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Chapter 3: Financial Instruments, Markets and Institutions

Financial Instruments Financial Markets Financial Institutions

People who need funds

borrowers/issuer/seller People who have funds to give lenders/savers/buyers

Indirect vs. Direct Finance

Indirect finance
Borrowers and lenders meet through a financial intermediary (e.g. bank) Loan is a liability for borrower, and asset for a bank

Direct finance
Borrowers sell securities directly to lenders e.g. corporate and Treasury bonds

I. Financial Instruments
aka. securities, financial assets

definition (p. 36 (1st) or 41 (2nd)) = written legal obligation of one party to transfer something of value, usually money, to antoher party at some future date, under certain conditions
a security is an asset for the buyer/lender, but a liability for the issuer/borrower/seller


shares of stock in Time Warner, Inc.

shares of ownership in TW a claim on the earnings/assets of TW a liability for Time Warner an asset for me

my mortgage
I am the borrower (liability) the bank is the buyer/holder (asset) the bank has a claim on my house

uses of financial instruments

means of payment but much less liquid than money store of value better than money over time, but also greater risk transfer of risk buyer transfers risk to seller e.g. insurance policies, futures contract

Valuing financial instruments

sizing, timing & certainty of promised cash flows Size: how much is promised? the larger the cash flows, the greater the value Timing: when is it promised? the sooner the cash flows are received, the greater the value

Certainty: how likely its it that payments will be made? the likelier the payments the greater the value Under what conditions? e.g. insurance, derivatives payments when we need them the most are more valuable

examples (p. 43/44 or 46/47)

bank loans stocks bonds home mortgages asset-backed securities option and futures contracts insurance policies

II. Financial Markets

where financial instruments are

bought and sold these markets provide liquidity for buying/selling information through prices risk-sharing among buyers/sellers classified in various ways

Primary vs. Secondary Markets

primary market

newly issued securities -- investment banking secondary market brokers match buyers and sellers dealers act as buyers and sellers -- market-makers

Debt vs. Equity Markets

debt security
cash flows are fixed bonds, loans equity security cash flow variable, residual common stock

Exchanges vs. OTC Markets

buying & selling of securities in physical location NYSE OTC (over-the-counter) dealers in many locations buy & sell securities

Money vs. Capital Markets

money market
short-term debt securities (up to 1 yr.) highly liquid, low risk capital market longer-term debt equity

Money Market
3% 9% 0% 4% 20%

U.S. Tbills CDs Commercial Paper Banker's Acceptances Repos Federal Funds Eurodollars



Capital Market
4% 11% 8%

Stock Mortgages U.S. bonds



Municipal bonds Loans

III. Financial Institutions

aka. financial intermediaries Why have them? Transactions costs search costs to find borrower & lender contract costs economies of scale

Risk sharing
intermediaries are experts at bearing risk Asset transformation short-term to long-term illiquid to liquid

Types of intermediaries

Depository institutions
banks accept deposits, make loans

Commercial banks
largest in total assets least restricted Savings & Loans originally restricted to savings deposits and mortgages less restricted today Credit Unions consumer loans nonprofit, organized around a group

Nondepository institutions
insurance companies pension funds finance companies
Mortgage, auto, office equipment

Securities firms govt-sponsored enterprises (GSEs)

Subprime mortgage meltdown

Hit several types of financial

institutions: finance companies

securities firms
Citigroup, Merrill Lynch

Fannie Mae, Freddie Mac