Chapter 3
Financial Instruments, Financial Markets,
and Financial Institutions
The Financial System:
The Big Questions
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1.
What is a financial instrument and what is their role in the
economy?
2.
What are financial markets and how do they work?
3.
What are financial institutions and why are they so
important?
The Financial System:
Roadmap
 Financial Instruments
 Financial Markets
 Financial Institutions
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Preliminaries:
Definitions
Assets & Liabilities
 Asset: Something of value that you own
 Liability: Something you owe.
Question: to a bank, what is its assets? Liability?
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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.
Example: student loan
Why do we need financial instruments?
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Financial Instruments:
Uses
 Means of Payment
Purchase goods and services
 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: 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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Financial Instruments:
Classes
 Underlying
Used to transfer resources
Examples: stocks and bonds
 Derivative
Value derived from underlying instruments
Examples: Futures and options
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Financial Instruments:
How to price financial instruments?
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1.
Size of the payment:
2.
Timing of payment:
3.
Likelihood payment is made
4.
Conditions under with payment is made
Larger  more valuable
Sooner  more valuable
More likely  more valuable
When you need it most  more valuable
ICE:
Assume you have $1,000 and would like to invest
in the stock market. In a good economy (20%
likelihood), you can make about 20% of return. In
a normal economy (50% likelihood), your return
could be 5%. But in a crisis, you are going to lose
5%. You can borrow another $1000 from your
friend at 3% of interest rate. What is your return
under each economic condition, with and without
the loan?
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Financial Instruments:
Examples
Primarily Used as Stores of Value

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
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Bank Loans
Bonds
Home Mortgages
Stocks
Asset-backed securities
Financial Instruments:
Examples
Primarily used to Transfer Risk



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Insurance Contracts
Futures Contracts
Options
Financial Markets:
Definition
Places where financial instruments
are bought and sold.
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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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Importance of Financial Markets
 This is important. For example, if you save $1,000, but there are
no financial markets, then you can earn no return on this – might
as well put the money under your mattress.
 However, if a carpenter could use that money to buy a new saw
(increasing her productivity), then she’d be willing to pay you
some interest for the use of the funds.
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Importance of Financial Markets
 Financial markets are critical for producing an efficient
allocation of capital, allowing funds to move from people
who lack productive investment opportunities to people who
have them.
 Financial markets also improve the well-being of consumers,
allowing them to time their purchases better.
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Structure of Financial Markets
1.
Debt Markets




Short-Term (maturity < 1 year)
Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
Represented $41 trillion at the end of 2007.
2.
Derivative market: Financial claims based on underlying
instruments are bought and sold for payment at a future date
3.
Equity Markets



Pay dividends, in theory forever
Represents an ownership claim in the firm
Total value of all U.S. equity was $18 trillion at the end of 2005.
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Structure of Financial Markets
1. Primary Market
 New security issues sold to initial buyers
 Typically involves an investment bank who underwrites the
offering
2. Secondary Market
 Securities previously issued are bought
and sold
 Examples include the NYSE and Nasdaq
 Involves both brokers and dealers (do you know the
difference?)
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Structure of Financial Markets
Even though firms don’t get any money, per se, from the
secondary market, it serves two important functions:
•
Provide liquidity, making it easy to buy and sell the
securities of the companies
•
Establish a price for the securities
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Structure of Financial Markets
1.
We can further classify secondary markets as follows:
Exchanges

2.
Trades conducted in central locations
(e.g., New York Stock Exchange)
Over-the-Counter Markets


Dealers at different locations buy and sell
Best example is the market for Treasury securities
NYSE home page
http://www.nyse.com
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Classifications of Financial Markets
We can also further classify markets by the maturity of the
securities:
1.
2.
Money Market: Short-Term (maturity < 1 year)
Capital Market : Long-Term (maturity > 1 year) plus
equities
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Financial Markets:
Characteristics
Well functioning markets have
 Low transaction costs
 Communicate accurate information
 Protect Investors
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Flow of Funds through
Financial Institutions
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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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Asymmetric Information:
Adverse Selection and Moral Hazard
 Financial intermediaries reduce adverse selection and moral
hazard problems, enabling them to make profits.
Adverse Selection
1.Before transaction occurs
2.Potential borrowers most likely to produce adverse outcomes are
ones most likely to seek loans and be selected
Moral Hazard
1.After transaction occurs
2.Hazard that borrower has incentives to engage in undesirable
(immoral) activities making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and
moral hazard problems, enabling them to make profits
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Types of Financial Intermediaries
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Size of Financial Intermediaries
Videos to watch (optional)
Wall Street trader's NYSE Trading Floor Tour
http://www.youtube.com/watch?v=TPUDPhpCecA
http://www.youtube.com/watch?v=EX33ZpRPoUU&feature=related
NASDAQ on AWS - Customer Success Story
http://www.youtube.com/watch?v=vHSuwbklX4g
Introduction to The NASDAQ
http://www.youtube.com/watch?v=BXCUe6M8BAs
CBOT Trading Soybean market pit trading
http://www.youtube.com/watch?v=XZEBz01t5vg
MGEX - The final minute of trading in the pits, forever.
http://www.youtube.com/watch?v=S43zvtdJcxI&feature=related
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Ira, Fixed Income Capital Markets, BNP Paribas CIB, New York
http://www.youtube.com/watch?v=qk8DxoLYj0w
http://www.youtube.com/watch?v=g-QZMW2zbhw&feature=relmfu
HWs:
Page P66, questions 4, 5, 10, 12,
13 and 14.
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