Lecture 4:
Financial instruments
and regulation
Mishkin chapter 2 – part C
Page 28-32, 42-47
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Role in the financial system
Indirect finance
Money
Financial Intermediaries
(e.g. bank)
Financial instrument A
(e.g. saving account)
Lender
Regulation
Money
Financial instrument B
(e.g. student loans)
Borrower
Financial instruments (e.g. bond, stock)
Financial markets
Money
Direct finance
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Financial instruments
A financial instrument (also called security)
is a claim on the issuer’s future income or
assets.
 Financial assets vs. real assets
 Classification:

 Money
market instruments and capital market
instruments
 Bonds (debt instruments) and stocks (equity)
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Money
Lender
Money
Bank
Financial Instrument B:
e.g. Deposit
Borrower
Financial
Instrument A:
e.g. Mortgage loan
•Financial instrument A is ‘issued’ by the borrower and is
essentially a claim on borrower’s future income or asset.
Financial instrument B is ‘issued’ by the Bank and is
essentially a claim on Bank’s future income or asset.
After financial instrument A is issued and sold to the Bank,
it becomes a financial asset of the Bank.
After financial instrument B is issued and sold to the lender,
it becomes a financial asset of the lender, the liability of
the Bank.
back
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Financial asset vs. real asset
Real assets: houses, equipments, human
resources, etc.
 Financial assets: claims against real
assets.
 Generally, borrowers obtain funds from
lenders by selling newly issued claims
("IOU's") against their (borrower’s) real
assets.
 IOUs are essentially financial assets.

graph
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Money market instruments
Money market instrument is shorter-term
security generally with one year or less
remaining to maturity.
 Treasury bill, commercial paper, CDs, etc.
 Many are held by institutions like banks,
insurance companies and mutual funds,
less often by individuals.

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Capital market instruments
More than one year to maturity.
 Stock, residential mortgages, long-term
bonds, consumer loans, etc.

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back
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Bonds
A bond is a debt security/instrument that
promises to make payments periodically
for a specified period of time.
 Bond price is closely (negatively) related
to interest rate.
 Default risk: the possibility that the issuer
(borrower) fail to pay back.

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Stocks


A share of stock is a claim on the net
income and assets of the corporation.
Holders of common stocks:

earn from price appreciation and dividends.
 have ownership interest in the company
proportional to shares owned:
1. ‘residual claimant’
2. have voting rights, or ‘vote with feet’.

Stock prices are volatile.
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Regulation in the financial system
More regulation than in other industries.
 Why need regulation?

 information
(efficiency concern)
 bankruptcy (stability concern)
 control of monetary policy (optimality concern)
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How would regulations help?

Increase the information available to investors:
 SEC
forces listed corporations to disclose information
 reduce

insider trading
Ensure the soundness of financial intermediaries,
fight against bankruptcy, prevent financial panics:
 Restrictions
on entry (chartering), reporting
requirements, restrictions on assets and activities,
deposit insurance, limits on competition, etc.
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Recap
Financial instrument
 Money market instrument vs. capital
market instrument
 Bonds vs. stocks
 Why is regulation in financial system so
important? How would regulation help?

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