Chapter 3
Financial Instruments,
Markets, and
Institutions

CHAPTER OUTLINE
I.
Flow of Funds
II.
Financial Instruments and Markets
A. Bonds represent borrowing
B. Stocks represent ownership
C. Mortgages involve real estate
D. Derivatives: options and futures
E. The money and capital markets: a summary
III. Financial Intermediaries: Purposes and Profile
A. The role of financial intermediaries
B. Financial intermediaries in profile

CHAPTER SUMMARY
This chapter focuses on the role of financial markets as the transmission mechanism between savers and
borrowers. Savers are those who spend less than their incomes, while borrowers are those who spend more
than their incomes. The chapter also highlights the many avenues through which modern financial markets
fulfill this role. The transmission may be direct, such as through savers buying securities from borrowers,
or indirect, such as savers lending to banks in the form of deposits and banks making loans to borrowers.
The indirect method is known as financial intermediation. The bank is one type of financial intermediary.
Other types of financial intermediaries include mutual funds, insurance companies, savings and loan
associations, and credit unions. Well functioning financial markets improve the allocation of resources and
the growth of GDP by giving both saver-lenders and borrower-spenders increased options.
A broad range of financial instruments is a hallmark of developed financial markets. Bonds are issued by
governments and corporations and may be coupon-bearing securities or be zero-coupon bonds. They,
however, always indicate that the issuer has borrowed funds at a specified interest rate for a stated period
of time and always represent a claim by the holder of the bond on the issuer. In contrast, stocks represent
an ownership claim rather than indebtedness. The value of the claim of the stockholder is dependent on the
performance of the issuing corporation (of which the stockholder is an owner), while the claim of the
bondholder is independent of the issuing corporation’s performance.
Over the last 20 years, derivatives have become increasingly important in the financial markets. They
represent a financial transaction between two parties whose value depends on the value of an underlying
asset. They are important tools for managing risk. Futures and options contracts are two of the most widely
used types of derivative contracts. Accounting appropriately (or inappropriately) for the value of these
derivatives has been a significant issue in recent corporate scandals (e.g., Enron).
5
6  Ritter/Silber/Udell Money, Banking, and Financial Markets, Eleventh Edition

TEACHING
A general overview of financial markets and financial intermediation is provided. Specific financial
instruments such as stocks, bonds, mortgages, and futures contracts are described in limited detail. Students
interested in further details should be told that they will follow in later chapters. The underlying theme is
improved efficiency through reduced transactions costs.
The advantages associated with financial intermediation are discussed, followed by an industry-by-industry
introduction of intermediaries.
This is all straightforward and students usually enjoy learning the categories into which they can put things
they have heard about. It is a good chapter to combine with current events.
Useful Internet sites
1.
www.dowjones.com — for information on the performance of the Dow Jones index, including how it
has responded to various world events.
2.
www.federalreserve.gov — for key interest rates and quantities outstanding for many of the
instruments mentioned in the chapter.

DISCUSSION QUESTIONS
1.
“Financial intermediaries are just middlemen. Borrowers and lenders would be better off if they were
cut out of the process.” What do you think?
transactions costs, diversification, information
2.
What future expectations of the economy would encourage you to buy stocks? Bonds?
prospects for profits, expected future interest rate, volatility and risk
3.
Why are honesty and trust in handling financial market transactions likely to win out in the long run?
competition among financial firms
4.
Under what conditions would financial disintermediation increase? Under what conditions would
disintermediation be advisable?
Regulations, such as Regulation Q in the 1960s and 1970s, that impose interest rate ceilings
on certain types of savings vehicles encourage disintermediation as savers seek higher
returns; financial innovation, such as the initial issue junk bond market developed in the
1980s, also encouraged disintermediation as firms sold securities rather than borrowing
using bank loans.
5.
Is there any reason to prefer opening an account with a bank over a savings-and-loan or vice versa.
What should be your deciding factors?
So long as they are both insured, look at the variety of the deposits and services; for the
saver, there is little difference between banks and savings and loans.

ANSWERS TO QUESTIONS IN TEXT
1.
Direct finance is the flow of funds from saver-lenders directly to borrower-spenders through financial
markets. Indirect finance is the flow of funds from saver-lenders to borrower-spenders indirectly
through financial intermediaries. Primary securities are liabilities issued by borrower-spenders (e.g.,
bonds and stocks). Saver-lenders are the source of funds. Borrower-spenders are the ultimate users of
funds.
2.
The function of financial markets is to serve as a conduit through which all who do not spend all their
income (savers) can make those excess funds available to those who want to spend more than their
income (borrowers).
Chapter 3 Financial Instruments, Markets, and Institutions  7
3.
“Interest” on a zero takes the form of a rise in its market price as it approaches maturity (just as in the
case of a coupon-less Treasury bill).
4.
Reducing transactions and information costs and the ability to (indirectly) hold a broadly diversified
portfolio.
5.
Financial intermediaries facilitate the flow of funds from saver-lenders to borrower-spenders, which
finances much of our capital investment. Without financial markets, those who desire to save-lend
would find it far more difficult to distribute those funds to those who desire to borrow-spend. Funds
would be less likely to find their most efficient use. The U.S. government subsidizes financial
intermediation through the provision of government-backed deposit insurance. An economic argument
can be made that such a subsidy increases efficiency and promotes growth. The key tenet of that
argument is that there are external benefits to preventing banking panics. As always though one
should be suspicious of claims that government can improve upon private market decisions.

ESSAY QUESTIONS
1.
What are the similarities and differences in stocks and bonds?
Both are securities which are a source of funds for a corporation and a claim to future
streams of payment. Stocks are ownership shares with infinite maturity, while bonds are
debt with, in most cases, a finite maturity. Bonds make fixed-dollar commitments, where
the value of stocks are contingent on the issuers’ performance.
2.
Describe the similarities and differences in futures and options contracts.
Both are derivatives representing a contract between two parties regarding a third asset.
Futures contracts represent a promise by both sides to make a transaction in the future.
Options contracts separate rights and obligations. The seller of the option commits to make
the specified transaction if the purchaser of the option wants to. The purchaser of the
option will choose to exercise the option if it is profitable to do so. The purchaser has the
right but not the obligation to exercise the option.
3.
What is the primary difference between the money market and the capital market? Give three
examples of financial instruments in each.
The money market is for short-term borrowing (commercial paper, T-bills, certificates of
deposit), and the capital market for long-term borrowing or selling ownership (stocks,
bonds, mortgages).
4.
How can the profits of financial intermediaries be justified? In general terms, what are they selling to
saver-lenders?
They provide an efficient way of transferring funds. The primary services they offer are
expertise in evaluating creditor risk and risk reduction through pooling. They also allow
savers to maintain liquidity while saving.
5.
How do portfolios of life insurance and property and casualty insurance companies differ? Do they
require different investment strategies?
The portfolios of life insurance companies are much more concentrated in the capital
market. The proportions of large numbers of people that die tends to be highly predictable.
Property and casualty companies have a much greater need for liquidity, due to the greater
uncertainty of their obligations.