Financial Instruments, Financial Markets, and Financial Institutions

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Chapter 3

• Financial Instruments, Financial Markets, and
  Financial Institutions

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The Financial SystemThree Elements

• Financial Instruments
• Financial Markets
• Financial Institutions (intermediaries)

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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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Funds Flowing throughthe Financial System
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1.Financial Instruments The things you should
know

• Definition.
• Uses.
• Characteristics.
• Classes.
• What Makes Them Valuable?

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1.1 Financial Instruments Definition

• A 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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1.2 Financial Instruments Uses

• Means of Payment Purchase goods and services
  (ex employees accept
• 
  stock as payment )
• Store of Value Transfer purchasing power into
  the future
• Transfer of Risk Transfer risk to from one
  person to another

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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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1.3 Financial Instruments Characteristics

• Standardization Overcome the costs of complexity
• Makes them easier to understand
• Communicate Information Summarize essential
  information about issuer Eliminate expense of
  collecting information

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1.4 Financial Instruments Classes

• Underlying Used to transfer resources
  Examples stocks and bonds (Ch8 Ch6)
• Derivative Value derived from underlying
  instruments Examples Futures and options (Ch.
  9)

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1.5 Financial InstrumentsWhat Makes Them
Valuable?

• Size of the payment Larger ? more valuable
• 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

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2. Financial Markets The things you should know

• Definition.
• Roles.
• Structures
• Characteristics.

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2.1 Financial Markets Definition

• Places where financial instruments are
  bought and sold.

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2.2 Financial Markets Roles

• 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.

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2.3 Financial Market StructurePrimary vs.
Secondary

• Primary Buy and Sell Newly Issued Securities
• Secondary
• Trade Existing Securities

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Financial Market StructureCentralized, OTC, and
ECNs

• Centralized Exchange
• Physical location where trading takes place
• Over-the-Counter Market (OTC)
• Networks of dealers connected
  electronicallyElectronic Communications Network
  (ECN)
• Electronic networks where buyers and sellers
  interact directly.

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Financial Market StructureDebt, Equity, and
Derivatives

• Debt and Equity Markets Financial claims are
  bought and sold for immediate cash payment
• Derivative Markets
• Financial claims based on underlying
  instruments are bought and sold for payment at
  a future date

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2.4 Financial Markets Characteristics

• Well functioning markets have
• Low transaction costs
• Communicate accurate information
• Protect Investors

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• Placing an order
• Stock you wish to trade
• Buy or sell
• Size of order
• Price

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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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3. Financial Institutions The things you
should know

• Definition.
• Roles.
• Structures

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3.1 Financial Institutions Definition

• Financial institutions (intermediaries) are the
  firms that provides access to the financial
  markets both to savers and to borrowers.

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3.2 Financial Institutions Their Role

• 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.

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Flow of Funds throughFinancial Institutions
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Financial InstitutionsA Simplified Balance Sheet
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Financial Industry Structure I

• Depository Institutions Take deposits and make
  loans
• Insurance Companies Accept premiums, pay out
  based on events
• Pension Funds Invest contributions, provide
  payments to retirees

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Financial Industry Structure II

• 4. Security Firms Proved access to financial
  markets
• 5. Finance Companies Raise funds in financial
  markets, make loans
• 6. Government Sponsored Enterprises Raise
  funds in financial markets, make loans,
  provide guarantees.