of equity capital to total assets is less than 8%. As a result, there are concerns by regulators about potential bankruptcy due to low levels of capital provided by owners. An additional concern is that the amount of equity capital is insufficient, because of potential liabilities that do not appear on the bank's balance sheet, so called liabilities on OTC derivatives and off balance sheet liabilities such as letters of credit. This is addressed by regulators through risk-based capital requirements.

The Basel Committee on Banking Supervision is an international organization that has established guidelines for risk-based capital requirements. The committee is made up of banking supervisory authorities from 13 countries. This means that a bank's capital requirement depends on the various risks it faces.

Non-Depository Financial Institutions

Non-depository financial institutions are intermediaries. These institutions offer funds to consumers and businesses even though they do not accept deposits. Non-depository financial institutions include consumer loan companies, trust companies, mortgage loan companies, credit counseling agencies, and finance companies.

Unlike depository institutions, non-depository financial institutions have been regulated only at the state level, but increased regulation of these institutions at the national level is currently debated, especially in cases of major non-depository financial failures. One such failure of organization is CIT Group, Inc. It belonged to a commercial and consumer finance company that filed for bankruptcy in 2009.

Non-Depository Financial Institutions are also referred to as NBFI :- Non-Bank Financial Institutions. The classification of these types of companies as financial institutions began with the Annunzio-Wylie Anti-Money Laundering Act of 1992. The Act broadened the definition of financial institution beyond deposit-taking institutions.

Chairman Ben S. Bernanke launched economic reforms on March 10, 2009 to address systemic risk.

Insurance companies

Insurance companies play an important role in the economy as risk underwriters or risk carriers for a wide range of insurable events. Furthermore, beyond their risk bearing role, insurance companies are also key participants in financial markets as investors.

Let us explain the basic economics of the insurance industry. As compensation for insurance companies selling protection against future events, they receive one or more payments over the life of the policy. The payment they receive is called premium. The premium is paid to the insurance company by the policyholder and the claim is paid to the insurance company (if such a claim is made) the insurance company can invest the amount in the financial market.

Insurance products sold by insurance companies include:

Life Insurance :- In case of death of the insured, the beneficiary of the policy takes out a policy against death with the issuing insurance company. Life policies can be pure life insurance investment components (e.g. cash value life insurance) or protection (e.g. term life insurance).

Health Insurance :- Health insurance is the cost of medical treatment of the insured.

Property and Casualty Insurance :- Risk insured against financial loss arising out of loss, destruction or damage to property insured due to sudden, unexpected or unusual cognizable event. The major types of such insurance are (1) residential property home and contents and (2) automobiles.

Liability Insurance :- The risk insured against is litigation, as well as the risk of lawsuits against the insured due to the actions of the insured or others.

Disability Insurance :- This product insures against the inability of the employed person to earn income in the insured's own business or any business.

Long Term Care Insurance :- This insurance product provides long term coverage for those who can no longer take care of themselves.

Structured Settlement :- Structured settlement policies provide fixed guaranteed periodic payments over a long period of time, typically as a result of settlement on a disability or other type of policy.

Investment-Oriented Products :- Products have a major investment component. It includes GIC - Guaranteed Investment Contracts and Annuities. In case of GIC, the life insurance company agrees that on payment of a single premium it will repay that premium and return a predetermined rate of interest earned on this premium throughout the life of the policy. There are many types of annuities, all of which have two basic characteristics: (1) periodic payments begin immediately or are deferred until some future date, and (2) whether the dollar amount is fixed (i.e. a guaranteed dollar amount) or variable depending on investment performance.

Financial Guarantee Insurance :- The risk insured by this product Financial Guarantee Insurance is credit risk. Credit risk The issuer of an insured bond or other financial contract fails to pay interest and principal on time. Such financial liability is said to be an insurance or other guaranteed bond wrap. Once a large percentage of bonds issued by municipal governments were insured bonds, as well as asset-backed securities.

The table below lists the leading insurance companies globally by revenue:

In the United States, leading companies include Berkshire Hathaway, State Farm Insurance, and MetLife.

Investment companies

Investment companies, also known as asset management companies, manage the funds of individuals, businesses, state and local governments and are charged a fee for this service. Fees are performance linked to assets managed for the client and in some cases to the amount managed. Some asset management companies are subsidiaries of commercial banks, insurance companies and investment banking firms.

Basically, GIC - Guaranteed Investment Contracts insures the policyholder that he will receive a guaranteed rate of interest over the life of the policy against the risk of falling interest rates. In case of annuity the policyholder pays a single premium for the policy and the life insurance company agrees to make periodic payments to the policyholder over time. The source of this information is at the Insurance Information Institute.

The types of accounts, clients and businesses of asset management companies include the following lines:

• Regulated investment companies
• Exchange Traded Funds
• Hedge funds
• Separately managed accounts
• Pension Fund

Regulated investment companies

RICs - Regulated Investment Companies are financial intermediaries, these RICs sell shares to the public and invest the money in a portfolio of various securities. Asset management companies are hired to manage the portfolios of regulated investment companies. Various United States securities laws regulate these entities.

There are three types of RICs managed by asset management companies: open-end funds, closed-end funds and unit investment trusts (UIT). As you can see in the chart, mutual funds are the dominant form of RIC.

Each share sold represents a proportionate interest in a portfolio of securities managed by regulated investment companies on behalf of its shareholders. The value of each share of the portfolio is called NAV - Net Asset Value and is calculated as follows:

For example, suppose a Regulated Investment Company with 20 million shares outstanding has a portfolio with a market value of $430 million and liabilities of $30 million. There is a nav

Net Asset Value is determined only at the end of the trading day.

Mutual funds :- In open-end funds, commonly referred to as mutual funds, the number of mutual fund shares is not fixed. All new investments in mutual funds are purchased at NAV and all redemptions (sale of funds) from the fund are purchased at Net Asset Value. If you invest more than you withdraw during the day, the total number of shares in the fund increases.

For example, society begins day one with a mutual fund portfolio valued at $300 million, no liabilities, and 10 million shares outstanding. Thus the Net Asset Value of the mutual fund is $30. Assume that during a trading day investors deposit $5 million into the fund, withdraw $2 million, and the prices of all securities in the portfolio remain constant. A net investment of $3 million in this fund means that 100,000 shares were issued ($3 million divided by $30). After the transaction, 10.1 million shares are outstanding and the market value of the portfolio is $303 million. Hence the unchanged Net Asset Value from the previous day is $30.

Instead, the Net Asset Value will change if the value of the portfolio and the number of shares change. However at the end of the day the Net Asset Value will remain the same regardless of whether the shares are added or redeemed. In the previous example, assume that the end-of-day portfolio value increases to $320 million, because the cost of new investments and withdrawals depends on the end-of-day Net Asset Value, which is now $32. The new investment of $5 million will accumulate to $5 million ÷ $32 = 156250 shares plus redemption of $2 million will reduce the number of shares, i.e. $2 million ÷ $32 = 62500 shares. Thus at the end of the day the mutual fund will have 10 million + 156250 − 62500 = 10093750 shares. Because the portfolio has a total value of $323 million ($320 million plus $3 million in new investments), the Net Asset Value at the end of the day is $32 and transactions are not affected.

Closed-end funds :- Unlike open-end funds, closed-end funds do not redeem shares or issue additional shares. That is, the number of fund shares is fixed at the time of issue (i.e. at the time of initial public offering) at the number sold. Instead, investors who want to sell their shares or investors who want to buy shares must do so in the secondary market (either on an exchange or in the over-the-counter market).

In a closed-end fund, the supply and demand of the market in which the fund is traded determines the price of the shares of the closed-end fund. Therefore, the fund share price may trade below or above the Net Asset Value. Shares selling below Net Asset Value are said to be trading at a discount, while shares above Net Asset Value are trading at a premium. Investors dealing in closed-end fund shares are required to pay brokerage commissions at the time of purchase and sale.

Unit Investment Trust :- 

A third type of regulated investment companies is called Unit Investment Trust - UIT. These types of regulated investment companies are incorporated, but not actively managed. UIT - Unit Investment Trust has a limited life and a fixed portfolio of investments.

Cost to investors :- 

Investors in regulated investment companies bear two types of costs: (1) shareholder fees, commonly called sales fees, which are one-time fees; and (2) annual fund operating expenses, commonly called the expense ratio, which includes the fund's expenses. Management fees are the largest expense component of the expense ratio (also called investment advisory fees). An investment advisory fee is an annual fee paid to an asset management company for its services.

Regulated investment companies are available with different investment objectives and invest in different asset classes – stock funds, bond funds and money market funds. These funds are passively managed and actively managed funds. Passive funds are also called index funds, these index funds are designed to replicate a market index, such as the S&P 500 stock index in the case of common stocks. In contrast, fund advisors with active funds attempt to outperform indexes and other funds by actively trading fund portfolios.

Exchange-traded funds

Open-end funds i.e. mutual funds are often criticized as an investment vehicle for two reasons. The first is the price of the fund's shares, which can only be traded at the closing price or at the end of the day. In particular, transactions (i.e. buying and selling) cannot be done on intraday prices but only on the closing price. Second, although the tax treatment of open-end funds is not discussed, it is noted that they are inefficient tax vehicles, because as some fund shareholders withdraw, shareholders who retain their positions may have taxable capital gains.

These two drawbacks of mutual funds led to the introduction of a new investment vehicle in the United States financial market in 1993 called exchange-traded funds (ETFs) with many of the same features as mutual funds. Exchange-traded funds are investment vehicles similar to mutual funds, but these funds trade like stocks on an exchange. Although they are open-end funds, exchange-traded funds are similar to closed-end funds in a sense, with a smaller premium or discount from their Net Asset Value. An investment advisor in an exchange-traded fund is responsible for managing the portfolio so that it accurately replicates the index and index returns, as supply and demand determine the secondary market price of the shares. The exchange price may deviate slightly from the value of the portfolio resulting in some uncertainty in pricing. However the deviations remain small as arbitrators can create or redeem large blocks of shares on any given day at the Net Asset Value thus significantly limiting the deviations.

Another advantage of exchange-traded funds is that exchange-traded funds have the flexibility to trade throughout the day at current prices, as well as limit orders, stop orders, and short sell and buy on margin, none of which can be done with an open-end. In terms of fund taxation, exchange-traded funds overcome the disadvantages of open-end funds but the advantages are not discussed here.

From 1995 to 2008, there has been steady growth in exchange-traded funds. There are exchange-traded funds that invest in a wide range of asset classes and are introduced weekly.

Hedge funds

United States securities law does not provide a definition of a pool of investment funds operated by asset managers known as hedge funds. These institutions are not regulated under this article.

The following is the definition of hedge funds offered by the Financial Services Authority of the United Kingdom, the regulatory body for all financial services providers in that country:

The term can also be explained by considering characteristics commonly associated with hedge funds:

• Hedge funds are usually organized as private investment partnerships or offshore investment corporations.
• Using a variety of trading strategies, including position-taking in different markets.
• Using an assortment of trading techniques and instruments, usually including short-selling, derivatives and leverage.
• Paying performance fees to their managers.
• An investor base consisting of wealthy individuals and institutions and a relatively high minimum investment limit (set at US$100,000 or more for most funds).

This definition of a hedge fund helps to understand several characteristics. As such, first of all the term hedge in hedge fund is misleading because this fund is not typical of today's hedge funds. Second, hedge funds use a variety of trading strategies and techniques to not only generate abnormal returns, but hedge funds to try to generate stellar returns regardless of market movements. Strategies used by hedge funds may include any of the following:

• Leverage is the use of borrowed funds.
• Short selling is the sale of a financial instrument that one does not own in anticipation of a decline in the price of the financial instrument.
• Derivatives are great leverage and control risk.
• Derivatives Simultaneous buying and selling of related financial instruments to profit from temporary misalignment of prices.

The term hedge fund was first coined by Fortune in 1966 to describe Alfred Winslow Jones' private investment fund. In managing the portfolio, Jones tried to hedge the fund's market risk by creating a portfolio that was equally short and long the stock market.

Hedge funds operate in areas of the financial markets, such as the cash market for stocks, bonds and currencies, as well as the derivatives market.

Third, when evaluating a hedge fund investors are not interested in the relative returns generated by the asset manager, but rather in the absolute returns generated by the manager. Absolute return is the realized return rather than the relative return, the difference between the realized absolute return and the return on some benchmark or index. Absolute return is quite different from the criteria used in evaluating the performance of an asset manager.

Fourth, the management fee structure for hedge funds is a combination of a fixed fee based on the market value of the assets managed and a share of positive returns. Next is the performance based compensation which is referred to as incentive fee.

Hedge funds in the US are available to accredited investors. As defined by the Securities and Exchange Commission, accredited investors include individuals, banks, insurance companies, and registered investment firms with assets in excess of $1 million.

Separately managed accounts 

Instead of investing directly in stocks or bonds, or through alternatives such as mutual funds, exchange-traded funds, or hedge funds, asset management companies offer individual and institutional investors the opportunity to invest in separately managed accounts (also called individually managed accounts). In such managed accounts the investments selected by the asset manager are customized according to the investor's objectives. Although Separately Managed Accounts offer asset management clients an investment vehicle that overcomes all the limitations of Regulated Investment Companies, they are more expensive than Regulated Investment Companies in terms of fees.

Pension Fund 

A pension scheme fund is established for the final payment of post-retirement benefits, it is a scheme sponsoring organization, the sponsoring organization establishes the pension scheme. The plan sponsor can be from the information below:

• A private business entity may sponsor plans on behalf of its employees, called corporate plans or private plans.
• A federal, state, and local government may sponsor plans on behalf of their employees, called public plans.
• Federal, state, and local governments form a union on behalf of its members, called the Taft-Hartley Plan.
• Plans can be sponsored by an individual, called individually sponsored plans.

The two basic and widely used pension plans are called defined benefit plans and defined contribution plans. In addition to defined benefit plans and defined contribution plans, a hybrid type of plan known as a cash balance plan combines features of both pension plan types.

In a DB-defined benefit plan, plan sponsors agree to make specified dollar payments to eligible employees beginning at retirement (some payments to beneficiaries in the event of death before retirement). Effectively, the pension liability in a defined benefit plan is the debt liability of the plan sponsor. The plan sponsor therefore assumes the risk of having insufficient funds in the plan to meet regular contractual payments to currently retired employees as well as employees who may retire in the future.

A plan sponsor has several options to decide who should manage the plan assets, these options are as follows:

• Internal Management – Internal management The plan sponsor uses its own investment staff to manage the plan's assets.
• External Management – External management The plan sponsor engages the services of one or more asset management companies to manage the plan's assets.
• Combination of Internal and External Management - A combination of internal and external management Some of the assets in a plan are managed internally by the plan sponsor, and the balance of these management combination plans are managed by one or more asset management companies.

Asset managers who manage defined benefit plans receive compensation in the form of management fees for assets.

There are several federal laws that regulate pension plans. ERISA-Employee Retirement Income Security Act (1974). The Department of Labor and the Internal Revenue Service are responsible for administering the Employee Retirement Income Security Act. The Employee Retirement Income Security Act established fiduciary standards for pension fund trustees, managers or advisers.

In a DC-defined contribution plan the plan sponsor is only responsible for making specified contributions to the plan on behalf of eligible participants, often contributing either a percentage of the employee's profits or a percentage of the employer's salary. The plan sponsor is not guaranteed any specific amount at retirement. The amount an employee will receive at retirement is not guaranteed, instead the employee plan depends on asset growth. Plan sponsors offer plan participants various options for investment vehicles in which participants can invest. DC-defined contribution pension plans come in several legal forms: 401(k) plans, money purchase pension plans, and ESOP-employee stock ownership plans.

A hybrid pension scheme is a combination of a defined benefit and a defined contribution scheme. Cash balance plan is the most common type of this plan. This cash balance plan defines future pension benefits, not employer contributions.

Retirement benefits are based on a fixed annual employer contribution and a guaranteed minimum annual investment return. A dollar amount equal to the employer's contribution is credited to each participant's account in the cash balance plan. This deposit is usually determined as a percentage of wages. All accounts of the participant are also credited with interest linked to some fixed or variable index such as the Consumer Price Index (CPI). This interest usually provides benefits in the form of a lump sum distribution like a cash balance plan annuity.

Investment banks 

Like commercial banks, investment banks are highly leveraged institutions playing important roles in the primary and secondary markets, investment banks are involved in the following important activities:

• Investment banks are involved in raising funds through public offerings and private placement of securities.
• Investment banks are involved in trading securities.
• Mergers, acquisitions and financial restructuring advice includes investment banks.
• Merchant banking includes investment banks.
• Investment banks also include securities finance and prime brokerage services.

The primary role of investment banks is to assist in raising funds by corporations, United States government agencies, state, local governments, and foreign entities (sovereigns and corporations). Another role of investment banks is to assist investors who wish to invest funds by acting as brokers or dealers in secondary market transactions.

Investment banking which plays such an important role can be classified into two categories:

1. Investment banking can be classified into firms affiliated with large financial services holding companies.
2. Investment banking can be classified into firms independent of the larger financial services holding company.

Large investment banks are affiliated with large commercial bank holding companies, so these banks are called bank-affiliated investment banks. Examples of bank holding companies known as bank-affiliated investment banks are Bank of America Securities (which is a subsidiary of Bank of America), JPMorgan Securities (which is a subsidiary of JPMorgan Chase), and Wachovia Securities (which is a subsidiary of Wells Fargo) and Goldman Sachs. Sax.

This is another class of investment banks referred to as independent investment banks, and independent investment banks are a shrinking group. By mid-2008 the group of independent investment banks included Greenhill & Company and Houlihan, Lokey Howard & Zukin.

Investment banking firms can also be classified based on their activities as full-service investment banks and boutique investment banks. The former is active in a wide range of investment banking activities while the latter specializes in a limited number of investment banking activities.

Investment bankers perform any of the following three functions to assist organizations in raising funds in the public markets:

• Investment bankers are tasked with advising the issuer on the terms and timing of the offer.
• Investment bankers perform underwriting functions.
• Investment bankers do the work of distributing numbers to the public.

Investment bankers in their advisory role to investment banks may need to design security structures that are more attractive to investors than available financial instruments.

The underwriting function involves the manner in which investment banks agree to place newly issued securities in the market on behalf of the issuer. The price paid for the security to the issuer and the price at which the security is re-offered to the public is called the reoffering price. The fee earned by an investment banking firm from underwriting is the difference between the price paid to the issuer for the security and the price at which the security is re-offered to the public, this difference is called the gross spread. The two main types of underwriting arrangements are firm commitment and best efforts. In a firm commitment arrangement, an investment bank buys a newly issued security from the issuer at a fixed price, then resells the security to the public at the offering price. In a best-effort underwriting arrangement, the investment banking firm does not purchase the newly issued security from the issuer, instead the investment bank agrees to use its expertise to sell the security only to the public, earning a gross spread only on what it can sell to them.

Firm-commitment underwriting typically involves multiple investment banks, as capital must be committed and the newly issued security cannot be sold to the public at a price higher than the purchase price, potentially resulting in a loss of the firm's capital. A group of companies is formed to underwrite the matter, referred to as lead underwriters or underwriting syndicates. Also the gross spread is then split between the lead underwriter and other companies in the underwriting syndicate.

Gross spread is important for both issuers and investment banks. The entire issue of securities must be sold to the public at the scheduled reoffering price to realize the total spread, so a larger marketing effort may be required depending on the size of the issue. Members of the underwriting syndicate will be able to sell the newly issued security to their investor customer base. Lead underwriters often put together a sales group, which includes the underwriting syndicate and other companies not in the syndicate, to broaden the base of potential investors. The gross spread of these companies is then divided among the lead underwriters, members of the underwriting syndicate and members of the selling group.

Private Placement of Securities 

Companies may issue securities through private placement to limited institutional investors such as insurance companies, investment companies, and pension funds to issue new securities in the public market. These securities are classified by private placement offering type, called non-Rule 144A offerings (traditional private placements) and Rule 144A offerings. These 144A securities are underwritten by investment bankers.

Trading Securities 

Providing better transactional services to customers is an obvious activity of investment banks. Revenue is generated on transactions in which investment banks act as brokers or agents in the form of commissions. Investment banking does not take place in such revenue transactions. This suggests that investment banks are not risking their own capital. Other Transaction Revenue Investment banks may act as market makers by putting their own capital at risk. such as:

1. The price at which an investment bank sells a security and the price paid for the security is called the bid-ask spread.
2. Appreciation of the value of securities held in inventory by investment banks. Obviously, if the price of the securities falls, the revenue will fall.

In addition to trading in the secondary market for clients, investment banks also perform market making in the secondary market, as well as proprietary trading by investment banks, called prop trading. In prop trading, some of the company's capital is held to bet on movements between investment banker's trading financial instrument prices, interest rates or foreign exchange.

Advising on mergers, acquisitions and financial restructuring 

Investment banks are active in M&A - mergers and acquisitions, LBO - leveraged buyouts, restructuring and recapitalization of companies, restructuring of insolvent and distressed companies. Also these banks do so in one or more of the following ways:

1. Investment banks are tasked with identifying candidates for mergers or acquisitions, M&A candidates.
2. These banks act to advise the board of directors of the acquiring companies or target companies on price and non-price terms for the exchange.
3. investment banks attempt to assist companies that are takeover targets, as well as to prevent unfriendly takeover attempts;
4. Investment banks function to assist acquired companies in obtaining the necessary funds to complete acquisitions.
5. Investment banks also perform the function of providing an unbiased opinion to the board of directors on proposed mergers, acquisitions or asset sales.

Another important area where investment banks advise is the capital structure of corporations. A significant change in operating structure or corporate strategy aimed at improving performance is referred to as financial restructuring of a company. This may be the result of the company's attempt to avoid bankruptcy, to avoid problems with creditors, or to reorganize the company as permitted by the United States Bankruptcy Code.

The activities described in the article above generate fee income. This fee income can either be a fixed retainer or a fee based on the size of the transaction in case of mergers and acquisitions. Thus investment bank capital is not at risk for most of the company's activities. However, if an investment bank finances the acquisition, the bank puts its capital at risk, as understood by the merchant banking activity.

Merchant Banking 

In which an investment bank raises its own capital either as a borrower or to take an equity stake is called merchant banking. An investment bank has groups or divisions dedicated to merchant banking. A division or group may be in the form of a series of private equity funds in the case of equity investments.

Securities, finance and prime brokerage services 

Investment banks have clients who, as part of their investment strategy, either need to borrow funds to buy securities or borrow securities to short sell or short sell securities. The standard mechanism for borrowing funds in the securities market is called repo through an agreement to repurchase rather than bank borrowing. Repo is a collateralized loan, this repo consists of collateral purchased security. Investment banks get a lot of leverage in terms of interest on repo transactions. A customer can borrow securities in a transaction known as a securities lending transaction with investment banks. In transactions such as securities lending transactions, the lender of securities receives a fee for lending the securities. The activity of borrowing or borrowing securities through securities lending transactions is called securities finance.

Investment banks can offer a package of services to hedge funds and large institutional investors. Such a package of services by investment banks is called prime brokerage. Prime brokerage includes the securities finance just described as well as global custody, operational support and risk management systems.

Asset Management 

An investment bank may have one or more subsidiaries that manage assets for clients such as insurance companies, endowments, foundations, corporates, public pension funds, and high-net-worth individuals. These asset management divisions of banks may also manage mutual funds and hedge funds. Investment bank asset management generates fee income based on a percentage of assets under management.

Foreign investors 

The sector known as foreign investors includes individuals, non-financial businesses and financial institutions not resident in the United States, as well as foreign central governments and supranationals. A foreign central bank is a foreign country's monetary authority, such as the PBC - People's Bank of China, the European Central Bank, and the Bank of Canada. Foreign central banks participate in United States financial markets for two reasons. The first reason is that foreign central banks participate in U.S. financial markets to stabilize their currencies against the United States dollar. Another reason is to buy financial instruments with excess funds because they are perceived to be an attractive investment vehicle so foreign central banks participate in US financial markets.

A supranational organization is an international organization created by two or more central governments through international treaties. We can divide supranational institutions into two categories, multilateral development banks and others. The former are supranational financial institutions that provide financial assistance with funds received from member countries to developing countries and promote regional integration in specific geographic regions. The largest multilateral development bank is the European Investment Bank, with total assets of over $300 billion, and the International Bank for Reconstruction and Development, also known as the World Bank, with total assets of over $250 billion. After the European Investment Bank, the Inter-American Development Bank and the Asian Development Bank are the two largest multilateral development banks, accounting for less than a third of the investment banks' assets.

Bottom line

• It combines economics, psychology, accounting, statistics, mathematics and probability theory to make decisions involving future outcomes.
• Finance usually includes three related areas: capital markets and capital market theory, financial management and investment management.
• Capital markets and capital markets theory focus on the financial system of markets, intermediaries and regulators.
• Financial management focuses on making business enterprise decisions, including decisions related to investing in long-term assets and financing these investments.
• Investment management manages the investments of individuals and organizations.
• Financial intermediaries serve the financial system by facilitating the flow of funds from institutions with funds to invest to institutions seeking funds.
• Financial markets provide liquidity, provide price discovery and reduce transaction costs in the financial system.
• Financial intermediaries not only facilitate the flow of funds in the financial system, but also transform financial claims, provide greater choice to both investors and borrowers, reduce risk through diversification, and lower costs.
• Regulation of financial markets takes one of four forms: regulation of financial activities, regulation of disclosure, regulation of financial institutions, and regulation of foreign participants.
• Financial markets can be classified as follows: money market vs capital market, cash vs derivatives market, primary vs secondary market and market structure (order driven vs quote driven).
• Market price efficiency falls into three categories (weak form, semi-strong form, and strong form), and the nature of this efficiency determines whether investors can consistently earn abnormal profits.
• The financial system includes financial companies, government agencies, non-financial business organizations, households and non-profit organizations. The largest sector in the system consists of non-financial business organizations.
• Governmental entities in the financial system include federal, state, and local governments, as well as government-owned and government-sponsored enterprises.
• The financial sector of the economy includes depository institutions, non-depository financial institutions, insurance companies and investment companies.
• The major services provided by commercial banks are personal banking, institutional banking and global banking.
• Insurance companies are risk carriers or risk holders for a wide range of insurable events and are major participants in financial markets as investors.
• Investment firms manage the funds of individuals, businesses, and state and local governments and are compensated for this service. Asset management companies' account types, clients, and lines of business include regulated investment companies, exchange-traded funds, hedge funds, independently managed accounts, and pension funds.
• Investment banks play an important role in both the primary and secondary markets and their activities include raising funds through public offerings and private placement of securities. Advising on securities trading, mergers, acquisitions and financial restructuring, merchant banking and securities finance and prime brokerage services.
• Foreign investors include individuals, nonfinancial businesses, and financial institutions not resident in the United States, as well as foreign central governments and supranational organizations.

Related questions

1. What is distinguishing investment management from financial management?
2. What is the role of discount rate in decision making?
3. What are the responsibilities of an investment manager with respect to an investment portfolio?
4. Explain the difference between capital budgeting and capital structure.
5. What are current assets?
6. If the market price is efficient,
• Can an investor beat the market?
• Which type of portfolio management (active or passive) is best?
7. What is involved in a firm's financing decision?
8. List the common steps in company risk management.
9. What is Enterprise Risk Management?
10. List five activities of an investment manager.
11. What is the difference between leverage and equity?
12. Is preferred stock a debt or equity instrument? explain.
13. How does a mutual fund function as a financial intermediary?
14. What is meant by the term maturity mediation?
15. Who are the regulators of financial markets in the United States?
16. What are examples of money market securities? Give at least four examples.
17. What is the difference between the exchange and the over-the-counter market?
18. What are the three types of market efficiency?
19. What distinguishes the primary market from the secondary market?
20. What is the difference between the spot market and the derivative market?
21. What and how differentiates money market from capital market?
22. How does market efficiency affect an investor's strategy?
23. Who are the government sector players?
24. What is the difference between a government-owned corporation and a government-sponsored enterprise?
25. What is the difference between a depository financial institution and a non-depository bank financial institution?
26. What is excess reserve stock and how is it different from required stock?
27. List at least five different types of insurance companies.
28. What is the difference between mutual funds and closed-end funds?
29. If a mutual fund has a portfolio market value of $1 million and liabilities of $0.2 million, what is the net asset value if the fund has 0.5 million shares outstanding?
30. List two advantages of exchange traded funds over closed-end funds from an investor's perspective?
31. Explain the difference between defined benefit pension plan and defined contribution plan.
32. List at least four functions of an investment bank.
33. List the major types of depository institutions.
34. How do commercial banks get their funds?
35. What is financial restructuring advice? Give an example.

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Business & Career

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Non-financial businesses are enterprises formed by individuals and other businesses to engage in activities for profit, where the activities are not primarily those of financial intermediaries such as commercial banks. These businesses issue debt and More

Distribution of gross domestic product (GDP) among economic sectors

Financial sectors include the institutions and regulators that provide the framework to facilitate lending and borrowing. These activities can be classified into different sectors, depending on the type of More

Financial sector of foreign investment

The sector known as foreign investors includes individuals, non-financial businesses and financial institutions not domiciled in the United States, as well as foreign central governments and supranationals. A foreign central bank is the monetary authority of More

Domestic financial insurance companies

Insurance companies play an important role in the economy as they are risk carriers or risk underwriters for a wide range of insurable events. Moreover, beyond that risk-bearing role, insurance companies are major participants in More

Depository institutions are the most diverse type

Depository institutions include commercial banks and thrifts. Thrifts include savings, savings banks, credit unions and credit unions. As the name suggests these institutions accept deposits which represent the liabilities of More

Financial investment companies

Investment companies also known as asset management companies. These companies manage the funds of individuals, state local governments and businesses. Also the companies are reimbursed for the fees charged by More

Exchange Traded Fund Companies

As an investment vehicle, mutual funds ie open end funds are often criticized for two reasons. First being the price of their shares and being able to trade only at the end of the day or at the closing price. In particular, transactions such as More

A hedge fund is a type of investment that involves investing

The Securities Act does not provide a definition of a pool of investment funds run by asset managers known as hedge funds. The term can also be defined by considering characteristics commonly associated with More

Pension Fund Investment Management

A pension scheme fund is established for final payment of post-retirement benefits. A scheme sponsor is the organization that sets up the pension scheme. The two basic and widely used pension plans are defined benefit plans and defined contribution plans. In addition, a hybrid type of plan called More

What do investment banks do?

Like commercial banks, investment banks are highly leveraged institutions that play an important role in both the primary and secondary markets. This includes investment banking activities. The first role is to assist in raising funds by corporations government agencies, state, local governments and More

Advising on mergers, acquisitions and financial restructuring

M&A - Investment banks are active in mergers and acquisitions, LBOs - leveraged buyouts, restructuring of companies, recapitalizations, restructuring of insolvent and distressed companies. These companies operate in one or more of the following ways More

Marketing

• Introduction to marketing strategy
• What Is Business Strategy?
• Towards Strategic Management
• Change The Business Shaping Strategy
• Summary of Marketing Strategy
• External Analysis of Marketing
• Macro Environmental Analysis
• Industry Analysis
• Competitive Analysis of Marketing (Strategic groups - 1 & 2)
• Problems in competitor identification in strategic analysis
• Strategic analysis of the market
• Summary of Strategic Analysis
• What is competitive intelligence in marketing
• CI - Competitive Intelligence Cycle
• What are the sources of competitive information?
• Why and how businesses segment their markets
• Briefly describe the steps in the segmentation process
• Implementing Behavioral Marketing And Customer Segmentation
• Segmentation criteria for consumer markets
• Complete information about profile variables in marketing

Summary of Marketing Strategy

Today's business world knows the importance of marketing strategy and marketing strategic management. Generally any strategic process consists of three distinct phases: analysis, planning More

External Analysis of Marketing

External analysis of marketing is an important and first stage of the auditing process. It creates the information and analysis necessary to identify the key issues an organization needs to More

Macro Environmental Analysis

A macro-environmental audit examines a wide range of environmental issues that may affect the organization. Macro environmental analysis will include economic factors, political/legal issues, social/cultural issues More

Industry Analysis

An organization needs to understand the nature of relationships within its industry to allow the enterprise to develop strategies to leverage existing relationships. A useful framework to use in this analysis is More

Competitive Analysis of Marketing

The analysis examines the overall five forces of the industry and is a starting point for assessing a company's competitive position. This is likely to be a broad definition of an industry More

Problems in competitor identification in strategic analysis

Analyzing the members of a strategic group provides important information on which to base strategic decisions. However, there are risks in the process of identifying the organization's competitors and several mistakes should be More

Strategic analysis of the market

A market analysis will consist of a range of factors relevant to the particular situation under review, but this range typically includes More

What is competitive intelligence in marketing

CI - Competitive Intelligence has an image problem. The term conjures up images of conspicuous activity involving private detectives, telephoto lenses, and hidden microphones. Although such images are not entirely unpleasant, they are far from the truth. Simply put, CI is an ethical, structured, and More

CI - Competitive Intelligence Cycle

The CI cycle begins with establishing intelligence requirements. It is important to prioritize information needs and set appropriate schedules/reporting periods. This phase requires a detailed understanding of what business decisions are being made and More

What are the sources of competitive information?

Competitive information comes from three general areas. First is public domain information - this information is available to anyone. Many industries are heavily regulated and any publicly listed company has a legal obligation to More

Why and how businesses segment their markets

There are several reasons why organizations are divided: Meet customer needs more precisely, Increase Profits, Segment Leadership, More

Briefly describe the steps in the segmentation process

The segmentation process involves establishing criteria by which groups of customers with similar needs can be identified. These criteria require establishing customer groups with the following characteristics:

1. Customers within a segment respond similarly to a particular marketing mix.

2. Consumers within a segment tend to react distinctly differently from other consumer groups. More

Implementing Behavioral Marketing And Customer Segmentation

Consumer buyer behavior relates to the end consumer who purchases products and services for employee use. This section will summarize the main sources of influence on consumer buyer behavior to explain the influences that More

Segmentation criteria for consumer markets

Customer segmentation criteria can be divided into three main categories: Profile variables, Behavioral Variables More

Complete information about profile variables in marketing

This category includes a range of demographic, socio-economic and More

Strategic Marketing - Behavioural variables

Benefit segmentation uses the underlying reasons why a person buys a particular product or service, rather than trying to identify specific personal attributes of that person. Benefit segmentation is based on the concept that the main More

Leadership

• Renewal of strategic planning
• A conceptual model and methodology for leadership
• The phenomenon of leadership
• The precarious position of leadership in higher education
• Patterns in Leadership
• A case study about leadership
• Relation to the Phenomenology of Leadership
• Leadership as agency
• Leadership as fundamental
• Leadership as relational
• Leadership as Sense Making
• Ethical leadership
• Leadership, Conflict and Change
• Difference between leadership and empowerment
• Positions of leadership and authority
• Insightful articles on transactional and transformational leadership
• Implications for contemporary concepts of leadership
• Implications for higher education

Renewal of strategic planning

The leadership literature suggests that teams at the top of an organization face much greater challenges than other teams. A team leading an organization must deal with failure and More

The phenomenon of leadership

The precarious position of leadership in higher education

When it comes to institutions of higher education, there are many paradoxes about the phenomenon of leadership, such as - the field of study, the mission of education More

A conceptual model and methodology for leadership

Renewal of strategic planning needs to be done within a deeper conceptual framework than is usually the case. By shifting the ideological register from management to leadership, we can achieve much of More

Patterns in Leadership

Leadership scholars have developed schools, categories, and classifications of leadership and leadership theories to distinguish between different approaches and concepts. To get a bearing on this More

A case study about leadership

To understand the changing definitions of the phenomenon, it is useful to look briefly at the findings of an influential analysis of business leadership, Jim Collins's widely read book Good to Great, which attempts to More

Relation To The Phenomenology Of Leadership

Without claiming to be anything like a comprehensive explanation of the ever-growing body of knowledge and inquiry, it is still possible to find common themes and parallel findings, especially regarding the More

Positions of leadership and authority

These comments on empowerment illustrate an important theme about empowerment that has important implications for the exercise of leadership in higher education institutions. Educational professionals carry a lot of authority and More

Insightful articles on transactional and transformational leadership

While continuing to explore the molecular components of interpersonal leadership, it would be good to pause on the important distinction between transactional and transformational leadership. The concept of transformative leadership has become More

Contemporary concepts of leadership and education

For many contemporary commentators, these ideas lead to the conclusion that leadership is understood as a form of service to others and shared values. A new moral principle is emerging which holds that the only right worthy of one's loyalty is that which is freely and knowingly given by More

Economic

• Why is the study of business and economics important?
• What is the importance of economics analysis in our daily life
• What is going on in capitalism in the present era?
• Questions essential for learning economics
• what is the economy and how does it work
• Contribution Of Entrepreneurship To Economy And Society
• What is economics and why is it important
• Relationship Between Economics And Politics
• Measuring the level of economic activity of an economy
• The best economy of our country

Why is the study of business and economics important?

Many people think that economics is a technical confusing and even mysterious subject. Economists are best left to experts. But in reality the economics should be quite straightforward. Economics is how we work, what we produce and More

What is the importance of economics analysis in our daily life

Whether in universities or in the real world, most economists firmly believe that competitive inequality and private wealth accumulation are central, natural, and desirable features of a vibrant, efficient economy. This value system provides their analysis More

What is going on in capitalism in the present era?

Capitalism has certain characteristics and forces that need to be recognized in order to understand how it works. To understand what is going on in capitalism right now, we need to recognize and study its More

Questions essential for learning economics

The economy must be a very complex, volatile thing. Mind-blowing stock market tables, charts and graphs, GDP figures, foreign exchange rates are what appear on the business pages of newspapers. No wonder the media turn to economists, the high priests of More

What is economics and why is it important

Economics is not a physical science, economics is a social science. Many economists are confused on this point! They foolishly attempt to describe human economic activity as physicists describe the behavior of atoms. Economics is the study of More

What is the economy and how does it work

The economy is at once mysterious and straightforward. We all know the experience of economy very well, everyone participates in it. The forces and relationships we examine along the way are more important to economic life than the meaningless ups and More

Contribution Of Entrepreneurship To Economy And Society

Economy is fundamentally a social activity. No one does it all by themselves. We depend on each other and we interact with each other during our work. It is common to compare the economy with private or individual wealth, profit and selfishness, so it More

Relationship Between Economics And Politics

Economics and politics are intertwined. Because economics and politics are intertwined, the first economists named the discipline political economy. The relationship between economics and politics partly reflects the importance of More

Measuring the level of economic activity of an economy

Gross domestic product (GDP) is the most common way to measure an economy. But one should be careful about this as it is a very dangerous solution. GDP adds up the value of all the various goods and services produced for More

The best economy of our country

Economics tries to explain how and in what manner the economy works. But economists are just as concerned with trying to do better. This requires economists to make judgments about which type of economy is more desirable. Unfortunately, most economists are More

Time management

• Understanding Time Management
• Misconceptions about time
• Symptoms of poor time management
• Thieves who steal time
• The importance of planning every moment of your workday
• Monochronic and polychronic views of time
• Five time zone concepts
• Time Management Matrix
• Orientation to time management
• Overcoming barriers to effective time management

Understanding Time Management

Good time management skills control one's time, stress and energy levels. One can maintain a balance between work and personal life. One finds the individual flexible enough in time to respond to surprises or More

Misconceptions about time

We all have many misconceptions about time. They affect everyone, including those who are considered successful and influential. Following are some of the misconceptions identified by More

Symptoms of poor time management

Poor time management is characterized by a combination of specific cognitive symptoms. Managers would do well to detect and reflect on whether they are subject to any More

Thieves who steal time

Lack of understanding of the value of planning and impatience to complete something are the causes of poor planning. Absence of an action plan is likely to lead to false starts, resulting in unproductive use of More

The importance of planning every moment of your workday

Classifies managers into different personality types based on certain patterns of behavior that frustrate people's efforts at effective time management and recommends the More

Monochronic and polychronic views of time

A monolithic approach to time management is essentially objective and emphasizes promptness, speed, brevity and punctuality. It is a very efficient and focused way of managing work and life. Monochronic time managers thrive on detailed More

Five time zone concepts

To accelerate their ability to manage time, managers need to strike the right balance between the monochronic and polychronic aspects of More

Time Management Matrix

Each of a manager's activities can be identified as one of four types, represented by the four quadrants of the time management matrix. Categorizing a manager's activities into these quadrants helps him identify More

Orientation to time management

To better manage their time, managers should answer the following questions More

Overcoming barriers to effective time management

Delegating authority and responsibility is an ideal way to control telephone interruptions. Designating specific time slots for socializing and business will help managers effectively reduce More