Financial Instruments, Financial Markets,

and Financial Institutions

Chapter 3

The Financial System:The Big Questions

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1. What is a financial instrument and what is their role in the economy?

2. What are financial markets and how do they work?

3. What are financial institutions and why are they so important?

The Financial System:Roadmap

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Financial InstrumentsFinancial MarketsFinancial Institutions

Preliminaries: Definitions

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Assets & LiabilitiesAsset: Something of value that you ownLiability: Something you owe.Question: to a bank, what is its assets?

Liability?

Financial Instruments: Definition

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A written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions.

Example: student loan

Why do we need financial instruments?

Financial Instruments: Uses

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Means of PaymentPurchase goods and services

Store of ValueTransfer purchasing power into the

futureTransfer of Risk

Transfer risk to from one person to another

Financial Instruments: Characteristics

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StandardizationOvercome the costs of complexity

Makes them easier to understand

Communicate InformationSummarize essential information about

issuer Eliminate expense of collecting information

Financial Instruments:Classes

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UnderlyingUsed to transfer resources

Examples: stocks and bonds

DerivativeValue derived from underlying

instrumentsExamples: Futures and options

Financial Instruments:How to price financial instruments?

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1. Size of the payment: Larger more valuable

2. Timing of payment: Sooner more valuable

3. Likelihood payment is made More likely more valuable

4. Conditions under with payment is made When you need it most more valuable

Assume you have $1,000 and would like to invest in the stock market. In a good economy (20% likelihood), you can make about 20% of return. In a normal economy (50% likelihood), your return could be 5%. But in a crisis, you are going to lose 5%. You can borrow another $1000 from your friend at 3% of interest rate. What is your return under each economic condition, with and without the loan?

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ICE:

Financial Instruments:Examples

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Primarily Used as Stores of Value Bank Loans Bonds Home Mortgages Stocks Asset-backed securities

Financial Instruments:Examples

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Primarily used to Transfer Risk Insurance Contracts Futures Contracts Options

Financial Markets:Definition

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Places where financial instruments are bought and sold.

Financial Markets:Roles

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Liquidity: Ensure owners can buy and sell financial instruments cheaply.

Information: Pool and communication information about issuers of financial instruments.

Risk sharing: Provide individuals a place to buy and sell risk.

Importance of Financial Markets

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This is important. For example, if you save $1,000, but there are no financial markets, then you can earn no return on this – might as well put the money under your mattress.

However, if a carpenter could use that money to buy a new saw (increasing her productivity), then she’d be willing to pay you some interest for the use of the funds.

Importance of Financial Markets

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Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them.

Financial markets also improve the well-being of consumers, allowing them to time their purchases better.

Structure of Financial Markets

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1. Debt Markets Short-Term (maturity < 1 year) Long-Term (maturity > 10 year) Intermediate term (maturity in-between) Represented $41 trillion at the end of 2007.

2. Derivative market: Financial claims based on underlying instruments are bought and sold for payment at a future date

3. Equity Markets Pay dividends, in theory forever Represents an ownership claim in the firm Total value of all U.S. equity was $18 trillion at the

end of 2005.

Structure of Financial Markets

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1. Primary Market New security issues sold to initial buyers Typically involves an investment bank who

underwrites the offering

2. Secondary Market Securities previously issued are bought

and sold Examples include the NYSE and Nasdaq Involves both brokers and dealers (do you

know the difference?)

Structure of Financial Markets

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Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:

• Provide liquidity, making it easy to buy and sell the securities of the companies

• Establish a price for the securities

Structure of Financial Markets

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We can further classify secondary markets as follows:

1. Exchanges Trades conducted in central locations

(e.g., New York Stock Exchange)

2. Over-the-Counter Markets Dealers at different locations buy and sell Best example is the market for Treasury

securities

NYSE home pagehttp://www.nyse.com

Classifications of Financial Markets

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We can also further classify markets by the maturity of the securities:1. Money Market: Short-Term (maturity < 1

year) 2. Capital Market : Long-Term (maturity > 1

year) plus equities

Financial Markets:Characteristics

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Well functioning markets haveLow transaction costsCommunicate accurate information

Protect Investors

Flow of Funds throughFinancial Institutions

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Financial Institutions:Their Role

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Reduce transactions cost by specializing in the issuance of standardized securities

Reduce information costs of screening and monitoring borrowers.

Issue short term liabilities and purchase long-term loans.

Asymmetric Information: Adverse Selection and Moral Hazard

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Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits.

Adverse Selection1. Before transaction occurs2. Potential borrowers most likely to produce adverse

outcomes are ones most likely to seek loans and be selected

Moral Hazard1. After transaction occurs2. Hazard that borrower has incentives to engage in

undesirable (immoral) activities making it more likely that won’t pay loan back

Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

Types of Financial Intermediaries

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Size of Financial Intermediaries

Videos to watch (optional)

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Wall Street trader's NYSE Trading Floor Tourhttp://www.youtube.com/watch?v=TPUDPhpCecAhttp://www.youtube.com/watch?v=EX33ZpRPoUU&feature=related

NASDAQ on AWS - Customer Success Story http://www.youtube.com/watch?v=vHSuwbklX4g

Introduction to The NASDAQ http://www.youtube.com/watch?v=BXCUe6M8BAs

CBOT Trading Soybean market pit tradinghttp://www.youtube.com/watch?v=XZEBz01t5vg

MGEX - The final minute of trading in the pits, forever. http://www.youtube.com/watch?v=S43zvtdJcxI&feature=related

Ira, Fixed Income Capital Markets, BNP Paribas CIB, New York http://www.youtube.com/watch?v=qk8DxoLYj0whttp://www.youtube.com/watch?v=g-QZMW2zbhw&feature=relmfu

HWs:

Page P66, questions 4, 5, 10, 12, 13 and 14.

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