Title: Money and Banking ECO 2115 Chapter 3 Financial Instruments, Financial Markets, and Financial Institutions
1Money and BankingECO 2115Chapter 3Financial
Instruments, Financial Markets, and Financial
Institutions
- Instructor Marc PrudHomme
2The Financial System The Big Questions
- What are financial markets and how do they work?
- What are financial institutions and why are they
so important? - What is a financial instrument and what is their
role in the economy?
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3The Financial System A Roadmap
- Financial Instruments
- Financial Markets
- Financial Institutions
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4Preliminaries Definitions
- Types of Finance
- Indirect Institution stands between lender and
borrower. - Direct Borrowers sell securities directly to
lenders in the financial markets - Assets Liabilities
- Asset Something of value that you own
- Liability Something you owe.
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5Money and Banking Chapter 3
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6Financial instruments
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7Financial instruments
- Financial instrument is the written legal
obligation of one party to transfer something of
value, usually money, to another party at some
future date, under certain conditions.
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8Financial instruments Uses
- Store of Value
- Transfer purchasing power into the future
- Your consumption doesnt need to exactly match
your income. - Consumption smoothing (model in appendix).
- As a store of value, financial instruments are
better than money. - Allow savings to be pooled.
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9Financial instruments Uses
- Transfer of Risk
- Transfer risk from one person to another
- Ability to transfers risk between buyer and
seller. - Wheat futures contract.
- Insurance contracts.
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10Financial instruments Uses
- Means of Payment
- Not common but can be used for this purpose
sometimes. - Purchase goods and services
- Company pays for your labour services with stocks.
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11Financial instruments Characteristics
- Financial instruments can be complex
- Complexity is costly
- Standardization
- Overcomes the costs of complexity
- Makes them easier to understand
- Communicate Information
- Summarize essential information about issuer
- Eliminate expense of collecting information
- Handles the problem of asymmetric information.
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12Financial instruments Classes
- Underlying instruments (primitive securities)
- used by savers/ lenders to transfer resources
directly to investors/ borrowers. - Through these instruments, the financial system
improves the efficient allocation of resources in
the real economy.Examples stocks and bonds - Derivative
- Value derived from underlying instruments One of
the oldest derivatives is rice futures - The primary use of derivatives is to shift risk
among investors.Examples futures and options - Option is a derivative financial instrument that
specifies a contract between two parties for a
future transaction on an asset at a reference
price. - Futures a standardized contract between two
parties to exchange a specified asset of
standardized quantity and quality for a price
agreed today (the futures price or the strike
price) with delivery occurring at a specified
future date, the delivery date.
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13Financial InstrumentsWhat Makes Them Valuable?
- Why are some financial instruments more valuable
than others? - If you look at the Web site of The Globe and Mail
or The Financial Post, youll see the prices of
many bonds and stocks. - They are quite different from each other. Not
only that, but from day to day, the prices of an
individual bond or stock can vary quite a bit. - What characteristics affect the price someone
will pay to buy or sell a financial instrument?
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14Financial InstrumentsWhat Makes Them Valuable?
- Four fundamental characteristics influence the
value of a financial instrument - the size of the payment that is promised
- when the promised payment is to be made
- the likelihood that the payment will be made and
- the circumstances under which the payment is to
be made.
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15Financial Instruments Examples
- Primarily Used as Stores of Value
- Bank loans
- Bonds
- Home mortgages
- Stocks
- Asset-backed securities
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16Financial Instruments Examples
- Primarily used to transfer risk
- Insurance contracts
- Futures contracts
- Options
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17Financial markets definition
- Places where financial instruments are bought
and sold - They are the economys central nervous system,
relaying and reacting to information quickly,
allocating resources, and determining prices. - In doing so, financial markets enable both firms
and individuals to find financing for their
activities.
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18Financial markets roles
- Liquidity Ensure owners can buy and sell
financial instruments cheaply (keeps transaction
costs low). It is the crucial characteristics of
financial markets. Would you buy a security if
you knew you could not sell it? - Information Pool and communicate information
about issuers of financial instruments. - Risk sharing Provide individuals a place to buy
and sell risk.
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19Financial market structure primary vs. secondary
- Primary market where a borrower obtains funds
from a lender or investor by selling newly issued
securities. - Secondary Market buy and sell existing
securities.
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20Financial market structure Centralized, OTC, and
ECNs
- Centralized Exchange Physical location where
trading takes place. TSX - TSE - http//library.thinkquest.org/3088/stockmarket/how
itworks.html - Over-the-Counter Market (OTC) Networks of
dealers connected electronically. NASDAQ
(National Association of Securities Dealers
Automated Quotations) - Electronic Communications Network (ECN) (or
electronic trading networks) Electronic networks
where buyers and sellers interact directly.
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21Dealer vs. broker
- A broker is a person who executes the trade on
behalf of others, whereas a dealer is a person
who trades business (stocks and bonds) on their
own behalf. - A dealer is a person who will buy and sell
securities on their account. On the other hand, a
broker is one who will buy and sell securities
for their clients. - While dealers have all the rights and freedom
regarding the buying and selling of securities,
brokers seldom seldom have this freedom and these
rights. - A broker has only a little experience in the
field compared to dealers. It has also been seen
that brokers become dealers once they get
experience.
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22Financial Market StructureDebt, Equity, and
Derivatives
- Debt and Equity Markets Financial claims are
bought and sold for immediate cash payment (e.g.,
loans, mortgages, bonds, and stocks - the
instruments that allow for the transfer of
resources from lenders to borrowers and at the
same time give investors a store of value for
their wealth.) - Debt instruments that are completely repaid in a
year or less ( from their original issue date)
are traded in money markets. - Debt instruments with a maturity of more than a
year are traded in bond (or capital) markets.
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23Financial Market StructureDebt, Equity, and
Derivatives
- Derivative Markets Financial claims based on
underlying instruments are bought and sold for
payment at a future date. - They are the markets where investors trade
instruments such as futures and options (i.e.,
contracts), which are designed primarily to
transfer risk. - Montreal exchange http//www.m-x.ca/marc_terme_en
.php - Example http//www.sfu.ca/mvolker/biz/futures.ht
m
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24Financial Markets Characteristics
- Well functioning markets have the following
characteristics - Low transaction costs
- Communicate accurate and widely available
information - Protect Investors
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25- Investors provide capital when they know they can
get it back. - Disparities in investor protection help explain
differences in financial development. - Without investor protection a countrys financial
system does not develop. - This hampers growth.
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26Financial Institutions
- Financial institutions are the firms that provide
access to the financial markets, both to savers
who wish to purchase financial instruments
directly and to borrowers who want to issue them.
- Because financial institutions sit between savers
and borrowers, they are also known as financial
intermediaries, and what they do is known as
intermediation. - Banks, insurance companies, securities firms, and
pension funds are all financial intermediaries.
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27Financial Institutions
- Financial institutions are important for three
reasons - Without FIs direct finance, which would not
work very well - Transactions expensive
- Monitoring costs
- Flow of funds restricted in the economy
borrowers want to borrow for long term but
lenders want to lend short term. Lenders would
require compensation for the illiquidity of long
term loans.
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28Financial InstitutionsTheir Role
- Reduce transactions cost by specializing in the
issuance of standardized securities - Reduce information costs of screening and
monitoring borrowers (i.e., curb information
asymmetries helping resources flow to their most
productive uses.) - Issue short term liabilities and purchase
long-term loans.
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29The structure of the financial industry
- In analyzing the structure of the financial
industry, we can start by dividing intermediaries
into two broad categories called depository and
non-depository institutions. - Depository institutions take deposits and make
loans they are what most people think of as
banks, whether they are commercial banks, savings
banks, credit unions, or caisses populaires. - Non-depository institutions include insurance
companies, securities firms, mutual fund
companies, finance companies, and pension funds.
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30The structure of the financial industry
- Depository Institutions Take deposits and make
loans - Insurance Companies Accept premiums and pay out
based on events - Pension Funds Invest contributions, provide
payments to retirees.
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31The structure of the financial industry
- Security Firms Proved access to financial
markets - Finance Companies Raise funds in financial
markets, make loans - Government Sponsored Enterprises Raise funds in
financial markets and make loans and provide
guarantees.
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32Money and Banking Chapter 3
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33Summary
- Financial instruments are crucial to the
operation of the economy. - Financial arrangements can be either formal or
informal. Industrial economies are dominated
by formal arrangements. - A financial instrument is the written legal
obligation of one party to transfer something of
value, usually money, to another party at some
future date, under certain conditions.
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34Summary
- contd
- Financial instruments are used primarily as
stores of value and means of trading risk. They
are less likely to be used as means of payment,
although many of them can be. - Financial instruments are most useful when they
are simple and standardized.
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35Summary
- contd
- There are two basic classes of financial
instruments underlying and derivative. - Underlying instruments are used to transfer
resources directly from one part to another. - Derivative instruments derive their value from
the behaviour of an underlying instrument.
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36Summary
- contd
- The payments promised by a financial instrument
are more valuable - The larger they are.
- The sooner they are made
- The more likely they are to be made
- If they are made when they are needed most.
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37Summary
- contd
- Common examples of financial instruments include
- Those that serve primarily as stores of value,
including bank loans, bonds, mortgages stocks,
and asset-backed securities. - Those that are used primarily to transfer risk,
including futures and options.
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38Summary
- Financial markets are essential to the operation
of our economic system. - Financial market
- Offer savers and borrowers liquidity so that they
can buy and sell financial instruments easily. - Pool and communicate information through prices.
- Allow for the sharing of risk.
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39Summary
- Contd
- There are several ways to categorize financial
markets. - Primary markets that issue new securities versus
secondary markets, where existing securities are
bought and sold. - Physically centralized exchanges, dealer-based
electronic systems (over-the-counter markets), or
electronic networks.
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40Summary
- Contd
- There are several ways to categorize financial
markets. - Debt and equity markets (where instruments that
are used primarily for financing are traded)
versus derivative markets (where instruments that
are used to transfer risk are traded).
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41Summary
- Contd
- A well-functioning financial market is
characterized by - Low transactions costs and sufficient liquidity.
- Accurate and widely available information.
- Legal protection of investors against the
arbitrary seizure of their property.
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42Summary
- Financial institutions perform brokerage and
asset transformation functions. - In their role as brokers, they provide access to
financial markets. - In transforming assets, they provide indirect
finance.
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43Summary
- Contd
- Indirect finance reduces transaction and
information costs. - Financial institutions, also known as financial
intermediaries, help individuals and firms to
transfer and reduce risk.
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44End of chapter
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