A Closer Look at Financial
Institutions and Financial
Markets
Chapter 27 Appendix
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Financial Assets and Financial
Liabilities
Financial assets – assets, such as stocks
or bonds, whose benefit to the owner
depends on the issuer of the asset meeting
certain obligations.
 Financial liabilities – liabilities incurred by
the issuer of a financial asset to stand
behind the issued asset.

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Financial Assets and Financial
Liabilities
Stocks – a financial asset that conveys
ownership rights in a corporation.
 Bond – a promise to pay a certain amount
of money plus interest in the future.

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Valuing Stocks and Bonds
A financial asset’s worth comes from the
stream of income it pays in the future.
 An average share of stock in a company in
a mature industry sells for about 15 to 20
times its normal profits.
 Bond prices rise as market interest rates
fall.

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Valuing Stocks and Bonds
Present value – a method of translating a
flow of future income or savings into its
current worth.
 All future dollars must be discounted by the
interest rate in the economy.
 Discounting is required because a dollar in
the future is worth less than a dollar today.

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The Present Value Formula

The present value (PV) of future income
formula is:
A1
A2
An
PV 

  
2
n
(1  i) (1  i)
(1  i)
An= the amount of money received in n periods
in the future.
i = the interest rate in the economy (assumed
constant)
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The Present Value Formula

It is easier to use a business calculator or a
present value table to determine present
value for periods greater than two years.
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The Present Value Formula
The further into the future you go, the lower
the present value.
 The higher the interest rate, the lower the
present value.

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Some Rules of Thumb for
Determining Present Value

There are a few rules of thumb and
simplified formulas for which don’t need a
present value table or a calculator.
The infinite annuity rule.
 The Rule of 72.

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The Annuity Rule

Annuity rule – the present value of any
annuity is the annual income yield divided
by the interest rate.
PV = X/i
X = annual income
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i = interest rate
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The Rule of 72

Rule of 72 – the number of years it takes
for a certain amount to double in value
equals 72 divided by the rate of interest.
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The Importance of Present
Value
Many business decisions require present
value calculations.
 Income flows in the future are compared to
present costs or to other future money
flows.

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The Importance of Present
Value

Why average stock sells for about 15 times
normal profit:

If a share of stock is expected to earn $1 per
share per year and the interest rate is 6.5
percent, then its present value is:
$1
PV 
 $15
0.065
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The Importance of Present
Value

Why bond prices and interest rates are
inversely related:

If the interest rate rises to 10 percent, then the
value of bond earning a fixed amount will go
down.
$1
PV 
 $10
0.10
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Financial Institutions
A financial institution is a business
whose primary activity is buying, selling, or
holding financial assets.
 A depository institution is a financial
institution whose primary financial liability
is deposits in checking or savings
accounts.

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Financial Institutions

Financial institution channel savings from
savers to borrowers.
Savers – individuals who give other people
money now in return for promises to pay it
back with interest later.
 Borrowers – investors or consumers who get
the money now in return for their promise to
pay it and the interest later.

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Financial Institutions

A contractual intermediary is a financial
institution that holds and stores individuals’
financial assets.
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Types of Financial Institutions
Depository institutions.
 Contractual intermediaries.
 Investment intermediaries.
 Financial brokers.

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Depository Institutions
Commercial banks, savings and loans,
mutual savings banks, and credit unions.
 The primary liabilities of depository
institutions are checking and savings
accounts.
 They hold about 36 percent of all financial
assets in the U.S.

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Contractual Intermediaries
Pension funds, life insurance, and fire and
casualty insurance companies.
 These institutions promise to pay an
individual a certain amount of money in the
future.
 About 33 percent of all financial assets in
the U.S. are in contractual intermediaries.

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Investment Intermediaries
Money market mutual funds, mutual funds,
and finance companies.
 These institutions promise allow small
savers to pool their funds to purchase a
variety of financial assets.
 About 21 percent of all financial assets in
the U.S. are in investment intermediaries.

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Investment Intermediaries
A mutual fund allow small savers to
diversify their savings.
 Diversification – spreading the risks by
holding many different types of financial
assets.

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Investment Intermediaries
A finance company borrow from savers by
selling bonds and commercial paper.
 Commercial paper – a short-term
promissory note that a certain amount of
money plus interest will be paid back on
demand.

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Financial Brokers
Investment banks and brokerage houses.
 Investment banks help companies to sell
their stocks and bonds.
 Brokerage houses help individuals to sell
previously issued financial assets.

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Financial Brokers
Brokerage houses create a secondary
market in financial assets.
 Secondary financial market – a market in
which previously issued financial assets
can be bought and sold.

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Financial Markets

A financial market is a market where
financial assets and financial liabilities are
bought and sold.
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Primary and Secondary
Financial Markets
A primary financial market is a market in
which newly issued financial assets are
sold.
 Sellers include venture capital firms and
investment banks.

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Primary and Secondary
Financial Markets
Venture capital firms sell part
ownerships in new companies.
 Investment banks sell new stock and
bonds for existing companies.

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Primary and Secondary
Financial Markets
A secondary financial market transfers
existing financial assets from one saver to
another.
 This transfer does not represent any new
saving – it is saving for one person and
dissaving for another.

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Primary and Secondary
Financial Markets
Secondary financial markets encourage
people to own financial assets by providing
liquidity.
 Liquidity – the ability to turn an asset into
cash quickly.

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Money Markets and Capital
Markets

Financial markets can be divided into
money markets and capital markets.
Money markets – where financial assets
having a maturity of less than one year are
bought and sold.
 Capital markets – where financial assets
having a maturity of more than one year are
bought and sold.

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Money Markets and Capital
Markets

Maturity refers to the date the issuer must
pay back the money that was borrowed
plus any remaining interest, as agreed
when the asset was issued.
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Principal Capital Market
Instruments
1970s
6%6% 39%
13%
5%
7%
9% 15%
1980s
7% 6%
33%
7%
7%
7%
11%
4%
2002
4% 4% 5%
22%
15%
Corporate stocks (market value)
Residential mortgages
Corporate bonds
U.S. government securities (marketable long-term) 14%
Commercial and farm mortgages
Bank commercial loans
Consumer loans
State and local government bonds
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34%
34%
20%
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Type of Financial Assets

Financial assets are generally divided into
money market assets and capital market
assets.
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Money Market Assets
Money market assets mature in less than
one year.
 Because they offer more liquidity, they pay
lower interest rates than longer-term
capital assets.

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Money Market Assets

The most important money market assets
are negotiable CDs, commercial paper,
and U.S. Treasury bills.
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Negotiable CDs

A certificate of deposit (CD) is a piece of
paper certifying that you have a sum of
money in a savings account in the bank for
a specified period of time.
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Commercial Paper
Commercial paper is a short-term IOU of a
corporation.
 By selling commercial paper, Corporations
avoid borrowing from commercial banks.

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Commercial Paper

Disintermediation – the process of
lending directly and going through a
financial intermediary.
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U.S. Treasury Bills
U.S. Treasury bills are government IOUs
that mature in less than a year.
 Selling U.S. Treasury bills is one way the
U.S. government finances the deficit.

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Differences Among Money
Market Assets
Money market instruments differ slightly
from each other.
 For the most part, they are
interchangeable.
 The interest paid on them tend to increase
and decrease together.

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Principal Money Market
Instruments
Negotiable bank certificates of deposit (large denomination)
Commercial paper
U.S. Treasury bills
Federal funds
Other (includes repurchasing agreements, Eurodollars, bankers’ acceptances)
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Capital Market Assets
Capital market assets have a maturity of
over one year.
 The most important are stocks, bonds, and
mortgages.

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Stocks
A stock is a partial ownership right to a
company.
 Stocks are sold in secondary markets.

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Bonds
A bond is an IOU, of either the government
or a firm, that matures in more than one
year.
 Unlike stock, bonds must be repaid at
maturity.
 Bonds are also traded in secondary
markets.

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Leading You Through Two
Financial Transactions

Insuring a car and buying a house are two
financial transactions that many people are
likely to make.
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Insuring Your Car
You buy automobile insurance from an
insurance company.
 The company earns income in two ways:

In the difference between the money it
receives in payments and claims it pays out.
 In the interest it makes on financial assets.

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Insuring Your Car

Financial assets purchased by insurance
companies include promissory notes
evidencing loans that finance real
investment and bonds.
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Buying a House
Most people borrow money from a bank or
other financial institution to purchase a
house.
 The funds banks use to make loans come
primarily from depositors.
 A mortgage is a special name for a
secured loan on real estate.

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Buying a House

Banks get additional funds to make
mortgage loans by selling existing
mortgages on the secondary market.
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Buying a House

Buyers in the secondary market include the
Federal National Mortgage Association
(FNMA or Fannie Mae) and the
Government National Mortgage
Association (GNMA or Ginnie Mae).
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Buying a House
Fannie Mae and Ginnie Mae put a number
of mortgages into a $100 million bond fund
secured by the mortgages.
 They then sell shares in that fund to others.

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A Closer Look at Financial
Institutions and Financial
Markets
End of Chapter 27 Appendix
McGraw-Hill/Irwin
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