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Chapter 3: Financial Chapter 3: Financial Instruments, Markets and Instruments, Markets and Institutions Institutions Financial Instruments Financial Markets Financial Institutions

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Page 1: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Chapter 3: Financial Instruments, Chapter 3: Financial Instruments, Markets and InstitutionsMarkets and InstitutionsChapter 3: Financial Instruments, Chapter 3: Financial Instruments, Markets and InstitutionsMarkets and Institutions

• Financial Instruments

• Financial Markets

• Financial Institutions

• Financial Instruments

• Financial Markets

• Financial Institutions

Page 2: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

• People who need funds borrowers/issuer/seller

• People who have funds to give lenders/savers/buyers

• People who need funds borrowers/issuer/seller

• People who have funds to give lenders/savers/buyers

Page 3: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Indirect vs. Direct FinanceIndirect vs. Direct FinanceIndirect vs. Direct FinanceIndirect vs. Direct Finance

• Indirect finance Borrowers and lenders meet

through a financial intermediary (e.g. bank)

Loan is a liability for borrower, and asset for a bank

• Indirect finance Borrowers and lenders meet

through a financial intermediary (e.g. bank)

Loan is a liability for borrower, and asset for a bank

Page 4: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

• Direct finance Borrowers sell securities directly

to lenders e.g. corporate and Treasury bonds

• Direct finance Borrowers sell securities directly

to lenders e.g. corporate and Treasury bonds

Page 5: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial
Page 6: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

I. Financial InstrumentsI. Financial InstrumentsI. Financial InstrumentsI. Financial Instruments

aka. securities, financial assets

definition (p. 36 (1st) or 41 (2nd))= written legal obligation of one party to transfer

something of value, usually money, to antoher party at some future date, under certain conditions

a security is an asset for the buyer/lender,but a liability for the issuer/borrower/seller

aka. securities, financial assets

definition (p. 36 (1st) or 41 (2nd))= written legal obligation of one party to transfer

something of value, usually money, to antoher party at some future date, under certain conditions

a security is an asset for the buyer/lender,but a liability for the issuer/borrower/seller

Page 7: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

exampleexampleexampleexample

• shares of stock in Time Warner, Inc. shares of ownership in TW a claim on the earnings/assets of

TW a liability for Time Warner an asset for me

• shares of stock in Time Warner, Inc. shares of ownership in TW a claim on the earnings/assets of

TW a liability for Time Warner an asset for me

Page 8: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

• my mortgage I am the borrower (liability) the bank is the buyer/holder

(asset) the bank has a claim on my house

• my mortgage I am the borrower (liability) the bank is the buyer/holder

(asset) the bank has a claim on my house

Page 9: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

uses of financial instrumentsuses of financial instrumentsuses of financial instrumentsuses of financial instruments

• means of payment but much less liquid than money

• store of value better than money over time, but also

greater risk

• transfer of risk buyer transfers risk to seller e.g. insurance policies, futures contract

• means of payment but much less liquid than money

• store of value better than money over time, but also

greater risk

• transfer of risk buyer transfers risk to seller e.g. insurance policies, futures contract

Page 10: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Valuing financial instrumentsValuing financial instrumentsValuing financial instrumentsValuing financial instruments

• sizing, timing & certainty of promised cash flows

• Size: how much is promised? the larger the cash flows, the greater

the value

• Timing: when is it promised? the sooner the cash flows are received,

the greater the value

• sizing, timing & certainty of promised cash flows

• Size: how much is promised? the larger the cash flows, the greater

the value

• Timing: when is it promised? the sooner the cash flows are received,

the greater the value

Page 11: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

• Certainty: how likely its it that payments will be made? the likelier the payments the greater the

value

• Under what conditions? e.g. insurance, derivatives payments when we need them the most

are more valuable

• Certainty: how likely its it that payments will be made? the likelier the payments the greater the

value

• Under what conditions? e.g. insurance, derivatives payments when we need them the most

are more valuable

Page 12: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

examples (p. 43/44 or 46/47)examples (p. 43/44 or 46/47)examples (p. 43/44 or 46/47)examples (p. 43/44 or 46/47)

• bank loans

• stocks

• bonds

• home mortgages

• asset-backed securities

• option and futures contracts

• insurance policies

• bank loans

• stocks

• bonds

• home mortgages

• asset-backed securities

• option and futures contracts

• insurance policies

Page 13: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

II. Financial MarketsII. Financial MarketsII. Financial MarketsII. Financial Markets

• where financial instruments are bought and sold

• these markets provide liquidity for buying/selling information through prices risk-sharing among buyers/sellers

• classified in various ways…

• where financial instruments are bought and sold

• these markets provide liquidity for buying/selling information through prices risk-sharing among buyers/sellers

• classified in various ways…

Page 14: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Primary vs. Secondary MarketsPrimary vs. Secondary MarketsPrimary vs. Secondary MarketsPrimary vs. Secondary Markets

• primary market newly issued securities

-- investment banking

• secondary market brokers match buyers and sellers dealers act as buyers and sellers

-- “market-makers”

• primary market newly issued securities

-- investment banking

• secondary market brokers match buyers and sellers dealers act as buyers and sellers

-- “market-makers”

Page 15: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Debt vs. Equity MarketsDebt vs. Equity MarketsDebt vs. Equity MarketsDebt vs. Equity Markets

• debt security cash flows are fixed bonds, loans

• equity security cash flow variable, residual common stock

• debt security cash flows are fixed bonds, loans

• equity security cash flow variable, residual common stock

Page 16: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Exchanges vs. OTC MarketsExchanges vs. OTC MarketsExchanges vs. OTC MarketsExchanges vs. OTC Markets

• exchange buying & selling of securities in

physical location NYSE

• OTC (over-the-counter) dealers in many locations buy &

sell securities

• exchange buying & selling of securities in

physical location NYSE

• OTC (over-the-counter) dealers in many locations buy &

sell securities

Page 17: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Money vs. Capital MarketsMoney vs. Capital MarketsMoney vs. Capital MarketsMoney vs. Capital Markets

• money market short-term debt securities (up to 1

yr.) highly liquid, low risk

• capital market longer-term debt equity

• money market short-term debt securities (up to 1

yr.) highly liquid, low risk

• capital market longer-term debt equity

Page 18: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Money Market

20%

25%39%

9%0%

4%3%

U.S. Tbills

CDs

CommercialPaperBanker'sAcceptancesRepos

FederalFundsEurodollars

Page 19: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Capital Market

4% 8%11%

18% 59%

Stock

Mortgages

U.S. bonds

MunicipalbondsLoans

Page 20: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

III. Financial InstitutionsIII. Financial InstitutionsIII. Financial InstitutionsIII. Financial Institutions

aka. financial intermediariesWhy have them?

• Transactions costs search costs to find borrower &

lender contract costs economies of scale

aka. financial intermediariesWhy have them?

• Transactions costs search costs to find borrower &

lender contract costs economies of scale

Page 21: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

• Risk sharing intermediaries are experts at

bearing risk

• Asset transformation short-term to long-term illiquid to liquid

• Risk sharing intermediaries are experts at

bearing risk

• Asset transformation short-term to long-term illiquid to liquid

Page 22: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Types of intermediariesTypes of intermediariesTypes of intermediariesTypes of intermediaries

• Depository institutions “banks” accept deposits, make loans

• Depository institutions “banks” accept deposits, make loans

Page 23: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

• Commercial banks largest in total assets least restricted

• Savings & Loans originally restricted to savings deposits

and mortgages less restricted today

• Credit Unions consumer loans nonprofit, organized around a group

• Commercial banks largest in total assets least restricted

• Savings & Loans originally restricted to savings deposits

and mortgages less restricted today

• Credit Unions consumer loans nonprofit, organized around a group

Page 24: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

• Nondepository institutions insurance companies pension funds finance companies

• Mortgage, auto, office equipment

Securities firms gov’t-sponsored enterprises

(GSEs)

• Nondepository institutions insurance companies pension funds finance companies

• Mortgage, auto, office equipment

Securities firms gov’t-sponsored enterprises

(GSEs)

Page 25: Chapter 3: Financial Instruments, Markets and Institutions Financial Instruments Financial Markets Financial Institutions Financial Instruments Financial

Subprime mortgage meltdownSubprime mortgage meltdownSubprime mortgage meltdownSubprime mortgage meltdown

• Hit several types of financial institutions: finance companies

• Countrywide

securities firms• Citigroup, Merrill Lynch

GSEs• Fannie Mae, Freddie Mac

• Hit several types of financial institutions: finance companies

• Countrywide

securities firms• Citigroup, Merrill Lynch

GSEs• Fannie Mae, Freddie Mac