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Financial Instruments, FinancialMarkets, and Financial
Institutions
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• Well-functioning nancial markets are an essentpart of any modern healthy economy
• funds are oered by the lenders/savers ho have!cess funds and purchased by the
borroers/spenders ho need those funds• direct fnance- when borrowers and lenders
meet directly
• Indirect fnance- when borrowers and lendemeet through fnancial intermediary
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• "hrough these markets the funds #o that
for the development of ne products/ideas,e!pansion of the production of e!isting prodand consumer spending on $big ticket$ itemlike houses, cars, and college tuition
• Without these markets, rms may be unable
e!pand production or invent ne products aconsumers ill be unable to aord certainproducts%
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Financial Instruments
• transfer of available funds
• buying and selling of fnancial instrumentssecurities
• A fnancial instrument is the written legalobligation o one party to transer somethingvalue, usually money, to another party at som uture date, under certain conditions.
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Financial Instruments
• '( binding, enforceable contract under the rule la, protecting potential buyers%
• )( transfer of value beteen to parties, here party can be a bank, insurance company, a
government, a rm, or an individual%
• "he future dates may be very specic *like a momortgage payment( or may be +uite uncertain adepend on certain events *like an insurance poli
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Financial instruments
• can function as a means of payment or a store of
• means of payment
• fall ell short of money in terms of li+uidity, divis
and acceptance• better stores of value since they allo for greater
increases in ealth over time, but ith higher levrisk
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Financial instruments
• ( function of these instruments is risktransfer
• buyers are shifting risk to the seller
• paying the seller to assume certain risk
• !% insurance
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Financial instruments
• standardi.ed in that they have the samobligations and contract for buyers
• !% tocks, loans
• 0niformity reduce cost
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Financial instruments
• provide certain relevant information abthe issuer, the characteristics and the rof the security
• even the playing eld among dierentparties and reduce unfair advantages
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Financial instruments• si.e, timing and certainty of cash #os are all importa
• The larger amount promised, the greater the valu
• The sooner the payments are promised, the greathe value
• The more certain the payments, the greater the v
• The more needed the payment, the greater the va• Ex. insurance
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1sset class
Instrument type
ecurities 2ther cash!change-tradedderivatives
4ebt *longterm(5 ' year
6onds 7oans6ond futures2ptions onbond futures
4ebt *shortterm(8 ' year
6ills, e%g% "-bills3ommercialpaper
4eposits3erticates ofdeposit
hortterm interestrate futures
+uity tock 9/1 tock options+uity futures
http://en%ikipedia%org/iki/Financial;instrument
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Financial Marets
• many markets, each dealing ith aparticular type of nancial instrument
• providing a mechanism for +uickly and
cheap buying and selling of securities• nancial markets oer liquidity
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Financial Marets
• interaction of buyers and sellers todetermine the price
• price conveys important inormation ab
the prospects of the issuer• mechanism for buying and selling the
instruments that transer risks beteenbuyers and sellers%
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Primary vs. Secondary Marke
• primary maret are brand ne, or neissues
• sold to the buyer by the issuer
• "econdary- resold by the previous buy
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• primary market, investment bans assibusiness in selling a ne issue to the pub
• Investment banks underwrite ne secur
meaning that they buy the ne issue frombusiness and sell it to the public
• banks charge fees for this service
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• the secondary market
• ecurities broers facilitate trade bymatch buyers ith sellers
• commission on each match *or trade(%
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• ecurities dealers act as the buyer and sel
• +uoting a price at hich they ill buy asecurity *the bid price( and the price at
they ill sell the security *the as price(%• dierence is knon as the bid-as spread
• ho dealers make their money
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• dealers are often referred to as $markemakers<
• $make a market$ in that security
• on an inventory of the securities
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• the better the secondary market, the betteprimary market%
• li#uidity
• If, for e!ample, Microsoft stock is easy to and sell in the secondary market *highly lithen it ill be popular in the primary mark
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Exchanges vs. OTC Market
• buying and selling occurs in a central,physical location, then securities are tron an exchange%
• !% =
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• dispersed buyers and sellers, linked bycomputer% "his is knon as an over-thecounter *2"3( market
• "oday 2"3 markets link buyers and selelectronically through dealers
• !% =4>, 9141?
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• 39s or electronic communicationnetorks oer yet a third option for buand seller to nd each other directly i
no dealer or broker
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Debt vs. Equity vs. Derivative Mar
• debt instruments, like a bond or a bankloan, involve a promise by the borroepay the lender%
• !ed payments at specied intervals unnal date
• "he time until all payments are made isknon as the maturity
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• "hort-term debt securities have a maturityup to ' year% "his part of the debt market is knon as the money maret.
•
Intermediate-term debt securities have amaturity of beteen ' and '@ years%
• $ong-term debt securities have a maturity years or more%
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• +uity instruments
• shares of common stock
• claims on the earnings and assets of a
corporation• ntitled to the percentage that you are
holding
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•
the si.e and timing of the payments are not !edome e+uities securities entitle the oner to perpayments *knon as dividends( but these paymare not guaranteed% "his means that e+uity holdbenet from a rmAs protability in a ay that deholders do not%
• there is no maturity date for e+uity securities soare considered long-term securities
• stock holders are considered residual claimantthe event of bankruptcy%
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• 4erivatives markets
• value from other underlying assets
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• Financial Institutions
• Depository nstitutions
• !on"depository nstitutions
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• Depository nstitutions
•
%ommercial bans- include commercial loanconsumer loans, mortgages, 0%% governmentbonds, municipal bonds%
• "avings and $oan &ssociations- originallyrestricted to oering savings accounts and 34making mortgage loans *Mutual "avings ban
• %redit 'nions - are nonprot and credit uniomembership is organi.ed around a particular gsuch as company employees, a union, or even church parish
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• !on"depository nstitutions
• $i(e insurance companies - buyer of corpobonds and mortgages *long term(
• Fire and casualty insurance -less predictabthan life insurance% assets are more li+uid thainsurance companies, municipal bonds, corpobonds, stocks, and 0%% government bonds
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• )ension (unds - private or government *BI(, assets are more long term
• Finance companies - raise funds by usingcommercial paper, then use these funds to mbusiness loans, construction loans, auto loanand other consumer loans
-e!% B Finance 3ompany
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• "ecurities frms - brokers, investmentbanking/underriting and mutual fund
• Mutual funds- for diversication purposes
•Money maret mutual (unds - buy monemarket instruments, like interest bearingchecking account
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• *"Es or *overnment-sponsoredenterprises - Fannie Mae *homemortgages(, allie Mae, Freddie Mac