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Title: Money and Banking ECO 2115 Chapter 3 Financial Instruments, Financial Markets, and Financial Institutions


1
Money and BankingECO 2115Chapter 3Financial
Instruments, Financial Markets, and Financial
Institutions
  • Instructor Marc PrudHomme

2
The 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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The Financial System A Roadmap
  • Financial Instruments
  • Financial Markets
  • Financial Institutions

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Preliminaries 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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Financial instruments
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Financial 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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Financial 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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Financial 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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Financial 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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Financial 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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Financial 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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Financial 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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Financial 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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Financial Instruments Examples
  • Primarily Used as Stores of Value
  • Bank loans
  • Bonds
  • Home mortgages
  • Stocks
  • Asset-backed securities

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Financial Instruments Examples
  • Primarily used to transfer risk
  • Insurance contracts
  • Futures contracts
  • Options

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Financial 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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Financial 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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Financial 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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Financial 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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Dealer 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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Financial 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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Financial 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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Financial Markets Characteristics
  • Well functioning markets have the following
    characteristics
  • Low transaction costs
  • Communicate accurate and widely available
    information
  • Protect Investors

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  • 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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Financial 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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Financial 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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Financial InstitutionsTheir Role
  1. Reduce transactions cost by specializing in the
    issuance of standardized securities
  2. Reduce information costs of screening and
    monitoring borrowers (i.e., curb information
    asymmetries helping resources flow to their most
    productive uses.)
  3. Issue short term liabilities and purchase
    long-term loans.

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The 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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The structure of the financial industry
  1. Depository Institutions Take deposits and make
    loans
  2. Insurance Companies Accept premiums and pay out
    based on events
  3. Pension Funds Invest contributions, provide
    payments to retirees.

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The 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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Summary
  1. Financial instruments are crucial to the
    operation of the economy.
  2. Financial arrangements can be either formal or
    informal. Industrial economies are dominated
    by formal arrangements.
  3. 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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Summary
  • 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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Summary
  • 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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Summary
  • 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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Summary
  • 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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Summary
  • 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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Summary
  1. Contd
  2. There are several ways to categorize financial
    markets.
  3. Primary markets that issue new securities versus
    secondary markets, where existing securities are
    bought and sold.
  4. Physically centralized exchanges, dealer-based
    electronic systems (over-the-counter markets), or
    electronic networks.

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Summary
  • 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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Summary
  • 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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Summary
  • 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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Summary
  • 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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End of chapter
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