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Chapter 3: Financial Instruments,
Markets and Institutions
Financial Instruments
Financial Markets
Financial Institutions
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People who need funds
borrowers/issuer/seller
People who have funds to give lenders/savers/buyers
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Indirect 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
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I. Financial Instruments
aka. securities, financial assets
definition (p. 36 (1st) or 41 (2nd))
= wri t ten legal obl igat ion o f on e party to trans fersomething of value, usual ly money, to antoherparty at some futu re date, under certaincond i t ions
a security is an asset for the buyer/lender,but a liability for the issuer/borrower/seller
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example
shares of stock in Time Warner, Inc.
shares of ownership in TW
a claim on the earnings/assets ofTW
a liability for Time Warner
an asset for me
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my mortgage
I am the borrower (liability)
the bank is the buyer/holder(asset)
the bank has a claim on my house
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uses of financial instruments
means of payment
but much less liquid than money
store of value
better than money over time, but alsogreater risk
transfer of risk
buyer transfers risk to seller e.g. insurance policies, futures contract
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Valuing financial instruments
sizing, timing & certainty of promisedcash flows
Size: how much is promised?
the larger the cash flows, the greaterthe value
Timing: when is it promised?
the sooner the cash flows are received,the greater the value
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Certainty: how likely its it that paymentswill be made?
the likelier the payments the greater the
value Under what conditions?
e.g. insurance, derivatives
payments when we need them the mostare more valuable
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examples (p. 43/44 or 46/47)
bank loans
stocks
bonds
home mortgages
asset-backed securities
option and futures contracts insurance policies
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II. Financial Markets
where financial instruments arebought and sold
these markets provide
liquidity for buying/selling
information through prices
risk-sharing among buyers/sellers classified in various ways
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Primary 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
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Debt vs. Equity Markets
debt security
cash flows are fixed
bonds, loans equity security
cash flow variable, residual
common stock
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Exchanges vs. OTC Markets
exchange
buying & selling of securities in
physical location NYSE
OTC (over-the-counter)
dealers in many locations buy &
sell securities
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Money vs. Capital Markets
money market
short-term debt securities (up to 1
yr.)
highly liquid, low risk
capital market
longer-term debt
equity
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Money Market
20%
25%39%
9%0%
4%3%
U.S. Tbills
CDs
CommercialPaper
Banker'sAcceptancesRepos
Federal
FundsEurodollars
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Capital Market
4% 8%
11%
18% 59%
Stock
Mortgages
U.S. bonds
MunicipalbondsLoans
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III. Financial Institutions
aka. financial intermediaries
Why have them?
Transactions costs search costs to find borrower &
lender
contract costs economies of scale
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Risk sharing
intermediaries are experts at
bearing risk
Asset transformation short-term to long-term
illiquid to liquid
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Types of intermediaries
Depository institutions
banks
accept deposits, make loans
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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
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Nondepository institutions
insurance companies pension funds
finance companies
Mortgage, auto, office equipment
Securities firms
govt-sponsored enterprises(GSEs)
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Subprime mortgage meltdown
Hit several types of financialinstitutions:
finance companies
Countrywide
securities firms
Citigroup, Merrill Lynch
GSEs
Fannie Mae, Freddie Mac
